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Summary
Summary of facts
The taxpayer engaged in designing, manufacturing and selling personal computers (PCs), was a Delaware corporation
with its principal place of business in Houston, Texas. The site at Houston also included a manufacturing plant. The
taxpayer was engaged in the manufacturing of Central Processing Units (CPUs) and Printed Circuited Assemblies
(PCAs) as part of its manufacturing operations. In the mid 1980’s, in order to take advantage of the lower material costs
prevalent in Asia, the taxpayer initiated dealings with two independent companies in Singapore, both of which, however,
ended in failure. Consequently, the taxpayer organized a wholly-controlled subsidiary, viz., Compaq Asia in Singapore
in 1986, which was entrusted with the task of manufacturing high-quality PCAs for the taxpayer for use in manufacturing
CPUs. In addition, the taxpayer also purchased PCAs from unrelated subcontractors, majority of whom were located in
the United States. The purchases from unrelated subcontractors were primarily on a consignment basis, meaning that
the taxpayer consigned raw materials and components to the subcontractors, and the consignment price paid by the
taxpayer compensated the unrelated subcontractors for their labour and overhead costs with a profit markup on each.
The transactions with Compaq Asia were on a turnkey basis, meaning that the taxpayer purchased raw materials and
components from approved suppliers paying the same prices as the taxpayer, and the taxpayer compensated Compaq
Asia for materials, labour and overhead as well as a profit mark-up on each. For the years in question, i.e., 1991 and 1992,
in setting the transfer price for the PCAs purchased by the taxpayer from Compaq Asia, the taxpayer used the cost-plus
method. The transfer price was determined according to a formula, which added taxpayer’s material costs to 1.5 times
the difference between the taxpayer’s labour and overhead costs and the taxpayer’s fixed overhead costs. Expressing
the transfer price in terms of taxpayer’s standard costs (standard costs were the forecasted/estimated material, labour
and overhead costs of the taxpayer) for those two years, the average price for the controlled transaction was equal to
93.9% of those costs.
The Commissioner, on the other hand, adopted a modified cost-plus or profits-based method, marking-up Compaq Asia’s
manufacturing costs by an operating profit mark-up of 7.5%, which produced an aggregate price for Compaq Asia’s
purchases that was $232,402,000 less than the taxpayer’s 1991 and 1992 combined return positions. Accordingly, the
Commissioner determined deficiency in taxes paid by the taxpayer, which was vehemently objected by the taxpayer.
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Issues
Whether the transfer price for PCAs, charged between the taxpayer and its subsidiary, Compaq Asia, satisfied the arm’s
length standard of S.482 IRC?
Court decision
The Tax Court ruled in favour of the taxpayer, thus setting aside the deficiency determination made by the Commissioner.
The Court held that subsequent use of the CUP method by the taxpayer at trial to establish conformity of its transfer price
with the arm’s length price in the uncontrolled transactions was not prohibited as it did not prejudice the Commissioner’s
determination under S.482. After concluding that the purchase transactions with 14 unrelated subcontractors, although
not “ identical or nearly identical ” but still being “ sufficiently similar ” to the controlled transactions, the Court proceeded
to determine if reasonably ascertainable adjustments could be made to the uncontrolled price to eliminate the effect of
any differences existing between two set of transactions. The Court concluded that reasonably ascertainable adjustments
could be made to account for differences such as freight and duty charges paid by the taxpayer for Compaq Asia but not
for unrelated subcontractors, or costs incurred by the taxpayer for set up and cancellation in case of unrelated taxpayers
but not for Compaq Asia, or risk borne by the taxpayer with respect to material inventories in case of subcontractors only,
and therefore the two sets of transactions were comparable. The Court, after comparing the prices which the taxpayer
paid to Compaq Asia and unrelated subcontractors held that taxpayer, in fact, paid more to subcontractors for nearly
identical goods (adjusted for differences), thus, in essence holding that there was no underestimation of the taxpayer’s
income for Federal tax purposes.
Language(s) English
© Copyright 2021 IBFD: No part of this information may be reproduced or distributed without permission of IBFD. 2
Disclaimer: IBFD will not be liable for any damages arising from the use of this information.