Controlled services transactions.

The IRS has issued final and temporary regulations on the treatment of controlled services transactions under Sec. 482 and the allocation of income from intangibles, in particular with respect to contributions by a controlled party to the value of an intangible owned by another controlled party; see TD 9278, NPRM REG146893-02, NPRM REG-115037-00 and NPRM REG-138603-03 (all dated 8/1/06).

The regulations also modify the Sec. 861 regulations on stewardship expenses, to make them consistent with the changes to the Sec. 482 regulations.

Background: Under Sec. 482 generally, the IRS may allocate gross income, deductions and credits between or among two or more taxpayers owned or controlled by the same interests, to prevent tax evasion or to reflect clearly a controlled taxpayer's income.

Proposed regulations (and subsequent corrections) issued in 2003 triggered a substantial volume of taxpayer comments, which resulted in significant changes to the proposed regulations. Among other suggestions, commentators recommended issuing the regulations in proposed and temporary form, to give taxpayers an opportunity to submit additional continents and to consider the interaction between these regulations and the cost-sharing regulations. The IRS has done so.

Controlled services: The previously proposed regulations set forth a simplified cost-based method (SCBM) to preserve the Regs. Sec. 1.482-2(b) cost safe harbor and to bring the existing rules more in line with the arms-length standard. The goal was to provide certainty for the pricing of low-margin services. Based on the comments received, however, the IRS eliminated the SCBM and replaced it with the services cost method (SCM) described in Temp. Regs. Sec. 1.482-9T(b). Covered services eligible for the SCM include certain low-margin covered services described in Temp. Regs. Sec. 1.482-9T(b)(2), as well as those that will be described in a revenue procedure and in an initial list to be published in an IRS announcement.

Shared service arrangements (SSAs) are addressed in Temp. Regs. Sec. 1.482-9T(b)(5). In general, an SSA must have at least two participants. It must include as participants all controlled taxpayers that benefit from one or more covered services subject to the SSA, and it must be structured so that each covered service or group of covered services confers a benefit on at least one participant. The arm's-length charge to each participant is the portion of the total costs of the services otherwise determined under the SCM properly allocated to the participant. The regulation clarifies the documentation taxpayers have to maintain for an SSA and provides guidance on coordination of cost allocations under an SSA and cost allocations under a qualified cost-sharing arrangement.

The comparable uncontrolled services price method, the comparable profits method, the unspecified method and the gross services margin method provisions of the temporary regulations remain substantially similar to the provisions found in the previously proposed regulations. The cost-of-services-plus method set forth in the previously proposed regulations has, however, been modified, as have the profit-split method and the contingent-payment contractual term provisions.

Income attributable to intangibles: Many commentators remarked on the revised approach for determining ownership of intangibles under the previously proposed regulations. The temporary regulations are based on the conclusion that legal ownership provides the appropriate framework for determining intangibles ownership under Sec. 482. These rules will not, as some had suggested, incorporate by reference substantive intellectual property rules. Issues on contributions to the value of an intangible have also been clarified.

Stewardship expenses: The temporary regulations modify Regs. Sec. 1.861-8(e)(4) to conform to and be consistent with the revised language on controlled services transactions set forth in Temp. Regs. Sec. 1.482-9T(1).

Effective dates: The temporary regulations are effective on Jan. 1, 2007, and apply to tax years beginning after 2006. The delay in the effective date was determined to facilitate further public input in refining final rules. Controlled taxpayers may also elect to apply the temporary regulations to any tax year beginning after Sept. 10, 2003, by attaching a statement to their timely filed tax returns for their first tax year after 2006.

Proposed regs.: As to regulations on the treatment of controlled services under Sec. 482 and related issues, the temporary regulations serve as the text of the proposed regulations. In addition, the proposed regulations contain a coordination rule with global dealing operations.

The IRS is working on new global dealing regulations, which are expected to govern activities performed by a global dealing operation. Until those regulations are finalized, taxpayers may rely on the proposed global dealing regulations; thus, Prop. Regs. Sec. 1.482-9(m)(5) clarifies that a controlled services transaction does not include a financial transaction entered into in connection with a global dealing operation.

Comments: Feedback on the proposed regulations must be received by Nov. 2, 2006. Submissions should be sent to CC:PA:LPD:PR (REG146893-02, REG-115037-00 and REG-138603-03), IRS, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044, or submitted electronically via www.irs.gov/regs or the Federal eRulemaking portal at www.regulations.gov.

Lesli S. Laffie, J.D., LL.M.