TEI comments on proposed section 482 services regulations: December 22, 2003.

• Position: Tax Executives Institute

On December 22, 2003, Tax Executives Institute submitted comments to the Internal Revenue Service relating to the propossed section 482 services regulations. The comments were prepared under the aegis of TEI's International Tax Committee, whose chair is Bruce R. Maggin of IBM Corporation.

On September 5, 2003, the Internal Revenue Service issued proposed regulations providing guidance on the treatment of controlled services transactions under section 482 of the Internal Revenue Code and the allocation of income from intangibles, particularly with respect to contributions by a controlled party to the value of an intangible that is owned by another controlled party. The proposed regulations were published in the September 10, 2003, issue of the Federal Register (68 FED. REG. 53448). A hearing is scheduled for January 14, 2004.

Background

Tax Executives Institute is the preeminent association of business tax executives in North America. Our more than 5,400 members represent 2,800 of the leading corporations in the United States, Canada, and Europe. TEI represents a cross-section of the business community, and is dedicated to developing and effectively implementing sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply in a cost-efficient manner.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations under section 482, relating to the treatment of controlled services transactions and the allocation of income from intangibles.

Executive Summary

The release of proposed regulations in September represents the first attempt to revamp the section 482 services regulations since the 1960s. Much has changed in the world of cross-border transactions in the past 35 years and the Department of Treasury and Internal Revenue Service are to be commended for attempting to bring the rules more in line with today's global economy. Transfer pricing is not done in a vacuum and the proposed regulations recognize that the U.S. rules must comport with international guidelines. Thus, the proposed regulations seek to harmonize the transfer pricing rules for services with guidelines issued by the Organisation for Economic Cooperation and Development in several areas, including the definition of benefit, the exclusion of shareholder services, the requirement to use a standard pricing method, and the need to charge a profit element in many circumstances.

TEI is concerned, however, about several aspects of the proposed regulations, particularly the elimination of the cost safe harbor and its replacement with the simplified cost-based method (SCBM). The treatment of non-integral services under current Treas. Reg. [section] 1.482-2(b)(3)--which permits a taxpayer to charge services at cost where they are not an integral part of the business activity of either the member rendering the services or the member receiving the benefit of the services--is a practical approach to an area that is incredibly difficult to track. It has served taxpayers and the government well for nearly four decades.

Although Treasury and the IRS have attempted to provide an alternative in the SCBM method, the proposed regulations will permit far fewer services to be charged at cost, thereby increasing complexity and adding compliance burdens and expense. With the introduction of comparability standards and range rules for low-margin services, the sheer volume of transactions required to be analyzed under the proposed regulations will undoubtedly increase. In addition, the proposed rules are likely to cause additional controversy, not only with the IRS but with foreign jurisdictions, thereby increasing the potential for double taxation. For example, requiring a cost-plus approach for centralized services may run afoul of other jurisdictions that favor--and often require--a charge for such services at cost. Finally, the cost rates used in many of the examples may create de facto standards for auditing management and other services. In sum, the SCBM method is neither simple nor safe to use.

For these reasons, TEI urges Treasury and the IRS to retain the cost safe harbor. The vast majority of back-office services are routine, low-margin services for which charging cost is reasonable and appropriate. These services support the core profit-making activities of the taxpayer, but are not themselves integral to such activities. These services include finance, treasury, comptrollers or controllers, accounting, legal, tax, human resources, and procurement. To the extent that intangibles assist in providing these services, they typically make the service more efficient, not more valuable. TEI believes that the cost safe harbor should be retained, at least with respect to certain enumerated services.

In its analysis of the proposed regulations, TEI also offers the following conclusions and recommendations:

* Changes are needed in the area of centralized services to aid taxpayers seeking to comply with the requirements of both the United States and foreign jurisdictions. Possible changes include the explicit provision for a cost-sharing model similar to the qualified cost-sharing arrangement for intangible property development under Treas. Reg. [section]1.482-7 and to the concept of the cost contribution arrangement under guidelines issued by the OECD.

* The concept of legal ownership in the intangibles regulations is at odds with longstanding tax principles of beneficial ownership. The proposed regulations should be clarified by eliminating the concept of "legal ownership" from the transfer pricing analysis.

* The examples in Prop. Reg. [subsection] 1.482-1(d)(3)(ii)(C), 1.482-9(i)(3), and -9(i)(4) should clarify that an adjustment cannot be made in later years for transfer pricing errors that occurred in years for which the statute of limitations has closed.

* The SCBM method is far from simple since it effectively requires taxpayers to perform a full transfer pricing analysis for routine, low-margin services. To avoid adverse effects on U.S. businesses, the final regulations should provide a true cost safe harbor method for these services. In addition, examples of what constitutes "low-margin" services should be provided.

* Taxpayers should be protected from penalties if they have reasonably applied SCBM. The definition of "total service costs" should permit taxpayers to rely on generally accepted accounting or tax accounting principles in determining such costs. The terms "significantly," "material," and "de minimis" should be defined. The 50-percent recipient test in Prop. Reg. [section] 1.482-9(f)(4)(ii) should be eliminated.

* The exclusions from use of SCBM set forth in Prop. Reg. [section]1.4829(f)(4)(v)(E) should be narrowed and clarified. The final regulations should provide a safe harbor that a parent-subsidiary charge for a guarantee at cost-only is one measure of an arm's-length charge. Finally, SCBM should be revised to permit the safe harbor to apply to inbound transactions.

* The proposed regulations assume that back-office services are performed in the United States. If taxpayers may no longer charge out these services at cost, however, it could create an incentive to consolidate the services elsewhere or discourage foreign-owned multinationals from placing general support services operations in the United States.

* The proposed services regulations should not be finalized before taxpayers have had an opportunity to review and comment upon the proposed cost-sharing regulations when they are issued.

* The final regulations should address the grandfathering of existing compliance approaches. In particular, multinationals should be permitted a transition period in which to comply with the final regulations.

GENERAL COMMENTS

1. Scope of the regulations

   1. The Need for Cost Sharing

      The proposed regulations add a new Prop. Reg. [section] 1.482-9 to deal with "coutrolled services transactions," which are broadly defined in subsection (1) as any activity by a controlled taxpayer that results in a benefit to one or more controlled taxpayers. The term "activity" is defined to include the use by the renderer (or making available to the renderer) of any property or other resources of the renderer. An activity provides a benefit if it results in a reasonably identifiable increment of economic or commercial value that enhances the recipient's commercial position (or is reasonably anticipated to de so). An activity confers a benefit if an uncontrolled taxpayer in circumstances comparable to those of the recipient would be willing to pay an uncontrolled party to perform the same or similar activity.

      In adopting a "specific benefit" approach, the proposed regulations revamp the "benefit" test of the current regulations, which focused on the service provider, rather than the recipient, i.e., on whether an uncontrolled taxpayer in circumstances similar to the renderer would charge for the service. The Preamble specifically rejects the general benefit theory, which "requires that expenses incurred for the benefit of the group as a whole be allocated to members on the same ratable basis even if there is no specific, identifiable benefit received by the affiliates currently." (1) TEI questions whether this level of review is warranted.

      For sound business reasons, many multinational taxpayers choose to consolidate the performance of certain services that...