Treasury Issues Final and Temporary Regulations on Intercompany Services
On August 1, the Treasury issued widely anticipated final and temporary regulations on the pricing of intercompany services, replacing outdated service regulations put in place in 1968. The new regulations supersede some of the most criticized parts of the proposed services regulations initially issued in 2003. These new regulations will be effective for tax years starting after December 31, 2006.The core focus of the services regulations, in their proposed and final form, is twofold: (i) to clarify the definition and methods for determination of the appropriate cost pool charged out to an affiliate, and (ii) to introduce pricing methodologies for intercompany services that contribute to the core capabilities and competitiveness of the beneficiary of such services.
Regulations Become Effective in about Five Months
The regulations generally become effective approximately five months from now. Given the necessary lead time to perform supporting analyses under the new rules and the time required to make necessary accounting and IT changes, companies need to act now. Also, companies may elect to adopt the regulations now for certain prior periods. As discussed below, in some cases such an election may be beneficial.The next section provides a brief overview of the incremental changes to the proposed regulations, now reflected in the final regulations. Following that, we summarize the main elements of the services regulations as a whole. We close with some recommendations.
Changes to the Regulations
Responding to intense criticism from taxpayers and practitioners, the final regulations introduce the following changes that supersede the 2003 proposed regulations.
Changes Aimed at Determining Arm’s Length Mark-up
The cumbersome Simplified Cost-Based Method (SCBM) has been replaced with a more practical Services Cost Method (SCM). In the SCM, the prior complex and controversial markup and adjustment mechanism has been replaced with a two-pronged safe harbor rule that allows taxpayers to charge out, at cost, all services that are either on a list of routine and non-core services (such as administrative head office activities), or that have a comparables-supported median markup equal to or less than 7 percent. In all events, the SCM requires a conclusion that the services do not contribute significantly to key competitive advantages, core capabilities, or fundamental chances of success in the business.
Changes Aimed at Determining Cost Base
The definition of shareholder stewardship activities has been narrowed to include activities whose sole effect is to protect an investment or comply with regulatory requirements. The regulations contain numerous examples that distinguish stewardship expenses from activities that confer some benefit on an affiliate, for which reimbursement is required. Also, expenses related to stock-based compensation of employees now need to be included in the costs charged out to affiliates. Finally, the regulations outline the requirements for a Shared Services Arrangement (SSA) among two or more affiliated taxpayers. The SSA applies to routine services that qualify for the SCM approach and allows for the aggregation of services if economically reasonable.
Key Elements of the New Regulations
According to the Treasury, the services regulations are intended to simplify the analysis of service transactions and prevent the perceived abuses that resulted from application of the former regulations.
Determining an Arm’s Length Markup
The regulations generally require that the arm’s length amount charged in a controlled services transaction be determined pursuant to one of six specified transfer pricing methods set forth in the final regulations.
With respect to “routine services,” the proposed regulations institute the above-mentioned SCM as a replacement for the current cost safe harbor under Regulations 1.482-2(b)(3). In addition to the SCM, the five methods outlined generally mirror those employed to price intercompany transactions involving tangible products (and in most cases, transfer of intangibles), which is clearly reflected in the terminology of the regulations:
Rules Are Based on Significant Conceptual Changes
The Treasury reasoned that service transactions should not be treated any differently than other types of intercompany transactions. It therefore designed these new methods to harmonize with the rules governing allocation and assignment of income based on functions performed, risks undertaken, and intangibles employed or developed.
In addition to the introduction of the SCM that regulates the use of the cost safe harbor to a defined group of low-margin services, another significant conceptual change is the idea of non-routine contributions in connection with rendering services to an affiliate and the introduction of the profit split method as a potential best method in this context. Examples of such non-routine contributions include, but are not limited to, proprietary software used in connection with rendering services, institutional know-how and experience, and licenses to perform certain services.
Treasury’s new services regulations seek to be consistent with the proposed cost sharing regulations by attempting to broaden the definition of relevant intangibles beyond what was historically considered a valuable, non-routine intangible under Section 482. In the proposed cost sharing regulations this is based on the broad concept of “contributions” that provide a measurable and identifiable benefit to a buyer or licensee. The concept is mirrored in the services regulations with the equally broad concept of an “activity” that provides a measurable and identifiable “benefit” to the recipient or beneficiary. A benefit is defined as the result of an activity that results in a reasonably identifiable increment of economic value that enhances the recipient’s commercial position; an activity, on the other hand, is defined as any contribution of property or other resources for the benefit of one or more taxpayers. This definition of activities and benefits is broad enough to allow for non-routine contributions embedded in a routine service and achieve Treasury’s goal of avoiding transfer of IP without equivalent compensation.
Determining the Appropriate Cost Base
In addition to clarifying the determination and use of arm’s length markups for intercompany services, Treasury seeks to better define the cost pool to be charged out to a company’s affiliate. We expect that this particular group of changes will actually have a more profound impact on overall intercompany charges than will the changes in the methodologies for determining an arm’s length markup.
This new definition means that the concept of Total Services Costs now includes all costs directly identified with the provision of such services, plus other costs that are reasonably allocable to such services. This includes costs for all resources expended, used, or made available in rendering the service. The definition of Total Services Costs leaves the door open for a reinterpretation of relevant costs that differs from common financial and tax accounting standards and would be closer to an economic or cost-accounting view of resource allocation. The regulations state that GAAP or tax accounting rules may not always be a good basis to determine the appropriate cost pool.
The broader definition of services based on the activity and benefit concept discussed above also leads to the inclusion of activities that historically had been either consciously or accidentally neglected in intercompany allocations. The treatment of financial guarantees, and financial transactions in general, is certainly the most relevant group of activities that are to be included in intercompany charges. They are explicitly excluded from the SCM.
The regulations clarify the types of activities for which no reimbursement payment need be made, including (i) activities that involve shareholder stewardship, (ii) activities that provide an indirect or remote benefit to affiliates, and (iii) activities that simply duplicate activities performed by affiliates. This has been an area of uncertainty with taxpayers often taking differing positions. The regulations contain numerous examples that illustrate these rules. Depending on past transfer pricing practices, these clarifications could result in significantly different allocations.
The new services regulations specifically require costs related to stock-based compensation to be included in Total Services Costs even though this provision seems to be in conflict with the recent Xilinx case. This could have a potentially significant impact on companies that rely heavily on stock-based compensation and may also result in double taxation if foreign jurisdictions do not adopt a similar rule.
Finally, the new regulations further clarify the rules for “pass-through” of external costs without further markup. This opportunity for segmentation of internal and external costs is limited to material external cost items only and subject to certain restrictions.
Regulations Take Effect in Five Months
Every multinational company, US-headquartered or not, likely has intercompany transactions that are impacted by these new services regulations. The regulations’ effective date is January 1, 2007. This means companies have five months to develop a practical and defendable transfer pricing policy by identifying all relevant transactions and perform an analysis under the rules of the new regulations. The focus of the U.S. tax authorities on intercompany services will increase significantly as a result of this new regulation.
Also, the regulations may be applied to tax years beginning after September 10, 2003. Taxpayers should consider whether application of the regulations to prior years would be beneficial. In general, for US based companies, if there is no (or nominal) stock option expense in those years and most services subject to these rules would be treated as falling under the SCM rule, then application of the new regulations could be beneficial. An election to apply these rules to a prior year must be made with the filing of the tax return for the first taxable year after December 31, 2006.
Accordingly, it is essential to review the application of these new rules and develop a strategy for implementing new transfer pricing policies.
This publication is intended to provide clients with information on recent legal developments. It should not be construed as legal advice or legal opinion on specific facts. Pursuant to applicable Rules of Professional Conduct, it may constitute advertising.
Circular 230 Notice: In accordance with Treasury Regulations which became applicable to all tax practitioners as of June 20, 2005, please note that any tax advice given herein (and in any attachments) is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of (i) avoiding tax penalties or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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