On December 20, 2006, the IRS issued guidance that (1) delays the effective date of the temporary transfer pricing services regulations (Notice 2007-5), (2) expands the “Covered Services List” of services eligible for at-cost pricing (Revenue Procedure 2007-13), and (3) clarifies other issues raised by commentators (Notice 2007-5). Generally, the guidance is good news for taxpayers because taxpayers would have faced significant systems and other issues if they had been required to comply with the temporary regulations starting on January 1, 2007.

IRS Delays Effective Date

On July 31, 2006, the IRS issued temporary regulations that were intended to apply to taxable years beginning after December 31, 2006. See M&C Alert on temporary regulations. Several provisions mitigate or delay the effective date of the temporary regulations. While the IRS stopped short of issuing the blanket one-year delay requested by commentators, the new guidance is responsive to many taxpayer concerns in this regard.

Notice 2007-5 generally delays the effective date of the temporary regulations for one year, but only as applied to services that would have been eligible for the broad cost safe harbor of the 1968 services regulations. The 1968 regulations allow at-cost pricing for services unless the activity is considered to be “integral” to the business of the renderer or recipient under one of four specified tests. Thus, under Notice 2007-5, the temporary regulations will apply to “nonintegral” services in tax years beginning after December 31, 2007, and taxpayers can continue to price services at cost under their current transfer pricing policies. The only exception is for services that fail the so-called “business judgment test.” These are services that the taxpayer -- in its business judgment -- believes contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure in one or more of the corporate group’s businesses. As a result, the amorphous and subjective business judgment test will have immediate and significant import for taxpayers in 2007.

With respect to services to which the temporary regulations apply in 2007 (i.e., integral services and services that fail the business judgment test), the IRS will waive transfer pricing penalties unless the taxpayer fails to make a reasonable effort to comply with the contemporaneous documentation requirements. Further, the IRS will consider contingent payment contracts entered into before the filing of the 2007 tax return to have effect from the beginning of 2007.

Services Cost Method Is Optional

The temporary regulations introduced the Services Cost Method. Several commentators had observed that the temporary regulations could be interpreted to require the use of the method. Notice 2007-5 confirms that a taxpayer may decide whether to apply the services cost method, and the taxpayer is not required to attach a statement of intent to apply that method to its tax return.

IRS Expands Covered Services List

Rev. Proc. 2007-13 expands the Covered Services List of services eligible for at-cost pricing. In particular, the Covered Services List includes additional activities related to a company’s accounting, tax, IT, and treasury functions. In addition, Rev. Proc. 2007-13 includes as a covered service procurement related to support activities. Although the IRS declined to adopt an approach suggested by commentators whereby all activities performed by certain departments (e.g., legal and human resources) would be eligible for cost pricing, it included a “catch-all” provision under each departmental heading for activities similar to those enumerated. The IRS solicits comments on the list, and in particular whether it should add warehousing or other distribution support functions to the list. The IRS will probably issue an updated Revenue Procedure before the January 1, 2008 effective date.

IRS Modifies Business Judgment Test

Notice 2007-5 clarifies that the IRS will apply the business judgment at the corporate-group level and not the entity level. This clarification addresses the concern that entities that primarily provide support services would fail the business judgment test. The IRS also clarified that in applying the business judgment test, it will consider whether an activity contributes to the operating profit of one or more entities, and that the taxpayer’s business judgment is of paramount importance. Notwithstanding these useful clarifications, the business judgment test remains amorphous and subjective.

Shared Service Concept

Notice 2007-5 confirms that the shared services arrangement rules do not apply to services that are ineligible for at-cost pricing under the Services Cost Method. The IRS will test similar arrangements with respect to such services under the general transfer pricing rules.

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

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

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

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