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

delivered the opinion of the court:

Taxpayer Du Pont de Nemours, the American chemical concern, created early in 1959 a wholly-owned Swiss marketing and sales subsidiary for foreign sales — Du Pont International S.A. (known to the record and the parties as DISA). Most of the Du Pont chemical products marketed abroad were first sold by taxpayer to DISA, which then arranged for resale to the ultimate consumer through independent distributors. The profits on these Du Pont sales were divided for income tax purposes between plaintiff and DISA via the mechanism of the prices plaintiff charged DISA. For 1959 and 1960 the Commissioner of Internal Revenue, acting under section 482 of the Internal Revenue Code which gives him authority to reallocate profits among commonly controlled enterprises, found these divisions of profits economically unrealistic as giving DISA too great a share. Accordingly, he reallocated a substantial part of DISA’s income to taxpayer, thus increasing the latter’s taxes for 1959 and 1960 by considerable sums. The additional taxes were paid and this refund suit was brought in due course. Du Pont assails the Service’s reallocation, urging that the prices plaintiff charged DISA were valid under the Treasury regulations implementing section 482. We hold that taxpayer has failed to demonstrate that, under the regulation it invokes and must invoke, it is entitled to any refund of taxes.

*337I. Design, Objectives and Functioning of DISA1

A. Du Pont first considered formation of an international sales subsidiary in 1957. A decreasing volume of domestic sales, increasing profits on exports, and the recent formation of the Common Market in Europe convinced taxpayer’s president of the need for such a subsidiary. He envisioned an international sales branch capable of marketing Du Pont’s most profitable type of products — Du Pont proprietary products, particularly textile fibers and elastomers2 specially designed for use as raw materials by other manufacturers. Du Pont had utilized two major marketing techniques to sell such customized products.3 One mechanism consisted of technical sales services: an elaborate set of laboratory services making technical improvements, developing new applications, and solving customer problems for Du Pont products. The other was "indirect selling,” a method of promoting demand for Du Pont products at every point in the distribution chain. These two techniques were to be developed by DISA, Du Pont’s international branch in Europe. DISA was not to displace plaintiffs set of independent European distributors, but rather to augment the distributors’ efforts by the two marketing methods and to police the independents adequately.

B. Neither in the planning stage nor in actual operation was DISA a sham entity; nor can it be denied that it was intended to, and did, perform substantial commercial functions which taxpayer legitimately saw as needed in its *338foreign (primarily European) market. Nevertheless, we think it also undeniable that the tax advantages of such a foreign entity were also an important, though not the primary, consideration in DISA’s creation and operation. During the planning stages, plaintiffs internal memoranda were replete with references to tax advantages, particularly in planning prices on Du Pont goods to be sold to the new entity. The tax strategy was simple. If Du Pont sold its goods to the new international subsidiary at prices below fair market value, that company, upon resale of the goods, would recognize the greater part of the total profit (i.e., manufacturing and selling profits). Since this foreign subsidiary could be located in a country where its profits would be taxed at a much lower level than the parent Du Pont would be taxed here, the enterprise as a whole would minimize its taxes. Cf. Baldwin-Lima-Hamilton Corp. v. United States, 435 F.2d 182, 184 (7th Cir. 1970). The new company’s accumulated profits would be used to finance further foreign investments. The details of this planning are set forth in the findings, and they leave us without doubt that a significant objective of plaintiff was to create a foreign subsidiary which would be able to accumulate large profits with which to finance Du Pont capital improvements in Europe.4

*339C. Consistently with that aim, plaintiffs prices on its intercorporate sales to DISA were deliberately calculated to give the subsidiary the lion’s share of the profits. Instead of allowing each individual producing department to value its goods economically and to set a realistic price,5 Du Pont left pricing on the sales to DISA with the Treasury and Legal Departments. Neither department was competent to set an economic value on goods sold to DISA, and no economic correlation of costs to prices was attempted.6 Rather, an official of the Treasury Department established a pricing system designed to leave DISA with 75 percent of the total profits. If the goods’ cost was greater than DISA’s selling price, the department would price the item at its cost less DISA’s selling expense. This latter provision was designed to insulate DISA from any loss. On the whole, the pricing system was based solely on Treasury and Legal Department estimates of the greatest amount of profits that could be shifted to DISA without evoking IRS intervention.7

As it turned out, for the taxable years involved here, 1959 and 1960, the actual division of total profits between plaintiff and DISA was closer to a 50-50 split. In 1959 *340DISA realized 48.3 percent of the total profits, while in 1960 its share climbed to 57.1 percent. This departure from the original plan was the result of the omission of certain intercorporate transfers — a result not contemplated in the initial pricing scheme.

D. In operation, DISA enjoyed certain market advantages which helped it to accumulate large, tax-free profits. For its technical service function, the subsidiary did not develop its own extensive laboratories (with resulting costs and risks), but could rely on its parent’s laboratory network in the United States and England. DISA was not required to hunt intensively (or pay as highly) for qualified personnel, since in both 1959 and 1960 it drew extensively on its parent’s reservoir of talent. The international company’s credit risks were very low, in part because of a favorable trade credit timetable by Du Pont. DISA also selected its customers to avoid credit losses, having a bad debt provision of less than one-tenth of one percent of sales. Unlike other distributor or advertising service agencies, DISA, because of its special relationship to the Du Pont manufacturing departments, had relatively little risk of termination.8 And as explained supra, Du Pont’s pricing formula was intended to insulate DISA from losses on sales.9

In operating DISA, Du Pont also maximized its subsidiary’s income by funneling a large volume of sales through DISA which did not call for large expenditures by the latter. Many of the products Du Pont sold through DISA required no special services, or already had ample technical services provided. Du Pont routed sales to Australia and South Africa through DISA although the latter provided no additional services to sales in these non-European countries. DISA made sales of commodity-type *341products and opportunistic spot sales to competitors temporarily short in a raw material, although neither type of sale required DISA’s specialized marketing expertise. Du Pont also routed all European sales of elastomers through DISA, even though the parent had a well-established English subsidiary which had all the necessary technical services and marketing ability.

E. We have itemized the special status of DISA — as a subsidiary intended and operated to accumulate profits without much regard to the functions it performed or their real worth — not as direct proof, in itself, supporting the Commissioner’s reallocation of profits under Section 482, but instead as suggesting the basic reason why plaintiffs sales to DISA were unique and without any direct comparable in the real world. As we shall see in Part II, infra, taxpayer has staked its entire case on proving that the profits made by DISA in 1959 and 1960 were comparable to those made on similar resales by uncontrolled merchandizing agencies. DISA’s special status and mode of functioning help to explain why that effort has failed. It is not that there was anything "illegal” or immoral in Du Pont’s plan; it is simply that that plan made it very difficult, perhaps impossible, to satisfy the controlling Treasury regulations under Section 482.10

II. Section 482 and the "Resale Price Method” of Allocating Profits.

A. Section 48211 gives the Secretary of the Treasury (or his delegate) discretion to allocate income between related corporations when necessary to "prevent evasion of taxes *342or clearly to reflect the income” of any of such corporations. The legislative history parallels the general purpose of the statutory text to prevent evasion by "improper manipulation of financial accounts”, "arbitrary shifting of profits,” and to accurately reflect "true tax liability.” See H.R. Rep. No. 350, 67th Cong., 1st Sess. 14 (1921) (section 240(d) of 1921 Act); S.Rep No. 275, 67th Cong., 1st Sess. 20 (1921) (same section); H.R. Rep. No. 2, 70th Cong., 1st Sess. 16 (1928) (predecessor section to § 482); Young & Rubicam, Inc. v. United States, 187 Ct. Cl. 635, 654, 410 F.2d 1233, 1244 (1969). See generally Bittker & Eustice, Federal Income Taxation of Corporations and Shareholders, ¶ 15.06 (4th ed. 1979) (hereinafter Bittker & Eustice). The overall aim is to enable the IRS to treat controlled taxpayers as if they were uncontrolled. See Eli Lilly & Co. v. United States, 178 Ct. Cl. 666, 372 F.2d 990 (1967); Young & Rubicam, Inc. v. United States, supra; Morton-Norwich Products, Inc. v. United States, ante at 83.12

B. We do not, however, have the initial problem of considering this case on the words of Section 482 alone, or on comparable broad criteria. In 1968 the Secretary of the Treasury issued revised regulations governing action under the statute, and setting forth rules for certain specific situations. Treas. Reg. § 1.482-1, et seq. These regulations, which were issued before the trial here, were made retroactive to cover the taxable years before us (1959-1960), and both sides agree that the regulations must control. In some quarters these regulations have been faulted as not giving enough meaningful guidance in specific situations, or as being too narrow in the specific situations they do cover, but there is here no challenge to the validity of the regulations and we have to apply them as they are, with fidelity to both their words and their spirit.

For sales of tangible goods, the directive mandates determination of an arm’s length price for the sale by one controlled entity to the other, and then sets out (in order of preference) four methods for calculating such an arm’s length price: the comparable uncontrolled price method, *343the resale price method, the cost plus method, and any other appropriate method. The parties correctly agree upon the inapplicability of the comparable uncontrolled price method (which calls for comparison with an uncontrolled sale of an almost identical product). Plaintiff makes no argument as to the possible application of the cost plus method. Instead it posits its whole case on the resale price method (Treas. Reg. § 1.482-2(e)(3))—which we now consider.13

C. Essentially, the resale price method reconstructs a fair arm’s length market price by discounting the controlled reseller’s selling price by the gross profit margin (or markup percentage) rates of comparable uncontrolled dealers.14 Thus, if DISA’s gross profit margin for resale was 35% and the prevailing margin for comparable uncontrolled resellers was 25%, the Commissioner could reallocate 10% of DISA’s gross income. But the vital prerequisite for applying the resale price method is the existence of substantially comparable uncontrolled resellers. Subpart (vi) of Section 1.482-2(e)(3) requires determination of the "most similar” resale or resales, considering the type of property, reseller’s functions, use of any intangibles, and similarity of geographic markets.15 Cases which have considered the regulation uniformly require substantial comparability. See, e.g., Woodward Governor Co. v. Commissioner, 55 T.C. 56, 65 (1970) (resale price method applicable only when evidence shows uncontrolled purchases and resales by same or similar reseller); American Terrazzo Strip Co. v. Commissioner, 56 T.C. 961, 972-73 (1971) (uncontrolled sales must be comparable in terms of similar *344goods and circumstances of sale); Edwards v. Commissioner, 67 T.C. 224, 236 (1976) (rejecting use of industry gross profit statistic when no evidence that such sales were comparable to taxpayer). Commentators agree on the need for close similarity of uncontrolled sales, and some criticize the regulation when no uncontrolled sales by the same party exist. See Fuller, Section 482 Revisited, 31 Tax L. Rev. 475, 505-07, 510-11 (1976); Jenks, Treasury Regulations under Section 482, 23 Tax Lawyer 279, 310 (1970) [hereinafter cited as Jenks]; Note, Multinational Corporations Income Allocation under Section 482 of the Internal Revenue Code, 89 Harv. L. Rev. 1202, 1220 (1976). dlt is quite plain from the text of the regulation itself that the evident purpose for the use of the particular resale price method, as set forth in the regulation, is to proffer a relatively precise mechanism for determining a realistically comparable, uncontrolled, arm’s-length resale price— not to leave the taxpayer, the Service, or the courts to grope at large for some figure drawn out of overly general indices or statistics.

The common starting point for our search in this case for a comparable meeting the requirements of the regulation is our finding 101 which states: "The parties agree, and their agreement is supported by the record, that there is not known to exist, presently or heretofore, an independent organization circumstanced as DISA was during the period in suit and performing the marketing functions that were assigned to it by plaintiff.” That being so, the regulation requires us (§ 1.482-2(e)(3) (vi) (a), (b), and (d)) to look for the "most similar” resales and "in determining the similarity of resales” to consider as the "most important characteristics” the type of property sold, the functions performed by the seller with, respect to the property, and the geographic market in which the functions are performed by the reseller. There is also special stress on the performance of "comparable functions” by the seller making the "most similar” resales. See subpart (vii).

Taxpayer tells us that a group of 21 distributors, whose general functions were similar to DISA’s, provides the proper base of comparison.16 Beyond the most general *345showing that this group, like DISA, distributed manufactured goods, there is nothing in the record showing the degree of similarity called for by the regulation. No data exist to establish similarity of products (with associated marketing costs), comparability of functions, or parallel geographic (and economic) market conditions. Rather, the record suggests significant differences. Defendant has introduced evidence that the six companies plaintiff identifies most closely with DISA all had average selling costs much higher than DISA.17 Because we agree with the trial judge and defendant’s expert that, in general, what a business spends to provide services is a reasonable indica*346tion of the magnitude of those services, and because plaintiff has not rebutted that normal presumption in this case, we cannot view these six companies as having made resales similar to DISA’s. They may have made gross profits comparable to DISA’s but their selling costs, reflecting the greater scale of their services or efforts, were much higher in each instance.18 Moreover, the record shows that these companies dealt with quite different products (electronic and photographic equipment) and functioned in different markets (primarily the United States).

Other industrial group or individual resales relied on by taxpayer also fall short of comparability to DISA. We are cited to the gross profit margin of certain drug and chemical wholesalers contained in the Internal Revenue Service’s Source Book of Statistics of Income for 1960. Because the gross profit for this group of undisclosed companies19 in 1960 averaged 21 percent, taxpayer infers that DISA’s gross profit of 26 percent was reasonable. Again, the lack of any data establishing comparability between DISA and the category of Source Book companies precludes any such conclusion. The fact that, within the wholesaler category, gross profits varied from 9 to 33 percent indicates that to take a mere arithmetic average, without considering underlying factual details, would risk a total distortion. See Simon, Section 482 Allocations, 46 Taxes 254 (1968) (criticizing lack of relevance, unavailability of third party data in gauging arm’s length prices); Edwards v. Commissioner, 67 T.C. 224, 236-37 (1976) (industry average of uncertain reliability in determining arm’s length sale price); cf. Major Coat Co. v. United States, 211 Ct. Cl. 1, 34, 543 F.2d 97, 116 (1976) (Source Book statistics on profitability of firms in same manufacturing category rejected in renegotiation case; no showing of relative character, efficiencies or risks of other companies). *347Plaintiff tells us that the IRS itself used these Source Book figures for 1960 and later years (not now before us). But the Service utilized net profit figures, not those for gross profit or gross markup. Whether or not this use of net profit computations contravened the regulations (which call for comparisions of gross profits in using the resale price method) or means that the IRS was following the "fourth method” (see Part III infra), we cannot say, as plaintiff wants us to, that the Service must have considered these drug and chemical wholesalers as comparable companies making similar resales, but that the IRS simply made a mistake in using net profits. The little we have on the IRS practice does not permit us to conclude anything as to the Service’s position on comparability of these companies for the purposes of the resale price method.20

The lack of any significantly comparable resale (or group of resales) in this record is underscored by taxpayer’s failure to suggest any means for adjusting for differences between DISA and the uncontrolled resellers. Subpart (ix) of section 1.482-2(e)(3) requires "appropriate adjustment” for "any material differences between the uncontrolled purchases and resales used as the basis for the calculation of the appropriate markup percentage and the resales of property involved in the controlled sale.” Such material differences must be "differences in functions or circumstances” and must have a "definite and reasonably ascertainable effect on price.” The trial judge premised his *348rejection of plaintiffs case on the failure to suggest appropriate adjustments under this subpart, particularly for DISA’s lack of "entrepreneurial risk.” Taxpayer mounts a vigorous assault on this position, arguing that DISA was exposed to all normal risks, including shipping and warehouse risks, sudden European market declines, or termination by manufacturing departments of Du Pont. Even if we assume arguendo that DISA did assume full market risks,21 we think taxpayer cannot escape the ultimate point of subpart (ix) — assuming a roughly comparable uncontrolled reseller (or resellers), taxpayer still bears the burden of showing adjustments to arrive at an arm’s length price.22 However, plaintiff proposes no adjustments for differences in marketing locations, selling functions, or production differences between DISA and the "comparable” 21 distributors. Taxpayer’s brief selects one of the distributors, Superscope, as the company "most similar in function” to DISA, but fails to suggest the appropriate adjustments for such aspects as Superscope’s different product line (tape recorders), different geographic market (the United States), or contractual obligation to make minimum purchases from the manufacturer.

This failure to proffer adjustments reflects the stark fact that, on this record, there is no company or group of companies so near and so comparable to DISA that the few material differences can be properly adjusted for under the regulatory pattern. Subpart (ix) and the example given under it (the same reseller selling two very similar products with only a difference in warranty coverage between the controlled and uncontrolled transactions) reinforce the view that under the resale price method the resales of uncontrolled companies must be substantially similar to those of the controlled reseller before that *349method can be used. And even if there is greater initial latitude in finding a comparable reseller than seems to us appropriate, subpart (ix) demands "appropriate adjustment * * * to reflect any material differences” which "have a definite and reasonably ascertainable effect on price.” Plaintiff, which urges that the resale price method be used, bears the burden of fulfilling all the requirements of the regulation, but has failed to do so.

Plaintiff contends, finally, that requiring it to prove the proper amount of adjustment is an unfair burden. The suggestion is that once Du Pont shows that its prices were arm’s length prices (by demonstrating that DISA’s gross profit margin was equivalent to that of uncontrolled distributors) any further readjustment should be left to the courts (or perhaps defendant). Our first response is, as we have said above, that taxpayer has not shown that, even apart from subpart (ix), any of its alleged comparables can be accepted as such under the resale price method portion of the regulation. And if we surmount that hurdle, we see no good reason why a taxpayer should be free from suggesting the appropriate adjustments under subpart (ix). As the opening words of the paragraph show, the adjustments called for by the subpart are integral to the determination of an "arm’s length price,” and the determination of an "arm’s length price” is the essence of the resale price method which plaintiff invokes.23

D. The upshot is that plaintiff has failed to bring itself within the resale price method. The record before us does not support use of that formula for this case.24 Indeed, it may very well be that, because of DISA’s unique position, the showing required by the regulation could simply not be *350made. At any rate, we have to conclude that, on this record, it is not possible to apply the resale price method.

As we have intimated in Part I, D, supra, this total failure of proof is no surprise. Taxpayer’s prices to DISA were set wholly without regard to the factors which normally enter into an arm’s length price (see Part I, C, supra), and it would have been pure happenstance if those prices had turned out to be equivalent to arm’s length prices. This is not a case in which a taxpayer does attempt, the best it can, to establish intercorporate prices on an arm’s length basis, and then runs up against an IRS which disagrees with this or that detail in the calculation. Plaintiff never made that effort, and it would have been undiluted luck — which under the regulation it probably could enjoy — if it had managed to discover comparable resales falling within the resale price method as set forth in the regulation (including adjustments to be made under subpart (ix)).

III. Validity of the Commissioner’s Allocation under the Regulation

In reviewing the Commissioner’s allocation of income under Section 482, we focus on the reasonableness of the result, not the details of the examining agent’s methodology. See Eli Lilly & Co. v. United States, 178 Ct. Cl. 666, 676, 372 F.2d 990, 997 (1967); Young & Rubicam, Inc. v. United States, 187 Ct. Cl. 635, 654-55, 410 F.2d 1233, 1245 (1969).25 Plaintiff contends that the Commissioner’s result does not conform to any of the specific methods under the regulations and is therefore unreasonable per se. But the regulations (§ 1.482 — 2(e)(1)(iii)) specifically allow for another appropriate method — "some appropriate method of pricing other than those described * * * * or variations on such methods” — when, as here, none of the three specific methods can properly be used. That alternative "fourth method” now comes into play, and we consider the *351reasonableness of the Commissioner’s result under its very broad delegation. This other "appropriate method of pricing” must, of course, conform to the general directives (stated at the outset of the regulation): "to place a controlled taxpayer on a tax parity with an uncontrolled taxpayer” and "in every case” to apply the standard "of an uncontrolled taxpayer dealing at arm’s length with another uncontrolled taxpayer.” See § 1.482 — 1(b)(1) and (c).26

That some reallocation was reasonable is demonstrated by recalling the facts of DISA’s operation. See Part I, supra. Several of the products sold through DISA received none of its special marketing or technical services. Nonetheless, DISA obtained its usual profit from Du Pont for minimal work on these goods — a result contrary to selling practices in the real world. Examples include: (1) opportunistic sales and sales of commodity-type products; (2) sales to South Africa and Australia routed through DISA; (3) sales of elastomers produced and serviced by Du Pont’s British subsidiary. DISA’s selling "expertise” was not employed on any of these goods, and the sole reason to sell them through DISA seems to have been to increase the volume of profits for that special subsidiary.27 Above all of these specific indications that DISA did not earn its profits is the overriding fact (discussed in Parts I and II, supra) that Du Pont’s prices to DISA were deliberately set high and with little or no regard to economic realities.

The amount of reallocation would not be easy for us to calculate if we were called upon to do it ourselves, but Section 482 gives that power to the Commissioner and we are content that his amount (totalling some $18 million) was within the zone of reasonableness. The language of the statute and the holdings of the courts recognize that the Service has broad discretion in reallocating income. See, e.g., Eli Lilly & Co. v. United States, 178 Ct. Cl. 666, 676-77, 372 F.2d 990, 997 (1967); Edwards v. Commissioner, 67 T.C. *352224, 230 (1976); Lufkin Foundry & Machine Co. v. Commissioner, 30 Tax Ct. Mem. Dec. 400, 437-38 (1971), rev’d on other grounds, 468 F.2d 805 (5th Cir. 1972); PPG Industries, Inc. v. Commissioner, 55 T.C. 928, 990-91 (1970). Once past the three specific methods for computing intercompany prices of tangible property, the determiner of realistic intercompany prices is hardly exercising an economic art susceptible of precision. A "broad brush” approach to this inexact field seems necessary and conforms with this court’s experience up to now under the Renegotiation Act, requiring post hoc and de novo determination of excessive profits on war and defense Government business. See, e.g., A.C. Ball Co. v. United States, 209 Ct. Cl. 223, 229, 531 F.2d 993, 996 (1976); Bata Shoe Co. v. United States, 219 Ct. Cl. 240, 269, 595 F. 2d 9, 25 (1979) (and cases cited). Du Pont has not convinced us, on this record, that the Commissioner abused the broad discretion he possessed (the specific methods being inapplicable), or that he acted unreasonably.

On the contrary, two economic indices presented by defendant support the result of the Commissioner’s reallocation. One index compares DISA’s ratio of gross income to total operating costs with the ratios for the 32 advertising, management-consultant, and distributor firms functionally similar, in general, to DISA. These are the results

Organization Average gross income/total cost percentage

6 management-consultant firms 108.3%

5 advertising firms 123.9%

21 distributors 129.3%

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

DISxV (after reallocation)* 108.6(1959);179.3%(1960)

Only twice in over a hundred years of these companies’ experience did any of the distributing firms attain in*353come/cost ratios of over 200%, and no distributor ever achieved the 280-400% range experienced by DISA.

The second index does not rely at all on general functional similarities, but rests solely on a very comprehensive study of the rates of return (along with margin and turnover ratios) of over 1,100 companies. The following table illustrates the results:

Index 10-year average of 1.133 companies DISA before allocation DISA after allocation

1959 1960 1959 1960

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

Margin 7.12% 13.1% 17.3% - -

Turnover 1.33 34.0 8.516 - -

Whether measured by income/cost ratios of functionally similar firms or by capital return rates for industry as a whole, DISA’s profits, before reallocation, vastly exceeded the uppermost limits. After reallocation, DISA’s return on capital would still be better than over 96% of the 1133 companies surveyed. Using the two indices as a general measure of economic profits, DISA stands supreme before reallocation.28

Plaintiff attacks the validity of the two studies, arguing that return on capital is an inaccurate measuring rod, and that the income/cost ratio is inappropriate because profits vary with the skills of the individual companies. Whatever the general limits of any particular gauge of industry profitability, plaintiff cannot escape the basic thrust of defendant’s proof. Defendant has shown that DISA made extraordinarily high profits which the Commissioner reallocated to an economically reasonable level. Plaintiff has not shown any specific comparable transactions refuting the general trend, and the record reveals none. See Part II, supra. Given the Commissioner’s general discretion and the *354necessary inexactitude of such economic allocations, we conclude that the Commissioner’s allocation was reasonable and should be accepted.

CONCLUSION OF LAW

Upon the findings of fact, which are made a part of the judgment herein, and the foregoing opinion, the court concludes as a matter of law that plaintiff is not entitled to recover, provided that plaintiff is accorded the opportunity to demonstrate in further proceedings in the Trial Division that it is entitled to relief under the provisions of Rev. Proc. 64-54, 1964-2 Cum. Bull. 1008. The cases are returned to the Trial Division for such further proceedings.

APPENDIX

Treasury Regulations on Income Tax (26 C.F.R.) § 1.482-2 provide in pertinent part:

§ 1.482-2. Determination of taxable income in specific situations.

* * *

(e) Sales of tangible property—

(1) In general.

(i) Where one member of a group of controlled entities (referred to in this paragraph as the "seller”) sells or otherwise disposes of tangible property to another member of such group (referred to in this paragraph as the "buyer”) at other than an arm’s length price (such a sale being referred to in this paragraph as a "controlled sale”), the district director may make appropriate allocations between the seller and the buyer to reflect an arm’s length price for such sale or disposition. An arm’s length price is the price that an unrelated party would have paid under the same circumstances for the property involved in the controlled sale. Since unrelated parties normally sell products at a profit, an arm’s length price normally involves a profit to the seller.

(ii) Subparagraphs (2), (3), and (4) of this paragraph describe three methods of determining an arm’s length price and the standards for applying each method. They are, respectively, the comparable uncontrolled price method, the resale price method, and the cost-plus method. In *355addition, a special rule is provided in subdivision (v) of this subparagraph for use (notwithstanding any other provision of this subdivision) in determining an arm’s length price for an ore or mineral. If there are comparable uncontrolled sales as defined in subparagraph (2) of this paragraph, the comparable uncontrolled price method must be utilized because it is the method likely to result in the most accurate estimate of an arm’s-length price (for the reason that it is based upon the price actually paid by unrelated parties for the same or similar products). If there are no comparable uncontrolled sales, then the resale price method must be utilized if the standards for its application are met because it is the method likely to result in the next most accurate estimate in such instances (for the reason that, in such instances, the arm’s length price determined under such method is based more directly upon actual arm’s-length transactions than is the cost-plus method). A typical situation where the resale price method may be required is where a manufacturer sells products to a related distributor which, without further processing, resells the products in uncontrolled transactions. If all the standards for the mandatory application of the resale price method are not satisfied, then, as provided in 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 manufacturer 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 subparagraph are met, such method must, for the purposes of this paragraph, be utilized unless the taxpayer can establish that, considering all the facts and circumstances, some 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 in a particular case, some appropriate method of pricing other than those described in subdivision (ii) of this subparagraph, or variations on such methods, can be used.

(iv) The methods of determining arm’s length prices described in this section are stated in terms of their application to individual sales of property. However, *356because of the possibility that a taxpayer may make controlled sales of many different products, or many separate sales of the same product, it may be impractical to analyze every sale for the purposes of determining the arm’s length price. It is therefore permissible to determine or verify arm’s length prices by applying the appropriate methods of pricing to product lines or other groupings where it is impractical to ascertain an arm’s length price for each product or sale. In addition, the district director may determine or verify the arm’s length price of all sales to a related entity by employing reasonable statistical sampling techniques.

(v) The price for a mineral product which is sold at the stage at which mining or extraction ends shall be determined under the provisions of §§ 1.613-3 and 1.613-4.

*****

(3) Resale price method.

(i) Under the pricing method described as the "resale price method”, the arm’s length price of a controlled sale is equal to the applicable resale price (as defined in subdivision (iv) or (v) of this subparagraph), reduced by an appropriate markup, and adjusted as provided in subdivision (ix) of this subparagraph. An appropriate markup is computed by multiplying the applicable resale price by the appropriate markup percentage as defined in subdivision (vi) of this subparagraph. Thus, where one member of a group of controlled entities sells property to another member which resells the property in uncontrolled sales, if the applicable resale price of the property involved in the uncontrolled sale is $100 and the appropriate markup percentage for resales by the buyer is 20 percent, the arm’s length price of the controlled sale is $80 ($100 minus 20 percent X $100), adjusted as provided in subdivision (ix) of this subparagraph.

(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 subdivision (iv) or (v) of this subparagraph, is available with respect to resales made within a reasonable time before or after the time of the controlled sale.

(c) The buyer (reseller) has not added more than an insubstantial amount to the value of the property by physically altering the product before resale. For this purpose packaging, repacking, labeling, or minor assembly of property does not constitute physical alteration.

*357(d) The buyer (reseller) has not added more than an insubstantial amount to the value of the property by the use of intangible property. See § 1.482 — 2(d)(3) for the definition of intangible property.

(iii) Notwithstanding the fact that one or both of the requirements of subdivision (ii) (c) or (d) of this subpara-graph may not be met, the resale price method may be used if such method is more feasible and is likely to result in a more accurate determination of an arm’s length price than the use of the cost plus method. Thus, even though one of the requirements of such subdivision is not satisfied, the resale price method may nevertheless be more appropriate 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 general, the resale price method is more appropriate when the functions performed by the seller are more extensive and more difficult to evaluate than the functions performed by the buyer (reseller). The principle of this subdivision may be illustrated by the following examples in each of which it is assumed that corporation X developed a valuable patent covering product M which it manufactures and sells to corporation Y in a controlled sale, and for which there is no comparable uncontrolled sale:

Example (1). Corporation Y adds a component to product M and resells the assembled product in an uncontrolled sale within a reasonable time after the controlled sale of product M. Assume further that the addition of the component added more than an insubstantial amount to the value of product M, but that Y’s function in purchasing the component and assembling the product prior to sale was subject to reasonably precise valuation. Although the controlled sale and resale does not meet the requirements of subdivision (ii) (c) of this subparagraph, the resale price method may be used under the circumstances because that method involves computations and evaluations which are fewer and easier to make than under the cost plus method. This is because X’s use of a patent may be more difficult to evaluate in determining an appropriate gross profit percentage under the cost plus method, than is evaluation of Y’s assembling function in determining the appropriate markup percentage under the resale price method.

Example (2). Corporation Y resells product M in an uncontrolled sale within a reasonable time after the controlled sale after attaching its valuable trademark to it. Assume further that it can be demonstrated through comparison with other uncontrolled sales of Y that the addition of Y’s trademark to a product usually adds 25 *358percent 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 circumstances, X’s use of a patent is more difficult to evaluate in determining an appropriate gross profit percentage under the cost plus method, than is evaluation of the use of Y’s trademark in determining the appropriate markup percentage under the resale price method.

(iv) For the purposes of this subparagraph the "applicable resale price” is the price at which it is anticipated that property purchased in the controlled sale will be resold by the buyer in an uncontrolled