IRS takes aim at service issues in transfer pricing: two important legal pronouncements that will affect transfer pricing compliance and planning for multinational corporations have come out recently. Two attorneys discuss some of the general highlights and the potential impact.

This past September, the Internal Revenue Service (IRS) made headlines when it announced a $3.4 billion settlement in the GlaxoSmithKline (GSK) case relating to transfer pricing for the U.S. rights to the drug Zantac[TM] as well as some of the pharmaceutical giant's other products. The settlement by GlaxoSmithKline Holdings (Americas) Inc. was the largest and likely most costly settlement that the IRS has ever negotiated relating to transfer pricing.

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That news came after the agency issued a new set of regulations in July--effective next year for calendar-year reporting companies--that highlight a new focus on services. In general, intercompany transfer pricing and intercompany transactions fall into the general categories relating to 1) tangible property, 2) intangible property, 3) loan/guarantee fees and 4) services. While the new regulations focus on intercompany services aspect, they also importantly apply to intangible property to the extent it is imbedded in such services.

A second very important aspect of the new rules is that they simplify the ultimate methodology that is applicable to so-called back-office services. Both of these concepts are significant departures from the prior regulations.

The GSK case, which will be discussed later, covered transactions involving more than a decade. The assessment against GSK seems to be part of a trend by the IRS to focus on transfer pricing and intercompany transactions.

Auditing firms will likely inquire into whether a corporation has contemporaneous documentation to support its intercompany transactions, especially in light of the new regulations. If no such documentation exists, such a corporation could be considered to have a material weakness under the Sarbanes-Oxley Act. This is because the IRS is now requesting such documentation as a matter of course, and significant penalties could apply if it is not in place in a timely manner.

Moreover, it is critical that the quality of the transfer pricing documentation be defensible; otherwise, a financial reserve for transfer pricing may be required to be booked. Thus, the requirements of the new regulations should be taken seriously, and compliance should be done in a timely way. Multinational corporations should begin considering compliance now, if they have not already done so.

True back-office services can now be allocated without a profit incorporated and can be treated as if the related parties are sharing the cost. The Services Cost Method (SCM) replaces the Simplified Cost Method in the proposed regulation. The preamble to these regulations lists items that are considered back-office expenses, such as payroll, accounts payable, tax preparation and similar items.

The IRS has indicated that it intends to have a more complete and final list very soon. Services not considered back-office services will have to continue to be analyzed under the regular alternative methods for transfer pricing.

In addition to back-office services, the other service category that will qualify for SCM are certain low-margin services where the arm's-length markup is usually 7 percent or less. If this is established, then the services may be charged at cost. It is important to understand that the regulations are clear that the key competitive advantages, core capabilities or fundamental chances or successes of that service have been analyzed to demonstrate that their services do not directly contribute to such factors.

Both the back-office service category, as well as services with a low margin, offer a planning opportunity. In some cases, the new rule could be helpful to U.S. multinationals because it means less profit may be required to be allocated from the foreign operations to compensate for services performed by the U.S. group.

On the other hand, foreign multinationals may find it more difficult to justify a profit being paid from the U.S. group for services performed by the foreign parent. Thus, it is critical that multinationals begin analyzing these issues, not only because compliance is required, but to maintain competitive effective tax rates through appropriate transfer pricing planning.

All Other Services

Services that do not qualify for sharing of costs under SCM must be analyzed under the five alternative tests in the new regulations: 1) comparable uncontrolled services method; 2) gross services margin method; 3) cost of services plus method; 4) comparable profits method for services; and 5) profit-split method.

Under the new regulations, imbedded intangibles must also be taken into account, which was not the case in the past, when all intercompany services were usually considered as a cost-plus transaction. However, under the new regulations, a service with an imbedded intangible will tend to have a higher compensation stream attributed to it as a result of the value of the intangible. Most multinationals will have this issue, since they will have developed their own method of providing services based on their own standards.

Many of the above notions are consistent with concepts that were embodied with the 1994 regulations. In addition, the regulations clarify the concept of total service cost to include all costs directly identified with the provision of the services, plus other costs that are reasonably allocable to such services. This includes costs for all resources expended, used, or made available in rendering the intercompany service.

It appears that this wording is intended to be close to an economic or cost accounting view of allocation under a full absorption method. Nevertheless, the regulations do indicate that generally accepted accounting principles (GAAP) may not always be a good basis to determine the appropriate cost pool.

Financial Guarantees and Financial Transactions

The regulations also address another area that the IRS felt was not being properly addressed in the past: intercompany loans and guarantees. The regulations state that these types of transactions do not qualify under the SCM; thus, a taxpayer will have to utilize one of the other five methods noted above. For the most part, it seems that taxpayers have not been aware that loan guarantees can generate an intercompany service charge.

This often occurs when a lower interest rate is obtained by a related corporation after an affiliate either guarantees the loan or in some other fashion lends its financial stability to the related corporation. There may also be planning opportunities as a result of this rule. For example, the rule could allow a U.S. subsidiary to make guarantee payments to its non-U.S. parent if the borrowing power of the U.S. subsidiary is enhanced by the non-U.S. parent. As a result, these payments could erode the U.S. tax base and allow for tax-efficient repatriation of profits out of the U.S.

Implications of the GSK Settlement

The period of assessment in the Glaxo case ranged from 1989 to 2000, and there were some transfer pricing issues relating to 2005 as well. The case originated when GSK filed a claim in the Tax Court in 2004 after the IRS made an adjustment on audit to GSK's U.S. income.

Essentially, the IRS reallocated a significant portion of its worldwide income to the U.S. group of companies under U.S. transfer pricing rules. It also limited the royalty paid from GSK's U.S. group to its UK parent to 15 percent.

The IRS claimed that, through its marketing efforts, GSK USA developed a secondary marketing intangible that was separate and distinct. Under the IRS position, a significant amount of income should have remained in the U.S. group rather than being allocated back to the UK parent. During the development of the case, the IRS modified some of its arguments and took the position that some of GSK USA's marketing expenses likely represented a value-added service that benefited the UK parent.

The argument was that GSK USA should have been compensated for this, thereby creating more income that was taxable in the U.S. This argument seems to have been incorporated in the theories contained in the new service regulations relating to imbedded intangibles and services.

In addition to GSK and the service regulations, regulations were issued last year that deal with cost-sharing and intellectual property buy-in payments. All of this indicates that the IRS is particularly concerned with intercompany services and the transfer or use of intangibles. Notwithstanding this concern, there are still many viable planning opportunities available that should always be considered as compliance is undertaken.

The regulations essentially encourage every multinational to begin to review and analyze its intercompany services to avoid the imposition of the transfer pricing penalties. Appropriate documentation must be in place to support such intercompany transactions in a timely manner.

As a result, corporate financial managers should consider engaging competent legal and tax advisors to assist in the development and issuance of transfer pricing policies and documentation, as well as consider appropriate transfer pricing planning techniques--with the proper support and documentation--to minimize corporate tax rates effectively.

Brian Andreoli ([e-mail]) and David Hryck ([e-mail]) are international tax partners in the New York office of DLA Piper US LLP.

RELATED ARTICLE: takeaways

* The IRS appears to have taken a new and tougher stance against intercompany services issues involved in transfer pricing, and has issued new regulations on those.

* Separately, the agency reached a $3.4 billion settlement with pharmaceutical giant GlaxoSmithKline related to transfer-pricing issues that began in 1989 and ended last year.

* While the new regulations focus on intercompany services aspects, they also importantly apply to intangible property to the extent it is imbedded in such services.

* It appears that the wording in the IRS rules is intended to be close to an economic or cost accounting view of allocation under a full absorption method.