IRS Issues Transfer Pricing Regulations For Services Transactions

International Tax Alert
08.02.06

On July 31, 2006, the Treasury and the IRS issued temporary and proposed transfer pricing regulations that provide much-anticipated guidance on the treatment of controlled services transactions and the allocation of income from intangibles. The temporary regulations generally apply to taxable years beginning after December 31, 2006. Taxpayers may formally elect to apply the new regulations in their entirety to any taxable year beginning after September 10, 2003.

The new regulations make several important changes to the regulations proposed in September 2003 (the “2003 regulations”). The new regulations also represent a material change from the longstanding current regulations (the “1968 regulations”), in particular imposing new restrictions on the ability of taxpayers to price certain services at cost. Taxpayers should begin assessing the impact of the new regulations on services that have been priced at cost under the 1968 regulations and should evaluate their transfer pricing policies related to services more generally.

Material highlights of the new regulations include the following:

  1. Introduction of New Services Cost Method. The new regulations introduce a new services cost method (“SCM”), which replaces the cost safe harbor of the current regulations and the simplified cost-based method (“SCBM”) of the 2003 regulations. The SCM allows taxpayers to price services at cost provided that certain requirements are met. Although the SCM is clearly less burdensome than the SCBM, it is significantly narrower than the safe harbor provided in the 1968 regulations. Two categories of services are eligible for the SCM: (i) specified covered services included in a “White List”; and (ii) certain low-margin covered services (i.e., services for which the arm’s-length mark-up is less than 7%). An initial proposed “White List” was issued in conjunction with the new regulations (in Announcement 2006-50) and will be finalized in a Revenue Procedure before December 31, 2006. The White List includes categories of back office and administrative services that are common to most industries, including payroll, HR, accounting, tax compliance, legal, and public relations services. It does not include significant categories of services proposed by commentators to the 2003 regulations, such as procurement.
     
  2. Clarification regarding the definition of "cost." The new regulations clarify two important issues related to the definition of “costs” for purposes of applying any cost-based transfer pricing method. First, stock-based compensation should be included in the cost of providing services. Second, to the extent the cost of services include charges from third parties, the transaction may be bifurcated and analyzed as: (i) the provision of services by the renderer; and (ii) the transfer of services or goods provided by third parties. Treasury and the IRS rejected taxpayer comments arguing for the pass through of such third party charges at cost.
  3. Shared services guidance. The new regulations contain explicit guidance for certain shared-services functions. These rules generally allow taxpayers to identify shared services activities that benefit two or more members of a controlled group. Taxpayers may allocate the cost of these activities to group members on a basis that reflects the anticipated benefits of the services to each member.
     
  4. Elimination of profit-split "default." In response to taxpayer comments, the new regulations eliminate any implication that the profit-split method is a “default” method for “high value” services.
     
  5. Exclusion of global dealing. The new regulations do not apply to global dealing and other financial transactions. Instead, taxpayers may rely on forthcoming re-proposed regulations. This strongly suggests that re-proposed global-dealing regulations will be issued by the end of 2006, which is consistent with recent statements from government officials.
     
  6. Financial guarantees excluded from "services." The new regulations clarify that financial guarantees provided by related parties are not services transactions. As a result, for tax years beginning after December 31, 2006, financial guarantee arrangements will not qualify for the SCM method or any cost-based safe harbor. This is a substantial change from current law. The regulations indicate that specific rules on financial guarantees will be included as part of the re-proposed global-dealing regulations.
     
  7. Services vs. intangibles transfers. In response to taxpayer comments, the new regulations narrow the circumstances in which a services transaction will be evaluated as the transfer of an intangible. For example, the provider of R&D contract services will not be considered to have transferred the know-how or other intangibles unless the service provider was the owner of the know-how pursuant to a contract or other arrangement. This focus on legal ownership is consistent with the 2003 regulations.
     
  8. Definition of "stewardship expenses." The new regulations make conforming changes to the definition of "stewardship expenses" for purposes of section 861. Thus, expenses will not be considered stewardship expenses for purposes of the foreign tax credit, for example, unless the expenses are undertaken solely to protect a parent company’s capital investment in a related company or to facilitate compliance by the corporation with reporting, legal, or regulatory requirements applicable specifically to the parent company. This is a change from current law and from the 2003 regulations. (The preamble to the 2003 regulations noted that such a change was being considered.)

The Treasury and the IRS are soliciting taxpayer comments, particularly with respect to the whether the list of items included in the proposed "White List" is sufficient, as well as with respect to the definitions of the included items. However, no hearing has been scheduled with respect to the new regulations, and there is not much time before temporary regulations come into effect. It is not likely that changes will be made to the temporary regulations before they come into effect. Thus, taxpayers should begin assessing the effect of the new regulations on services they had priced at cost pursuant to the 1968 regulations, and evaluating their services-related transfer-pricing policies more generally.

For more information, please contact any of the following lawyers:

Rocco Femia, rfemia@milchev.com, 202-626-5823

Kevin Kenworthy, kkenworthy@milchev.com, 202-626-5848

Kimberly Tan Majure

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