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BAUSCH & LOMB FAVORABLE TAX COURT RULING ON ALLOCATION OF INCOME

Executive Summary

BAUSCH & LOMB FAVORABLE TAX COURT RULING ON ALLOCATION OF INCOME to its Irish subsidiary was handed down by Judge Jules Korner III in U.S. Tax Court, Washington, D.C. on March 23. The ruling in Bausch & Lomb Inc. v. Commissioner of Internal Revenue found that the Internal Revenue Service acted "unreasonably" in allocating income between Bausch & Lomb and its Irish subsidiary for the years 1980-1982 based on the two companies' transfer costs for soft contact lenses. Following a review of Bausch & Lomb's returns for the 1980-1982 period, the IRS proposed significant adjustments in early 1986, focusing primarily on income earned by the company's operations in Ireland. The IRS has the authority to allocate income between controlled enterprises under Section 482 of the tax code if the IRS "determines that such an allocation is necessary to prevent evasion of taxes or clearly to reflect the true income" of the businesses, the opinion explains. In the case of Bausch & Lomb, the government specifically argued that the transfer price for soft contact lenses between Bausch & Lomb and B&L Ireland was too high and the royalty rate on the products was too low. According to Bausch & Lomb's 1986 annual report, the proposed tax adjustments and accrued interest amounted to about $ 16 mil. The March 23 opinion, viewed by some industry observers as a landmark ruling, primarily finds in favor of Bausch & Lomb's arguments. Bausch & Lomb established a wholly-owned manufacturing subsidiary in Ireland in February 1980. The company granted the subsidiary nonexclusive licenses to soft contact lens manufacturing technology and certain trademarks in return for a 5% royalty on sales. For the years in question, Bausch & Lomb purchased soft contact lenses from the Irish subsidiary at a transfer price of $ 7.50 per lens. The price dropped to $ 6.50 per lens in 1983. The IRS challenged the $ 7.50 per lens price on several grounds. For example, if the sale of lenses between the two firms had truly been an "arm's length" transaction, Bausch & Lomb would have received "significant volume discounts" on its purchases, lowering the price to well below $ 7.50, the government contended. The agency also argued that Bausch & Lomb would have been unwilling to pay as much for soft contact lenses as would other distributors, because unlike most distributors, the company has substantial R&D costs that must be supported by the profits from lens sales. It is possible that B&L could have received a more favorable price from an independent manufacturer based on volume, the court acknowledged, but to accept that argument "would cripple a taxpayer's ability to rely on the comparable uncontrolled cost price method in establishing transfer pricing by introducing to it a degree of economic sophistication which appears reasonable in theory, but which defies quantification in practice." The court also found that Bausch & Lomb "functioned as a distributor with respect to the lenses it purchased from B&L Ireland." An argument that Bausch & Lomb could have produced the lense Turning to the royalty issue, the court found an amount suggested by the IRS expert witnesses to be "excessive," but also judged the actual royalty of 5% too low. After evaluating various outside royalty agreements entered into the record, the court was unable to identify a "sufficiently similar transaction involving an unrelated party" and therefore decided to construct an arm's length figure itself, arriving at 20% of net sales. A spokesperson for the IRS said that no decision has yet been announced as to whether the agency will appeal the ruling. He added that while the IRS generally looks closely at companies filing under Section 482, there is no special initiative to look at how the health care industry is using those provisions as opposed to any other industry with offshore manufacturing interests.
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