Opinion ID: 561780
Heading Depth: 2
Heading Rank: 4

Heading: The Royalty Rate for B & L's Intangibles.

Text: 48 The relevant regulation provides two methods for determining an arm's-length price for the transfer or use of intangible property. If the transferor has made similar transfers to unrelated parties, the amount of the consideration for such transfers shall generally be the best indication of an arm's length consideration. Sec. 1.482-2(d)(2)(ii). In the absence of an adequately similar transaction, the arm's-length consideration may be determined with reference to a lengthy list of applicable factors. Sec. 1.482-2(d)(2)(iii). 49 The 1981 licensing agreement provided that B & L Ireland would pay royalties to B & L in the amount of five percent of B & L Ireland's total sales. Conceding that this royalty was unreasonably low, B & L presented expert opinions at trial that an arm's-length consideration would have been five percent of the average price realized by B & L and its subsidiaries upon the sale of the lenses to unrelated third parties (ARP). The Commissioner's experts calculated a much higher rate, between twenty-seven and thirty-three percent of ARP. 50 The Tax Court rejected the positions presented by both parties' experts. Concluding that there were no sufficiently similar transactions upon which to base an arm's-length rate, the court focused on two of the factors listed in the applicable regulation: the [p]rospective profits to be realized ... by the transferee through its use ... of the property, and the capital investment and starting up expenses required of the transferee. Sec. 1.482-2(d)(2)(iii)(g) and (h). The court relied primarily upon a proposal made by B & L to the IDA in early 1980, related internal B & L projections, and especially a Special Expenditure Application (SEA) submitted to B & L management on October 15, 1980 with respect to the Waterford facility as the best indications of (1) the profits that an independent entrepreneur would anticipate from the use of spin cast technology, and (2) the capital investment required to generate those profits. 51 The Tax Court made two adjustments to the SEA projections in order to reflect the approach of a prudent investor in the circumstances. First, the court reduced the projected output at the Waterford facility during the years 1986 through 1989 to account for anticipated erosion in the demand for both standard and thin lens sales as prolonged wear lenses made of new materials became available. Second, the court made reductions in projected transfer prices for 1983 and beyond on the basis that lower cost competitors would enter the market and drive down prices. 52 Reasoning that the purpose of a licensing agreement is to divide the profits attributable to use of the licensed intangibles, the Tax Court then reached the following determination: 53 Using our best judgment, we find that at arm's length B & L Ireland would have been willing to invest in the lens production facility even if required to share approximately 50 percent of the profits therefrom with B & L as consideration for use of its intangibles.... [T]his equates to a royalty rate of 20 percent of [B & L Ireland's] net sales. 54 92 T.C. at 611; cf. G.D. Searle & Co., 88 T.C. at 376 (royalty rate determined on basis of court's best judgment based on a consideration of the entire record before [it]); Ciba-Geigy Corp. v. Commissioner, 85 T.C. 172, 236 (1985) (same). 55 In response to this analysis, the Commissioner contends that the SEA projections did not correspond to the actual experience of the parties because: (1) the Waterford facility ended up with greater manufacturing capacity than the projections had assumed; and (2) a decision was made in late 1981 for that facility to maximize lens production by producing for the United States market, whereas the SEA projections assumed production primarily or exclusively for foreign markets. Since the license agreement between B & L and B & L Ireland was terminable at will, the Commissioner contends, B & L would have scrapped the agreement, if dealing at arm's length with an independent party, and insisted upon the negotiation of new terms. 56 We are not persuaded. Considerable deference to the Tax Court's evaluation of trial evidence, and especially expert testimony, is appropriate in appellate review of this sort of complex factual determination. See Eli Lilly & Co., 856 F.2d at 872. Here, as in R.T. French Co. v. Commissioner, 60 T.C. 836 (1973), another case involving section 482 reallocation of royalties paid to a foreign affiliate, the Tax Court was entitled to conclude that [w]hat later transpired in no way detracted from the reasonableness of the agreement when it was made. Id. at 852. 57 It is true that in R.T. French Co. the agreement had a fixed term, see id., whereas here the agreement between the parties was terminable at will. We regard this as too thin a foundation, however, for the Commissioner's argument that B & L would surely have terminated the agreement and negotiated new terms if dealing with an independent licensee, at least in the absence of a fuller record as to the manufacturing alternatives available to B & L at the time it was decided to increase lens production at B & L Ireland. Cf. Sunstrand Corp., slip op. at 169 (rejecting ready availability of alternative source of manufacture in view of specialized manufacturing know-how required to produce complex avionic device). Accordingly, we perceive no basis to reject the Tax Court's carefully considered determination as clearly erroneous.