by Prita Subramanian, Kaitlyn Wiatrak, and Tara Adams, Washington National Tax *

Transcription

1 What s News in Tax Analysis that matters from Washington National Tax The Services Cost Method and the New BEAT February 19, 2018 by Prita Subramanian, Kaitlyn Wiatrak, and Tara Adams, Washington National Tax * The Services Cost Method ( SCM ) in the regulations issued under section 482 of the Code 1 (the Section 482 Regulations ) has garnered significant attention since the enactment of new section 59A of the Code, the base erosion and anti-abuse tax ( BEAT ), which imposes a minimum tax on certain deductible payments made by U.S. taxpayers to related parties. Section 59A provides an exemption from the BEAT for certain amounts paid or accrued for services that meet (with one exception) the requirements for eligibility for use of the SCM. This article first summarizes the SCM exception in the BEAT and then explains the SCM as prescribed in the Section 482 Regulations. The SCM Exception in the BEAT The BEAT provision introduced in H.R. 1 2 (the Tax Act ) imposes a minimum tax of five percent for tax years beginning in 2018, 10 percent for tax years beginning in 2019 through tax years beginning in 2025, and 12.5 percent for all subsequent tax years on certain deductible payments made by U.S. taxpayers to related parties. 3 One feature of the BEAT provision is that it provides an exception tied to the SCM for certain amounts paid or accrued by a taxpayer for services. * Prita Subramanian is a principal, Kaitlyn Wiatrak is a manager, and Tara Adams is a tax managing director with the Economic and Valuation Services group in Washington National Tax ( WNT ). 1 The Code refers to the Internal Revenue Code of 1986, as amended. 2 P.L , 131 Stat (2017) (originally known as the Tax Cuts and Jobs Act ). 3 The BEAT provision is complex and is not fully described in this article.

2 The Services Cost Method and the New BEAT page 2 Section 59A(d)(5) states that the BEAT shall not apply to any amount paid or accrued by a taxpayer for services if (A) Such services are services which meet the requirements for eligibility for use of the Services Cost Method under Section 482 (determined without regard to the requirement that the services not contribute significantly to fundamental risks of business success or failure), and (B) Such amount constitutes the total services cost with no markup component. Understanding whether a service meets the eligibility requirements for use of the SCM is, therefore, important for determining whether the service meets the exception in section 59A(d)(5) to application of the BEAT. In evaluating eligibility for use of the SCM for the purposes of determining whether a service meets the BEAT exception in section 59A(d)(5), taxpayers should ignore one particular requirement i.e., the requirement that the service not contribute significantly to the fundamental risks of business success or failure. However, the other criteria for eligibility for use of the SCM must be met. The Joint Explanatory Statement of the Committee of Conference dated December 15, 2017, which explains the provisions of the Tax Act, notes that the requirements for eligibility for use of the SCM, as they were in effect as of the date of the enactment of the Tax Act, are relevant for the purposes of the BEAT evaluation. 4 The sections below describe the requirements for eligibility for use of the SCM as of the enactment date of the Tax Act and discuss some key considerations in evaluating these requirements. 5 The SCM in the Section Regulations Overview The Section 482 Regulations generally require that transactions between related parties occur at prices consistent with those between unrelated parties. The regulations state that, [a] controlled transaction meets the arm s-length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm s-length result). 6 4 [A] base erosion payment does not include any amount paid or accrued by a taxpayer for services if such services meet the requirements for eligibility for use of the services cost method described in Treas. Reg. sec , as in effect as of the date of enactment of [the Tax Act], without regard to 5 Note that this article does not explore the legal issue of whether the total services cost, excluding the markup component, for a service that was not priced using the SCM but is eligible for use of the SCM under section 59A(d)(5) meets the BEAT exception. This article solely focuses on exploring the SCM eligibility criteria under the Section 482 Regulations. The issue of whether charging a markup makes the entire service charge subject to the BEAT is an open issue, which is out of the scope of this memo. 6 Treas. Reg (b)(1).

3 The Services Cost Method and the New BEAT page 3 The Section 482 Regulations provide specified methods that practitioners may use to determine whether the prices charged in controlled transactions are consistent with the arm s-length standard. Practitioners may also apply unspecified methods if they are likely to yield more accurate results than the specified methods. The best method rule governs the selection of methods. This rule states that the selected transfer pricing method and its application should provide the most reliable measure of an arm s-length result for the controlled transaction. 7 The regulations under Section (the Services Regulations ) apply specifically to controlled services transactions. A controlled services transaction is defined as any activity by one member of a group of controlled taxpayers (the renderer) that results in a benefit to one or more other members of the controlled group (the recipient or recipients). 8 An activity is broadly defined as including: (1) the performance of functions; (2) the assumption of risks; (3) the use by a renderer of tangible or intangible property or other resources, capabilities, or knowledge (including the knowledge of and ability to take advantage of a particularly advantageous situation or circumstance); and (4) making available to the recipient any property or other resources of the renderer. 9 The Services Regulations specify five methods that, subject to the best method rule and other requirements of the Section 482 Regulations, may be used to determine the arm s-length nature of an amount charged in a transfer of services between controlled taxpayers, in addition to allowing for the use of unspecified methods. The Services Regulations also provide for the possible election of the SCM as an effective safe harbor. The SCM evaluates whether the amount charged for covered services is arm s length by reference to the total services costs with no markup. 10 Taxpayers must compute all costs in cash or in kind (including stock based compensation), that, based on analysis of the facts and circumstances, are directly identified with or reasonably allocated... to the services, in order to apply the SCM. The SCM is an elective method and taxpayers are permitted to use other methods under the regulations to determine the arm s-length compensation for covered services, even when the services are eligible for the use of the SCM. If the covered services are eligible for the use of the SCM, then the taxpayer may elect the SCM as the best method. Conversely, if the taxpayer does not elect the SCM, the SCM need not be considered in selecting the best method under the best method rule for evaluating the compensation paid for the services. The following two sections describe the requirements for services to be considered eligible for the use of the SCM and the conditions for electing to apply the SCM to eligible services. 7 Treas. Reg (c). 8 Treas. Reg (l)(1). 9 Treas. Reg (l)(2). 10 Treas. Reg (b)(1).

4 The Services Cost Method and the New BEAT page 4 Eligibility for the Use of the SCM For services to be considered eligible for the use of the SCM, the services must satisfy the following three conditions: 1. The service is a covered service Covered services are ones that meet the definition of specified covered services or low margin covered services. Specified covered services are controlled transactions that the Commissioner specifies by revenue procedure. Services are included in the revenue procedure based on the Commissioner's determination that the specified covered services are support services common among taxpayers across industry sectors and generally do not involve a significant median comparable markup on total services costs. 11 Low margin covered services are controlled services transactions for which the median comparable markup on total services costs is less than or equal to seven percent. The median comparable markup on total services costs for the purposes of the SCM is determined under the general Section 482 Regulations without regard to the SCM The service is not an excluded activity 13 The list of excluded activities that are ineligible for the use of the SCM consists of: Manufacturing Production Extraction, exploration, or processing of natural resources Construction Reselling, distribution, acting as a sales or purchasing agent, or acting under a commission or other similar arrangement Research, development, or experimentation Engineering or scientific Financial transactions, including guarantees Insurance or reinsurance 11 Section 3 of Revenue Procedure provides a list of specified covered services for the application of the SCM. 12 Treas. Reg (b)(3). 13 Treas. Reg. Section (b)(4)

5 The Services Cost Method and the New BEAT page 5 3. The service does not contribute significantly to the business success or failure 14 The taxpayer must reasonably conclude in its business judgment that the service does 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 controlled group (the business judgment rule ). The IRS clarified in a notice 15 that the business judgment rule applies in relation to business of the controlled group and not just the renderer or recipient of services. Further, the business judgment rule test is satisfied by a reasonable exercise of the taxpayer s business judgment, not a reasonable exercise of the IRS s judgment in examining the taxpayer. Taxpayers Must Maintain Adequate Books and Records To apply the SCM to a service that is eligible for use of the SCM, adequate books and records as described in the Services Regulations must be maintained: Permanent books of account and records are maintained for as long as the costs with respect to the covered services are incurred by the renderer. Such books and records must include a statement evidencing the taxpayer's intention to apply the services cost method to evaluate the arm's length charge for such services. Such books and records must be adequate to permit verification by the Commissioner of the total services costs incurred by the renderer, including a description of the services in question, identification of the renderer and the recipient of such services, and sufficient documentation to allow verification of the methods used to allocate and apportion such costs to the services in question... Considerations in Determining SCM-Eligibility for the Purposes of BEAT It is useful to note that the SCM is an elective safe harbor available to U.S. taxpayers under the Section 482 Regulations. Countries outside the United States do not follow the Section 482 Regulations but have their own transfer pricing rules, which generally follow the Organisation for Economic Cooperation and Development Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the OECD Guidelines ). While the 2017 version of the OECD Guidelines do include an elective safe harbor, 16 it differs from the SCM in requiring a markup of five percent over costs. Thus, in practice, the SCM is almost never used for services rendered by non-u.s. parties and is typically only used for services rendered by U.S. taxpayers to controlled parties. Because the BEAT applies to outbound payments of U.S. taxpayers, the service transactions of relevance for the BEAT are services rendered by non-u.s. parties to their U.S. affiliates, which typically include a profit markup over total services costs. Nevertheless, it is still possible to evaluate whether the services meet the requirements for eligibility to use the SCM (other than the business judgment rule) even if they are not priced using the SCM. 14 This criterion should be ignored for determining the SCM exemption of the BEAT. 15 Internal Revenue Bulletin , Notice , 3.04 Business Judgment Rule (Jan. 16, 2007). 16 The OECD Guidelines refer to these services as low value-adding intra-group services in Chapter VII, Section D.

6 The Services Cost Method and the New BEAT page 6 As crafted, the SCM is intended to apply to services that are generally low value services and are not integral to the business. If the services are low value services but are integral to the business, then they would not be eligible for use of the SCM under the business judgment rule since the taxpayer could not reasonably conclude that in its business judgment the services do not contribute significantly to core capabilities or fundamental risks of success or failure of the controlled group. For example, a specified covered service in Revenue Procedure is [c]ompiling, analyzing and recording current credit data and other financial information regarding individuals or firms (including preparing reports with this information for use in decision making). If the controlled group is a pharmaceutical manufacturer, then this activity of compiling, analyzing, and recording credit data would likely not be integral to the business of the controlled group and could reasonably be expected to pass the business judgment rule test. However, if the business of the controlled group is to manage accounts receivables for customers, then compiling, analyzing, and recording credit data could be expected to be integral to the business. It is, therefore, likely that this activity would not qualify for the SCM under the business judgment rule. By ignoring the business judgement rule in evaluating whether a service meets the requirements for eligibility for use of the SCM, section 59A(d)(5) effectively exempts from application of the BEAT activities that are core activities of the controlled group but meet the other requirements of the SCM i.e., are covered services and are not excluded services. Therefore, in the example above, the service transaction could meet the SCM exclusion requirement of section 59A(d)(5) for both businesses even though it fails the business judgment rule test for the SCM for the accounts receivable management business. As described above, a taxpayer must evaluate several criteria in order to assess whether a particular service is eligible for use of the SCM. The following are some considerations to factor into the evaluation. Revenue Procedure provides a list of 101 specified covered services. It is important to carefully evaluate whether a service matches an activity on the list. This evaluation should be done at a sufficiently granular level to closely match the descriptions in the list. Aggregating disparate services may lead to erroneous conclusions on SCM eligibility and risk the entire service charge being subject to the BEAT. 17 For instance, Revenue Procedure includes budgeting as a category of specified covered services, when budgeting includes the following: 17 Note that the level of aggregation for determination of SCM eligibility follows the aggregation principle of section T(f)(2)(i)(B).

7 The Services Cost Method and the New BEAT page 7 Budgeting: 53. Compiling data for use by cost estimators in determining cost projections and in preparing budget estimates, including verifying information for completeness, accuracy, and conformance with internal procedures and regulations. 54. Compiling data to prepare budget and accounting reports for management. 55. Other activities similar to those specified in paragraphs (53) and (54). Simply treating budgeting as a category of specified covered service and excluding all related expenses may not be appropriate. The budgeting process for a company may include significant time and expenses of senior executives to evaluate the direction of the business and the required resources, review the budget estimates from different business units and approve the budgets. Although compiling data for use in budget estimates might be a specified covered service eligible for the SCM, the activities of the senior executives are not they should not be grouped together with the other activities and deemed to be SCM-eligible. The determination of whether certain services qualify as low margin services depends on the median markup of comparable companies. The median markup of comparable companies is determined under the general Section 482 Regulations without regard to the SCM. The Section 482 Regulations are extensive containing guidance on comparability criteria, use of multiple years of data, adjustments to the financial data of comparable companies to improve their reliability, etc. All of this guidance should be considered in determining the median markup of comparable companies. Further, the guidance related to the comparable profits method ( CPM ), in particular, should be considered. The CPM evaluates whether the amount charged in a controlled transaction is arm s length based on objective measures of profitability (profit level indicators) derived from uncontrolled taxpayers that engage in similar business activities under similar circumstances. The CPM is often used to test the transfer prices of services transactions using the markup over costs of comparable companies as benchmarks. Some specific issues for consideration are discussed below: Multiple years of data is ordinarily used. Circumstances that may warrant consideration of data from multiple years include the extent to which complete and accurate data is available for the tax year under review, the effect of business cycles in the controlled taxpayer's industry, or the effects of life cycles of the product or intangible property being examined. The Section 482 Regulations note that data from one or more years before or after the tax year under review must ordinarily be considered for purposes of applying CPM for services. 18 A standard practice in transfer pricing analyses using the CPM is to use data from the tax year under consideration 18 Section (f)(2)(iii)(B).

8 The Services Cost Method and the New BEAT page 8 and the two years immediately preceding that year. While data periods other than the standard three-year period may be used, the taxpayer should be prepared to explain why that period provided the most reliable estimate of the comparable companies markups over cost. Careful thought needs to be given to the geographical location of the comparable companies. For instance, U.S. and Indian companies performing similar functions may have significantly different markups over cost due to differences in markets, regulatory environments, available labor pool, etc. Similarly, Eastern European companies may have different markups from Western European companies in the same industry and performing the same functions. The services relevant for purposes of 59A(d)(5) are likely to be provided by non-u.s. controlled parties; consequently, it is likely that services of the non-u.s. controlled parties will have to be benchmarked and that the comparable companies will most likely be non-u.s. companies too. If U.S. companies are used or if companies from regions other than the controlled service provider s country are used, then taxpayers should be able to articulate why the selected companies are comparable to the controlled service provider. They should also consider whether the IRS could reasonably take a contrary position. The search for comparable companies can be made challenging since data is typically less reliable for non-u.s. companies, in particular for certain regions of the world, such as Latin America. If there are differences between the controlled service provider and an uncontrolled comparable company that would materially affect their markups over cost, comparability adjustments may be appropriate under an application of the CPM. 19 The taxpayer should also consider whether the IRS could reasonably assert that adjustments are required to improve the reliability of the results. For instance, in some cases, the assets of an uncontrolled comparable company may need to be adjusted to achieve greater comparability between the controlled service provider and the uncontrolled comparable. In these situations, the uncontrolled comparable company s operating income attributable to those assets must also be adjusted. In determining the median markup of comparable companies, the taxpayer needs to consider whether adjustments should be made to the comparable companies financial data to make them more comparable to the controlled service provider. Data availability and the reliability of these adjustments, which can be an issue for non-u.s. companies, will need to be factored into an evaluation of the reliability of adjustments to the comparable companies financial data. It should be noted that, for a given functional and risk profile of the controlled services, a determination that those services meet the definition of covered services using the specified covered services rule may be more stable than a determination made using the low margin covered services rule. If the controlled services do not change over time, then they are unlikely to fall in and out of the specified covered services list over time. The median markup of comparable companies can, however, be more volatile over time. Thus, if a controlled service is not a specified covered service but is determined to be a low margin covered service based on the median markup 19 Section (c)(2)(iv).

9 The Services Cost Method and the New BEAT page 9 of comparable companies, the taxpayer should be prepared for the prospect that it may be subject to the BEAT in future years even if it is not currently subject to the new tax. Further, if the median markup is sensitive to the composition of the set of comparable companies such that dropping or adding one or two companies moves the median above or below seven percent, then the reliability of the comparable set and its median is reduced. The evaluation of the median markup will need to be performed annually. If there is no significant change in the controlled services or the business of the comparable companies, the composition of the comparable company set can be expected to be relatively stable over time. While transfer pricing documentation may be a starting point for determining SCM-eligibility for BEAT purposes, it may not be sufficient. For instance, depending on the circumstances, a U.S. transfer pricing documentation study evaluating a few services transactions in aggregate or using a set of U.S. companies for benchmarking services provided by a European service provider may be acceptable from a U.S. transfer pricing perspective; it may not be sufficient for BEAT purposes, however. The objectives of a transfer pricing study and an SCM-eligibility evaluation for BEAT purposes are different and the implications of disagreements on SCM-eligibility can be significantly different. A transfer pricing study is typically meant to document compliance with the arm s-length standard. Disagreement on SCM-eligibility may lead to a positive markup instead of no markup, but it is unlikely to negate the entire service charge. Disagreement on SCM-eligibility for BEAT purposes, on the other hand, could have significantly higher negative consequences and call into question the exemption of the entire service charge for BEAT purposes. Thus, taxpayers should be wary of simply using existing transfer pricing studies for their BEAT evaluation without giving greater thought to the requirements for eligibility for use of the SCM. It should be noted that the evaluation of whether a controlled service meets the requirements for eligibility for use of the SCM does not depend solely on the realized markup over costs for the service. It is conceivable that a controlled service matching a specified covered service on Revenue Procedure is priced by the taxpayer with a markup greater than seven percent over the total services costs. If that service is a covered service since it is a specified covered service and is not an excluded activity, it could still meet the requirements for SCM-eligibility (without regard to the business judgment rule). Conversely, it is conceivable that an excluded service such as research and development is priced by the taxpayer at total services costs plus a markup below seven percent. 20 Such a service would not be considered SCM-eligible despite its low markup since it is an excluded activity. The evaluation of whether a controlled service meets the requirements for eligibility for the use of the SCM (other than the business judgment rule) needs to be performed independent of the realized markup over costs for the service. Finally, we note that in order to apply the SCM, the taxpayer is required to maintain books and records that are adequate to permit verification by the Commissioner of the total services costs incurred by the 20 Note that the issue of whether a service charge that was not priced using the SCM is eligible for the BEAT exception, and if it is, whether the total services cost with or without the markup is exempt from the BEAT, is an open issue, which is outside the scope of this article.

10 The Services Cost Method and the New BEAT page 10 renderer, including a description of the services in question, identification of the renderer and the recipient of the services, and sufficient documentation to allow verification of the methods used to allocate and apportion those costs to the services in question. Therefore, it will be important for taxpayers to document their cost allocations and support their service charges with additional documentation. These books and records must also include a statement evidencing the taxpayer's intention to apply the SCM to evaluate the arm s-length charge for the services. Clearly, such a statement would not be included in the books and records of a taxpayer that did not elect to apply the SCM. In the context of the BEAT and the requirement for SCM-eligibility rather than actual election of the SCM, taxpayers may consider including a statement indicating that the taxpayer intends to treat these charges as meeting the requirements for eligibility for use of the SCM, disregarding the business judgment rule of section (b)(5), for purposes of applying section 59A. 21 The information in this article is not intended to be "written advice concerning one or more federal tax matters" subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230 because the content is issued for general informational purposes only. The information contained in this article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP. 21 A legal evaluation of the statement of intent is outside the scope of this article.