The New Services Regulations: Are We There Yet?

Transcription

1 Tax Management Memorandum April 30, 2007, Vol. 48 No. 09 MEMORANDUM The New Services Regulations: Are We There Yet? Page 1 of 17 The New Services Regulations: Are We There Yet? by Steven C. Wrappe and Brian P. Trauman Mayer, Brown, Rowe & Maw LLP INTRODUCTION The last time that new final transfer pricing regulations for intercompany services were released was 1968 (the "1968 Regulations"). 1 In the intervening 39 years, services have become an increasingly large and important segment of the U.S. and global economies. In particular, cross-border services transactions make up an increasingly significant segment of cross-border transactions among members of controlled groups. 2 In 1994, the transfer pricing regulations for nearly all types of intercompany transactions were overhauled, with the notable exception of the rules with respect to intercompany services. 3 Other transfer pricing regulations have been finalized since that time, but not intercompany services. 4 In September 2003, proposed intercompany services regulations (the "2003 Proposed Regulations") were released. 5 The Treasury and the IRS believed that new guidance on intercompany services transactions was necessary to reflect the major economic and legal developments that have taken place since the issuance of the 1968 Regulations. The 2003 Proposed Regulations contained four main areas of change: (i) regulatory consistency with the other transfer pricing regulations; (ii) a substantially revised "benefit test"; (iii) a replacement regime for cost-only allocations (the simplified cost based method, or "SCBM"); and (iv) an approach to addressing overlaps between services and intangibles. Following extensive hearings and comments, the IRS and Treasury released temporary and proposed regulations in August 2006 (the "2006 Temporary Regulations"). 6 The 2006 Temporary Regulations specifically responded to many of the comments received, often making refinements to address the concerns expressed. Overall, the issues addressed by the 2003 Proposed Regulations remain largely intact. The 2006 Temporary Regulations replaced the extremely unpopular SCBM with the new services cost method and new shared services arrangements, and made other refinements consistent with taxpayer viewpoints. These rules were further refined in December 2006 with some limited modification to the effective date. 7 Many articles already have been written that describe in detail the 2003 Proposed Regulations and the 2006 Temporary Regulations. 8 For each of the four main areas of change to the intercompany services regulations, this article reviews the issue under the 1968 Regulations, the IRS's intended purpose in making the change, and the resulting treatment under the 2006 Temporary Regulations. The changes to the transfer pricing regulations for services have been so extensive and so long in the making that despite a healthy collaboration between taxpayers and government during the drafting process, some practical implementation problems are inevitable. The article attempts to identify some of the practical implications that might require the IRS and Treasury to make further refinements before the 2006 Temporary Regulations are finalized. INCORPORATION OF REGS GENERAL RULES 1968 Regulations For taxable years beginning prior to January 1, 2007, Regs (b) 9 of the 1968 Regulations applies to intercompany service transactions. The 1968 Regulations are very basic in approach. The 1968 Regulations require that, where one member of a group of controlled entities performs marketing, managerial, administrative, technical, or other services for the benefit, or on behalf, of another member of the group, the service renderer must generally be compensated. If the renderer is not compensated, or is compensated at other than arm's length, the IRS may make an allocation to reflect arm's length compensation for those services. 10 No compensation is necessary if the benefit to the recipient is so remote or indirect that unrelated parties would not have charged for such services. 11 Unless the service is an "integral" part of the business of either the recipient or the renderer, a cost-only charge for services is considered appropriate. 12

2 Page 2 of 17 Although the arm's length principle applied to intercompany services under the 1968 Regulations, the 1968 Regulations contain no best method rule with respect to intercompany services. In fact, the only "methods" discussed related to the appropriate allocation of costs in the cost-only context. 13 The various transfer pricing methods -- comparable uncontrolled price, resale price, cost plus -- were available only by analogy. Further, the comparability and range concepts of Regs did not apply to intercompany services. Because some of the restrictions applicable to other types of transactions were absent, some tax planning focused on characterization of the planned transaction as a services transaction. For example, if a transaction were characterized as a license of an intangible, the "commensurate with income rule" under Regs would apply, thus exposing the transaction to the potential for periodic adjustment. If that same transaction were instead characterized as a services transaction, the commensurate with income rule would not apply and the taxpayer would have considerably more flexibility in reporting its prices. IRS Intentions The IRS extended the coverage of the general rules of Regs to intercompany services for a number or reasons. First, the IRS and Treasury considered the revisions necessary to achieve consistency with the guidance for other types of transfer pricing transactions and with international standards. Next, the revisions provide guidance to coordinate and harmonize the rules applicable to services with the rules applicable to other transactions, especially intangibles, in order to prevent "inappropriate results." 14 In this context, "inappropriate treatment" refers to the possibility that characterization of the transaction as a services transaction would produce a different result than an economically similar transaction characterized as an intangibles transaction Temporary Regulations Consistent with the rules governing transfers of tangible and intangible property, the 2006 Temporary Regulations provide guidance concerning selection and application of the appropriate transfer pricing method by explicitly incorporating the general rules in Regs (including the best method rule of Regs (c), the comparability analysis of Regs (d), and the arm's length range of Regs (e) of the existing regulations). The 2006 Temporary Regulations provide generally that the arm's length amount charged in a controlled services transaction must be determined under one of the transfer pricing methods provided in the regulations. The 2006 Temporary Regulations specify six transfer pricing methods. Three of the methods are transactional methods, two are profit-based methods, and one is a cost-based method that would replace the cost-only safe harbor from the 1968 Regulations. The six methods are: 1. The comparable uncontrolled services price method; The gross services margin method; The cost of services plus method; The comparable profits method; The services cost method (SCM); 19 and 6. The profit split method. 20 All of the specified methods, with the exception of the SCM, are closely analogous to the methods set forth in the existing regulations for transfers of tangible property 21 and transfers of intangible property, 22 adapted to account for particular circumstances surrounding services transactions. In addition, the 2006 Temporary Regulations provide that unspecified methods also may be used to determine an arm's length charge if such a method will provide the most reliable measure of an arm's length result under the best method rule. 23 The 2006 Temporary Regulations emphasize that under the arm's length standard "an unspecified method should provide information on the prices or profits that the controlled taxpayer might have realized by choosing a realistic alternative to the controlled transaction..." 24 The 2006 Temporary Regulations require that each method be applied consistently with generally applicable transfer pricing concepts such as the arm's length range, the best method rule, and comparability analysis. In addition, the description of each of the specified methods includes comparability factors that may be of particular importance for that method.

3 Page 3 of 17 Transfer of Tangible property Transfer of Intangible property CUP (Comparable Uncontrolled Price Method) 26 CUT (Comparable Uncontrolled Transaction Method) 27 Services (temporary regulations) 25 CUSP (Comparable Uncontrolled Services Price Method) 28 RPM X GSM (Resale Price Method) 29 (Gross Services Margin Method) 30 Cost Plus X CSPM (Cost Plus Method) 31 (Cost of Services Plus Method) 32 CPM (Comparable Profits Method) 33 TNMM (Transactional Net Margin Method) 34 CPM/TNMM Commensurate with income rules 35 CPM PSM PSM 37 PSM 38 (Profit Split Method) 36 CPS (Comparable Profit Split Method) 39 RPS (Residual Profit Split Method) 40 CPS RPS CPS RPS X X SCM (Services Cost Method) 41 Unspecified Methods 42 Unspecified Methods 43 Unspecified Methods 44 For purposes of applying the SCM, which is based on the service renderer's costs of providing services, the 2006 Temporary Regulations define total services costs 45 as the cost of rendering those services for which total services costs are being determined, including all costs in cash or in kind (including stock-based compensation) that, based on an analysis of the facts and circumstances, are directly identified with the act of rendering the services, as well as all other costs reasonably allocable to the services, except for interest expense, foreign income taxes, 46 or domestic income taxes. The 2006 Temporary Regulations add that for purposes of determining total services costs, generally accepted accounting principles or income tax accounting rules may provide a useful starting point, but caution that neither will be conclusive. 47 The 1968 Regulations provide that, where the arm's length charge for intercompany services is determined based on the costs or deductions incurred in connection with those services, costs may be allocated and apportioned to a services transaction under a method of allocation and apportionment that is reasonable and in keeping with sound accounting practices. 48 While the 2006 Temporary Regulations 49 retain this flexible approach, they also provide that consideration should be given to all bases and factors including, for example, total services costs, total costs for a relevant activity, assets, sales, compensation, space utilized, and time spent. The 2006 Temporary Regulations also provide that consideration should be given to taxpayers' general practices to apportion costs for other purposes, such as for use by management, creditors, minority shareholders, customers, and potential investors. The 2006 Temporary Regulations caution, however, that the IRS is not necessarily bound by the taxpayer's use of such general practices. Practical Implications Given that the general transfer pricing concepts extended by the 2006 Temporary Regulations to cover services transactions had already been in place for over 10 years with respect to other intercompany transactions, the move to apply those concepts to controlled services transactions was not particularly controversial. With the exception of the commonlydebated issue of stock-based compensation, 50 practical implications are more likely to be encountered in the more technical changes of the 2006 Temporary Regulations. In particular, the elimination of the differing transfer pricing analysis for intangibles and services is discussed below. BENEFIT RULE

4 1968 Regulations Page 4 of 17 Under the 1968 Regulations, when one member of a group of controlled entities performs marketing, managerial, administrative, technical, or other services for the benefit, or on behalf, of another member of the group, then the recipient generally has to compensate the renderer for such services. 51 Thus, the initial inquiry in a transfer pricing analysis of intercompany services focuses on the issue of benefit. The 1968 Regulations adopted a general benefits test under which the IRS may make allocations to reflect arm's length charges for services rendered, if the services are rendered for the joint benefit of the group, or for the sole benefit of another group member. The allocations must correspond to the relative benefits intended by the renderer to be conferred upon the recipient(s), based on the facts known at the time, even if the benefits ultimately were not realized by the intended recipient(s). 52 Thus, the test under the 1968 Regulations concentrates on the renderer's intent. No allocation is permitted, however, if the probable benefits inuring to the other members of the controlled group that are attributable to the services in question are "so indirect or remote" that unrelated parties would not have charged for such services. 53 For example, compensation would likely not be required if an airline increases its advertising for general vacation travel, even if the effect of increased vacation travel is to increase reservations at hotels owned by a related entity. 54 Compensation likely would be required, however, if the airline specifically named in its advertising the hotels owned by its affiliate. 55 The 1968 Regulations except from the general benefit test any duplicative services. Thus, no allocation may be made for services that are merely duplicative of services that a member of the controlled group has independently performed or has performed for itself. 56 "Stewardship" services, defined only in Regs and not under the 1968 Regulations, are the most notable of these duplicative services. Stewardship services have been interpreted as those services that the renderer performs for its own benefit as an investor in the related corporation. 57 Without specific guidance on what constitutes stewardship activities, taxpayers have generally relied on the decision in Young & Rubicam 58 and TAM In Young & Rubicam, the court examined the nature of the services provided by executives of a U.S. company whose responsibilities included supervision of the company's foreign subsidiaries. The court held that the executives' activities related to supervisory controls were stewardship services and the costs related to those activities could not be allocated to the subsidiaries. On the other hand, to the extent the activities related to the subsidiaries' day-to-day operations, any benefit to the U.S. parent was not "proximate and direct" to its own business, and an allocation could be made to the subsidiaries. The "proximate and direct" test was reinforced in TAM , as a corollary to the "indirect and remote" standard set forth in Regs (b)(2)(i). Thus, after considering all the facts and circumstances, if the activity has a proximate and direct effect on the parent-renderer's business, then there is likely an indirect and remote effect on the subsidiary-recipient's business, and no allocation is proper. TAM highlighted categories of services the proximate and indirect intended beneficiaries of which were easily determinable, leaving less certain areas for a facts and circumstances determination. For instance, charges were properly allocable to the subsidiaries where the expenses were made for the direct benefit of one or more subsidiaries (even if the parent may receive an indirect benefit), or where they were made for the operating members of the group as a whole. On the other hand, charges may not be made for stewardship expenses such as IRS and SEC compliance, and other top-level activities such as investigation of new business opportunities using employees of existing entities that would not participate in the business opportunity if it came to fruition. IRS Intentions In revising these regulations, Treasury and the IRS recognized it was difficult to approach the benefit test from the perspective of the renderer's subjective intent, and endeavored to move this test more in line with the arm's length standard, international standards, and the OECD Transfer Pricing Guidelines. 59 Similarly, the drafters believed the general benefit concept -- allowing charges for activities that were presumed to benefit the group as a whole, whether or not a benefit was actually received -- and the definition of duplicative activities found in the 1968 Regulations, were inconsistent with the arm's length standard. 60 In drafting the 2003 Proposed Regulations and the 2006 Temporary Regulations, Treasury and the IRS strove to narrow both the benefit test and the concept of "shareholder activity." 2006 Temporary Regulations The 2006 Temporary Regulations adopt a very broad definition of what constitutes a service. Regs T(l)(1) provides generally that a controlled services transaction includes any "activity" by one member of a group of controlled taxpayers that results in a "benefit" to one or more other members of the controlled group. The 2006 Temporary Regulations define "activity" as including "the performance of functions, assumptions of risks, or use by a renderer of tangible or intangible property or other resources, capabilities, or knowledge, such as knowledge of and ability to take advantage of particularly advantageous situations or circumstances. An activity also includes making available to the recipient any property or other resources of the renderer." 61 This overhaul of the definition of covered services is extremely broad, but it is consistent with the drafters' intent explained in the previous section and below -- the transfer pricing analysis file://c:\temp\6kiu6jk3.htm

5 appropriate to each transaction should not depend on whether the transfer is one of a good or a service. Page 5 of 17 A related issue is whether a related party's receipt of benefits through "passive association" requires it to pay consideration. The 2006 Temporary Regulations provide that a member of a controlled group that obtains a benefit solely on account of its status as a member of the group generally is not considered to receive a benefit for purposes of allocating costs. 62 Consistent with the OECD Guidelines, 63 the 2006 Temporary Regulations provide that although the member obtained a benefit, it was due to its status as a member of the group, and not to any specific activity of the parent or other related party. 64 This concept could extend to a relatively common situation where, for example, a subsidiary of a multinational group receives large discounts on its purchases from external parties due largely to its parent's relationship with the supplier. To the extent the parent company does not undertake any specific activity to obtain this purchasing benefit for each individual affiliate, it is foreseeable that no benefit will arise to the subsidiaries under the 2006 Temporary Regulations. The 2006 Temporary Regulations provide specific rules for determining whether such an activity results in a "benefit" to a related party, shifting the focus from the renderer's subjective intent to the recipient. Specifically, an activity is considered to provide a benefit to the recipient if the activity directly results in a reasonably identifiable increment of economic or commercial value that enhances the recipient's commercial position, or that may be reasonably anticipated to do so. 65 In other words, the 2006 Temporary Regulations generally provide that an activity is considered to confer 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, or would be willing to perform for itself the same or similar activity. 66 Similarly, the 2006 Temporary Regulations reject the general benefit approach of the 1968 Regulations, which presumed that the controlled group, as a whole, benefited from certain activities taken on behalf of the controlled group. The impact of this particular provision in the 2006 Temporary Regulations is expected to be a narrowing of the actions for which the recipient will perceive that a benefit has been conveyed. Shareholder Activities. Unlike the 1968 Regulations, the 2006 Temporary Regulations provide some detailed guidance regarding, and distinguishing between, duplicative and shareholder activities. Here, the drafters intended to retain the same underlying concepts of the 1968 Regulations, but again shifted to a focus on the benefit received by the recipient, and not on the renderer's intent. For instance, if an activity performed by a controlled taxpayer duplicates an activity performed, or that reasonably may be anticipated to be performed, by another controlled taxpayer on or for its own account, the activity is not considered to provide a benefit to the recipient, unless the duplicative activity itself actually provides an additional benefit to the recipient. 67 The 2006 Temporary Regulations narrow the exception regarding shareholder activities by shifting the test from the proximate and direct test to a "sole effect" test. Now, an activity is not considered to convey a benefit only if the sole effect of that activity is to protect the renderer's capital investment in the related party or other members of the controlled group, or if the activity primarily relates to compliance by the renderer with reporting, legal, or regulatory requirements imposed on a renderer that controls every other member of the group. 68 The intent of this revision was to narrowly limit the type of services that will be considered shareholder activities that would not be allocated out to related parties. Examples clarify that certain activities that might have been treated as duplicative under the 1968 Regulations are now required to be charged to related parties because some incremental benefit is realized. For instance, Regs T(l) (5), Ex. 6, describes a transaction where the legal documents are reviewed by both the company entering into the transaction and a related company. Under the 1968 Regulations, the related company's review would have been duplicative and not properly charged out; under the 2006 Temporary Regulations, these activities "substantially duplicate" the services the first company performed itself, "but they also reduce the commercial risk associated with the transaction," and the transacting company received a benefit for which a charge is proper. The tone of the 2006 Temporary Regulations suggests that the IRS is taking a fairly restrictive view of what qualifies as a non-chargeable shareholder activity or duplicative services. Practical Implications One overwhelming impact of these regulations is a substantially greater allocation of headquarters costs from U.S.-based multinationals to their foreign affiliates. This increased allocation of costs can be expected to generate healthy opposition from both the foreign affiliates of the U.S.-based multinationals and the tax authorities in the countries where those foreign affiliates reside. The 2006 Temporary Regulations require that cost allocations be made to affiliates for the same activities that were previously conducted without any allocation. That is, the narrower definitions of shareholder services will force U.S.-based multinationals to insist upon compensation from foreign affiliates for services that were free to affiliates in previous years. For U.S.-based multinationals of any size, the increase in cost allocations can easily amount to millions of dollars in additional charges to affiliates for services that were previously provided for free. Both foreign affiliates and revenue authorities can be expected to object strenuously to these additional charges. On the other hand, should the foreign affiliate wish to object to additional cost allocations, the shift in focus from the renderer's intent to the recipient's willingness to pay will bolster the arguments from the foreign affiliate. Whereas, under file://c:\temp\6kiu6jk3.htm

6 the 1968 Regulations the foreign affiliate (or foreign tax authority) would argue against the U.S. corporation's intention to charge out costs, under the 2006 Temporary Regulations the foreign affiliate would argue its own willingness to pay. In theory, these amendments may be justified to move closer to international norms. In practice, the narrowed definitions of benefit and shareholder activities can be expected to generate a great deal of turmoil within multinational groups and between foreign tax authorities and the IRS. The narrowed definition of shareholder activities encourages additional allocations of headquarters costs in direct conflict with the narrowed benefit test, which reduces the amount of charges that will be accepted. COST-ONLY ALLOCATIONS The 1968 Regulations contained a cost-only safe harbor, which taxpayers historically relied upon when performing their transfer pricing analyses for intercompany services. A cost-only safe harbor permits a renderer of services to charge the recipient of those services, in satisfaction or in substitution of the arm's length standard, an amount equal only to the direct and indirect costs incurred in rendering those services. The overarching purpose of a cost-only safe harbor is to allow taxpayers and revenue authorities to focus their resources on compliance with larger, more contentious, transfer pricing issues. Consistent with that overarching purpose, the 2006 Temporary Regulations replaced the nearly 40-year old costonly safe harbor with what is now known as the Services Cost Method or SCM, which may be used to price at cost only the low-margin controlled services transactions that meet certain quantitative and qualitative conditions and requirements Regulations -- Integral Services Once a benefit has been conferred upon a recipient, thus requiring an intercompany allocation for services, one must determine the amount of the required arm's length charge. For this purpose, the 1968 Regulations distinguished between (i) services that are an integral part of either the recipient's or renderer's business, and (ii) services that are not. For integral services, the arm's length charge is that "amount which was charged or would have been charged for the same or similar services in independent transactions with or between unrelated parties under similar circumstances considering all the relevant facts." 69 For non-integral services, one could elect, under the non-integral cost-only safe harbor, to charge only the cost of rendering the service. 70 The cost-only safe harbor allowed all services to be charged out at cost, unless they fell into one or more exclusionary categories (in which case, the services were deemed an integral part of either the recipient's or the renderer's business). 71 These excluded categories, or integral services, are discussed below. Trade or Business: 72 A service is integral if either the recipient or the renderer is engaged in the trade or business of rendering or providing similar services to unrelated parties. Principal Activities: 73 A service is integral if the renderer provides services to one or more related parties as one of its principal activities. Generally, the provision of services to related parties is presumed not to be a principal activity if the renderer' costs of providing services does not exceed 25% of its total costs or deductions for the taxable year. If the 25% threshold is crossed, or if the services at issue involve manufacturing, production, extraction, or construction activities, then the determination is based on the facts and circumstances of each case. Peculiarly Capable: 74 A service is integral if the renderer is peculiarly capable of rendering the services and such services are a principal element in the recipient's operations. Generally, the renderer is peculiarly capable of rendering a services where the renderer, in connection with the rendition of such services, makes use of a particularly advantageous situation or circumstance such as by utilization of special skills and reputation, utilization of an influential relationship with customers, or utilization of its intangible property. Further, for the renderer to be considered peculiarly capable, the value of these services must be substantially in excess of the renderer's related costs or deductions in providing those services. Substantial Services: 75 Finally, a service is integral if the recipient received the benefit of a substantial amount of services from related parties during the taxable year. Generally, services are substantial in amount if the renderers' total direct or indirect related costs or deductions exceed an amount equal to 25% of the recipient's total costs or deductions for that taxable year. All other services are not considered integral to the recipient's or renderer's business, and the arm's length charge is deemed equal to the costs or deductions incurred by the renderer for those services. The taxpayer always may elect to apply an arm's length charge. In either case, the taxpayer must maintain adequate books and records to permit verification of the appropriate costs or deductions. 76 IRS Intentions Page 6 of 17

7 Page 7 of 17 In drafting the 1968 Regulations, Treasury and the IRS recognized that transfer pricing regulations that address services potentially will affect a large volume of intragroup back office services that are common across many industries; therefore, they determined it would be in the interest of good tax administration to minimize the compliance burdens applicable to such services, especially to the extent that the arm's length markups are low and the activities do not significantly contribute to business success or failure. 77 The 2006 Temporary Regulations improve upon the cost-only safe harbor. Treasury and the IRS intended that, in general, services that qualified for the 1968 cost-only safe harbor also should qualify for the revised safe harbor. Further, consistent with the 1968 Regulations, the drafters intended to highlight certain activities that were not likely candidates for the cost-only safe harbor. 78 Also consistent with the 1968 Regulations, the drafters intended that the requirements for application of the safe harbor substitute for the traditional best method analysis. Thus, the Commissioner's ability to make allocations that could otherwise be made under the general transfer pricing rules was limited. The drafters intended this to be a true "safe harbor." 79 One motivation for the drafters to undertake this revision was the potential for arbitrariness and controversy under the 1968 cost-only safe harbor. 80 The IRS and Treasury believed that, in some cases, the 1968 Regulations had been interpreted or applied to allow high-margin controlled services to be priced at cost. Further, the qualitative and subjective tests in the cost-only safe harbor were determined to be difficult to apply and created opportunity for controversy. In short, the IRS and Treasury revised the cost-only safe harbor to reduce administrative and compliance burdens by providing certainty concerning the pricing for low-margin services, thus allowing the compliance efforts of both taxpayers and the IRS to concentrate on those services for which a robust transfer pricing analysis, including an analysis under the best method rule, is particularly appropriate 2006 Temporary Regulations -- SCM Treasury and the IRS replaced the 1968 non-integral cost-only safe harbor with the SCM. 81 The SCM prices at cost only the controlled services transactions that meet certain quantitative and qualitative conditions and requirements. To qualify for the SCM, which is deemed the "best method" if correctly applied, a service must be considered a "covered service." A covered service is one that (i) meets the business judgment rule, 82 (ii) meets the adequate books and records requirement, 83 (iii) is not on the list of excluded services, 84 and (iv) is either a service that the IRS has included on the list of approved specified covered services 85 or qualifies as a low-margin covered service. 86 Business Judgment Rule. To qualify for the SCM, a taxpayer must reasonably conclude using its business judgment that the service does not contribute significantly to the key competitive advantages, core capabilities, or fundamental risks of success or failure of the business of the renderer or the recipient. 87 Reasonableness is determined using a facts and circumstances test. The Preamble to the 2006 Temporary Regulations states that "in all but unusual cases, the taxpayer's business judgment will be respected"; 88 this condition is intended to focus transfer pricing compliance resources of both taxpayers and the IRS principally on significant valuation issues, as well as verification of total services costs and the allocation of those costs. 89 Books and Records. Adequate books and records must contain sufficient detail to allow the IRS to verify total services costs, the nature of the services rendered, the identification of the renderer and the recipient of the services, and the allocation and apportionment of costs. 90 Additionally, a taxpayer must have a statement evidencing the intent to apply the SCM, 91 and must reasonably conclude that the SCM applies and reasonably allocate and apportion costs. 92 Excluded Transactions. The 2006 Temporary Regulations list certain categories of services which, in whole or in part, are not covered services and therefore do not qualify for the SCM. 93 The list includes: manufacturing; production; extraction; construction; exploration or processing of natural resources; reselling, distribution, acting as a sales or purchasing agent, or acting under a commission or similar arrangement; research, development, or experimentation; engineering or scientific; financial transactions, including guarantees; and insurance or reinsurance. 94 The broadly stated rationale for excluding these services is that Treasury and the IRS believe that these transactions are "high-margin" transactions. 95 Note that the SCM preserves the same list of categories of controlled transactions that are not eligible to be priced under the 1968 cost-only safe harbor except under a facts and circumstances test (i.e., manufacturing, production, extraction, and construction), because they are deemed to generally constitute the core profit-making functions of an enterprise. 96 The other excluded transactions were introduced in the 2003 Proposed Regulations and retained for the 2006 Temporary Regulations, including reselling, distribution, and financial transactions for which costs were deemed an inappropriate reference point for determining profitability; and research and development, experimentation, and engineering or scientific services which may involve valuable intangibles. 97 Qualifying Services. The list of specified covered services 98 includes those types of services that the IRS specifies in revenue procedures. In Announcement , 99 the IRS provided a draft revenue procedure with the contemplated list of services, and then released Rev. Proc with an expanded list of specific covered services.

8 Page 8 of 17 Rev. Proc identifies 101 specified covered services, addressing with specificity certain activities within such broad groups as (i) payroll; (ii) premiums for unemployment, disability, and workers compensation; (iii) accounts receivable; (iv) accounts payable; (v) general administrative; (vi) corporate and public relations; (vii) meeting coordination and travel planning; (viii) accounting and auditing; (ix) tax; (x) health, safety, environmental, and regulatory affairs; (xi) budgeting; (xii) treasury activities; (xiii) statistical assistance; (xiv) staffing and recruiting; (xv) training and employee development; (xvi) benefits; (xvii) information and technology services; (xviii) legal services; (xix) insurance claims management; and (xx) purchasing. Treasury and the IRS determined these services constituted support services of a type common across industry sectors and generally did not involve a significant arm's length markup on total services costs. Treasury and the IRS have indicated that this list will be updated periodically, and the drafters currently are seeking comments as to whether the list "sufficiently covers the full range of back office services typical within multinational groups." 101 The drafters believe that because they already have performed the analysis necessary to determine the eligibility of specified covered services, the compliance burden that previously was imposed by the 1968 cost-only safe harbor will be eliminated for a broad class of commonly provided services. 102 Finally, low-margin covered services are those services that more often than not command arm's length markups on total services costs of 7% or less. 103 The arm's length markup is determined using general 482 principles and is based on the median comparable markup on total services costs. 104 Thus, a taxpayer may avail itself of the SCM for a low-margin covered service, even if not specifically covered by Rev. Proc (or its successor), so long as it is not specifically excluded and the taxpayer can satisfy the business judgment rule and the books and records requirement. Practical Implications The drafters' dual intent was to reduce administrative and compliance burdens by providing certainty concerning the pricing for low-margin services, and bring the rules more into line with the arm's length standard to eliminate problematic aspects. 105 The SCM appears to do just that by eliminating the controversy of the peculiarly capable standard, providing the certainty of a "black list" of excluded services and a "white list" of per se covered services, and associating the arm's length standard with low-margin services. However, some significant issues remain. Business Judgment Rule. The drafters introduced the business judgment rule to provide taxpayers flexibility in determining whether or not a service qualified under the SCM, when not addressed by the black list or the white list. The drafters recognized that the same service may contribute differently to businesses in different contexts. 106 However, this type of flexibility has been roundly criticized under the 1968 Regulations for creating controversy, when embodied as the "peculiarly capable" prong of determining whether a service was integral to one's business. Under the 2006 Temporary Regulations, the SCM applies only if the taxpayer can reasonably conclude using its business judgment that the service does not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure. Taxpayers and practitioners can expect to encounter some difficulty in determining whether a service that utilized a "particularly advantageous situation or circumstance" is now one that contributes significantly to its "key competitive advantages." A comparison of the examples under both sets of Regulations further identifies these "standards" as similarly difficult in application. Further, that the business judgment rule was intended to substitute for the peculiarly capable rule is made clearer through the effective date of the business judgment rule. The 2006 Temporary Regulations are largely not effective until taxable years beginning after December 31, 2007, with one exception: the business judgment rule is effective for all taxable years beginning after December 31, 2006, while the 1968 cost-only safe harbor is still in effect. Although the "peculiarly capable" and business judgment standards are similarly complex and may lead similarly to controversy, the drafters have attempted to reduce this controversy through a greater respect for the taxpayer's utilization of the SCM under the 2006 Temporary Regulations. That is, the taxpayer's exercise of the business judgment rule, unlike the its determination under the peculiarly capable rule, generally shall not be disturbed by the IRS. The drafters anticipated that in most cases the examination of relevant services will focus only on verification of total services costs and their appropriate allocation... There will be little need in all but the most unusual cases to challenge the taxpayer's reasonable business judgment in concluding that such typical back office services do not contribute significantly to fundamental risks of success or failure. Although these statements do not reduce the complexity in exercising one's business judgment, they do provide taxpayers with some amount of certainty that their judgment will be respected. Excluded Transactions. The 1968 Regulations focused special scrutiny on four types of transactions -- manufacturing, production, extraction, and construction. These categories were presumed ineligible for the cost-only safe harbor, but taxpayers could rebut that presumption upon an examination of the facts and circumstances.

9 The drafters excluded these four and other transactions under the 2006 Temporary Regulations for which they determined total services costs constitute an inappropriate reference point (reselling, distribution, and financial transactions), or other types of transactions (research and development, experimentation, and engineering or scientific services) that should be subject to a more robust arm's length analysis under the general 482 rules. To some taxpayers, these services are lowcost margin services and they do not contribute significantly to their key competitive advantages. However, the drafters recognized that typically large amounts of revenue are associated with these services, and they opted to ensure that no company attempts to charge for them at cost. In all practicality, most enterprises recognized the difficulties associated with these types of services, and did not charge them out at costs under the 1968 Regulations. In this regard, the drafters have reinforced the intent, and added to the content, of the 1968 Regulations, with somewhat predictable results. Qualifying Services/Specified Services. The listing of specific services that are per se eligible for treatment under the SCM certainly is directly aimed at reducing administrative and compliance burdens, providing certainty, and eliminating problematic areas. The list contains more than 80 specific services in 20 categories, and its most recent incarnation in Rev. Proc provides for the same treatment for "other activities similar to those" 80 specifically described services. 107 Certainly, there are routine back-office activities that are not included on this list, and Treasury and the IRS are actively seeking comments for additional items to add -- all in furtherance of reducing burden and providing certainty. However, from a practical perspective, the use of this white list is quite limited. To utilize this list properly, a taxpayer would need to allocate costs to each specified covered service, and determine to what extent each of its affiliates benefited from the service. Similar judgments and calculations would have to be made with respect to those services for which the taxpayer must charge with a profit markup. Very rare is the taxpayer that keeps track of its costs by specific service, such as "compiling and posting employee time and other information needed to calculate periodic compensation to employees," 108 or "operating any of the following office machines: photocopying, scanning, and facsimile machines." 109 To track expenses in this manner would create an enormous compliance burden, defeating the very purpose of the list. Rather, the vast majority of taxpayers track their costs by department, or by affiliate, which in many cases are organized by the service they provide. That is, many taxpayers track their costs for broader functions such as accounting, human resources, information and technology services, and purchasing. These broader functions are largely represented in Rev. Proc , but only for purposes of organizing the specified covered services within each such broader function. It would also be difficult to determine the benefit of each such service to the taxpayer's affiliates. Although the 2006 Temporary Regulations allow for the use of allocation keys, foreign affiliates are likely to disagree with these allocations of each such specific service, because each one will impact their cash flows, as discussed above in the context of "benefit." Whereas this is less of a compliance concern, it certainly remains a practical problematic area. Thus, the white list is anticipated to cause additional practical compliance burdens for taxpayers who utilize it, which will in turn add to administrative burdens for the IRS. Unfortunately, until these issues are resolved, these controversies are likely to draw effort and resources, but not attention, away from those services for which a robust transfer pricing analysis is appropriate. Qualifying Services/Low-Margin Covered Services. For reasons including those stated above, taxpayers are more likely to rely on the low-margin services rule than the list of specified covered services, although qualifying under this standard has its own compliance burdens and lack of certainty. More specifically, the specified covered services are indeed low-margin covered services, for which the median arm's length markup on costs is 7% or less. But those specified covered services are not the only services that can qualify under this test; rather, any service -- other than those services specifically excluded -- that meets the other tests (i.e., business judgment rule and books and records requirement) is eligible. Best of all, eligible services can be reasonably aggregated for purposes of qualifying as low-margin covered services. Therefore, taxpayers that account for costs by department or other function will reduce their compliance burden, and increase the volume of the services that can be charged at cost, by treating their services as low-margin covered services rather than as specified covered services. Indeed, qualification as a low-margin cost services requires support with a transfer pricing study showing a median markup of 7% or less, but these studies are practically accomplished with a modest amount of effort. This effort is even less daunting when a taxpayer weighs it against the burdens it would face in applying the white list. The drafters could further reduce the compliance and administrative burden by explicitly stating whether the median is based on a single-year or a multiple-year analysis or whether the comparable analysis of low-margin covered services has to be updated each year. While this is not a new issue specific to the SCM, the stated objectives of the SCM -- reduced complexity and administrative burden for low margin services -- would be furthered if a taxpayer could reasonably rely on a prior year's study without having to reconfirm that the arm's length markup does not exceed 7% on an annual basis. SERVICES/INTANGIBLES OVERLAP As mentioned above, one of the main objectives of the 2003 Proposed Regulations and the 2006 Temporary Regulations projects is to harmonize the rules with respect to services and other transactions to mitigate the extent to which the characterization of the transaction could lead to "inappropriate results." 110 The areas which address the overlap between services and intangibles are key to the reform intended by the IRS and Treasury. Page 9 of 17

10 1968 Regulations Page 10 of 17 Ownership/Contributions to Non-Owned Intangibles. Under the 1968 Regulations, determining the owner of the intangible is crucially important because the owner is entitled to compensation for any transfer or license of the intangible. In other words, the owner alone is entitled to the residual income from the intangible. The 1968 Regulations provide guidelines for determining the owner of an intangible in two situations: (i) when the intangible is legally protected, and (ii) when it is not. If the intangible is legally protected (e.g., a trademark that has been registered with the U.S. Patent and Trademark office), the legal owner will be treated as the owner for 482 purposes. 111 Legal ownership may be transferred by operation of law or contract. 112 The IRS also may impute an agreement by controlled parties to transfer legal ownership of the intangibles if their conduct indicates the existence of such agreement. 113 If the intangible is not legally protected, the "developer" of the intangible will be treated as the owner for 482 purposes. 114 In the case of a jointly developed intangible, the developer is ordinarily the taxpayer that bore the largest portion of the direct and indirect costs of developing the intangible, including the uncompensated provision of property or services that contributed to its development. 115 As this rule implies, only one taxpayer will be treated as the developer, thus creating an all-or-nothing result between the joint developers. If it cannot be determined which taxpayer bore the greatest share of the costs of development, the identity of the developer will be determined by reviewing all of the relevant facts and circumstances. 116 The other controlled parties involved in the development of the intangible will be treated as "assisters," and generally are entitled to arm's length compensation (determined using 482 principles) from the owner of the intangible. 117 Compensable assistance may take the form of loans, services, or the use of tangible or intangible property. 118 However, assistance in the form of expenditures of a routine nature that an unrelated party dealing at arm's length would be expected to incur in comparable circumstances are not compensable. 119 These rules, commonly referred to as the "developer-assister" rules, continue to be a source of controversy between taxpayers and the IRS. The 1968 Regulations contain four examples, designed to illustrate the developer-assister rules. The first example describes the situation where one controlled party loans equipment to a second controlled party for use in developing an intangible. 120 This example concludes that the lending party is entitled to arm's length compensation under 482 principles. The other three examples, commonly referred to as the "cheese examples," are based on the following fact pattern: FP, a foreign producer of cheese, markets its cheese worldwide except in the United States. The cheese carries a trade name that is well known outside the United States. USSub was established to distribute the cheese in the United States. In example two, USSub undertakes all marketing and advertising to develop the name in the United States. The example concludes that FP would not be required to compensate USSub for any portion of the market development expenses if comparable uncontrolled U.S. distributors (comparable to USSub) would incur comparable marketing and advertising expenses to develop the brand of the cheese they respectively distribute. In other words, no reallocation is required because USSub would have had to incur such marketing expenses if it were unrelated to FP. 121 In example three, USSub is factually found to have incurred significantly higher market development and marketing expenses than comparable independent cheese distributors in the United States. Consequently, FP must compensate USSub for the fair market value of the services that USSub is considered to have performed for FP. 122 Finally, in example four, FP and USSub are parties to a long-term agreement granting USSub the exclusive right to distribute cheese in the United States under FP's trade name. Consequently, no compensation is required. 123 The justification for this position is that, because the price of the cheese USSub purchases from FP is arm's length, USSub will derive all benefit from the resale of the cheese in the United States, including any enhanced value of the trade name. As such, the expenses incurred by USSub are not considered to be a service performed for the benefit of FP, but rather for the development of the marketing intangible surrounding the trade name. The 1968 Regulations explicitly provide that the ownership of an intangible may be subdivided, with the owners of each subdivided interest treated as an owner of intangible property for 482 purposes. 124 For example, the worldwide right to exploit a trademark may be subdivided into separate rights to exploit the same trademark in different geographic markets. 125 In summary, under the 1968 Regulations, all intangible income belongs to the owner of the intangible. The legal owner of any protected intangible is treated as the owner for transfer pricing purposes. The developer-assister rules govern the determination of ownership with respect to non-protected intangibles and compensation for contributions to the development of a non-owned intangible. Intangible ownership can be subdivided. Services Transactions That Effect a Transfer of Intangible Property. Lastly, the 1968 Regulations contained no specific provision to govern services transactions that effect a transfer of intangibles. This situation is at the center of the "inappropriate results" sought to be remedied by the 2003 Proposed Regulations and 2006 Temporary Regulations. file://c:\temp\6kiu6jk3.htm