CCA 200033016: Puerto Rico location savings under a section 936 cost sharing election

Plain-English summary

Chief Counsel advised a district office about a Puerto Rico manufacturer whose parent claimed location savings after the subsidiary was treated as having made a section 936(h) cost sharing election. The advice concludes that, while Rev. Proc. 63-10 remains in effect, its location savings method can apply despite that election, without changing the answer for comparable uncontrolled manufacturers or market bargaining positions. The conclusion depends on the taxpayer proving that the claimed savings exist and how much they are. The memorandum also warns that the same savings must be reflected consistently in intangible profit and intercompany pricing to avoid double counting, and it assumes a valid timely cost sharing election.

Ruling snapshot

• Question: May a Puerto Rico manufacturer claim location savings under Rev. Proc. 63-10 after a section 936(h) cost sharing election, despite arm's length market comparables?
• Outcome: Advice given. The method remains available while Rev. Proc. 63-10 is in effect, subject to proof of the savings and consistent pricing without double counting.
• Key authorities: IRC §§ 936(h)(5)(C)(i) and 482; Rev. Proc. 63-10 and Rev. Proc. 68-22; Treas. Reg. §§ 1.482-1T and 1.482-1.

Full text (IRS public release)

                            DEPARTMENT OF THE TREASURY
                                 I NTERNAL REVENUE SERVI CE
                                    WASHINGTON, D.C. 20224




Number: 200033016
Release Date: 8/18/2000
CC:INTL:BR6
TL-N-4847-99
UILC: 936.00-00

  INTERNAL REVENUE SERVICE NATIONAL OFFICE FIELD SERVICE ADVICE

DATE:                 May 15, 2000

MEMORANDUM FOR DISTRICT COUNSEL
               CONNECTICUT – RHODE ISLAND CC:NER:CTR:HAR

FROM:                 Steven A. Musher
                      Chief CC:INTL:BR6

SUBJECT:

This Field Service Advice responds to your memorandum dated March 15, 2000.
Field Service Advice is not binding on Examination or Appeals and is not a final
case determination. This document is not to be used or cited as precedent.

LEGEND

 Amount A                    =
 Date 1                      =
 Product A                   =


 Sub                         =
 Taxable Year 1              =
 Taxable Year 2              =
 USCo                        =
 Year X                      =
                                          2


ISSUE:

Whether Sub, a taxpayer that has made a cost sharing election under I.R.C.
§ 936(h)(5)(C)(i), is entitled to location savings under Rev. Proc. 63-10, 1963-1
C.B. 490. If so, whether this answer would be affected by a consideration of
comparable uncontrolled manufacturers operating at arm’s length and the
competitive positions of buyers and sellers in the relevant market. See Treas. Reg.
§ 1.482-1(d)(4)(ii)(C) (1994).

CONCLUSION:

As long as Rev. Proc. 63-10 is in effect, the benefit of location savings pursuant to
section 3.02(3) of Rev. Proc. 63-10 is available to a taxpayer that has made a cost
sharing election under section 936(h)(5)(C)(i). This answer would not be affected
by a consideration of comparable uncontrolled manufacturers operating at arm’s
length and the competitive positions of buyers and sellers in the relevant market.

FACTS:

USCo, a leading manufacturer of Product A, filed consolidated Federal income tax
returns for Taxable Year 1 and Taxable Year 2. USCo manufactures the majority of
its Product A itself.

Sub is a United States corporation owned by USCo. Sub began operations in Year
X and remains actively engaged in manufacturing Product A. For taxable years
beginning on Date 1, Sub elected the section 936(a) Puerto Rico and possession
tax credit.

For the purposes of this advice, we assume Sub is treated as having timely filed a
valid cost sharing election under section 936(h)(5)(C)(i).

Citing Rev. Proc. 63-10, USCo has claimed for Taxable Years 1 and 2 that Sub is
entitled to approximately $ Amount A in location cost savings attributable to the fact
that Sub operates in Puerto Rico, in addition to whatever profit Sub would otherwise
be entitled to based on beneficial ownership of manufacturing intangibles. The
majority (85% to 90%) of the location savings relate to “burden” (general overhead
such as utilities), with the remainder attributable to labor savings.

LAW AND ANALYSIS:

Section 482 provides that the Secretary may allocate income, deductions, credits
and allowances between two or more commonly controlled organizations, trades, or
                                            3


businesses in order to prevent evasion of taxes or to clearly reflect the income of
any of such organizations, trades, or businesses. The temporary 1993 section 482
regulations are applicable to the taxable years at issue here,1 unless USCo has
made an election to apply the 1994 section 482 regulations retroactively.2 See
Treas. Reg. § 1.482-1(j)(2) (1994).

Where applicable,3 Temp. Treas. Reg. § 1.482-1T(b)(2)(iii) (1993) provides:

      The arm's length result of a controlled transaction must be determined
      under the method that provides the most accurate measure of an arm's
      length result under the facts and circumstances of the transaction
      under review. The factors to be considered in selecting a method
      include the completeness and accuracy of the data used to apply each
      method, the degree of comparability between controlled and
      uncontrolled transactions, and the number, magnitude, and accuracy
      of the adjustments required to apply each method. An arm’s length
      result may be determined under any of the available methods without
      first establishing the inapplicability of any other method. If additional
      evidence becomes available permitting the application of another
      method that is more accurate, the district director will apply such
      method to determine an arm’s length result.[4]

Furthermore, Temp. Treas. Reg. § 1.482-1T(c)(4)(ii)(C) (1993) provides:

      Location savings. If an uncontrolled taxpayer operates in a different
      geographic market than the controlled taxpayer, adjustments may be
      necessary to account for significant differences in costs attributable to
      the geographic locations. These adjustments must be based on the
      effect such differences may have on the consideration charged or paid
      in the controlled transfer given the relative competitive positions of
      buyers and sellers in each location. Thus, the fact that production is


      1
        The temporary 1993 section 482 regulations are generally effective for taxable
years beginning after April 21, 1993. Temp. Treas. Reg. § 1.482-1T(h) (1993). The
1994 section 482 regulations are generally applicable for taxable years beginning after
October 6, 1994.
      2
          It is our understanding that USCo has not made such an election.
      3
          See supra notes 1 and 2 and accompanying text.
      4
          Treas. Reg. § 1.482-1(c) (1994) contains substantially the same provision.
                                             4


      less costly in the taxpayer’s geographic market ordinarily justifies
      additional profits only where the location savings would increase the
      profits of uncontrolled taxpayers operating at arm’s length, given the
      competitive positions of buyers and sellers in that market.[5]

Temp. Treas. Reg. § 1.482-1T(c)(4)(ii)(D) (1993) contains an example illustrating
these principles. According to this example,

      the fact that production is less costly in Country Y will not, in and of
      itself, justify additional profits derived from lower costs of
      manufacturing in Country Y inuring to [a wholly-owned Country Y
      manufacturer], because of the competitive effects attributable to the
      other producers in similar geographic markets capable of performing
      the same functions at the same low costs.[6]

While it remains in effect, Rev. Proc. 63-10, 1963-1 C.B. 490, sets forth guidelines
to be followed for the application of section 482 in cases involving the allocation of
income and expenses between U.S. companies and their Puerto Rican
manufacturing affiliates. The revenue procedure antedated the 1968 section 482
regulations and is generally consistent with these regulations, except to the extent
that it allocated location savings to Puerto Rican affiliates regardless of whether
such an allocation would have occurred in the market. Section 3.02(3) of Rev.
Proc. 63-10 provides that in situations where there are no independent prices, and
the product involved "represents a type which is manufactured in the United States
or for which it is reasonable to assume that the mainland affiliate could, without
incurring a loss, have contracted for United States manufacture," the best
approximation of the arm's length price is the price necessary to induce a U.S.
manufacturer to produce in the United States the product in question for the
mainland affiliate, adjusted for any differences in costs incident to transportation.
In effect, the methodology takes the expenditures of the Puerto Rican entity and
adjusts them by any increases or decreases that would have resulted from
conducting the activity in the United States and then allows the Puerto Rican entity
a profit margin equivalent to that realized by similar U.S. manufacturers. This
provision allocates all income or loss resulting from the choice of Puerto Rico as
the manufacturing venue (i.e., location savings) to the Puerto Rican affiliate.




      5
        Treas. Reg. § 1.482-1(d)(4)(ii)(C) (1994) contains substantially the same
provision.
      6
          Treas. Reg. § 1.482-1(d)(4)(ii)(D) (1994) contains a similar example.
                                          5


We note that Rev. Proc. 68-22, 1968-1 C.B. 819, which concerned the application
of the 1968 section 482 regulations, provided that the Service would continue to
use the guidelines contained in Rev. Proc. 63-10 in cases involving the allocation
of income and deductions between U.S. companies and their Puerto Rican affiliates
where the result was more taxpayer-favorable than that reached under the section
482 regulations. 1968-1 C.B. at 821.

Pursuant to the cost sharing election under section 936(h)(5)(C)(i), Sub must bear
its portion of the related group's product area research expenses and is treated as
owning the nonmarketing intangibles associated with the products it manufactures
for purposes of earning a return on such intangibles. As a consequence of the
election, USCo and Sub are required to determine the intercompany pricing of the
products manufactured by Sub under the appropriate section 482 pricing method
(see I.R.C. § 936(h)(5)(C)(i)(IV)(b)). Use of the resale price method may not be
denied merely because the reseller adds more than an insubstantial amount to the
value of the products by the use of intangible property. Id.; Treas. Reg. § 1.936-
6(a)(5) Q&A 13.

In 1982, Congress made its own determination as to how it wanted income/profits to
be split between U.S. entities and their Puerto Rican manufacturing affiliates. In
essence, section 936(h) offers Puerto Rican manufacturers and their U.S. affiliates
the choice of splitting their total combined income 50-50 or paying an appropriate
share of product area research expenses and receiving a return on the
manufacturing intangibles portion of the arm’s length price of the products. Section
936(h)(5)(C)(i)(IV)(b) specifically provides that a company electing cost sharing
shall determine its intercompany pricing under the appropriate section 482 method.
Because the cost plus location savings method of Rev. Proc. 63-10 is not a method
provided in the section 482 regulations, the automatic allocation of location savings
to a Puerto Rican affiliate is arguably contrary to section 936(h)(5)(C)(i)(IV)(b).

The legislative history of section 936(h) does not make clear whether Rev. Proc.
63-10 should continue to apply in setting prices after a cost sharing election has
been made. The Conference Report on the Tax Equity and Fiscal Responsibility
Act of 1982 (TEFRA), H.R. Rep. 97-760, 97th Cong., 2d Sess. p. 510 (Aug. 17,
1982), contains a paragraph discussing pricing if a cost sharing payment is made,
which concludes with the following sentence:

      The regulations under section 482 and Internal Revenue Service
      revenue procedures (Revenue Procedure 63-10, as amplified by
      Revenue Procedure 68-22) will continue to apply except to the extent
      modified by the election.
                                            6


This statement may be interpreted in two different ways. One interpretation is that
the application of Rev. Proc. 63-10 would have to be modified to reflect the fact
that, after a cost sharing election, the island affiliate would be treated as the owner
of the manufacturing intangibles. In all other respects, the revenue procedure
would continue to apply. Because this sentence is included in a section specifically
dealing with pricing after a cost sharing election has been made, it could be argued
that Congress intended the special benefits of Rev. Proc. 63-10, as confirmed by
Rev. Proc. 68-22, to continue to apply after TEFRA in connection with calculating
transfer prices.

A second interpretation of the legislative history is that because the quoted
sentence does not specifically mention location savings, the cost plus pricing
method of Rev. Proc. 63-10 would be modified/eliminated by a section 936(h)
election, specifically by the provision in section 936(h)(5)(c)(i)(IV)(b) stating that if
an election of the cost sharing method is in effect, the electing corporation must
determine its intercompany pricing under the appropriate section 482 method
(subject to the expressly provided flexibility regarding the resale price method).

In light of the ambiguity of the legislative history, one could conclude that the
language of the statute should stand on its own — i.e., "the electing corporation
shall determine its intercompany pricing under the appropriate section 482 method.”
However, as long as Rev. Proc. 63-10 is in effect, the pricing method of section
3.02(3) should continue to be given effect when a section 936(h) cost sharing
election has been made. It should be noted that, if location savings are taken into
account, they should be taken into account both for purposes of calculating the
income attributable to manufacturing intangibles and in setting intercompany prices,
so as to avoid double counting.

Our conclusion is predicated on the taxpayer establishing an appropriate factual
basis for the claimed location savings – i.e., the existence and amount of the
location savings.

The existence of arm’s length transactions involving similar products between
unrelated buyers and sellers in the relevant geographic markets will not affect this
conclusion. As noted above, the cost plus method of Rev. Proc. 63-10 does not
follow the arm’s length standard as currently embodied in the section 482
regulations.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

1.     Examination indicates that there is a factual dispute regarding the existence
       and amount of the location savings in this case. The taxpayer’s burden in
                                          7


      establishing and quantifying any location savings is no different from that for
      any other factual issue in a transfer pricing case.

2.    Because USCo has provided very little information on the calculation of its
      transfer prices, the above discussion is necessarily abstract. It is stated in
      the request for advice that the taxpayer has claimed location savings “in
      addition to whatever profit [Sub] would otherwise be entitled to based on
      beneficial ownership of [manufacturing] intangibles.”




                                  Naturally, it would not be correct to allocate to Sub
      a return to non-existent intangibles. Furthermore, since the cost plus/
      location savings method allocates location savings to the Puerto Rican
      affiliate without regard to how the market would have allocated any location
      savings at arm’s length, adding a manufacturing intangible profit (determined
      by reference to comparables) on top of the location savings could result in a
      double counting of profit. Accordingly, as we have stated, if location savings
      are taken into account, they should be taken into account both for purposes
      of calculating the income attributable to manufacturing intangibles and in
      setting intercompany prices, so as to avoid double counting.

3.    Our analysis assumes that Sub is treated as having timely filed a valid cost
      sharing election. We understand that Sub did not make a formal section
      936(h)(5)(C)(i) election but rather that Examination accepted a District
      Counsel recommendation (in a memorandum dated April 15, 1998) that Sub
      be deemed to have timely filed a valid cost sharing election.

Please call (202) 874-1490 if you have any further questions.

                                 By:    STEVEN A. MUSHER
                                        Chief, Branch 6
                                        Office of Associate Chief Counsel,
                                        (International)