At your service--TEI testifies on section 482 services regulations: comments on PA bulletins and MTC's tax shelter report letter; testifies before IRS oversight board and Ontario Legislative Committee.

Despite the cold grip of winter, Tax Executives Institute has been a hotbed of activity. During the last two months, TEI responded to proposed regulations issued vby the U.S. Treasury Department, draft bulletins at the state level, and provincial intentions in Canada. Recommending improvements in tax administration to the Multistate Tax Commission and the IRS Oversight Board rounded out the Institute's technical activities.

Proposed Section 482 Services Regulations

Proposed regulations issued in September--relating to the treatment of controlled services transactions and the allocation of income from intangibles--represent the government's first attempt to revamp the section 482 services regulations since the 1960s. Much has changed in the world of cross-border transactions since then, and in comments filed in December, TEI commended the Treasury Department and IRS for attempting to bring the rules more in line with today's global economy and OECD guidelines. TEI raised concerns, however, about several aspects of the proposed regulations, particularly the elimination of the cost safe harbor and its replacement with the simplified cost-based method (SCBM).

In January, TEI President Ray Rossi testified at an IRS hearing on the new rules. Mr. Rossi focused on three issues: the desirability of retaining a cost-based sale harbor, the administrative difficulties of applying the proposed SCBM method, and the need for examples to reflect the application of the statute of limitations.

TEI's President urged the Treasury and IRS representatives to retain the cost safe harbor, pointing out that "the safe harbor provides a simple and reliable pricing method for dealing with intercompany services that cannot be considered integral to the business or business activity of either the service provider or recipient." Mr. Rossi explained one reason the safe harbor is helpful is that, in the case of non-integral services, neither the service provider nor recipient is normally in a good position to develop comparable uncontrolled transaction data.

Back-office services are by definition routine, low-margin services for which charging cost is reasonable and appropriate, he said. And while the proposed regulations assume that back-office services are performed in the United States, if taxpayers may no longer charge out these services at cost, an incentive is created to consolidate the services elsewhere. "For these reasons, the cost safe harbor should be retained, at least with respect to certain enumerated services," Mr. Rossi concluded.

Mr. Rossi described the SCBM method as far from simple to apply because it effectively requires taxpayers to perform a full transfer pricing analysis for low-margin services and misapprehends the nature of service activities between controlled entities. Other concerns identified included running afoul of other jurisdictions that require charging for such services at cost, engendering inconsistency with the OECD guidelines, and causing an increase in competent authority cases. Mr. Rossi summed up by saying that "SCBM will increase the administrative and compliance burdens of taxpayers that adopt it--exactly the opposite of what a safe harbor should do." He then suggested that the final regulations provide a true cost safe harbor method for both inbound and outbound services transactions, urging the government to develop a list of what it considers "low-margin" services.

With regard to imputed contracts and the statute of limitations, TEI's President highlighted two examples in the proposed regulations that considerably expand the authority of the IRS to rewrite agreements if the taxpayer rendering services is net adequately compensated when it renders the services. Significantly, the examples suggest that the IRS is net limited to making transfer pricing adjustments for the years under audit, but may make an adjustment to correct an "erroneous" methodology in past years. Mr. Rossi urged the government to confirm that that an adjustment for prior years cannot be made when the statute has closed.

The Institute's written comments discuss additional aspects of the proposed regulations. Among the recommendations offered by the Institute, TEI suggested that the proposed regulations be clarified by eliminating the concept of "legal ownership" from the transfer pricing analysis, since the concept of legal ownership in the intangibles regulations is at odds with longstanding tax principles of beneficial ownership. The Institute also recommended that the proposed services regulations not be finalized before taxpayers have had an opportunity to review and comment upon the proposed cost-sharing regulations when they are issued. Finally, TEI noted that the final regulations should grandfather existing compliance approaches and establish a transition period in which to comply with the final regulations.

TEI's written comments on the regulations are reprinted in this issue, beginning on page 49. An article on the proposed regulations was published in the November-December 2003 issue.

Pennsylvania Taxation of Retirement Benefits

On December 19, the Institute filed comments with the Pennsylvania Department of Revenue on Personal Income Tax Bulletins 2003-1 through 2003-5 (Discussion Drafts Revised 10/03/2003). In its comments, TEI expressed concern that the proposed definition of "Eligible Retirement Benefit Plan" in the discussion drafts is problematic, specifically arguing that the proposed application of the state's constructive receipt rules to nonqualified deferred compensation plans is misguided.

TEI recommended that the definition of Eligible Retirement Benefit Plan follow the Internal Revenue Code and the Employee Retirement Income Security Act by treating plans that are retirement plans under those statutes as retirement plans for Pennsylvania purposes. Harmonizing the state's rules with the abundant federal authority in this area will not only facilitate administration and compliance for employers, but also employees, plan administrators, and the state, the Institute noted. Unnecessary inconsistencies between Pennsylvania and federal tax treatment, however, engender significant administrative burdens, added reporting complexity and increased recordkeeping burdens for employers, plan administrators, and fiduciaries. States are generally better off adopting tax principles that are congruent with well-established federal tax principles, the Institute said.

TEI also took issue with the State's proposed application of the constructive receipt doctrine to nonqualified deferred compensation. Since this type of compensation is typically unfunded--in reality an unsecured promise by an employer to pay compensation in the future--the approach in the draft bulletins will inevitably lead to harsh and unfair results. TEI noted that it is patently unfair to tax an individual on income hot received, especially when if may never be received.

Subsequently, the Pennsylvania Department of Revenue thanked TEI for its comments, noting that the draft bulletins had generated significant comments from the practitioner and business community. The department announced that the time frame for completing the bulletins has been expanded to June in order to consider the comments.

TEI's letter to the Pennsylvania Department of Revenue is reprinted in this issue, beginning at page 61.

IRS Oversight Board

On January 26, TEI Executive Director Timothy McCormally testified before the IRS Oversight Board on two key challenges facing the IRS: the recruitment, retention, and training of its personnel; and securing sufficient, reliable funding for the agency. The Board oversees the IRS's administration, management, and direction.

In his testimony on TEI's behalf, Mr. McCormally described the recruitment, retention, and training of personnel as possibly "the greatest challenge for the IRS over the next five years," noting that within the Large and Mid-Size Business Division, 40 percent of all revenue agents will be eligible to retire in FY2006--rising to more than half by FY2008. Since LMSB is responsible for ensuring compliance by the country's largest enterprises, which have the most complex issues and the most complicated organizational structures, the Institute cautioned the Board that "the success of the agency--and LMSB in particular--depends on an effective, efficient, well-trained, and motivated staff."

TEI's testimony confirmed that LMSB has taken important steps to address this challenge, and the Institute commended the division for the two recruitment drives last year that sought qualified individuals from outside sources.

"Bringing in experienced, mid-career personnel at a competitive level not only provides LMSB with agents who can contribute more quickly, but also mitigates the ripple effect of hiring personnel from other divisions within the agency," Mr. McCormally said. He also highlighted the use of critical pay, which has enabled LMSB to attract highly experienced tax professionals at the most senior levels of the division, adding "it would be a mistake to abandon or curtail this practice."

TEI's testimony linked successful recruitment and retention of qualified personnel with sufficient and reliable funding for the IRS. "If the IRS is to respond to taxpayer needs and administer the tax code in a fair and efficient manner, the agency must have the resources necessary to fulfill its mission, including funds to attract, train, and retain top-notch tax professionals," the Institute's written statement concluded, urging the Board to continue its push for adequate funding, particularly in the areas of employment and training.

"Training is an important aspect of several initiatives LMSB has developed to streamline the compliance process and empower its agents to resolve issues and settle cases more quickly and efficiently," Mr. McCormally told the Board. He highlighted some of these initiatives, including a project to develop a focused audit planning process, which was rolled out to taxpayers and LMSB personnel in October. "TEI was pleased to participate not only in the design of the Joint Audit Planning Process but also in LMSB's training strategy with respect to it," he stated. (A feature article about the Joint Audit Planning Process appears in the November-December 2003 issue of The Tax Executive.) Based on the experiences of several TEI members, LMSB's limited issue focused examination (LIFE) is also streamlining the examination process, Mr. McCormally testified.

Citing a recent study finding that 86 percent of companies identified transfer pricing as the most important international issue they face, TEI informed the Board that in TEI's view the advance pricing agreement program has worked exceedingly well notwithstanding recent congressional inquiries questioning its efficacy. The Institute characterized the APA program as a "model dispute resolution process," adding that "it would be a serious error to scale back or abandon it."

Finally, TEI's testimony stressed the critical, ongoing need to simplify the tax law: "When the law is complex and ever-changing, employees need more and more training just to keep up, while enactment of simplifying measures can ease pressures and make workers more productive," Mr. McCormally testified. He also reminded the Board that both the Treasury Department and National Taxpayer Advocate have recently reiterated that simpler laws are needed and will benefit everyone--taxpayers and the government.

TEI's written testimony is reprinted in this issue, beginning on page 65.

Ontario Standing Committee on Finance and Economic Affairs

On February 11, TEI testified before the Ontario Standing Committee on Finance and Economic Affairs in connection with the Committee's pre-budget hearings. TEI's statement was delivered by Toronto Chapter members Vincent Alicandri of Hydro One Networks, Inc., and Robert G. Westlake of GE Capital Canada, Inc.

TEI's testimony made two recommendations to the Standing Committee: (1) phase out and repeal the Ontario Capital Tax over the same period during which the federal government is eliminating the Large Corporations Tax, and (2) reduce the Ontario corporate income tax rates to eight percent as soon as budgetary constraints permit. TEI's testimony followed up on its November 24, 2003, letter to Ontario's Minister of Finance, reacting to the announced rollback of the corporate income tax reductions.

TEI's written statement to the Ontario Standing Committee on Finance and Economic Affairs is reprinted in this issue, beginning at page 68. Its November letter to the Minister is published in the November-December 2003 issue of the magazine.

MTC "Tax Sheltering" Study

In January, TEI sent a letter te Bruce Johnson, Chair of the Multistate Tax Commission, expressing the Institute's growing concerns about the Commission's stance in respect of corporate activity to minimize income tax liability. Specifically citing the Commission's July 15, 2003, study, Corporate Tax Sheltering and Impact on State Corporate Income Tax Revenue Collections, TEI stated that the key te stopping tax abuses lies not in demonizing taxpayers or draconian penalties, but in the effective administration of the tax law, including the ability of examiners to identify and analyze transactions, and, where necessary, to challenge them.

TEI believes that the Commission's study and follow-up activity adopt a narrow view of the state and local tax burden on businesses and, at the same time, an overbroad (yet undefined) view of what constitutes a tax shelter. By failing to acknowledge the overall state and local tax burden on business, the Commission distorts reality, TEI stated. By defining "tax sheltering" expansively, the Commission unfairly criticizes wholly legal transactions and improperly impugns the activities of compliant taxpayers.

In the letter, the Institute proffers the following concepts, suggesting they are fundamental to any discussion regarding tax planning and tax shelters:

(1) Taxes legally owed should be paid;

(2) Strong enforcement efforts are essential to building a culture of compliance;

(3) Statutory provisions intended to benefit taxpayers are not "loopholes"; and

(4) Tax planning is net per se "tax sheltering."

Because businesses and tax administrators all have an interest in maintaining civil discourse on the ongoing problems of tax administration, TEI said it is past time to put aside harsh and unfair rhetoric, and suggested that the Commission and TEI work toward restoring just such an environment.

TEI's letter to the MTC is reprinted in this issue, beginning on page 70. This issue also features an article (on page 28) about the benefit the Commission's multistate audit program was to Hewlett-Packard. The cooperation and professionalism fostering that success story epitomizes the relationship that can exist between business taxpayers and tax administrators, TEI President Ray Rossi noted. "The circumstances recounted in the article highlight the type of activity undertaken by the Commission that benefits states and businesses alike."