Markers and musings: the proposed section 482 services regulations.

• Author: Lewis, Patricia Gimbel

Introduction

In September, the Internal Revenue Service promulgated comprehensive and important revisions to the regulations on the treatment of intercompany services under section 482 of the Internal Revenue Code, along with several key changes to the transfer pricing characterization of intangibles. (1) (Issued in proposed form, these regulations are referred to in this article as "the regulations.") Updating 35-year-old provisions, the regulations both complete the mid-1990s overhaul of the transfer pricing rules and have potential ripple effects. They in part respond to business trends and international developments and in part reflect IRS suspicion regarding offshore "migration" of revenue and intangibles. Considerable effort has been made to unify the transfer pricing provisions in a principled way, though this has the potential to seriously compromise the administrability of the services rules.

Few multinational taxpayers will be unaffected by the regulations. Even if their current transfer pricing practices pass muster under the new rules, companies must still review many transactions to identify risks or opportunities. Explicitly or subtly, the regulations will require markups on many intercompany services for which cost pass-throughs are currently permitted.

This article does not restate the lengthy rules or the IRS's explanation for them in the preamble to the notice of proposed rulemaking (preamble). Rather, after highlighting key aspects of the new provisions, this article offers observations and queries from a practical implementation perspective. (2)

Markers

Services

Supplying a definition absent from the current regulations, the regulations apply broadly to any "controlled services transaction." Controlled services transactions occur when a commonly controlled party undertakes an activity (performs a function, assumes a risk, or uses property--tangible or intangible) that gives another controlled party a reasonably identifiable increment of economic or commercial value. Basically, the new rules apply to any activity that an uncontrolled party in comparable circumstances would pay for or do itself. Duplicative and shareholder activities remain excluded. Allocation provisions address situations where services benefit more than one group member and the transfer pricing method (TPM) depends on costs.

Six specified TPMs

Permitted TPMs--largely analogous to those for tangible and intangible property transfers but carefully tailored to services--are: (i) comparable uncontrolled services price method; (ii) gross services margin method; (iii) cost of services plus method; (iv) comparable profits method (CPM); (v) simplified cost-based method; and (vi) profit split method. "Unspecified methods" are also allowed. The general provisions of Treas. Reg. [section] 1.482-1 apply, including the "best method" rule, comparability analysis, and ranges. The CPM provisions introduce--and favor--a new profit-level indicator, the ratio of operating profit to total services costs (referred to as "net cost plus"). The use of a Berry ratio is deemphasized because of accounting segmentation issues.

The "simplified cost-based method" replaces the cost safe harbor

The regulations replace the existing cost-only safe harbor for "non-integral services" (3) with a much narrower "simplified" method for "low-margin" services. (4) To qualify for the new Simplified Cost-Based Method (SCBM), the following criteria must be met:

* The service is not included in a long list of ineligible services: manufacturing, production, extraction, construction, reselling, distribution, acting as a sales or purchasing agent, acting under a commission (or similar) arrangement, research, development, experimentation, engineering, scientific, financial transactions (including guarantees), insurance, and reinsurance.

* Neither the renderer, the recipient, nor another group member renders similar services to uncontrolled parties.

* Valuable or unique intangible property or particular resources or capabilities of the renderer do not contribute significantly to the value of the services (unless the renderer's costs include significant costs with respect to the use of such intangible property or resources).

* The recipient does not receive significant amounts of services (e.g., accounting for 50 percent or more of its SG&A) from controlled parties.

* A written contract is in place describing the services and their pricing. (5)

* The arm's-length markup on the services would not exceed 10 percent.

Also, the simplified method is not available to non-service components of integrated transactions.

SCBM mechanics/phase-out

SCBM allows controlled parties to render eligible services at less than an arm's-length price, and without the hurdle of the best-method rule. The charge cannot be less than cost. Above that, the permissible charge is based on a formula that depends on the "correct" arm's-length markup (generally indicated as the median of an arm's-length range for comparable transactions). If the "correct" markup is six percent or less, the permitted markup may be zero or any other rate up to six percent. The cushion of allowable difference between the "correct" and "actual" markups shrinks ratably by one percentage point for every percentage point by which the "correct" markup increases (until the "correct" markup hits 10 percent). Services with lower "correct" markups--low-margin services--thus enjoy more protective cushion than higher-margin services.

Residual profit split method (RPSM)

By emphasizing this method in examples (6) and revising its conceptual basis to look to "nonroutine contributions," (7) the regulations suggest that RPSM could apply quite readily not only to controlled services transactions involving high-value intangibles, but also to integrated transactions that are difficult to break apart for evaluation. (8)

Imputed agreements

The regulations embellish the current provisions that permit the IRS to review controlled parties' dealings and impute agreements between them to more accurately reflect the economic substance of their conduct, even if such imputed agreements are contrary to express contractual agreements. New examples suggest that alternative IRS approaches could include contingent payment compensation or compensation for revised relationships (e.g., termination payments). (9)

Integrated transactions

Some service transactions have non-service components for which distinct arm's-length analytical methods already exist. These "integrated" transactions would not necessarily have to be unbundled for separate arm's-length evaluations. (10) Instead, they could be evaluated as a single controlled transaction if the chosen method's comparability inquiry adequately accounts for the non-service components. (11) A special corroboration rule applies to integrated transactions with intangible components that result in or have an effect similar to a transfer of intangible property. If the intangible element is "material," that element would have to be corroborated or determined under the rules for intangibles. The corroboration mechanics are unclear.

Revised intangibles framework

The current regulations allocate income from an intangible based on its owner (or deemed owners), applying the "developer/assister" rule to determine the owner of intangible property that is not legally protected. The regulations reframe this approach, albeit retaining the underlying principles. (12) First, ownership is determined under intellectual property law and contract and various intangible rights are recognized (e.g., license rights). These property rights merit appropriate amounts of income. In addition, income is allocated among the controlled parties, on an arm's-length basis, in accordance with each one's contribution to the development or enhancement of an intangible right owned by another. No separate allocation is required if the consideration for such contribution is embedded in the contractual terms for the pertinent transaction. This "contributor" rule replaces the so-called cheese examples in the current intangibles regulations.

Musings

What's in a Name?

The broad definition of services--in short, an activity that confers a benefit--makes the new regulations transfer pricing's "kitchen sink." (13) Going beyond a transactions-based perspective and sweeping in "the performance of functions" and "assumptions of risks" indicate, for example, that oversight and loan guarantees are services. Indeed, by including "making available to the recipient any property or other resources of the renderer," the regulations technically encompass intangible licenses, property rentals, and loans, although the Preamble to the regulations suggests otherwise. (14) This broad definition, together with the combination/integration rules (discussed below), is potentially confusing. Although the increasingly similar TPMs among different kinds of transactions are intended to make characterization less important, at some point one needs to differentiate because of the statutory commensurate-with-income rule uniquely applicable to intangibles. (15)

The regulations incorporate some concepts from the OECD Guidelines, (16) such as focusing on the value to the recipient rather than whether an arm's-length renderer would charge for the services. This should be helpful in a bilateral context.

No attempt is made to sort out difficult characterization issues for e-commerce and Internet-related services, which are the subject of extensive OECD studies. (17) And, even though the rules have been rephrased to better track OECD concepts, there is still little elucidation on the nettlesome issues of shareholder, stewardship, and duplicative activities.

Simplified Cost-Based Method: The Exceptions Swallow the Rule

The IRS's rationale...