Petition for Writ of Certiorari — Berger v. United States
Supreme Court brief1972
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LE COPY IN THE | ICHAEL RODAK, JR
Supreme Court of the United States
Octoser Term, 1971
Sot Bercer,
Petitioner,
—against—
Unitep STATES OF AMERICA.
PETITION FOR A WRIT OF CERTIORARI TO THE
UNITED STATES COURT OF APPEALS
FOR THE SECOND CIRCUIT
Grorce G. GALLANTZ
Davin I. GotpBLattT
Counsel for Petitioner
Of Counsel:
ProsKAvER Rose Goetz & MENDELSSOHN
ERE ACER TIM ETE NOTRE IE, SN IETIER EGNOS AY SAS EEE GR
INDEX
PAGE
Opinions of the Courts Below 220.022.2020 .2..eeeceeeeeeeeeeseeeeeeeees 1
Jurisdiction secesennnneseeeecenecennannssteeneeecenttne 2
a alan ore asshaientcininabiouercosehdense 2
Neen i ica hinseecermnsienseidinniionaaies 3
I AEE, I oi es inivneancdcpeniaiseien 3
Reasons for Granting the Writ ... hccbabnassh di sacitaldanie 5
Petitioner Was Deprived of the Protection Which
Would Have Been Accorded the Taxpayer in a
Civil Proceeding Hy)
The purpose of Section 482 and its protec-
I elena 6
The evils against which the Section is directed 8
The rejection of Section 482 10
Erroneous and prejudicial exclusion of evi-
dence proffered by petitioner 13
The rejection of civil standards 15
Petitioner’s Conviction Rests on Findings of
Fact Which Themselves Negate Any Possibility
i UI TINIE scssnirsnessisesheniacnindnloenineiessibtineesonsshensenetune
I Ses
bi i am Bid So) 4
i
PAGE
Appenpix oF Court OPINIONS AND STATUTES:
Opinion of the Court of Appeals A- 1
Judgment of the Court of Appeals A- 7
Order Denying Petition for Rehearing A- 9
Opinion of the District Court A-10
Judgment of the District Court A-27
Internal Revenue Code of 1954, Section 482 ............ A-29
Treas. Reg. §1.482-1 A-29
Treas. Reg. §1.482-2 A-41
TABLE OF AUTHORITIES
Cases:
American Terrazzo Strip Co., 56 T.C. 961 (1971) ........-- 9
Baldwin-Lima-Hamilton Corp. v. United States, 435
F.2d 182 (7th Cir. 1970) 9
Connery Coal & Investment Co. v. Commissioner, 84
F.2d 485 (7th Cir. 1936) 12
First Securities Corporation of Memphis v. Clements,
39-2 U.S. Tax Cas. 19607 (M.D. Tenn. 1937), aff'd
per curiam, 103 F.2d 1011 (6th Cir. 1939) -..............----- 12
Interstate Fire Insurance Co. v. United States, 215
F. Supp. 586 (E.D. Tenn. 1963), aff'd per curiam,
339 F.2d 603 (6th Cir. 1964) .@
PAGE
Lufkin Foundry and Machine Co., 30 CCH Tax Ct.
Mem. 400 (1971) 9
Old Colony Trust Co. v. Commissioner, 279 U.S. 716
(1929) 10
PPG Industries, Inc., 55 T.C. 928 (1970) 9
United States v. Campbell, 351 F.2d 336 (2d Cir. 1965) 19
United States Gypsum Co. v. United States, 71-2 US.
Tax Cas. 99706 (7th Cir. 1971) .. 9
United States v. Vardine, 305 F.2d 60 (2d Cir. 1962) . 19
Statutes, Regulations and Administrative Authorities:
19 U.S.C.A. §1401la (1965) 3
19 U.S.C.A. $1503 (1965) 3
28 U.S.C.A. §1254(1) (1966) 2
Int. Rev. Cove of 1954, §61(a) (12) 10
Int. Rev. Cove of 1954, §162 11
Int. Rev. Cope of 1954, §482 2
Revenue Act of June 2, 1924, ch. 234, 43 Stat. 253 ........ 12
Revenue Act of February 26, 1926, ch. 27, 44 Stat. 9... 12
Treas. Reg. §1.482-1 (1962, as amended, 1968) ..2, 6, 8, 12-15
Treas. Reg. §1.482-2 (1968, as amended, 1969, 1972) .... 2,9,
13-14
LT. 2151, IV-1 Cum. Butt. 53 (1925) 12
Treasury Dep’t Release, 7 CCH 1965 Stand. Fed.
Tax Rep. 96522 (March 31, 1965) ....... 7
Treasury Dep’t Release F-559, 7 CCH 1966 Stand. Fed.
Tax Rep. 6685 (August 2, 1966) 7
Treasury Dep’t Release F-1217, 7 CCH 1968 Stand.
Fed. Tax Rep. 6740 (April 16, 1968) we
iv
Miscellaneous:
PAGE
Cohen, “How the IRS Intends to Administer the New
Regulations Under Section 482,” 28 J. Tax 73
(1968)
Surrey, “Treasury’s Need to Curb Tax Avoidance in
Foreign Business Through Use of 482,” 28 J. Tax
75 (1968)
IN THE
Supreme Court of the United States
Ocroser Term, 1971
Sot Bercer,
Petitioner,
—against—
Unitep States or AMERICA.
—$—<>——
PETITION FOR A WRIT OF CERTIORARI TO THE
UNITED STATES COURT OF APPEALS
FOR THE SECOND CIRCUIT
Sol Berger petitions for a writ of certiorari to review a
judgment of the United States Court of Appeels for the
Second Circuit entered March 20, 1972 affirming petitioner’s
conviction by a District Judge, sitting without a jury, of
attempting to evade the United States corporate income tax
obligations of Colonial Corporation of America, A jail
sentence was imposed by the District Court. Rehearing
was denied by the Court of Appeals on April 20, 1972.
Opinions of the Courts Below
The opinion of the Court of Appeals appears beginning
at page A. 1 of the Appendix to this petition. The opinion
of the District Court for the Southern District of New
York is reported at 325 F. Supp. 1297 (1971) and is re-
printed beginning at page A. 10 of the Appendix.
a a a ie ae eae
Jurisdiction
The judgment of the United States Court of Appeals
(A. 7)* was entered on March 20, 1972, affirming peti-
tioner’s conviction dated June 4, 1971. The Court of
Appeals denied a timely petition for rehearing on April 20,
1972 (A. 9). Jurisdiction in this Court is invoked under
28 U.S.C. §1254(1).
Questions Presented
1. In a criminal prosecution against a former officer of
a “controlled taxpayer” (as defined in Section 482 of the
Internal Revenue Code), in which the Government under-
took to prove beyond a reasonable doubt that the manner
in which the taxpayer reported transactions with a sub-
sidiary gave rise to tax deficiencies, was the defendant
(petitioner here) entitled to the application of the Section
482 standards that would have had to be applied in a civil
tax case involving the taxpayer?
2. Where the underlying facts found by the trial court
were inconsistent with the conclusion that petitioner’s acts
affected the taxable income of the taxpayer, did the Court
below err in affirming the finding that petitioner acted with
intent to evade corporate income tax?
* The designation “A.” refers to the Appendix to this petition.
The designation “R.” refers to the Joint Appendix in the Court
of Appeals.
Section 482 of the Internal Revenue Code of 1954, as
amended, and Treasury Regulation §1.482-1 (1962, as
amended, 1968), and excerpts from Treasury Regulation
§1.482-2 (1968, as amended, 1969, 1972), appear beginning
| at pages A. 29 and A. 41, respectively, of the Appendix.
Statute Involved
Statement of the Case
Petitioner was convicted of attempting to evade the
| United States corporate income tax obligations of Colonial
Corporation of America (“Coldnial”) for the years 1962,
1963 and 1964. In those years, Colonial was a publicly-held
corporation engaged in the manufacture and sale of wear-
ing apparel and was subject to United States corporate
income tax. Petitioner was Colonial’s chief executive
] officer and he and his family owned a substantial bloe of the
corporation’s stock.
Colonial Shirts of Jamaica, Ltd. (“Jamaica”), a wholly-
owned subsidiary of Colonial, manufactured shirts in
Jamaica and sold its entire output to Colonial. Jamaica
was exempt from United States income tax and was
accorded favorable tax treatment under Jamaican law.
Colonial’s purchase of Jamaica’s production subjected
Colonial to an import duty calculated as a percentage of the
price invoiced by Jamaica to Colonial (“the invoice price”)
(R. 472-73). Because Colonial and Jamaica did not deal
at arm’s length, customs regulations required Colonial to
substantiate, through cost figures, the reasonableness of the
invoice price (R. 463, 490-91, 19 U.S.C.A. §§1401a, 1503
(1965)). In order to minimize customs duties, Colonial’s
4
financial vice-president, Leonard Friedman, presented to
customs officials unrealistically low cost figures which did
not reflect actual costs being incurred by Jamaica (R. 524,
577, 653-4, 661). The resulting invoice price, which pur-
portedly included a profit to Jamaica, in fact was less
than Jamaica’s actual cost. (Compare R. 1721-26 with
R. 1820-25.)
To preserve the benefits of the low invoice price, and at
the same time avoid an unreasonably high taxable profit
to Colonial on its resale of Jamaica’s products, Colonial
adopted the practice of supplementing its payment of
Jamaica’s invoices by satisfying part of Jamaica’s obliga-
tions to its suppliers of piece goods (fabric) and trim
(buttons, labels, ete.) (R. 1214-23, 1263, 1333). In its tax
returns, Colonial deducted as its cost the amounts paid by
it against Jamaica’s invoices and the amounts paid by it
to Jamaica’s suppliers (R. 755-56).*
Petitioner’s conviction rests upon holdings that Colo-
nial’s supplemental payments to Jamaica’s suppliers were
not deductible by Colonial, that petitioner caused the sup-
plemental payments to be made for the purpose of reduc-
ing Colonial’s tax obligations, and that he did so with
criminal intent.
* To illustrate, assume that Colonial paid Jamaica $5 per dozen
shirts against invoices in that amount and paid an additional $1
per dozen to Jamaica’s suppliers. In its tax returns, Colonial
reported $6 as its cost, i.e., the sum of the $9 and $1 payments.
REASONS FOR GRANTING THE WRIT
Petitioner Was Deprived of the Protection Which
Would Have Been Accorded the Taxpayer in a Civil
Proceeding.
This case presents a question of first impression concern-
ing the interpretation and application of Section 482 of the
Internal Revenue Code and its availability to taxpayers and
defendants in criminal cases.
While the Section and its Regulations give the District
Director the authority to reallocate income and expenses
of commonly-controlled taxable entities to prevent the
arbitrary shifting of income, the Regulations restrict the
exercise of, this authority to cases in which the commonly-
controlled entities have not dealt with each other at arm’s
length. The protection thus afforded taxpayers, the pro-
vision of “safe havens” prohibiting unwarranted realloca-
tions by the Internal Revenue Service, was denied to peti-
tioner in this case—apparently for the very reason that
it is a criminal case.
Fundamental to petitioner’s conviction was the deter-
mination that the tax returns of Colonial included the
deduction of costs properly attributable to a subsidiary.
Had that question been raised in a civil tax proceeding, the
propriety of the deductions taken by Colonial would have
been determined through the application of the standards
established under Section 482 of the Internal Revenue Code
and the Regulations promulgated thereunder.
Throughout the trial, the Government persisted in its
view that Section 482 was inapplicable and that it had
no burden to prove that Colonial had violated the stand-
ards of the Section 482 Regulations. Petitioner, while in-
— Bs tal : ms ser
—
6
sisting that no conviction could stand unless the prosecu-
tion proved such a violation beyond a reasonable doubt,
nevertheless offered affirmative proof that Colonial had in
fact met the statutory standards. His defense was frus-
trated by the trial court’s refusal to hear the proof. On
appeal, although the exclusionary rulings were fully
briefed and argued by both sides, the Court below ignored
the point.
The Purpose of Section 482 and Its Protection
of Taxpayers
Section 482 of the 1954 Code, and its predecessor sections
under earlier Codes, were enacted to permit the District
Director “to place a controlled taxpayer on @ tax parity
with an uncontrolled taxpayer, by determining, according
to the standard of an uncontrolled taxpayer, the true tax-
able income . . . of a controlled taxpayer” (Treas. Reg.
§1.482-1(b) (1), A. 30).
The detailed Regulations, which prescribe the tests for
determining whether controlled taxpayers have dealt with
each other at arm’s length, create what have been officially
characterized as “safe havens” for taxpayers. So long as
the transactions between the controlled taxpayers meet
these standards, they are immune from attack.
The Treasury Releases which announced the promulga-
tion of the Regulations, and Treasury officials in explanatory
articles, repeatedly emphasized that the Regulations pro-
vided “safe havens” or “prima facie rules” to protect tax-
payers against unwarranted reallocations and to provide
guidance with respect to the manner in which transactions
could be carried out with reasonable confidence that audit
would not result in reallocations under Section 482.
_——
7
Thus, when the current Section 482 regulations were
adopted, the Treasury stated:
“The plan of the regulations is to describe the applica-
tion of the arm’s length standard generally and then
to detail its application in five specifie types of trans-
actions. In each of these specific cases the general
rule is first stated—that is, that the proper arm’s
length consideration will be determined with reference
to all surrounding facts and cireumstances. Next, in
some instances, a safe haven or prima facie rule is
provided. The safe haven or prima facie rule provides
a specific rate or charge that will be accepted as arm’s
length unless the tarpayer (and not the Government)
desires to establish a more appropriate rate.” Treasury
Dep’t Release F-1217, 7 CCH 1968 Stand. Fed. Tax
Rep. 96740 (April 16, 1968). (Emphasis added.)
Throughout the period the regulations were being formu-
lated, the Treasury repeatedly stated to the public and the
tax bar that the regulations were intended as a guide to
taxpayers so that they might carry out transactions “with-
out concern that they will later have their income and their
tax liability increased as a result of Section 482 alloca-
tions.” (Treasury Dep’t Release, 7 CCH 1965 Stand. Fed.
Tax Rep. 96522 (March 31, 1965)). See also Treasury
Dep’t Release F-559, 7 CCH 1966 Stand. Fed. Tax Rep.
76685 (August 2, 1966).
To the same effect, see Cohen (then Commissioner of In-
ternal Revenue), “How the IRS Intends to Administer the
New Regulations Under Section 482”, 28 J. Tax. 73 (1968) ;
and Surrey (then Assistant Secretary of the Treasury for
Tax Policy), “Treasury’s Need to Curb Tax Avoidance in
Foreign Business Through Use of 482”, 28 J. Tax. 75
(1968).
a
8
These published statements announced a clear policy that
the District Director may not, even in a civil case, disallow
a portion of the purchase price paid by one member of a
controlled group to another if that price is an arm’s length
price within the meaning of Section 482.
It is these “safe havens”—the arm’s length tests spelled
out in the Regulations—which would have been available
to Colonial in a civil tax proceeding but were denied to
this petitioner. Here, because the Court below waved
Section 482 aside as inapplicable, the Government was not
required to prove that Colonial paid Jamaica more than an
arm’s length price and petitioner was not permitted to
prove that the transactions were within the “safe havens”
established by the Regulations.
The Evils Against Which the Section Is Directed
Transactions between controlled taxpayers are scrutinized
“to ascertain whether the common control is being used to
reduce, avoid, or escape taxes” (Treas. Reg. §1.482-1(c),
A. 32). “Section 482 authorizes the allocation of income
and deductions between related entities to prevent the eva-
sion of taxes by shifting of profits, the making of fictitious
sales, and other methods usually used to ‘milk’ a taxable
entity” (PPG Industries, Inc., 55 T.C. 928, 990-91 (1970)).
This is precisely what the Government claimed, and what
the courts below found, occurred here. In its brief to the
Court of Appeals, the Government characterized Colonial’s
payment of J amaica’s obligations and its deduction of those
payments as part of its cost as “a simple manipulation of
book entries . . . to reduce Colonial’s taxable income . .- -
while at the same time increasing Jamaica’s untaxed profits
by the same amount” (Govt. Br., p. 11).
wa
9
The Court below termed the transactions a “system by a
parent corporation to make payments to the creditors of
its subsidiary . . . in order to increase the already significant
tax free profits which that subsidiary could have ex-
pected...” (A. 5).
The nature of the transactions, the purchase or sale of
goods between a United States corporation and a sub-
sidiary exempt from tax, is in the classic model for a
reallocation of costs under Section 482. See American
Terrazzo Strip Co., 56 T.C. 961 (1971) (sales by foreign
corporations to commonly-controlled domestic corpora-
tions); United States Gypsum Co. v. United States, 71-2
U.S. Tax Cas. 19706 (7th Cir. 1971) (sales by Western
Hemisphere Trade Corporation subsidiary to domestic
parent) ; Lufkin Foundry and Machine Co., 30 C.C.H. Tax
Ct. Mem. 400 (1971) (commissions paid and discounts al-
lowed by domestic parent to Western Hemisphere Trade
Corporation subsidiary); PPG Industries, Inc., 55 T.C.
928 (1970) (sales by foreign subsidiaries to domestic par-
ent); and Baldwin-Lima-Hamilton Corp. v. United States,
435 F.2d 182 (7th Cir. 1970) (sales by domestic parent to
Western Hemisphere Trade Corporation subsidiary). See
also, the many examples, using similar transactions, con-
tained in Treas. Reg. §1.482-2.
Thus, while the evil found to exist is the very evil
against which Section 482 was directed, and the disputed
transactions were of the sort typically scrutinized under
that Section, the Court below held, without a word of sup-
porting reasoning, that Section 482 “does not pertain to
the case at bar” (A. 5).
In other words, the right to establish that the challenged
transactions met the standards of the Section 482 Regula-
tions, available to any taxpayer, including Colonial, in a
10
civil proceeding, was not available to petitioner in this
criminal prosecution.
The Rejection of Section 482
The unsupported statement of the Court below, made
in a footnote, that Section 482 “does not pertain to the
case at bar” was based upon an erroneous view of the
transactions and an erroneous interpretation of the Regu-
lations and their application to this proceeding.
The decisions below rest upon the treatment of Colonial’s
supplemental payments to Jamaica’s suppliers as being
of a different character from Colonial’s payments against
Jamaica’s invoices. Apparently, these payments were held
non-deductible merely because they were made indirectly
and satisfied Jamaica’s obligations for some of the raw
materials of its manufacturing process.
These supplemental payments cannot have been rendered
non-deductible merely because they were made indirectly.
The proposition that a buyer, who satisfies an obligation
of a seller to a third party, has made a payment to the
seller is not merely logically clear, but specifically recog-
nized in the Internal Revenue Code itself (Section 61(a)
(12) ; see, Old Colony Trust Co. v. Commissioner, 279 U.S.
716, 729 (1929)).
That the fabric and trim paid for by Colonial were
“routine manufacturing expenses of Jamaica” (A. 5) has
no bearing on the fact that, by paying those bills, Colonial
was making an additional payment for the goods it pur-
chased from Jamaica. If petitioner had purchased a suit
from a retail merchant and paid for it by paying the
merchant’s telephone bill of $150, would not petitioner’s
cost be $150? That the telephone bill was a necessary
11
expense of the clothier would have no bearing on the
economic fact that defendant paid $150 for his suit.
The trial court applied the “ordinary and necessary”
test by which a business expense is judged under Section
162 of the Code (A. 15, 17-18), and the Court below stated
that the indirect payments were not “necessary to the
continued existence” of Colonial (A. 5).
Even under this test, it would have been the Govern-
ment’s obligation to prove beyond a reasonable doubt that
Colonial’s payments were not ordinary and necessary ex-
penses of its business. Colonial’s business, in this context,
was the purchase of finished shirts and the resale of those
goods to others. Surely, any amounts paid by Colonial for
those goods, necessary to its continued existence as a seller
of finished shirts, constituted ordinary and necessary ex-
penses of its business.
Moreover, the District Court found that the supplemen-
tal payments were part of Colonial’s cost for the goods.
It found as a fact that if Colonial had not made these
payments to Jamaica’s suppliers, Jamaica would have
increased its invoice prices to Colonial by the equivalent
amounts, resulting in the same total cost (A. 16).
Colonial having actually paid the total amounts deducted
by it, and it having been established that those payments
represented Colonial’s cost for the goods, the only con-
ceivable basis on which the Government could disallow
any portion of that deduction would be that the amount
paid exceeded the arm’s length price of the goods and that
Colonial, in paying that excess, was diverting income to a
subsidiary exempt from tax. That is to say, a reallocation
of costs and income under Section 482.
12
The only basis given by the Court below for concluding
that Section 482 “does not pertain to the case at bar.”
was the citation: “See 26 C.F.R. §1.482-1(b)” (A. 5). The
Regulation does, of course, say that “Section 482 grants no
right to a controlled taxpayer to apply its provisions at
will, nor does it grant any right to compel the district
director to apply such provisions” (A. 31).
But it is the Regulation cited by the Court below that
does not pertain to the case at bar. It was adopted for the
purpose of eliminating a provision in a predecessor of
Section 482 which had granted to taxpayers the right to
compel the District Director to treat separately-filed re-
turns on a consolidated basis. Revenue Act of June 2, 1924,
ch. 234, 43 Stat. 253; Revenue Act of February 26, 1926,
ch. 27, 44 Stat. 9. See LT. 9151, IV-1 Cum. Butt. 53 (1925) ;
Connery Coal & Investment Co. v. Commissioner, 84 F.2d
485 (7th Cir., 1936). It has also been applied to prevent a
taxpayer from filing amended returns in which inter-com-
pany transactions were adjusted to reflect arm’s length
values. Interstate Fire Insurance Co. v. United States, 215
F. Supp. 586 (E.D. Tenn. 1963), aff’d per curiam, 339 F.2d
603 (6th Cir., 1964) ; see also, First Securities Corporation
of Memphis v. Clements, 39-2 U.S. Tax Cas. (9607 (M.D.
Tenn. 1937), aff'd per curiam, 103 F.2d 1011 (6th Cir.,
1939).
Here, petitioner did not seek the consolidation of
separately-filed returns nor any adjustment of Colonial’s
returns as filed. He sought no reallocation, no re-
classification, no alteration of any item in Colonial’s re-
turns. Both the trial court and the Court below were
somehow misled into believing that petitioner was seeking
to restructure the transactions, to reallocate in reliance
on Section 482. The Government called black white and
—
13
white black and succeeded in standing the statute on its
head.
To repeat, it was not petitioner who was seeking a change
in the returns as filed, or a different allocation of income
or expenses. It was the Government, not petitioner, which
was restructuring the tax returns, recasting the income
statements, reallocating the costs, disallowing sums con-
cededly spent by Colonial and deducted on its returns.
Petitioner’s invocation of Section 482 was purely defen-
sive. He insisted that in a criminal prosecution the Gov-
ernment must prove, under the tests laid down by the Sec-
tion 482 Regulations, that the total amounts paid by Colo-
nial exceeded the arm’s length price for the goods. Only
upon such proof of a deficiency in the taxes paid by Colonial
could the Government claim error in the tax returns, and
prosecute criminally. The Court below, in simply dismiss-
ing the Section as irrelevant in a one-sentence footnote,
revealed no understanding of petitioner’s purpose in invok-
ing it.
Erroneous and Prejudicial Exclusion of Evidence
Proffered by Petitioner
The District Director may allocate deductions among
commonly-controlled corporations where necessary to re-
flect clearly the true income of such corporations (Treas.
Reg. §1.482-1(b) (1), A. 30-31). True income is defined as
the income which would have resulted to the controlled
taxpayer had it dealt with the other member of the con-
trolled group at arm’s length (Treas. Reg. §1.482-1(a) (6),
A. 30). Here, the question was whether Colonial paid
Jamaica more than the arm’s length price for the goods
and thereby diverted income to a subsidiary exempt from
a
14
The Regulations specify in great detail the manner in
which arm’s length values are to be determined (Treas.
Reg. §1.482-2, A. 41-60), yet the Government made no at-
tempt to establish that the total price paid by Colonial
exceeded the arm’s length price of the goods and peti-
tioner’s proffered evidence on the point was excluded.
Petitioner offered to prove that the total amounts paid
by Colonial approximated the aggregate arm’s length price
of the goods and that the gross profits earned by Colo-
nial and Jamaica were equivalent to those being earned
by other companies in the uncontrolled sale and resale of
similar products (R. 1080-94, 1097-1100, 1184-88). This
evidence was excluded by the trial court, which viewed
transactions by unrelated companies as having no rele-
vance to the issues at bar (R. 1087, 1186).
Although the prejudice to petitioner caused by this
erroneous ruling was fully argued to the Court below, the
point was not considered or even mentioned in its opinion.
In finding the invoice price (the $5 element of the $6 cost)
to be not “unrealistic? (A. 3), the Court of Appeals
made no reference to the exclusion of proof on this very
issue, ignored the finding of the District Court that the
invoice price was “low” (A. 15), and applied none of the
tests established under the Regulations.
The determination of the Court below apparently rested
on the comparative net profit ratios of Colonial and Ja-
maica (A. 3, 4). In no case are net profit ratios relevant
factors under the Regulations. In some circumstances
gross profit ratios may be relevant, but then only in connec-
tion with the wncontrolled sale or resale of similar products
(Treas. Reg. §1.482-2(e)(3), (4), A. 50, 57). The Court
below also considered of importance that the customs
agents had accepted the invoice price (A. 2, 3), despite the
—
15
uncontradicted testimony of Government witnesses that
the costs reflected in the invoice price were intentionally
understated by Colonial (see pp. 3-4 supra). Moreover,
the Regulations explicitly reject, as a test of arm’s length
price, the price established by contract between members
of a controlled group (Treas. Reg. §1.482-1(a) (6), A. 30).
On the record made at trial, consideration of the Sec-
tion 482 Regulations, in view of the Government’s bur-
den to prove every element of the indictment beyond a rea-
sonable doubt, would have mandated a finding that no tax
deficiency had been proven and that the indictment must
be dismissed. Even if the Government had made out a
ease in a manner consistent with the Regulations, the
exclusion of the evidence tendered by petitioner would
require reversal and a new trial.
The Rejection of Civil Standards
In its brief below, the Government urged the rejection
of the many authorities cited by petitioner in support of
the deductions, characterizing them as “civil cases which
are completely irrelevant to this criminal prosecution”
(Govt. Br., p. 20, emphasis supplied). The adoption of
this argument by the Court of Appeals is implicit in its
discussion of those authorities and its rejection, in a one-
sentence footnote, of Section 482.
In an era which has seen an unprecedented expansion of
constitutional rights afforded to defendants in all manner
of criminal cases, it is to say the least shocking that, in
this case, the Court of Appeals has held that the standards
applied in civil tax cases and the protection afforded by a
civil tax statute are wholly irrelevant to the determination
of a tax deficiency in a criminal tax prosecution.
OE ARLE PE I TE, Me
16
Petitioner’s Conviction Rests on Findings of Fact
Which Themselves Negate Any Possibility of Criminal
Intent.
The trial court found that if Colonial had not satisfied
some of Jamaica’s obligations to its suppliers, Jamaica
would have paid those obligations directly and would have
increased its prices to Colonial to take account of its
additional costs.
“The simple fact is that had all the piece goods and
raw materials invoiced to Jamaica by foreign vendors
and others . . . been entered on the books of Jamaica
as its cost of production, an increase in the constructed
price charged to Colonial would have been required ...
‘(t)he only alternative to the adjustments would have
been to charge the Jamaican subsidiaries for the full
amount of purchases and supplies and in turn to have
increased the amount of the billings to the parent from
the Jamaican subsidiaries by an equivalent amount.’”
(A. 16, emphasis supplied.)
In other words, to revert to our hypothetical example
(ftn. supra, p. 4), if Colonial had not paid $1 per dozen to
Jamaica’s suppliers, Jamaica would have paid that $1 and
increased its invoice price per dozen from $5 to $6. The
conclusion is self-evident that the manner of payment had
no effect upon the income of either Colonial or Jamaica.
Regardless how it made payment, Colonial’s cost would be
$6 per dozen and it and Jamaica would have had precisely
the same amount of income.
Neither the trial court nor the Court below seemed to
perceive this simple proposition. The trial court’s con-
clusions that this change in the manner of payment would
17
have affected “the income picture of both corporations”
and that the indirect payments “reduced Colonial’s taxable
income” (A. 13, 16) were logically unsound and mathe-
matically incorrect. The statement of the Court below that
Colonial paid Jamaica $6 in two elements “in order to
manipulate Colonial’s profits” (A. 4) evinces a similar
misconception.
There was no manipulation of Colonial’s profits and no
effect upon Colonial’s income or that of Jamaica. Whether
Colonial paid Jamaica $6 against its invoices, or $5 against
invoices and $1 indirectly, the figures on Colonial’s tax re-
turns would remain unchanged. It necessarily follows that
the decision, attributed to petitioner, to cause Colonial to
pay Jamaica in two elements could not have been motivated
by any desire to reduce or in any way affect Colonial’s
tax obligations.
Concededly, the amount invoiced by J amaica affected the
amount of customs duty paid by Colonial; the lower the
invoice price, the lower the customs duty. The evidence
made it clear that this, the desire to minimize customs
duties, was the motivation for paying Jamaica in two ele-
ments. The Government conceded this: “... the so-called
low price [$5 in our example] was the product of a con-
scious decision by Colonial’s management to reduce cus-
toms duties...” (Govt. Br., pp. 21, 25).
Petitioner had no part in the establishment of the invoice
price for customs purposes; the Government’s witnesses
so testified (R. 471, 542) and the trial court so found (A.
14-15). Except as the explanation for Colonial’s paying Ja-
maica in two elements rather than one, customs duties had
no place in the determination of this case. The only rele-
vant question was whether petitioner intended to evade
corporate income taxes. The established facts proved that
PTR HIP as
Fe ee TS GN URI Coe ee ON
18
he could not have had such motivation because his acts
had no effect on Colonial’s taxable income.
When this argument was made in the Court below,
the Government made no attempt to answer it but dis-
missed it with the word “hypothetical” (Govt. Br., p. 29).
The Court adopted that terminology, characterizing peti-
tioner’s argument as “hypothetical restructuring of the
taxable transaction” (A. 3), thus demonstrating a total
misapprehension of the argument. Both the trial court and
the Court of Appeals apparently believed petitioner to be
arguing that the tax returns of Colonial should be treated
as though Jamaica had billed Colonial $6 per dozen shirts.
Petitioner never asked the Court to make a determina-
tion based on what might have been done. On the issue
whether additional tax was due he rested upon the returns
as filed. He did contend that, to determine whether he
acted with criminal intent, whether the manner in which
the transactions were actually reported was motivated by
tax considerations, the Court must look at the manner in
which the transactions would have otherwise been reported.
To put it differently, if what should have been done under
the Government’s theory would have resulted in precisely
the same deduction as what was done, then what was done
could not have been motivated by the desire to evade taxes.
The Government conceded that Colonial could have
achieved the same result by having Jamaica invoice Colo-
nial $6 per dozen (Govt. Br., p. 24). If Colonial would have
been entitled to deduct the entire $6 payment had that been
the invoice price, then reducing the invoice price to $5 and
paying an additional $1 indirectly could not have resulted
in any greater deduction and therefore could not have been
motivated by any desire to evade tax.
—_
19
The authorities relied on by the Court below are further
proof that it misconceived petitioner’s position. In United
States v. Campbell, 351 F.2d 336 (2d Cir. 1965), defendant
failed to report large amounts of capital gains income in his
tax returns. He justified the exclusion on the basis that he
was a resident of Canada, but failed to disclose the income
to Canadian taxing authorities. He asked the court to
rewrite his tax returns as if he had reported his capital
gains, had paid a Canadian tax and had taken a credit
against United States tax for the Canadian tax paid. This,
the court refused to do. In United States v. Vardine, 305
F.2d 60 (2d Cir. 1962), the defendant failed to report tax-
able income in his returns. He argued that if he had main-
tained his books on the accrual method, he would have
been able to offset expenses against the unreported income.
The court refused to permit him thus to restructure the
filed returns.
Here, Colonial reported and deducted the entire amount
of its payments to Jamaica, direct and indirect. Petitioner
did not ask the Court to change a single figure in those tax
returns. The returns reflected payment to Jamaica, in our
hypothetical example, of $6 per dozen shirts and petitioner
in no way sought to alter that transaction. Cases like
Campbell and Vardine are therefore entirely inapposite.
To belabor the obvious, petitioner’s position was simply
this: so long as Colonial actually paid $6 per dozen for the
shirts, it made no difference to its taxable income how that
payment was made. The method of payment could not have
been motivated by any intent or desire to affect Colonial’s
taxable income and the finding that petitioner caused
Colonial to pay Jamaica in two elements with the criminal
intent of evading Colonial’s tax obligations was contradicted
by the established facts found by the trial court.
20
Thus, in affirming petitioner’s conviction, the Court of
Appeals eliminated as an essential element of the crime
charged the intent to evade the payment of tax.
CONCLUSION
This case presents this Court with its first opportunity to
deal with the important Congressional policy enunciated in
Section 482 of the Internal Revenue Code which affects the
thousands of taxpayers who are members of controlled
groups, and who regularly do business with each other. The
holding below, that the Section and the Regulations adopted
under it are unavailable to a defendant in a criminal case,
goes far toward undermining the purpose of Congress in
enacting it.
To review that holding, and a conclusion of criminal in-
tent inconsistent with the facts as found, the writ of cer-
tiorari sought by petitioner should be granted.
Respectfully submitted,
Georce G. GALLANTZ
Davin I. GotpBLattT
Counsel for Petitioner
Of Counsel:
ProsKkaver Rose Goetz & MenpELSOHN
May 19, 1972
Opinion of the Court of Appeals
UNITED STATES COURT OF APPEALS
For THE Seconp Circuit
No. 326—September Term, 1971
——-—
Unitep States oF AMERICA,
Appellee,
—_—vV.—
Sot Bercer,
Appellant.
—
Before:
SmirH, KaurmMan and MULLIGAN,
Circuit Judges.
Smiru, Circuit Judge:
Sol Berger appeals from a judgment of conviction on
each of three counts of an indictment for the willful eva-
sion of income tax due from the Colonial Corporation of
America (“Colonial”), of which he was president and
chief executive officer, by causing to be prepared and filed
false corporate tax returns in each of the calendar years
1962, 1963 and 1964 (26 U.S.C. §7201 and 18 U.S.C. §2).
After trial without a jury in the United States District
Court for the Southern District of New York, 325 F. Supp.
1297 (1971), the Honorable Edward Weinfeld found ap-
pellant guilty and sentenced him to serve concurrent eigh-
teen month prison terms on each count, fifteen months of
which were suspended, to one year probation upon re-
A-2
lease from jail, and to pay a total of $30,000 in fines. Ap-
pellant insists that no substantial unreported tax was due
from Colonial in the relevant years, and that, in any
event, there was an insufficient showing he had acted with
criminal intent. We disagree with both contentions and
affirm the conviction.
Colonial, once wholly owned by appellant and his wife,
became a large and successful manufacturer and whole-
saler of low priced wearing apparel, making its first pub-
lic offering of shares in 1959. Appellant, however, retained
control of the firm and remained chief executive officer
during the relevant period, his ownership never falling
below 38% of the outstanding stock. Appellant sold his
entire interest in 1966 when Colonial was merged into
Kayser-Roth Corporation.
In 1959, already parent to several wholly-owned sub-
sidiaries whose output it largely consumed, Colonial con-
ceived yet another, Colonial Shirts of Jamaica, Ltd.
(“Jamaica”), a foreign corporation benefiting from its
permanent exemption from United States taxes and seven
year exemption from Jamaican taxes, as well as from ac-
cess to cheap labor. Jamaica procured piece goods (fab-
ric) and trim (threads, buttons, labels) from vendors in
Japan and elsewhere, who invoiced their sales to Jamaica,
which then sold its entire production of finished shirts to
Colonial. Appellant maintains that the price paid J amaica
for its output was unrealistically low in order to lessen
custom duties on import, albeit customs officials neces-
sarily approved the constructed price (19 U.S.C. §1401(a))
for the shirts in this non-arms length transaction. Pur-
portedly to allow its subsidiary a fair profit, Colonial
adopted the practice of supplementing the invoice price
by making payments directly to the vendors supplying
A-3
Jamaica with piece goods and trim. The payments were
made not at a fixed amount for each shirt purchased, but
by randomly selecting Jamaica invoices for payment to
total an arbitrary sum of $50,000 to $75,000 each quarter.
Colonial then entered these payments to Jamaica’s cred-
itors on Colonial’s own purchase journal, resulting in their
deduction from its gross income, and a corresponding re-
duction in taxes paid. Colonial was thereby able to create
for Jamaica “fair” profit margins of 28%, 28% and 29%
in the relevant years, rather than the profit margins of
6%, 13% and 9% which Jamaica would have enjoyed at
the constructed price had it paid all its own bills; on
these profits, no taxes at all were paid.
Appellant contends that the supplemental payments were
fairly an indirect cost to Colonial for its goods sold, which,
when added to the prices invoiced by Jamaica, resulted
in a fair arms length price for the garments purchased.
Since the alternative, the argument concludes, would sim-
ply be to add the cost of the supplemental payments to
Jamaica’s invoiced prices, the same income tax would be
paid by Colonial either way. Assuming, arguendo, that
such a conclusion is logically correct,’ appellant’s hypo-
thetical restructuring of the taxable transaction is ir-
relevant to our examination of his actual conduct. United
States v. Campbell, 351 F.2d 336, 340 (2d Cir. 1965),
* Appellant does not dispute that if his theory was incorrect,
the amount of tax due and owing from Colonial was substantial.
* The established constructed price was, after all, carefully sub-
stantiated by Colonial, approved by a United States Customs ex-
aminer, and based on the premise that Jamaica would pay its own
costs for piece goods and trim; it allowed Jamaica an average
profit margin of roughly 8%. Although naturally kept as low as
possible to minimize import duties, the constructed price does not
appear to have been unrealistic.
A4
cert. denied, 383 U.S. 907 (1966) ; United States v. Var-
dine, 305 F.2d 60, 64 (2d Cir. 1962). We are concerned
not with whether appellant might have sought a higher
constructed price for Jamaica’s apparel, thereby achieving
similar deductions for Colonial while simultaneously pay-
ing higher customs duties and reducing the untaxed profit
to Jamaica, but with the propriety of the procedure in fact
used: the clandestine payment of J amaica’s bills in order
to manipulate Colonial’s profits while paying lower cus-
toms duties and maintaining J amaica’s untaxed profits at
levels approaching 30%.
In maintaining that Colonial was indeed entitled to take
the disputed deductions, appellant concedes the fundamen-
tal principles that a parent corporation and its subsidiary
are separate taxable entities, however close their relation-
ship, National Carbide Corp. v. Commissioner, 336 U.S.
422 (1949), and that, ordinarily, a parent cannot deduct
expenses incurred by its subsidiary. Interstate Transit
Lines v. Commissioner, 319 U.S. 590 (1943). See 26 U.S.C.
§162(a). Rather appellant seeks to place himself within
the ambit of those exceptional cases such as Fishing Tackle
Products Co., 27 T.C. 638 (1957) and Texas and Pacific Ry.,
1 C.C.H. Tax Ct. Mem. 863 (1943), which under unusual
circumstances allow a parent corporation to deduct as ordi-
nary and necessary expenses items expended for a subsidi-
ary. In Fishing Tackle the deducted payment, appearing
openly on the parent’s books, was a temporary measure to
compensate its subsidiary for an actual loss in its opera-
tions. Moreover, the subsidiary in that case was the sole
source of supply of a product for which the original, arbi-
trarily established, price had proved inadequate, and was
therefore indispensable to the parent’s continued operation.
A-5
Similarly in Texas and Pacific Ry., the deducted payment
exactly equalled the operational loss of a subsidiary which
had been organized solely to provide a service to the parent,
and not to make a profit. Far different is the instant case
involving an ongoing and hidden system by a parent cor-
poration to make payments to the creditors of its subsidi-
ary, one not necessary to the continued existence of its
parent, in order to increase the already significant tax free
profits which that subsidiary could have expected on the
basis of the carefully documented constructed price for its
output. The piece goods and trim billed to Jamaica, but
paid for and deducted by Colonial, were no more than the
routine manufacturing expenses of Jamaica.° As the district
court observed: “[s]uch payments would not be deductible
as an expense to Colonial, but would be considered a con-
tribution or a loan to capital of Jamaica.” 325 F. Supp. at
1302.
Addressing itself to the issue of criminal intent, the dis-
trict court stated that:
[b]ased upon the Court’s trial notes, which include its
contemporaneous appraisal of each witness, a word by
word study and reading of the stenographic transcript
of the trial, the demeanor of the witnesses, an evalua-
tion of their credibility and the reasonable inferences
to be drawn from established facts and surrounding
circumstances, the Court accepts the substance of the
testimony of the government witnesses as credible,
5’ Having found the fraudulent deduction by Colonial of expenses
properly attributable to Jamaica, we are, as we have said, not
concerned with alternate procedures appellant might legitimately
have employed to reach the tax result he sought. We agree with
the district court that 26 U.S.C. §482 does not pertain to the case
at bar. See 26 C.F.R. §1.482-1(b).
A-6
and their version of the matters referred to as sub-
stantially true.
[325 F. Supp. at 1305]
The government’s independent evidence of willful affirma-
tive acts beyond its proof of understated taxes, Spies v.
United States, 317 U.S. 492, 499 (1943) included the fol-
lowing: (1) appellant directed Colonial’s bookkeeper to
remove Jamaica invoices in the amount of $50,000 to $75,000
each quarter for treatment as expenses on the books of
Colonial; (2) he and only he received from the bookkeeper
separate records which were kept of each false entry; (3)
he concealed this procedure from all other top officers of
Colonial, from Colonial’s accountants and from its outside
auditors. Appellant’s denials not having been credited by
the trial court, its finding of criminal intent beyond a rea-
sonable doubt is amply supported by the evidence.
Affirmed.
A-7
Judgment of the Court of Appeals
UNITED STATES COURT OF APPEALS
For tHE Seconp Circuir
At a stated Term of the United States Court of Appeals,
in and for the Second Circuit, held at the United States
Courthouse in the City of New York, on the twentieth day
of March one thousand nine hundred and seventy-two.
Present:
Hon. J. JosepH Situ,
Hon. Irvine R. Kaurman,
Hon. Wituram H. Mu.wiean,
Circuit Judges.
<i ——
Unirep States oF AMERICA,
Plaintiff-Appellee,
--V.—
Sot Bercer,
Defendant-A ppellant.
<<
Appeal from the United States District Court for the
Southern District of New York.
This cause came on to be heard on the transcript of rec-
ord from the United States District Court for the South-
ern District of New York, and was argued by counsel.
,
Se se
A-8
WHEREOF, it is now hereby ordered,
that the judgment of said District
is affirmed with costs to be taxed
ON CONSIDERATION
adjudged, and decreed
Court be and it hereby
against the appellant.
A. DANIEL Fusaro
Clerk
A-9
Order Denying Petition for Rehearing
UNITED STATES COURT OF APPEALS
Seconp Circulr
71-1856
—~>—
Unirep States or AMERICA,
Plaintiff-Appellee,
—_—V.—
So. BERGER,
Defendant-Appellant.
-
A petition for a rehearing having been filed herein by
counsel for the appellant,
Upon consideration thereof, it is
Ordered that said petition be and it hereby is Denn.
April 20, 1972
J. JosepH SMITH
Irvine R. KavrmMan
Wiuim H. Mutiican
Circwt Judges
A-10
Opinion of the District Court
——~—>-
Unrrep States OF AMERICA
So. Bercer
Epwarp Werxretp, District Judge:
While many witnesses have testified and many exhibits
have been received in evidence, with a tendency at times
on the part of counsel to proliferate matters by the intro-
duction of doubtful relevant testimony and exhibits, the
issues presented are comparatively simple.
Thus, it is desirable to start with the indictment, to con-
sider the essential elements of the crime charged, and
to determine whether the government has sustained its
burden of establishing these essential elements bevond a
reasonable doubt.
Count 1 of the indictment charges:
“The Grand Jury charges:
“On or about the 17th day of June, 1963, in the South-
ern District of New York, Sol Berger, the defendant
who was then and there the president and chief execu-
tive officer of Colonial Corporation of America, a cor-
A-1l
poration, unlawfully, wilfully and knowingly did at-
tempt to evade and defeat a large part of the income
tax due and owing by the said corporation to the
United States of America for the calendar year of
1962, by preparing and causing to be prepared and fil-
ing and causing to be filed with the District Director of
Internal Revenue for the Manhattan District, New
York, New York, a false and fraudulent income tax
return, wherein it was stated that the taxable income
of the said corporation for the said calendar year was
the sum of $1,360,287.06 and that the amount of income
tax due and owing thereon was the sum of $690,024.48,
whereas, as the defendant then and there well knew,
the taxable income of the said corporation for the said
calendar year was the sum of approximately $1,654,-
430.72, upon which said taxable income there was due
and owing to the United States of America an income
tax of approximately $842,979.19. (Title 26, United
States Code, Section 7201; Title 18, United States
Code, Section 2.)”
A similar charge is made for the years 1963 and 1964,
but the amounts of alleged evasion of tax are different in
each year.
With respect to each count, the burden of proof is upon
the government to establish beyond a reasonable doubt:
(1) that a substantial tax was due and owing from
Colonial Corporation of America in addition to that re-
ported in its return;
A-12
(2) that Sol Berger, the defendant, made an attempt to
evade or defeat the additional tax due; and
(3) that he did so wilfully.
At the outset, issue is joined on the first element, that
additional taxes were due—a matter of sharp dispute. The
defendant, in the years in question, and in preceding years,
was the chief executive officer of Colonial Corporation of
America (hereafter Colonial, or the parent corporation).
Uriginally, he and his wife owned 100 per cent of its capital
stock. The corporation achieved a substantial success and
srowth in the manufacture, sale and distribution of low-
priced shirts, blouses and related items. Subsequently, in
the latter part of 1959, the stock was sold publicly, and in
the period in question the defendant and his wife owned
at least 38 per cent of Colonial’s outstanding stock. The
corporation had various wholly-owned subsidiaries which
manufactured products and sold most of their output to
the parent corporation.
In 1959, the defendant caused the organization of another
wholly-owned subsidiary, Colonial Shirts of Jamaica, Ltd.
(hereafter Jamaica, or the subsidiary), under the laws of
Jamaica, British West Indies, a so-called offshore corpora-
tion, which had the benefit of tax exemption for a period
of seven years. In addition, another advantage was an
available labor supply at lower wages than that obtainable
in the domestic market, where other subsidiaries of Colonial
also manufactured shirts, as well as other products.
Colonial bought for resale to its retailers the entire pro-
duction of the finished products manufactured by Jamaica.
The price at which the manufactured product was shipped
A-13
to and exported from Jamaica, British West Indies, to
Colonial in the United States was the constructed value,
referred to hereafter. In the manufacture of the shirts so
acquired by the parent corporation the subsidiary used
piece goods, which had been imported from Japan, which
the vendors there invoiced to Jamaica, the subsidiary A
portion of the cost of these piece goods, as well as trim
and supplies—$294,251 in 1962, $237,023 in 1963, and $383,-
412 in 1964—although invoiced by the vendors to Jamaica
and used by it in the manufacture of the finished product,
was entered on the books of Colonial as its purchases.
The net effect, no matter how stated, is that the entries
in Colonial’s purchase journal—treating the cost of piece
goods and the other items as Colonial’s cost, and deductible
as such—reduced the gross income of Colonial of America
as shown on its tax returns, and correspondingly reduced
its tax in each year. Stating it somewhat differently, had
Jamaica, the subsidiary, been debited with the entire cost
of the piece goods, as well as items of supply and trim, used
by it to manufacture the finished product which it exported
to its parent, the taxable income of the parent would have
been increased, as shown by the exhibits submitted by the
government in the amounts stated in the indictment.
Whether or not those amounts of additional taxable in-
come are precise, they are substantial and the tax due and
owing substantially more than that reported. And this is
so, even eliminating the trim and supplies, sinee the piece
goods formed the greatest part of the items so entered.
The piece goods debits alone amount to $261,370 for the
year 1962; $192,121 for the year 1963; and $307,668 for the
year 1964.
a
A-14
The government’s position is that entering these items
on the purchase journals of Colonial and treating them as
a part of its cost of goods sold was fraudulent in that the
cost was a part of Jamaica’s cost of manufacture, and that
the defendant caused such items to be debited to Colonial’s
purchase journals in an attempt to evade or defeat a por-
tion of Colonial’s taxes.
The defendant’s position is that Colonial was entitled
to offset from its gross receipts the cost of raw materials,
including the piece goods, trim and supplies, which it paid
for; that “expensing,” as the term has been used, of the
piece goods by Colonial was an indirect cost to it of goods
sold. The defendant’s further claim is that the entries
reflected, in accordance with Colonial’s policy, an adjust-
ment to allocate a fair portion of the profits to Jamaica
and, to use the language of his counsel, “(h)ad the alloca-
tion not been made, the subsidiary would have had to oper-
ate at a loss or at a relatively trifling profit well below the
profits” of the parent corporation. However, the record
does not bear out the contention that the subsidiary was
operating at a trifling profit or a loss.
The finished shirts and blouses exported by Jamaica to
its parent were subject to an import duty. Since the trans-
actions were not at arm’s length, a constructed value was
determined under 19 U. S. C., Section 1401a. In substance,
“eonstructed value” is the sum of the cost of materials,
fabrication, processing, overhead, general expenses and
profit equal to that usually reflected in sales of merchan-
dise of the same kind by producers in the country of ex-
portation. The “eonstructed price” was arrived at as a
result of conferences between Leonard Friedman, in charge
—
A-15
of production of all the companies owned by the parent and
customs officials. The imported goods were invoiced, as
they had to be under the statute, at the constructed price,
on which a duty of 20 or 25 per cent, according to the item
of merchandise, was payable.
There appears to be no dispute that the constructed
value, the invoice price to Colonial, was at a low price,
which some witnesses described as not reflecting a realistic
price, or a fair price for the exported product.
And the defense position that no tax is due derives in
large measure from this situation. The claim is that since
the price at which Jamaica billed the goods to Colonial was
too low, in order to yield a fair profit to Jamaica or one
proportionate to the profit realized by Colonial in the re-
sale of the product, Colonial absorbed part of the expense
for the piece goods and other items used in the manufacture
of the finished product, and that the adjustments were
made for this purpose and consistent with Colonial’s al-
leged basic policy to allow a fair profit to its subsidiaries.
But this does not resolve the question as to whether or not
the so-called adjustments or entries in the purchase jour-
nals of Colonial, under the circumstances here presented,
reflected items of necessary expense of Colonial’s business
or its cost of goods sold.
The defendant’s position also is that had all piece goods
and other raw materials been charged to Jamaica as part
of its cost of production, the same gross profit would have
been divided between Colonial and Jamaica, but on a dif-
ferent profit ratio.
The various conceptual and alternative theories of what
might have been done must yield to the facts. The Court
A-16
must take the transactions as they occurred and in the
manner they were treated at the time of the occurrence.
it is the fact situation at the time of the alleged offense
that controls.
United States v. Vardine, 305 F. 2d 60, 64 (2d Cir.
1962) ;
Seanlon v. United States, 223 F. 2d 382, 389 (ist
Cir. 1955) ;
Clark v. United States, 211 F. 2d 100, 105 (8th
Cir. 1954), cert. denied, 348 U.S. 911 (1955) ; cf.
National Carbide Corp. v. Commissioner, 336
U. S. 422, 435 (1949).
The simple fact is that had all the piece goods and raw
materials invoiced to Jamaica by foreign vendors and
others, and used in the manufacture of the finished shirts
and blouses, been entered on the books of Jamaica as its
cost of production, an increase in the constructed price
charged to Colonial would have been required, with the in-
come picture of both corporations affected accordingly;
or as defense counsel put it:
“(t)he only alternative to the adjustments would
have been to charge the Jamaican subsidiaries for the
full amount of purchases and supplies and in turn to
have increased the amount of the billings to the parent
from the Jamaican subsidiaries by an equivalent
amount.”
The policy of Colonial was to keep the constructed price
down, since the higher the price the higher the duty that
A-17
Colonial had to pay. In end result, this reduced customs
duties on the merchandise and the adjustments also reduced
Colonial’s taxable income.
The corporations were separate entities; however, this
did not give Colonial the right to make intercompany ad-
justments as it willed—but only within the law. C/. Na-
tional Carbide Corp. v. Commissioner, 336 U.S. 422, 434-36
(1949). The basic rule is that for tax purposes, parent and
wholly-owned subsidiaries are treated as separate entities
no matter how closely affiliated. Ordinarily, the separate
corporate entities of parent and subsidiary preclude the
parent from deducting expenses incurred by its subsidiary.
The concept is that the payment by the parent to cover
such expenses is related to the business of the subsidiary
and not its own business, and as such is not deductible.
Fall River Gas Appliance Co. v. Commissioner,
42 T.C. 850, 858 (1964), aff’d 349 F. 2d 515 (1st
Cir. 1965) ;
see also National Carbide Corp. v. Commissioner,
336 U.S. 422 (1949) ;
Interstate Transit Lines v. Commissioner, 319 U.S.
590 (1943) ;
Young & Rubicam, Inc. v. United States, 410 F. 2d
1233 (Ct. Cl. 1969) ;
Columbian Rope Co., 42 T. C. 800 (1964).
It is true that items expended for a subsidiary may be
deductible by a parent corporation as an ordinary or neces-
sary expense of the parent, such as was allowed in Fishing
Tackle Prods. Co., 27 T. C. 638 (1957), and Fall River
A-18
Gas Appliance Co. v. Commissioner, 42 T. C. 850 (1964),
but only under unique and compelling circumstances.
It is significant that in the Fishing Tackle case the parent
needed the product of the subsidiary, which was its sole
source of supply and without which the parent would have
been unable to meet the demands of its customers and its
position in the industry threatened. The payments made
by the parent covered operating losses of. the subsidiary
and were held deductible as a necessary business expense
made to maintain and preserve its source of supply. The
threatened elimination of the parent’s sole source of sup-
ply, without which it would have ceased operation, was
the compelling cireumstance underlying the court’s holding.
However, the facts of this case do not parallel those of
Fishing Tackle. The cost of the piece goods and other items
used by Jamaica was part of its day to day manufacturing
activity in furtherance of its business. Without the raw
materials there could be no finished product. The piece
goods used by Jamaica in the manufacture of the shirts
were, to use the words of Colonial’s production chief, “a
vital component of our cost.”
That Colonial supplied the funds for the purchase of
the goods is not material, especially when Colonial had
numerous other sources of supply. Such payments would
not be deductible as an expense to Colonial, but would be
considered a contribution or a loan to capital of Jamaica.
Cf. Interstate Transit Lines v. Commissioner, 319 U. 8. 590,
594 (1943). The cost of piece goods, as accurately as could
be determined, was used in determining constructed value.
That cost was Jamaica’s ordinary and necessary expense
A-19
required in order to manufacture the finished product, and
no amount of dialectical discussion of what might have oc-
curred if the transaction had been treated differently can
down that fact. That the payments by Colonial are now
referred to as both a direct and indirect payment for the
cost of goods acquired does not alter the fact.
Moreover, despite the reference to what might have been
the end result of a “C, M, T,” a cut, make and trim opera-
tion, this was not the situation that existed. The defendant
participated in the decision that Jamaica was to function
otherwise and was to manufacture the completed garment
and that piece goods from the Far East were to be pur-
chased by and billed directly to Jamaica.
The fact that the quarterly adjustments of piece goods
invoices were taken at random and reflected only a por-
tion of the invoices to Jamaica militates against the conten-
tion that the adjustments were made as a cost of goods
sold to Colonial. The alternative argument that the items
were absorbed by Colonial to “assure a fair profit” to
Jamaica is faced with the fact that had the piece goods and
other materials been expensed to Jamaica, Jamaica still
would have reflected a profit, unlike the subsidiary in the
Fishing Tackle case.
The defendant’s contention that the piece goods and
other items were properly charged to Colonial and deducted
under section 482 of Title 26 is without substance. This is a
section to be invoked by the Commissioner of Internal Reve-
nue to allocate gross income or deductions between or
among related businesses when the Commissioner deems
it necessary to prevent the evasion of taxes or clearly to re-
flect the income of such businesses. Its purpose is to prevent
|
A-20
the arbitrary shifting of income and deductions among con-
trolled and controlling corporations. 26 C. F. R. § 1.482-1
(b). It is not a delegation of authority to a parent to treat
at will the necessary expenses of its subsidiary as its own,
for the parent’s benefit and to the detriment of government
in its right to taxes justly due.
The Court finds with respect to the first essential element
that the debit entries on the purchase journals of Colonial
for the piece goods and other raw materials purchased by |
and invoiced to Jamaica, delivered by the vendors to
Jamaica, which raw materials were used by Jamaica in
the manufacture of the finished product, were improperly
deducted by Colonial as its expense or its cost of goods sold;
that the government has sustained its burden of proving
that Colonial overstated its cost of goods sold in its tax
returns for the years 1962, 1963 and 1964 by deducting
expenses for goods acquired by J amaica, which should
not have been charged on the purchase journals of Colonial.
The Court further finds the government has established
that a substantial amount of income tax was due and owing
from Colonial for each tax year in question in addition to
that set forth in the return for each year. A substantial
additional tax was due even if only the piece goods items
are taken into account, and trim and supplies excluded.
It necessarily follows, upon the entire evidence, that the
returns in question were false in the material respect of
the improper deductions by Colonial, and also that the de-
fendant knew this. While the defendant urges he person-
ally did not sign the Colonial returns, that they were pre-
pared and executed by Epstein, the vice president in charge
of financial matters for Colonial, the evidence is abundant
ww
A-21
that the entries on Colonial’s books of the cost of the in-
voiced items to Jamaica for the piece goods and other items
were made at his direction and at all times with his knowl-
edge—that they were made with his knowledge and consent
is not in dispute. And he-also knew the entries on Colonial’s
books would be reflected in Colonial’s tax returns with
consequent reduction of taxable income and taxes due.
The fact that he himself did not sign the return is
of no consequence. The government has sustained its-
burden as to the second element.
Thus, there remains for consideration the final element
—did the defendant wilfully attempt to evade or defeat the
additional tax due and owing. The presumption of inno-
cence with which the law endows the defendant extends to
every element of the crime charged, and here the question
is whether the government has carried its burden of estab-
lishing that the defendant acted wilfully and with a specific
intent to defraud the government of the taxes due.
The term “wilful” connotes deliberate, voluntary and pur-
poseful action, with a specific wrongful intent to violate
the law, as distinguished from inadvertent or accidental,
or an honest misunderstanding of what the law requires
or permits. Various terms have been used to define wilful-
ness or guilty knowledge, such as fraudulent intent, and evil
motive, a bad motive, or a vicious will.
Cf. Morissette v. United States, 342 U. S. 246, 252
(1952) ;
see also United States v. Freed, —— U.S. ——
(Apr. 5, 1971);
United States v. Platt, 435 F. 2d 789, 794 (2d Cir.
1970).
A-22
It has also been defined as a state of mind of a person
wherein he is fully aware of the existence of a tax obliga-
tion which he seeks to conceal or evade.
United States v. Martell, 199 F. 2d 670, 672 (3rd
Cir. 1952), cert. denied, 345 U. S. 917 (1953) ;
see also United States v. Vitiello, 363 F. 2d 240, 242
(3rd Cir. 1966).
However, wilfulness may not be inferred solely from,
-- proof of understated taxes. A specifie intent to evade or
defeat the tax must be proved by independent evidence of
wilful affirmative acts. Spies v. United States, 317 U. S.
492, 499 (1942), the leading case on the element of wilful-
ness, points out some such acts which may be considered.
These include making false entries and any conduct the
likely effect of which would be to mislead or to conceal, and
if the tax evasion motive plays any part in such conduct, the
offense may be made out, even though the conduct may also
serve other purposes.
To the extent that the entries of the invoices on Colonial’s
books were improper deductions, as the Court has already
found, they may be said to be false; but this does not, in
and of itself, necessarily establish that they were made or
conceived of with a fraudulent and criminal intent to evade
taxes. More must be shown by affirmative conduct to effect
that purpose.
The government contends that the defendant’s acts and
conduct establish that the entries on Colonial’s books which
purported to be its expenses when in fact they were
Jamaica’s were not only false entries, but were made at
the defendant’s specific direction with the fraudulent in-
—
A-23
tent to defeat a portion of Colonial’s taxes, and that his
clandestine acts and conduct with respect to the transac-
tions evidence a purpose to conceal and mislead, which
the government contends in fact they did.
The determination of the issue of wilfulness turns in
large measure upon the evaluation of the credibility of
government witnesses and the defendant. Their respective
versions of the original of the entries, knowledge of records
with respect thereto, and other significant factors relating
thereto are in sharp conflict.
Mrs. Milligan, the principal bookkeeper of the Colonial
corporation, under whose immediate direction all entries
were made in the books of original entry, testified that
late in 1959 or early 1960, the defendant directed her to
enter on Colonial’s books a portion of the invoices for piece
goods shipped and invoiced to the Jamaica corporation, in
the approximate amounts of $50,000 to $75,000 in each quar-
ter; such entries were made in Colonial’s purchase journals ;
that the defendant asked her to keep a separate record of
such transactions, which she did; that he was the sole per-
son to whom she delivered, either in person or by mail,
the reports of the quarter-annual entries.
Friedman, the production chief of all the companies, and
Epstein, originally the certified public accountant for
Colonial, and at the period here in question its chief finan-
cial officer, who, together with the defendant, constituted the
top management team of Colonial, each categorically denied
he ever knew of the entries, or that piece goods invoiced to
Jamaica were treated on Colonial’s books as its expense or
purchase until early 1965, when they first learned of the
practice, although each was aware of a general practice with
a
A-2%4
respect to trim and supplies delivered to Colonial’s sub-
sidiaries or contractors. Epstein and Friedman each denied
they ever saw or received records or reports of the entries
which Mrs. Milligan testified she submitted regularly to the
defendant at the end of each quarter.
The government also points to the testimony that the
regular accountants of Colonial and those working under
them were unaware that piece goods, trim and supplies
invoiced to Jamaica were not entered on its books, but
instead on the purchase journal of Colonial as its own pur-
chases, and this was also true of the company’s outside
auditors.
Finally, while the bookkeeper knew the entries were made,
she was not told the purpose thereof; she just did what she
was told to do.
This and other evidence, the government contends,
demonstrates that the defendant’s acts were intentional
and fraudulent; also that he concealed from the top execu-
tives and accountants the false nature of the entries. In
sum—it contends it has established that what the defendant
did amounted to padding the books of Colonial with ex-
penses not its own—expenses that he knew were those of
Jamaica.
The defendant, as already noted, contends that the
entries were made as an adjustment to reflect a fair price
and fair profit to Jamaica, consistent with Colonial’s
policy as to all its subsidiaries—in sum, that they were
made in good faith without fraudulent purpose and that
the transactions were open and known to others. He de-
nied, or did not recall, that in 1959 or thereabouts he in-
structed Mrs. Milligan to make deductions, as she testified ;
A-25
he denied he directed her to keep a record thereof or to re-
port to him; he had no recollection of seeing specific reports
of piece goods invoice adjustments, although he said such
reports were submitted at the quarterly meetings when
Friedman and Epstein were present. He testified, contrary
to Epstein and Friedman, that usually at the quarter-
annual meetings allocations between parent and subsidi-
aries, including Jamaica, were discussed and adjustments
determined.
In sum, he testified that both Friedman and Epstein dis-
cussed and participated in the quarterly adjustments of the
piece goods invoices, but was not sure how the information
was transmitted to Mrs. Milligan to make the appropriate
entries. On a number of matters of substance, defendant’s
testimony was vague and at times irresponsive.
The spiral notebooks in which Mrs. Milligan and others
under her direction recorded the Jamaica piece goods in-
voices and other items, reports of which were either de-
livered or mailed to the defendant, are in evidence. These
reports speak for themselves. Thus, one dated 12/31/62
reads :
“Mr. Berger
“Below are entries made on Colonial’s books, which
purchases and expense actually belong to Jamaica.
For—4th quarter”
Another, dated 3/31/63, reads:
“Mr. Berger,
“below are entries made on Colonial’s books which
actually belong to Jamaica.”
A-26
Other reports use substantially the same language.
Also in evidence is an exhibit bearing defendant’s typed
name and the initials SB:HF, Exhibit 72B, dated May 22,
1961, addressed to Mrs. Milligan, which reads in part:
“At the end of each month please send to me a list
of transactions paid by Colonial which should have
applied to Colonial Shirts of Jamaica.”
An issue was raised as to whether or not it was the defen-
dant himself who dictated and caused this letter to be sent.
His testimony was that he had no recollection as to whether
he dictated it. However, upon all the evidence, I am satis-
fied that the letter was dictated by the defendant and was
mailed to Mrs. Milligan pursuant to his directions.
Based upon the Court’s trial notes, which include its con-
temporaneous appraisal of each witness, a word-by-word
reading and study of the stenographic transcript of the
trial, the demeanor of the witnesses, an evaluation of their
credibility and the reasonable inferences to be drawn from
established facts and surrounding circumstances, the Court
accepts the substance of the testimony of the government
witnesses as credible, and their version of the matters re-
ferred to as substantially true.
Upon the entire record the Court finds that the govern-
ment has also established beyond a reasonable doubt the
requisite element of wilfulness.
Accordingly, the Court finds that the government has
established beyond a reasonable doubt all the essential
elements of the crime charged and finds the defendant
guilty under each count.
The foregoing shall constitute the Court’s Findings under
Rule 23 of the Federal Rules of Criminal Procedure.
A-27
Judgment of the District Court
UNITED STATES DISTRICT COURT
For tHe Souruern District or New York
No. 69 Cr. 496
ee
Untrep Stares or AMERICA
v.
Sox Bercer
—j>_
Un this 4th day of June, 1971, came the attorney for
the government and the defendant appeared in person and
by Boris Kostelanetz and Jules Ritholz, Esqs., counsel.
It Is Apsupcep that the defendant upon his plea of not
guilty and a verdict of guilty by a jury has been convicted
of the offense of unlawfully, wilfully and knowingly at-
tempting to evade and defeat a large part of corporate
income tax due and owing to the United States by filing
false and fraudulent income tax returns. (Title 26, See-
tion 7201 U.S. Code; Title 18, Section 2 U.S. Code.) as
charged in counts 1, 2 and 3 and the court having asked
the defendant whether he has anything to say why judg-
ment should not be pronounced, and no sufficient cause to
the contrary being shown or appearing to the Court,
Ir Is Apsupcep that the defendant is guilty as charged
and convicted.
Ir Is Apsupeep that the defendant is hereby committed
to the custody of the Attorney General or his authorized
representative for imprisonment for a period of E1icGHTEEN
(18) Monrus on each of counts 1, 2 and 3 to run concur-
a
A-28
rently with each other and pursuant to Section 3651 of
Title 18, U.S. Code, as amended with provision that defen-
dant be confined in a Jam. Tyre institution for a period
of Turee (3) Montus.
Ir Is Apsupcep that the execution of prison sentence re-
mmaining be suspended and defendant placed on probation
for a period of One (1) Year, to commence upon expira-
tion of confinement, subject to the standing probation order
of this Court.
—AND—
Ir Is Apsupcep that the defendant Fixep $10,000 on each
of counts 1, 2 and 3 plus cost of prosecution. Total fines
of $30,000.00 plus cost of prosecution are to be paid or
defendant to stand committed until the fines plus costs of
prosecution are paid or he is otherwise discharged accord-
ing to law.
Defendant continued on present bail until 4 P.M. today at
which time he is to post Bail Pending Appeal in the amount
of $10,000.00. Bail pending appeal conditioned upon the
appeal being prosecuted expeditiously and in strict com-
pliance with the rules of this Court and the Court of Ap-
peals.
Ir Is Orperep that the Clerk deliver a certified copy of
this judgment and commitment to the United States Mar-
shal or other qualified officer and that the copy serve as the
commitment of the defendant. ;
Epwarp WEINFELD
United States District Judge
Joun Livineston
Clerk
A-29
Section 482 and Regulations
Sec. 482 [1954 Code]. In any case of two or more
organizations, trades, or businesses (whether or not in-
corporated, 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 or his delegate may distribute, appor-
tion, or allocate gross income, deductions, credits, or
allowances between or among such organizations,
trades, or businesses, if he determines that such dis-
tribution, 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.
REGULATIONS
$ 1.482-1. Allocation of income and deductions among
taxpayers.—(a) Definitions. When used in this section and
in § 1.482-2—
(1) The term “organization” includes any organization
of any kind, whether it be a sole proprietorship, a partner-
ship, a trust, an estate, an association, or a corporation (as
each is defined or understood in the Internal Revenue Code
or the regulations thereunder), irrespective of the place
where organized, where operated, or where its trade or
business is conducted, and regardless of whether domestic
or foreign, whether exempt, whether affiliated, or whether
a party to a consolidated return.
(2) The term “trade” or “business” includes any trade
or business activity of any kind, regardless of whether or
A-30
where organized, whether owned individually or otherwise,
and regardless of the place where carried on.
(3) The term “controlled” includes any kind of control,
direct or indirect, whether legally enforceable, and however
exercisable or exercised. It is the reality of the control
which is decisive, not its form or the mode of its exercise.
A presumption of control arises if income or deductions
have been arbitrarily shifted.
(4) The term “controlled taxpayer” means any one of
two or more organizations, trades, or businesses owned or
controlled directly or indirectly by the same interests.
(5) The terms “group” and “group of controlled tax-
payers” mean the organizafions, trades, or businesses
owned or controlled by the same interests.
(6) The term “true taxable income” means, in the case of
a controlled taxpayer, the taxable income (or, as the case
may be, any item or element affecting taxable income) which
would have resulted to the controlled taxpayer, had it in
the conduct of its affairs (or, as the case may be, in the
particular contract, transaction, arrangement, or other act)
dealt with the other member or members of the group at
arm’s length. It does not mean the income, the deductions,
the credits, the allowances, or the item or element of income,
deductions, credits, or allowances, resulting to the con-
trolled taxpayer by reason of the particular contract, trans-
action, or arrangement, the controlled taxpayer, or the
interests controlling it, chose to make (even though such
contract, transaction, or arrangement be legally binding
upon the parties thereto).
(b) Scope and purpose. (1) The purpose of section 482
is to place a controlled taxpayer on a tax parity with an
ww
A-31
uncontrolled taxpayer, by determining, according to the
standard of an uncontrolled taxpayer, the true taxable in-
come from the property and business of a controlled tax-
payer. The interests controlling a group of controlled tax-
payers are assumed to have complete power to cause each
controlled taxpayer so to conduct its affairs that its trans-
actions and accounting records truly reflect the taxable in-
come from the property and business of each of the con-
trolled taxpayers. If, however, this has not been done, and
the taxable incomes are thereby understated, the district
director shall intervene, and, by making such distributions,
apportionments, or allocations as he may deem necessary
of gross income, deductions, credits, or allowances, or of
any item or element affecting taxable income, between or
among the controlled taxpayers constituting the group,
shall determine the true taxable income of each controlled
taxpayer. The standard to be applied in every case is that
of an uncontrolled taxpayer dealing at arm’s length with
another uncontrolled taxpayer.
(2) Section 482 and this section apply to the case of any
controlled taxpayer, whether such taxpayer makes a sepa-
rate or a consolidated return. If a controlled taxpayer
makes a separate return, the determination is of its true
separate taxable income. If a controlled taxpayer is a
party to a consolidated return, the true consolidated tax-
able income of the affiliated group and the true separate
taxable income of the controlled taxpayer are determined
consistently with the principles of a consolidated return.
(3) Section 482 grants no right to a controlled taxpayer
to apply its provisions at will, nor does it grant any right
to compel the district director to apply such provisions.
It is not intended (except in the case of the computation of
A-32
consolidated taxable income under a consolidated return)
to effect in any case such a distribution, apportionment,
or allocation of gross income, deductions, credits, or allow-
ances, or any item of gross income, deductions, credits, or
allowances, as would produce a result equivalent to a com-
putation of consolidated taxable income under subchapter
A, chapter 6 of the Code.
(ce) Application. Transactions between one controlled
taxpayer and another will be subjected to special scrutiny
to ascertain whether the common control is being used to
reduce, avoid, or escape taxes. In determining the true
taxable income of a controlled taxpayer, the district di-
rector is not restricted to the case of improper accounting,
to the case of a fraudulent, colorable, or sham transaction,
or to the case of a device designed to reduce or avoid tax
by shifting or distorting income, deductions, credits, or
allowances. The authority to determine true taxable in-
come extends 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 uncon-
trolled taxpayer dealing at arm’s length with another
uncontrolled taxpayer.
(d) Method of allocation. (1) The method of allocating,
apportioning, or distributing income, deductions, credits,
and allowances to be used by the district director in any
case, including the form of the adjustments and the char-
acter and source of amounts allocated, shall be determined
with reference to the substance of the particular transac-
tions or arrangements which result in the avoidance of
taxes or the failure to clearly reflect income. The appro-
priate adjustments may take the form of an increase Or
A-33
decrease in gross income, increase or decrease in deduc-
tions (including depreciation), increase or decrease in ba-
sis of assets (including inventory), or any other adjustment
which may be appropriate under the circumstances. See
§1.482-2 for specific rules relating to methods of alloca-
tion in the case of several types of business transactions.
(2) Whenever the district diréctor makes adjustments
to the income of one member of a group of controlled tax-
payers (such adjustments being referred to in this para-
graph as “primary” adjustments) he shall also make
appropriate correlative adjustments to the income of any
other member of the group involved in the allocation.
The correlative adjustment shall actually be made if the
U. S. income tax liability of the other member would be
affected for any pending taxable year. Thus, if the dis-
trict director makes an allocation of income, he shall not
only increase the income of one member of the group, but
shall decrease the income of the other member if such
adjustment would have an effect on the U. S. income tax
liability of the other member for any pending taxable
year. For the purposes of this subparagraph, a “pending
taxable year” is any taxable year with respect to which
the U. S. income tax return of the other member has been
filed by the time the allocation is made, and with respect
to which a credit or refund is not barred by the operation
of any law or rule of law. If a correlative adjustment is
not actually made because it would have no effect on the
U. S. income tax liability of the other member involved
in the allocation for any pending taxable year, such ad-
justment shall nevertheless be deemed to have been made
for the purpose of determining the U. S. income tax lia-
bility of such member for a later taxable year, or for the
A-34
purposes of determining the U. S. income tax liability of
any person for any taxable year. The district director
shall furnish to the taxpayer with respect to which the
primary adjustment is made a written statement of the
amount and nature of the correlative adjustment which is
deemed to have been made. For purposes of this sub-
paragraph, a primary adjustment shall not be considered
to have been made (and therefore a correlative adjustment
is not required to be made) until the first occurring of the
following events with respect to the primary adjustment:
(i) The date of assessment of the tax following execu-
tion by the taxpayer of a Form 870 (Waiver of Restric-
tions on Assessment and Collection of Deficiency in Tax
and Acceptance of Overassessment) with respect to such
adjustment,
(ii) Acceptance of a Form 870-AD (Offer of Waiver of
Restriction on Assessment and Collection of Deficiency in
Tax and Acceptance of Overassessment),
(iii) Payment of the deficiency,
(iv) Stipulation in the Tax Court of the United States, or
(v) Final determination of tax liability by offer-in-com-
promise, closing agreement, or court action.
The principles of this subparagraph may be illustrated by
the following examples in each of which it is assumed that
X and Y are members of the same group of controlled
entities and that they regularly compute their incomes on
the basis of a calendar year:
Example (1). Assume that in 1968 the district director
proposes to adjust X’s income for 1966 to reflect an arm’s
length rental charge for Y’s use of X’s tangible property
A-35
in 1966; that X consents to an assessment reflecting such
adjustment by executing a Waiver, Form 870; and that an
assessment of the tax with respect to such adjustment is
made in 1968. The primary adjustment is therefore con-
sidered to have been made in 1968. Assume further that
both X and Y are United States corporations and that Y
had net operating losses in 1963, 1964, 1965, 1966, and
1967. Although a correlative adjustment would not have
an effect on Y’s U. S. income tax liability for any pending
taxable year, an adjustment increasing Y’s net operating
loss for 1966 shall be deemed to have been made for the
purposes of determining Y’s U. 8S. income tax liability for
1968 or a later taxable year to which the increased oper-
ating loss may be carried. The district director shall notify
X in writing of the amount and nature of the adjustment
which is deemed to have been made to Y.
Example (2). Assume that X and Y are United States
corporations; that X is in the business of rendering en-
gineering services; that in 1968 the district director pro-
poses to adjust X’s income for 1966 to reflect an arm’s
length fee for the rendition of engineering services by X
in 1966 relating to the construction of Y’s factory; that
X consents to an assessment reflecting such adjustment by
executing a Waiver, Form 870; and that an assessment of
the tax with respect to such adjustment is made in 1968.
Assume further that fees for such services would properly
constitute a capital expenditure by Y, and that Y does not
place the factory in service until 1969. Although a cor-
relative adjustment (increase in basis) would not have an
effect on Y’s U. S. income tax liability for a pending tax-
able year, an adjustment increasing the basis of Y’s assets
for 1966 shall be deemed to have been made in 1968 for
A-36
the purpose of computing allowable depreciation or gain
or loss on disposition for 1969 and any future taxable year.
The district director shall notify X in writing of the amount
and nature of the adjustment which is deemed to have been
made to Y.
Example (3). Assume that X is a U. 8. taxpayer and
Y is a foreign taxpayer not engaged in a trade or business
in the United States; that in 1968 the district director
proposes to adjust X’s income for 1966 to reflect an arm’s
length interest charge on a loan made to Y; that X con-
sents to an assessment reflecting such allocation by execut-
ing a Waiver, Form 870; and that an assessment of the
tax with respect to such adjustment is made in 1968. Al-
though a correlative adjustment would not have an effect
on Y’s U. 8S. income tax liability, an adjustment in Y’s
ineome for 1966 shall be deemed to have been made in 1968
for the purposes of determining the amount of Y’s earn-
ings and profits for 1966 and subsequent years, and of any
other effect it may have on any person’s U. S. income tax
liability for any taxable year. The district director shall
notify X in writing of the amount and nature of the allo-
cation which is deemed to have been made to Y.
(3) In making distributions, apportionments, or alloca-
tions between two members of a group of controlled en-
tities with respect to particular transactions, the district
director shall consider the effect upon such members of an
arrangement between them for reimbursement within a
reasonable period before or after the taxable year if the
taxpayer can establish that such an arrangement in fact
existed during the taxable year under consideration. The
district director shall also consider the effect of any other
nonarm’s length transaction between them in the taxable
A-37
year which, if taken into account, would result in a setoff
against any allocation which would otherwise be made,
provided the taxpayer is able to establish with reasonable
specificity that the transaction was not at arm’s length and
the amount of the appropriate arm’s length charge. For
purposes of the preceding sentence, the term arm’s length
refers to the amount which was charged or would have
been charged in independent transactions with unrelated
parties under the same or similar circumstances consider-
ing all the relevant facts and without regard to the rules
found in § 1.482-2 by which certain charges are deemed to
be equal to arm’s length. For example, assume that one
member of a group performs services which benefit a sec-
ond member, which would in itself require an allocation
to reflect an arm’s length charge for the performance of
such services. Assume further that the first member can
establish that during the same taxable year the second
member engages in other nonarm’s length transactions
which benefit the first member, such as by selling products
to the first member at a discount, or purchasing products
from the first member at a premium, or paying royalties
to the first member in an excessive amount. In such case,
the value of the benefits received by the first member as
a result of the other activities will be set off against the
allocation which would otherwise be made. If the effect
of the set-off is to change the characterization or source
of the income or deductions, or otherwise distort taxable
income, in such a manner as to affect the United States
tax liability of any member, allocations will be made to
reflect the correct amount of each category of income or
deductions. In order to establish that a set-off to the ad-
justments proposed by the district director is appropriate,
the taxpayer must notify the district director of the basis
A-38
of any claimed set-off at any time before the expiration
of the period ending 30 days after the date of a letter by
which the district director transmits an examination re-
port notifying the taxpayer of proposed adjustments or
before July 16, 1968, whichever is later. The principles
of this subparagraph may be illustrated by the following
examples, in each of which it is assumed that P and S
are calendar year corporations and are both members of
the same group of controlled entities:
Example (1). P performs services in 1966 for the benefit
of S in connection with S’s manufacture and sale of a
product. S does not pay P for such services in 1966, but
in consideration for such services, agrees in 1966 to pay
P a percentage of the amount of sales of the product in
1966 through 1970. In 1966 it appeared this agreement
would provide adequate consideration for the services. No
allocation will be made with respect to the services per-
formed by P.
Example (2). P renders services to S in connection with
the construction of S’s factory. An arm’s length charge
for such services, determined under paragraph (b) of
§ 1.482-2, would be $100,000. During the same taxable year
P makes available to S a machine to be used in such con-
struction. P bills S $125,000 for the services, but does not
bill for the use of the machine. No allocation will be made
with respect to the excessive charge for services or the
undercharge for the machine if P can establish that the
excessive charge for services was equal to an arm’s length
charge for the use of the machine, and if the taxable in-
come and income tax liabilities of P and S are not distorted.
Example (3). Assume the same facts as in example (2),
except that, if P had reported $25,000 as rental income and
A-39
$25,000 less service income, it would have been subject to the
tax on personal holding companies. Allocations will be
made to reflect the correct amounts of rental income and
ser\ ce income.
(4) If the members of a group of controlled taxpayers
engage in transactions with one another, the district direc-
tor may distribute, apportion, ‘or allocate income, deduc-
tions, credits, or allowances to reflect the true taxable in-
come of the individual members under the standards set
forth in this section and in § 1.482-2 notwithstanding the
fact that the ultimate income anticipated from a series of
transactions may not be realized or is realized during a
later period. For example, if one member of a controlled
group sells a product at less than an arm’s length price to
a second member of the group in one taxable year and the
second member resells the product to an unrelated party in
the next taxable year, the district director may make an
appropriate allocation to reflect an arm’s length price for
the sale of the product in the first taxable year, notwith-
standing that the second member of the group had not
realized any gross income from the resale of the product in
the first year. Similarly, if one member of a group lends
money to a second member of the group in a taxable year,
the district director may make an appropriate allocation
to reflect an arm’s length charge for interest during such
taxable year even if the second member does not realize
income during such year. The provisions of this subpara-
graph apply even if the gross income contemplated from a
series of transactions is never, in fact, realized by the other
members.
(5) Section 482 may, when necessary to prevent the
avoidance of taxes or to clearly reflect income, be applied
in circumstances described in sections of the Code (such
A440
as section 351) providing for nonrecognition of gain or loss.
See, for example, National Securities Corporation v. Com-
missioner of Internal Revenue, 137 F.2d 600 (3rd Cir. 1943),
cert. denied 320 U. S. 794 (1943).
(6) If payment or reimbursement for the sale, exchange,
or use of property, the rendition of services, or the advance
of other consideration among members of a group of con-
trolled entities was prevented, or would have been pre-
vented, at the time of the transaction because of currency
or other restrictions imposed under the laws of any for-
eign country, any distributions, apportionments, or alloca-
tions which may be made under section 482 with respect
to such transactions may be treated .s deferrable income or
deductions, providing the taxpayer has, for the year to
which the distributions, apportionments, or allocations re-
late, elected to use a method of accounting in which the re-
porting of deferrable income is deferred until the income
ceases to be deferrable income. Under such method of ae-
counting, referred to in this section as the deferred income
method of accounting, any payments or reimbursements
which were prevented or would have been prevented, and
any deductions attributable directly or indirectly to such
payments or reimbursements, shall be deferred until they
cease to be deferrable under such method of accounting. If
such method of accounting has not been elected with respect
to the taxable year to which the allocations under section
482 relate, the taxpayer may elect such method with respect
to such allocations (but not with respect to other deferrable
ineome ) at any time before the first occurring of the follow-
ing events with respect to the allocations:
(i) Execution by the taxpayer of Form 870 (Waiver of
Restrictions on Assessment and Collection of Deficiency in
Tax and Acceptance of Overassessment) ;
—
Al
(ii) Expiration of the period ending 30 days after the
date of a letter by which the district director transmits an
examination report notifying the taxpayer of the proposed
adjustments reflecting such allocations or before July 16,
1968, whichever is later; or
(iii) Exeeution of a closing agreement or offer-in-com-
promise. The principles of this subparagraph may be illus-
trated by the following example in which it is assumed that
X, a domestic corporation, and Y, a foreign corporation, are
members of the same group of controlled entities:
Example. X, which is in the business of rendering a cer-
tain type of service to unrelated parties, renders such ser-
vices for the benefit of Y in 1965. The direct and indirect
costs allocable to such services are $60,000, and an arm’s
length charge for such services is $100,000. Assume that the
district director proposes to increase X’s income by $100,-
000, but that the country in which Y is located would have
blocked payment in 1965 for such services. If, prior to the
first occurring of the events described in subdivisions (i),
(ii), or (iii) of this subparagraph, X elects to use the de-
ferred income method of accounting with respect to such
allocation, the $100,000 allocation and the $60,000 of costs
are deferrable until such amounts cease to be deferrable
under X’s method of accounting. [Reg. § 1.482-1.]
§ 1.482-2. DeTerRMINaTION OF TAXABLE INCOME IN SPECIFIC
siTuaTions.—(a) Loans or advances—(1) In general.
Where one member of a group of controlled entities makes
a loan or advance directly or indirectly to, or otherwise
becomes a creditor of, another member of such group, and
eharges no interest, or charges interest at a rate which is
not equal to an arm’s length rate as defined in subpara-
graph (2) of this paragraph, the district director may make
A-42
appropriate allocations to reflect an arm’s length interest
rate for the use of such loan or advance.
(2) Arm’s length interest rate. For the purposes of this
paragraph, the arm’s length interest rate shall be the rate
of interest which was charged, or would have been charged
at the time the indebtedness arose, in independent transac-
tions with or between unrelated parties under similar cir-
cumstances.
© . o
(b) Performance of services for another—(1) General
rule. Where one member of a group of controlled entities
performs marketing, managerial, administrative, technical,
or other services for the benefit of, or on behalf of another
member of the group without charge, or at a charge which is
not equal to an arm’s length charge as defined in subpara-
graph (3) of this paragraph, the district director may make
appropriate allocations to reflect an arm’s length charge
for such services.
(3) Arm’s length charge. For the purpose of this para-
graph an arm’s length charge for services rendered shall
be the amount which was charged or would have been
charged for the same or similar services in independent
transactions with or between unrelated parties under
similar circumstances considering all relevant facts.
(c) Use of tangible property—(1) General rule. Where
possession, use, or occupancy of tangible property owned
or leased by one member of a group of controlled entities
(referred to in this paragraph as the owner) is transferred
by lease or other arrangement to another member of such
—
A-43
group (referred to in this paragraph as the user) without
charge or at a charge which is not equal to an arm’s length
rental charge (as defined in subdivision (i) of subpara-
graph (2) of this paragraph), the district director may
make appropriate allocations to properly reflect such arm’s
length charge. Where possession, use, or occupancy of
only a portion of such property’ is transferred, the deter-
mination of the arm’s length charge and the allocation shall
be made with reference to the portion transferred.
(2) Arm’s length charge. (i) For the purposes of this
paragraph, an arm’s length rental charge shall be the
amount of rent which was charged, or would have been
charged for the use of the same or similar property, dur-
ing the time it was in use, in independent transactions
with or between unrelated parties under similar circum-
stances considering the period and location of the use, the
owner’s investment in the property or rent paid for the
property, expenses of maintaining the property, the type
of property involved, its condition, and all other relevant
facts.
* * .
(d) Transfer or use of intangible property—(1) In gen-
eral. (i) Except as otherwise provided in subparagraph
(4) of this paragraph, where intangible property or an
interest therein is transferred, sold, assigned, loaned, or
otherwise made available in any manner by one member of
a group of controlled entities (referred to in this paragraph
as the transferor) to another member of the group (refer-
red to in this paragraph as the transferee) for other than
an arm’s length consideration, the district director may
make appropriate allocations to reflect an arm’s length con-
sideration for such property or its use.
A44
(2) Arm’s length consideration. (i) An arm’s length
consideration shall be in a form which is consistent with
the form which would be adopted in transactions between
unrelated parties under the same circumstances.
(e) Sales of tangible property—(1) In general. (i)
Where one member of a group of controlled entities (re-
ferred to in this paragraph as the “seller”) sells or other-
wise 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 re-
ferred 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 con-
trolled sale. Since unrelated parties normally sell prod-
ucts 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, respectively, the comparable uncontrolled price
method, the resale 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
A-45
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 appli-
cation 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 deter-
mined 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 subparagraph
(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 manu-
facturer sells products to a related entity which performs
substantial manufacturing, assembly, or other processing
of the product or adds significant value by reason of its
utilization of its intangible 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 sub-
paragraph are met, such method must, for the purposes of
this paragraph, be utilized unless the taxpayer can estab-
lish that, considering all the facts and circumstances, some
oo
A-46
method 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 ina
particular case, some appropriate method of pricing other
than those described in subdivision (ii) of this subpara-
graph, or variations on such methods, can be used.
(iv) The methods of determining arm’s length prices de-
scribed in this section are stated in terms of their applica-
tion 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 deter-
mined 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 sub-
paragraph.
A-47
(ii) “Uncontrolled sales” are sales in which the seller
and the buyers are not members of the same controlled
group. These include (a) sales made 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 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 un-
realistic 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 com-
parable to controlled sales if the physical property and cir-
cumstances 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 differences 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 dif-
ferences render sales noncomparable, depends upon the
— NEAL LESLIE TI ORCL AMPS A EELS SIE ape RW SR
Gee,
particular circumstances and property involved. The prin-
ciples of this subdivision may be illustrated by the follow-
ing 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 surround-
ing the controlled and the uncontrolled sales are identical,
except for the fact that the controlled sales price is a de-
livered price and the uncontrolled sales are made f. o. 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 nor-
mally render the uncontrolled sales noncomparable to the
controlled sales.
A48
Example (2). Assume that the circumstances surround-
ing the controlled and uncontrolled sales are identical, ex-
cept for the fact that X affixes its valuable trademark in|
the controlled sales, and does not affix its trademark in
uncontrolled sales. Since the effects on price of differences
in intangible property associated with the sale of tangible :
property, such as trademarks, are normally not reasonably
ascertainable, such differences would normally render the
uncontrolled sales noncomparable.
Example (3). Assume that the circumstances surround-
ing the controlled and uncontrolled sales are identical ex-
cept for the fact that X, a manufacturer of business ma-
chines, 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 gen-
A-49
erally have a definite and reasonably ascertainable effect on
prices, such differences do not normally render the uncon-
trolled sales noncomparable to the controlled sales.
(iii) Where there are two or more comparable uncon-
trolled sales susceptible of adjustment as defined in sub-
division (ii) of this subparagraph, the comparable uncon-
trolled sale or sales requiring the fewest and simplest ad-
justments provided in subdivision (ii) of this subparagraph
should generally be selected. Thus, for example, if a tax-
payer makes comparable uncontrolled sales of a particular
product which differ from the controlled sale only with re-
spect 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 differ-
ing only with respect to terms of delivery should be selected
as the comparable uncontrolled sale.
(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 prod-
uct, for a time, in order to introduce his product into an
area or in order to meet competition. However, controlled
sales may be priced in such a manner only if such price
would have been charged in an uncontrolled sale under com-
parable circumstances. Such fact may be demonstrated by
showing that the buyer in the controlled sale made corre-
sponding reductions in the resale price to uncontrolled
purchasers, or that such buyer engaged in substantially
greater sales promotion activities with respect to the prod-
a 2G ENTERAL RTS, FONT ENR RR REE LE TY
ie
A-50
uct involved in the controlled sale than with respect to other
products. For example, assume X, a manufacturer of bat-
teries, 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 sales of other products.
Under these circumstances 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 re-
sult 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 sub-
paragraph), reduced by an appropriate markup, and ad-
justed as provided in subdivision (ix) of this subparagraph.
An appropriate markup is computed by multiplying the
applicable resale price by the appropriate markup percent-
age 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 uncontrolled 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
A-51
$80 ($100 minus 20 percent < $100), adjusted as provided
in subdivision (ix) of this subparagraph.
(ii) 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 sub-
division (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 al-
teration. os
(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 aa arm’s length price than
the use of the cost plus method. Thus, even though one of
the requirements of such subdivision is not satisfied, the
resale price method may nevertheless be more appropriate
A-52
than the cost plus method because the computations and
evaluations required under the former method may be fewer
and easier to make than under the latter method. In gen-
eral, 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 prod-
uct 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 com-
ponent 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 con-
trolled 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 con-
A-53
trolled sale after attaching its valuable trademark to it.
Assume further that it can be demonstrated through com-
parison 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 evaluate in applying
the cost plus method because no reasonable standard of
comparison is available. Although the controlled 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 computations and
evaluations which are fewer and easier to make than under
the cost plus method. This is because, under the circum-
stances, 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 “appli-
cable resale price” is the price at which it is anticipated
that property purchased in the controlled sale will be re-
sold 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 in-
volved.
(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 uncontrolled sale, providing that the series of sales
as a whole meets all the requirements of subdivision (ii)
—
A-54
of this subparagraph or that the resale price method is
used pursuant to subdivision (iii) of this subparagraph.
In such ease, 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 con-
trolled sale, and Z sells the product in an uncontrolled
sale, the resale price method must be used if Y and Z to-
gether have not added more than an insubstantial amount
to the value of the product through physical alteration or
the application of intangible property, and the final resale
occurs within a reasonable time of the sale from X to Y.
In such ease, 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 appro-
priate 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 un-
controlled 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
A-55
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 prob-
able 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 simi-
larity 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.
(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 made 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, evi-
dence of an appropriate markup percentage may be de-
rived from resales by other resellers selling in the same
or a similar market in which the controlled buyer (re-
seller) is selling, providing such resellers perform compar-
able functions. Where the function performed by the
A-56
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 con-
stitute the appropriate markup percentage. If the con-
trolled buyer (reseller) is located in a foreign country
and information on resale by other resellers in the same
foreign market is not available, then markup percentages
earned by United States resellers performing comparable
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 caleulating 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 uncon-
trolled purchases and resales should enter into such com-
putation in the case of the property involved in the con-
trolled purchases and resales. Thus, if freight-in and
packaging expense are elements of the cost of goods sold
in comparable uncontrolled purchases, then 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 uncon-
trolled 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 differ-
ences 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 sub-
division are those differences in functions or cireum-
stances which have a definite and reasonably ascertain-
able effect on price. The principles of this subdivision
may be illustrated by the following example:
A-57
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 uncon-
trolled 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 pro-
vide 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).
(4) Cost plus method. (i) Under the pricing method de-
scribed as the “cost plus method”, the arm’s length price
of a controlled sale of property shall be computed by add-
ing to the cost of producing such property (as computed
in subdivision (ii) of this subparagraph), an amount which
is equal to such cost multiplied by the appropriate gross
profit percentage (as computed in subdivision (iii) of this
subparagraph), plus or minus any adjustments as provided
in subdivision (v) of this subparagraph.
t
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(ii) For the purposes of this subparagraph, the cost of
producing the property involved in the controlled sale, and
the costs which enter into the computation of the appro-
priate gross profit percentage shall be computed in a con-
sistent manner in accordance with sound accounting prac-
tices for allocating or apportioning costs, with neither
favors nor burdens controlled sales in comparison with
uncontrolled sales. Thus, if the costs used in computing
the appropriate gross profit percentage are comprised of
the full cost of goods sold, including direct and indirect
costs, then the cost of producing the property involved in
the controlled sales must be comprised of the full cost of
goods sold, including direct and indirect costs. On the other
hand, if the costs used in computing the appropriate gross
profit percentage are comprised only of direct costs, the
eost of producing the property involved in the controlled
sale must be comprised only of direct costs. The term “cost
of producing”, as used in this subparagraph, includes the
cost of acquiring property which is held for resale.
(iii) For the purposes of this subparagraph, the appro-
priate gross profit percentage is equal to the gross profit
percentage (expressed as a percentage of cost) earned by
the seller or another party on the uncontrolled sale or sales
of property which are most similar to the controlled sale
in question. The following are the most important charac-
teristics to be considered in determining the similarity of
the uncontrolled sale or sales:
(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 seller with re-
spect to the property sold. For example: contract
ea
manufacturing, product assembly, selling activity,
processing, servicing, delivering.
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(c) The effect of any intangible property used by
the seller in connection with the property sold. For
example: patents, trademarks, trade names.
(d) The geographic market in which the functions
are performed by the seller.
In general, the similarity to be sought relates to the prob-
able effect upon the margin of gross profit of any differ-
ences in such characteristics between the uncontrolled sales
and the controlled sale. Thus, close physical similarity of
the property involved in the sales compared is not required
under the cost plus method since a lack of close physical
similarity is not necessarily indicative of dissimilar profit
margins. See subparagraph (2) (iv) of this paragraph, re-
lating to sales made at less than a normal profit for the
primary purpose of establishing or maintaining a market.
(iv) Whenever possible, gross profit percentages should
be derived from uncontrolled sales made by the seller in-
volved in the controlled sale, because similar characteristics
are more likely to be found among sales of property made
by the same seller than among sales made by other sellers.
In the absence of such sales, evidence of an appropriate
gross profit percentage may be derived from similar un-
controlled sales by other sellers whether or not such sellers
are members of the controlled group. Where the function
performed by the seller is similar to the function per-
formed by a purchasing agent which does not take title,
such purchasing agent will be considered a seller for the
purpose of determining an appropriate gross profit per-
centage under this subparagraph and the commission
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earned by such purchasing agent, expressed as a percentage
of the purchase price of the goods, may constitute the ap-
propriate gross profit percentage. In the absence of data
on gross profit percentages of particular sales or groups
of sales which are similar to the controlled sale, the pre-
vailing gross profit percentages in the particular industry
involved may be appropriate.
(v) Where the most similar sale or sales from which
the appropriate gross profit percentage is derived differ
in any material respect from the controlled sale, the arm’s
length price which is computed by applying such percent-
age must be adjusted to reflect such differences to the
extent such differences would warrant an adjustment of
price in uncontrolled transactions. The differences referred
to in this subdivision are those differences which have a
definite and reasonably ascertainable effect on price. [Reg.
§ 1.482-2.]
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.