Play it again, Sam - the IRS (more or less) finishes the section 482 services regulations.

• Author: Lewis, Patricia Gimbel

Almost 40 years after the current section 482 regulations governing intercompany services were promulgated, the Internal Revenue Service has issued updated temporary regulations on this subject (the "New Regulations"). (1) The New Regulations improve upon 2003 proposed regulations (the "Proposed Regulations") that attracted serious criticism from the business community. (2) It is clear, and gratifying, that business's comments were heeded to a meaningful degree. (3) Since most multinational businesses entail some cross-border intercompany services--and since the New Regulations are quickly effective, beginning January 1, 2007, for calendar-year taxpayers--the new rules require close immediate attention. As temporary regulations, they have only a three-year life, to July 31, 2009. This will permit interim comments and potential further improvement to the rules, but could also necessitate a second round of comprehensive review and revisions by taxpayers.

Tips for Taxpayers

* Move quickly to inventory, categorize, and review all intercompany service arrangements, identifying pertinent corporate objectives and using an evaluation template. (4) Contract revisions may be needed on an expedited basis.

* Provide comments for the IRS hearings about legitimate interpretation or implementation problems.

* Document and preserve analysis.

Key Topics

The New Regulations comprehensively address the transfer pricing of services rendered to related parties. Analytically, they can be broken down as follows:

** Critical Definitions: Revised principles for determining when services requiring intercompany compensation have been rendered.

** Services Cost Method (SCM): A new method for charging cost only, without any mark-up, for basic intercompany services, along with permitted cost-sharing arrangements for such services (Shared Services Arrangements or SSAs).

** Updated TPMs: Six other articulated transfer pricing methods for determining the arm's-length charge for intercompany services.

** Rules for Cost-Based TPMs: Cost calculations, allocations, and handling of passed-through third-party costs.

** Imputed Agreements: IRS approach to recasting transactions.

** Integrated Transactions: Standards for determining which set of intercompany pricing rules applies to transactions with multiple components.

** Effective Date Rules and Considerations

** Intangibles Framework: A separate, non-services-related part of the New Regulations addresses standards for determining the ownership of intangibles for transfer pricing purposes.

Tip for Taxpayers

* Focus intently on SCM and whether it can be practically (or desirably) implemented.

1. Definitions (5)--Ring in the New

   The New Regulations apply broadly to any "controlled services transaction." A controlled services transaction occurs when a commonly controlled party undertakes an activity that gives another controlled party a reasonably identifiable increment of economic or commercial value ("benefit"). Activities include the performance of functions, assumptions of risks, or use of tangible or intangible property or other resources, capabilities, or knowledge, including the ability to take advantage of particularly advantageous situations or circumstances.

   The "benefit" concept adopts the OECD (6) test of whether an uncontrolled taxpayer in comparable circumstances would be willing to pay for the activity (on either a fixed or contingent payment basis) or would have performed the activity for itself. This approach replaces the "would-have-charged-for" test under the Old Regulations, which focused on whether the renderer would expect payment for the activity in question. The preamble to the New Regulations, however, clarifies that valuation of the charge is not limited to the recipient's perspective, but depends on the particular TPM used. As before, activities that confer "indirect or remote" benefits on affiliates are not considered chargeable services.

   Of particular significance, the New Regulations change the emphasis in identifying "shareholder" activities which a parent company cannot charge to its subsidiaries. These activities are those that have the sole effect--changed from the "primary" effect in the Proposed Regulations--of protecting the renderer's investment in the group members and / or of facilitating compliance with reporting, legal or regulatory requirements applicable specifically to the renderer. (The broader concept of "stewardship" activities also includes "duplicative" activities, which likewise may not be charged out. (7))

   Tips for Taxpayers

   * On the one hand, this change means that fewer shareholder-related activities will be non-allocable. On the other hand, it is still necessary to pass the "direct benefit" test before allocation to subsidiaries can be justified; the New Regulations confirm the Proposed Regulations' change in policy that "[i]n no event will an allocation of costs based on a generalized or non-specific benefit be appropriate," (8) and reiterate that no allocations are permitted for indirect or remote benefits. (9) Implicitly, there remains a category of activities that, while not shareholder activities per se under the new definition, are still not direct enough to be allocable out and thus remain expenses just of the parent.

   * The intricate interplay between these offsetting effects and deductions, taxable income, tax rates, mark-up requirements and levels, foreign tax credit situations, and local law requirements makes it impossible to generalize about "typical" U.S. or foreign multinational preferences. Much will depend on how the direct benefit test is interpreted in practice.

   Benefits attributable to mere "passive association" as a member of a controlled group will, as first articulated in the Proposed Regulations, not constitute a service. In an effort to clarify the meaning of these terms, the IRS (10) has added several new examples. For instance, a "comfort letter" to a subsidiary's customer, affirming the parent's ownership and intent to maintain such interest until the contract is completed, does not provide a chargeable benefit. (11) Along the same lines, volume discounts granted solely because of the size of the controlled group constitute passive association benefits and do not support an intercompany charge, that is, the subsidiary keeps the discount without having to pay anything to the parent. (12) Interestingly, the latter example takes group membership into account for comparability (i.e., determining which vendor price levels can be passed through), while simultaneously viewing group membership as not conferring a compensable benefit.

   Tip for Taxpayers

   * The volume discount example may require changes in some groups' practice of recovering from affiliates part or all of the purchasing power benefit of centralized procurement or logistics.

   The Preamble also comments on the inference drawn by some observers under the Proposed Regulations that financial guarantees are considered services. Noting that case law holds that guarantees are not considered services for sourcing purposes and that the IRS considers it inappropriate to uniformly treat guarantees as noncompensatory by making them eligible for the SCM method (discussed below), the Preamble defers the transfer-pricing characterization of services to forthcoming global dealing regulations.

2. SCM--Every Day in Every Way ...

   The most dramatic improvement from the Proposed Regulations is the replacement of the much-maligned Simplified Cost Based Method (SCBM) with the Services Cost Method (SCM). (13) SCBM had substituted a complex, graduated-rate approach for the Old Regulations' cost-only safe harbor for "non-integral" services. Because SCBM required a threshold determination of the arm's-length mark-up for subject services (i.e., 6 percent or less), it trounced administrative simplicity and threatened heavy compliance burdens for even the most elemental services. (As TEI put it in its comments, "the SCBM method is neither simple nor safe". (14))

   The New Regulations restore the cost-only approach for a reasonably broad category of back-office services and, in some respects, move past the often imponderable "non-integral" requirement and the related "peculiarly capable" / "significant element" concepts. But there is no free lunch:

   ** A more restrictive "business judgment" test replaces the non-integral test, employing different, but still fuzzy, concepts.

   ** Specific new limitations on SCM are driven by the IRS perception that many intercompany services today have value significantly in excess of their cost.

   ** As with SCM's predecessors, there will be questions of international acceptance and harmonization problems. (15)

   SCM applies to services that:

   ** Are not "excluded transactions"--A "Black List" of services will not qualify for SCM. This includes activities previously ineligible for the Old Regulations' cost-only safe harbor--manufacturing; production; extraction, exploration or processing of natural resources; and construction--as well as far-reaching new exclusions for reselling, distribution or similar agency or commission arrangements; research, development or experimentation; engineering or scientific; financial transactions (including guarantees); and insurance or reinsurance;

   ** Are either--

   --"Specified covered services"--A "White List" of common support services that generally do not involve a significant median comparable markup, as specified in a published revenue procedure, or

   --"Low margin covered services"--Services for which the median comparable markup does not exceed 7 percent;

   ** Pass the "business judgment" test--The taxpayer must reasonably conclude in its business judgment that the services do not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure in one or more trades or businesses of the renderer or the recipient; and

   ** Are covered by adequate books and...