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

Heading: Independent Significance of Transfer Price and Royalty Rate.

Text: 30 The Tax Court framed this issue in the following terms: 31 As a preliminary matter, we must first address [the Commissioner's] contention that it is inappropriate to analyze the transfer price and royalty rate used by B & L separately, on the theory that B & L and B & L Ireland would have constructed their relationship in a different manner had they been conducting their affairs at arm's length. [The Commissioner] argues that B & L would never have agreed to license its spin cast technology which allowed it to produce soft contact lenses for approximately $1.50 per lens and then purchase lenses from the licensee for $7.50 per lens. [The Commissioner] argues that B & L would have been unwilling to pay an independent third party much more than its costs would have been had it chosen to produce the contact lenses itself. [The Commissioner] is indifferent as to whether the royalty is increased or the transfer price is decreased as long as the result is that B & L Ireland receives only its costs of production and a reasonable mark up. In essence, [the Commissioner] argues that B & L Ireland was little more than a contract manufacturer the sale of whose total production was assured and who thus was not entitled to the return normally associated with an enterprise which bears the risk as to the volume of its product it will be able to sell and at what price. 92 T.C. at 583. 3 32 The Commissioner's position is not without force. It failed, however, to persuade the Tax Court, which concluded that B & L was not committed to purchase the entire output of B & L Ireland, and that B & L Ireland accordingly should not be considered a contract manufacturer entitled only to a modest markup on its manufacturing costs. 92 T.C. at 584; see also Eli Lilly & Co., 856 F.2d at 863-64 & n. 9 (rejecting Commissioner's contract manufacturer contention); G.D. Searle & Co. v. Commissioner, 88 T.C. 252, 373 (1987) (same). The Tax Court further noted that B & L Ireland was not guaranteed a continuing $7.50 resale price, and that the price declined to $6.50 in 1983 as a result of market pressures. 92 T.C. at 584. It is undoubtedly true, as the Commissioner contends, that B & L was in a general sense committed to the success of B & L Ireland. We nonetheless find no clear error in the Tax Court's conclusion that: 33 The most that can be said is that B & L Ireland had certain expectations as to the volume and price of lenses it could anticipate selling to B & L or its affiliates. However, such expectations are no different than those which any supplier has with regard to the business of a major customer and do not constitute a guarantee which effectively insulated B & L Ireland from market risks. 34 Id.; accord, Sundstrand Corp. v. Commissioner, 96 T.C. No. 12, slip op. at 187 (Feb. 19, 1991). 35 Furthermore, the structure of the Commission's regulations argues against the contract manufacturer thesis advanced by the Commissioner. The allowance of a markup of production costs, as the contract manufacturer theory postulates and as the Commissioner's notice of deficiency in this case explicitly provided (D.A. 74), is simply an application of the cost-plus method provided in the Commissioner's regulations. See Treas.Reg. Sec. 1.482-2(e)(4). Those regulations explicitly provide, however, that the comparable uncontrolled price method is to be utilized, in preference to the cost-plus method, if the conditions for application of the former method are satisfied. See Treas.Reg. Sec. 1.482-2(e)(1)(ii). Since, as will hereinafter appear, we find those conditions to be fulfilled in this case, we are accordingly constrained by section 1.482-2(e)(1)(ii) to reject the Commissioner's contention that B & L Ireland should be treated as a contract manufacturer. 36 We therefore proceed to independent consideration of the Tax Court's treatment of the transfer price paid by B & L for the lenses manufactured by B & L Ireland, and the royalty rate paid by B & L Ireland to B & L for the use of B & L's intangibles. 37