## Facts

- The Procter & Gamble Company (P&G) owned Procter & Gamble A.G. (AG), a Swiss subsidiary that marketed P&G products and paid P&G royalties under a license and services (“package fee”) agreement.
- In 1967, P&G sought to establish a wholly owned Spanish subsidiary (España) to manufacture and sell P&G products in Spain.
- Spanish foreign-exchange and investment controls—enforced through criminal penalties for unauthorized payments—required governmental approval for payments by Spanish entities to foreign residents, including royalties and technical-assistance fees.
- Spanish authorities approved the formation and foreign ownership of España but imposed conditions restricting España from paying royalties or technical-assistance fees to foreign persons without further approval.
- For reasons not fully explained in the record, AG (not P&G directly) ultimately held 100% of España.
- P&G and AG repeatedly sought authorization for España to make package-fee style royalty/assistance payments to AG; the Spanish government consistently refused.
- For tax years 1978 and 1979, España made no such royalty payments to AG because the payments were not legally permitted.
- The Commissioner issued a deficiency notice reallocating income under I.R.C. § 482 from España to AG, using a 2% royalty on España’s net sales (approximately $1.23 million for 1978 and $1.79 million for 1979).
- P&G challenged the allocation in the U.S. Tax Court, arguing § 482 could not attribute royalty income that could not legally be paid or received under Spanish law.

## Issues

1. Whether I.R.C. § 482 permits the Commissioner to allocate to a related foreign affiliate royalty income based on an arm’s-length royalty when the payor subsidiary is legally prohibited by foreign law from making such royalty payments.
2. Whether the arm’s-length analysis under § 482 may assume a transaction (royalty payment) that could not occur under the applicable legal constraints.

## Decision

- The Tax Court held for P&G and rejected the Commissioner’s § 482 allocation for 1978 and 1979.
- The court concluded that § 482 did not authorize allocating royalty income premised on payments that Spanish law prohibited and Spanish authorities refused to approve.
- The court treated the foreign-law prohibition as a real constraint on any arm’s-length arrangement, including arrangements between unrelated parties in Spain.
- The Sixth Circuit later affirmed the Tax Court’s decision.

## Legal Principles

- I.R.C. § 482 permits allocations among commonly controlled entities only to prevent tax evasion or to clearly reflect income under comparable circumstances.
- The arm’s-length standard must account for binding legal restrictions affecting the parties; it cannot rest on transactions that could not legally occur.
- Consistent with *Commissioner v. First Security Bank of Utah, N.A.*, the Commissioner may not allocate income that the taxpayer (or the allocatee) could not legally receive under the governing legal regime.
- The possibility that a group could have pursued an alternative historical structure does not justify a § 482 allocation based on a prohibited transaction within the structure actually used and subject to the applicable law.

## Conclusion

The Tax Court invalidated the Commissioner’s § 482 royalty allocation because Spanish law and governmental action barred España from making the assumed royalty payments; an arm’s-length analysis could not impute income from a transaction that was legally impossible.


Procter & Gamble Co. v. Comm’r, 95 T.C. 323 (1990)