Markers and musings: the proposed section 482 services regulations.

Introduction

In September, the Internal Revenue Service promulgated comprehensive and important revisions to the regulations on the treatment of intercompany services under section 482 of the Internal Revenue Code, along with several key changes to the transfer pricing characterization of intangibles. (1) (Issued in proposed form, these regulations are referred to in this article as "the regulations.") Updating 35-year-old provisions, the regulations both complete the mid-1990s overhaul of the transfer pricing rules and have potential ripple effects. They in part respond to business trends and international developments and in part reflect IRS suspicion regarding offshore "migration" of revenue and intangibles. Considerable effort has been made to unify the transfer pricing provisions in a principled way, though this has the potential to seriously compromise the administrability of the services rules.

Few multinational taxpayers will be unaffected by the regulations. Even if their current transfer pricing practices pass muster under the new rules, companies must still review many transactions to identify risks or opportunities. Explicitly or subtly, the regulations will require markups on many intercompany services for which cost pass-throughs are currently permitted.

This article does not restate the lengthy rules or the IRS's explanation for them in the preamble to the notice of proposed rulemaking (preamble). Rather, after highlighting key aspects of the new provisions, this article offers observations and queries from a practical implementation perspective. (2)

Markers

Services

Supplying a definition absent from the current regulations, the regulations apply broadly to any "controlled services transaction." Controlled services transactions occur when a commonly controlled party undertakes an activity (performs a function, assumes a risk, or uses property--tangible or intangible) that gives another controlled party a reasonably identifiable increment of economic or commercial value. Basically, the new rules apply to any activity that an uncontrolled party in comparable circumstances would pay for or do itself. Duplicative and shareholder activities remain excluded. Allocation provisions address situations where services benefit more than one group member and the transfer pricing method (TPM) depends on costs.

Six specified TPMs

Permitted TPMs--largely analogous to those for tangible and intangible property transfers but carefully tailored to services--are: (i) comparable uncontrolled services price method; (ii) gross services margin method; (iii) cost of services plus method; (iv) comparable profits method (CPM); (v) simplified cost-based method; and (vi) profit split method. "Unspecified methods" are also allowed. The general provisions of Treas. Reg. [section] 1.482-1 apply, including the "best method" rule, comparability analysis, and ranges. The CPM provisions introduce--and favor--a new profit-level indicator, the ratio of operating profit to total services costs (referred to as "net cost plus"). The use of a Berry ratio is deemphasized because of accounting segmentation issues.

The "simplified cost-based method" replaces the cost safe harbor

The regulations replace the existing cost-only safe harbor for "non-integral services" (3) with a much narrower "simplified" method for "low-margin" services. (4) To qualify for the new Simplified Cost-Based Method (SCBM), the following criteria must be met:

* The service is not included in a long list of ineligible services: manufacturing, production, extraction, construction, reselling, distribution, acting as a sales or purchasing agent, acting under a commission (or similar) arrangement, research, development, experimentation, engineering, scientific, financial transactions (including guarantees), insurance, and reinsurance.

* Neither the renderer, the recipient, nor another group member renders similar services to uncontrolled parties.

* Valuable or unique intangible property or particular resources or capabilities of the renderer do not contribute significantly to the value of the services (unless the renderer's costs include significant costs with respect to the use of such intangible property or resources).

* The recipient does not receive significant amounts of services (e.g., accounting for 50 percent or more of its SG&A) from controlled parties.

* A written contract is in place describing the services and their pricing. (5)

* The arm's-length markup on the services would not exceed 10 percent.

Also, the simplified method is not available to non-service components of integrated transactions.

SCBM mechanics/phase-out

SCBM allows controlled parties to render eligible services at less than an arm's-length price, and without the hurdle of the best-method rule. The charge cannot be less than cost. Above that, the permissible charge is based on a formula that depends on the "correct" arm's-length markup (generally indicated as the median of an arm's-length range for comparable transactions). If the "correct" markup is six percent or less, the permitted markup may be zero or any other rate up to six percent. The cushion of allowable difference between the "correct" and "actual" markups shrinks ratably by one percentage point for every percentage point by which the "correct" markup increases (until the "correct" markup hits 10 percent). Services with lower "correct" markups--low-margin services--thus enjoy more protective cushion than higher-margin services.

Residual profit split method (RPSM)

By emphasizing this method in examples (6) and revising its conceptual basis to look to "nonroutine contributions," (7) the regulations suggest that RPSM could apply quite readily not only to controlled services transactions involving high-value intangibles, but also to integrated transactions that are difficult to break apart for evaluation. (8)

Imputed agreements

The regulations embellish the current provisions that permit the IRS to review controlled parties' dealings and impute agreements between them to more accurately reflect the economic substance of their conduct, even if such imputed agreements are contrary to express contractual agreements. New examples suggest that alternative IRS approaches could include contingent payment compensation or compensation for revised relationships (e.g., termination payments). (9)

Integrated transactions

Some service transactions have non-service components for which distinct arm's-length analytical methods already exist. These "integrated" transactions would not necessarily have to be unbundled for separate arm's-length evaluations. (10) Instead, they could be evaluated as a single controlled transaction if the chosen method's comparability inquiry adequately accounts for the non-service components. (11) A special corroboration rule applies to integrated transactions with intangible components that result in or have an effect similar to a transfer of intangible property. If the intangible element is "material," that element would have to be corroborated or determined under the rules for intangibles. The corroboration mechanics are unclear.

Revised intangibles framework

The current regulations allocate income from an intangible based on its owner (or deemed owners), applying the "developer/assister" rule to determine the owner of intangible property that is not legally protected. The regulations reframe this approach, albeit retaining the underlying principles. (12) First, ownership is determined under intellectual property law and contract and various intangible rights are recognized (e.g., license rights). These property rights merit appropriate amounts of income. In addition, income is allocated among the controlled parties, on an arm's-length basis, in accordance with each one's contribution to the development or enhancement of an intangible right owned by another. No separate allocation is required if the consideration for such contribution is embedded in the contractual terms for the pertinent transaction. This "contributor" rule replaces the so-called cheese examples in the current intangibles regulations.

Musings

What's in a Name?

The broad definition of services--in short, an activity that confers a benefit--makes the new regulations transfer pricing's "kitchen sink." (13) Going beyond a transactions-based perspective and sweeping in "the performance of functions" and "assumptions of risks" indicate, for example, that oversight and loan guarantees are services. Indeed, by including "making available to the recipient any property or other resources of the renderer," the regulations technically encompass intangible licenses, property rentals, and loans, although the Preamble to the regulations suggests otherwise. (14) This broad definition, together with the combination/integration rules (discussed below), is potentially confusing. Although the increasingly similar TPMs among different kinds of transactions are intended to make characterization less important, at some point one needs to differentiate because of the statutory commensurate-with-income rule uniquely applicable to intangibles. (15)

The regulations incorporate some concepts from the OECD Guidelines, (16) such as focusing on the value to the recipient rather than whether an arm's-length renderer would charge for the services. This should be helpful in a bilateral context.

No attempt is made to sort out difficult characterization issues for e-commerce and Internet-related services, which are the subject of extensive OECD studies. (17) And, even though the rules have been rephrased to better track OECD concepts, there is still little elucidation on the nettlesome issues of shareholder, stewardship, and duplicative activities.

Simplified Cost-Based Method: The Exceptions Swallow the Rule

The IRS's rationale for replacing the current cost safe harbor with SCBM is (i) to avoid cost-only charges for high-margin services and (ii) to minimize controversy regarding the "qualitative and subjective tests" in the current regulations (i.e., the "integral part" and "peculiarly capable" concepts), while (iii) providing "reduced compliance and administrative burdens." (18) The new method achieves the first objective, with a vengeance, by limiting use of the method to low-margin services, reducing the benefit as the value of the services rises, and, just to be sure, excluding whole categories of services that might be high-margin services, whether or not they actually are. Moreover, the helpfulness of the method for eligible services (beyond eliminating the best-method rule) may be less than appears at first blush. SCBM only reduces the low end of the applicable range for covered services to ensure that the spread between the median and the low end is a certain breadth (i.e., two to six percent, depending on the "correct" markup rate). In effect, SCBM creates a new low-edge-to-median range instead of the CPM lower-quartile-to-upper-quartile range. As an example in the regulations illustrates, a taxpayer may be better off using CPM if the range is broad. (19)

From a practical perspective, SCBM is unlikely to achieve the IRS's administrative goal. Under the method's comparability focus, every intercompany service will have to be identified and valued in order to determine whether it may be eligible for SCBM, and, if so, to what extent. Absent IRS clarification, headquarters services may have to be broken into many pieces for both eligibility and valuation purposes. Saying that only rough values are needed (20) ignores taxpayers' desire for certainty. Taxpayers will worry about whether they can find an appropriate group of comparables and whether they can get valid information (e.g., should headquarters accounting services of a large multinational be measured against outsourcing charges of major accounting firms, (21) and, if so, how can their markup be determined?). If taxpayers hedge their bets by overestimating the "correct" markup, the benefit of SCBM will be reduced. Early precision will be needed to help taxpayers make the potential Catch-22 decision whether to rely on the median-based SCBM or the interquartile range of CPM, unless the IRS clarifies the interrelationship. (22) If the SCBM approach is retained, the IRS should consider providing a list of "under six percent" services or identifying pertinent comparables in routine service categories for safe-harbor-type use.

Also interfering with the utility of SCBM is the list of excluded categories--because of both the breadth of the list and remaining interpretative issues. The regulations retain most of the exclusions from the current cost safe harbor--including the "peculiarly capable" exclusion mildly disguised as "services involving the use of intangible property"--and add additional exclusions, such as research, engineering, financial, and insurance transactions. Situations where non-service transactions account for more than a de minimis amount of value are also excluded, except to the extent the pure service aspects can be carved out. Each exclusion raises definitional issues that the regulations do not address. The propriety of these exclusions depends on one's view of the overriding goal of the special rule: easier rules for non-core low-risk services, regardless of value, or just for low-value low-tech functions.

Most troublesome today, given the technological component of so many back-office services, is the intangibles rule. This rule excludes services where intangible property of the renderer contributes significantly to the value of the services but not much pertinent cost is included in the renderer's costs. While this framing should helpfully ignore purchased intangibles, it leaves hard questions unresolved. For instance, how should this be interpreted if headquarters gradually develops systems, albeit routine ones, to render accounting services? Must the development costs be tracked, capitalized, and amortized in the cost base? When does skill, talent, or efficiency (likely untrackable) rise to the status of an intangible for this purpose? "Particular resources or capabilities"--such as the ability to take advantage of particularly advantageous situations--can be very broad and its absence hard to confirm. The IRS could improve the situation by describing common types of intangibles and resources that will not stand in the way of using SCBM.

Other observations on SCBM:

* Although the regulatory examples look to the median of the "correct" range for testing the applicability of SCBM, use of the median is not specified in the regulations themselves, nor is it consistent with retaining a range concept.

* Comparables data should be adjusted to reflect differences between the tested party and the comparables along the lines of Treas. Reg. [section] 1.4825(c)(2)(iv) (e.g., "asset intensity adjustments"), (23) which requires often difficult balance sheet allocations.

* By eliminating the current provision that generally makes the cost safe harbor unavailable if the costs of rendering services to controlled parties account for five percent or more of the renderer's costs, the regulations make dedicated service entities in non-core countries eligible for SCBM.

* Helpfully, the Preamble (24) provides that no inference is to be drawn from the framework of SCBM that the arm's-length rate for excluded types of transactions should exceed 10 percent--rather, only that a full (colloquially, "more robust") analysis is appropriate.

* The regulations do not specify particular documentation with respect to the "correct" markup. Proposed amendments to the section 6662(e) penalty regulations look to the reasonableness of" the taxpayer's determination that SCBM applies, based on all the facts and circumstances. These amendments incorporate, without diminution, the evidentiary and documentation requirements applicable to other TPMs such as CPM. (25)

* SCBM does not protect against an IRS audit adjustment if the correct price is below the amount charged. If overcharges are more likely to be asserted with respect to inbound services, does this improperly discriminate against foreign service-providers? It is not clear how the recipient of such services can avoid SCBM and rely on CPM for its higher permitted markup level.

* SCBM (as well as CPM using "net cost plus" as the profit- level indicator) tests the markup on "total services costs," a full cost computation. (26) How should outsourced services be handled? While these services generate "costs," it seems inappropriate to add (or test) an arm's-length markup for such costs based on the type of services, because such a markup is already embedded in the third-party's charges. Absent a modification allowing such costs to be carved out, the regulations should be clarified that the arm's-length markup could be determined by reference to what an uncontrolled taxpayer engaged in a similar, low-risk, pass-through arrangement would earn (e.g., an administrative handling charge). (27)

* With limited exceptions, written agreements must be in place throughout the covered service period. The strong message of the regulations is that clear and comprehensive intercompany agreements are important, and good practice would suggest this is an appropriate time to review, memorialize, and update intercompany relationships. Pending promulgation of final regulations, it may be best to concentrate on inventorying and analyzing the current situation, deferring new contracting until the final rules and effective dates are known.

In short, the scope of SCBM is very limited, and the cost safe harbor has been largely eviscerated. Whether or not intended, the likely effect is to force most services to be priced at arm's-length rates. Even though the regulations' approach is more in line with the OECD Guidelines, the improved international balance (and complexity) of centralized services argues for expansion, rather than contraction, of the cost safe harbor.

Not Home Free: Centralized Services

Efficiencies, economies of scale, and desires for uniformity and control often lead multinational companies to centralize intercompany services, including management and administration. Although intended to harmonize with the OECD Guidelines, the regulations significantly change the long-understood IRS policy for allocating the costs of such services among group members for purposes of TPMs based on total service costs. An oft-noted technical advice memorandum issued by the IRS National Office in 1987 stated:

   The United States subscribes to the general benefit
   theory which requires that expenses incurred for
   the benefit of the group as a whole be allocated to
   the members on some ratable basis even if there
   is no specific, identifiable benefit received by the
   affiliates currently. (28)

The TAM contrasted this U.S. rule with the OECD's "specific benefit" approach, under which parent-incurred costs should be borne by the parent unless "a positive, ascertainable benefit accrues to the affiliate or is expected to accrue to the affiliate."

The regulations now adopt the "specific benefit" approach on the basis that the general benefit concept "is inconsistent with the arm's length standard." (29) The regulations contain strong repudiatory language: "In no event will an allocation of costs based on a generalized or non-specific benefit be appropriate." (30)

The effect of this change will be to require a much closer look at actual benefits. The question will be less which services may be charged out (e.g., not duplicative or shareholder services) than to which group members--and in what relative amounts--the centralized costs must be allocated. The supportive and sometimes indirect nature of centralized services makes this challenging and burdensome, requiring difficult line-drawing and time-keeping exercises. In addition, the regulations do not discuss "on-call" services, for which the OECD Guidelines permit an allocation if an independent enterprise in comparable circumstances would incur "standby charges" to ensure the availability of the services when needed. (31) Such an approach is logical, but confirmation would be helpful.

In addition, centrally-provided services may need to be broken apart to determine both eligibility for SCBM and the appropriate markup. While this is theoretically no different from CPM, the complexity of subjecting centralized services to multiple methods (e.g., SCBM and CPM) may push taxpayers away from SCBM altogether. And determining the arm's-length returns for centralized services could be perplexing; for example, where headquarters efforts result in significant discounts or cost savings for group members. Difficulties in finding appropriate comparables may unjustifiably preclude group members from sharing the efficiency benefits. Some aggregation guidance would be welcome.

One wonders whether this level of detailed review and taxpayer burden is necessary or, at bottom, revenue-generating, if multinationals operating in the United States are increasingly less U.S.-centric. An intermediate idea would be for the IRS to provide a safe-harbor rate of return and allocation method for headquarters services, covering conventional categories.

The IRS should also consider expressly permitting cost-sharing arrangements for services, which seems a practical alternative and disperses the efficiency savings. (32) The tantalizing comment in the Preamble that "in certain cases" the sharing of headquarters expenses "may be consistent with the rules of the proposed regulations" needs elaboration. (33)

RPSM Rising

The regulations adhere to the "best method" principle under the section 482 regulations and do not prescribe priorities among available TPMs. One senses, however, that the IRS anticipates an increased role for RPSM. Prop. Reg. [section] 1.482-9(g) provides that RPSM "is ordinarily used in controlled services transactions involving high-value services or transactions that are highly integrated and that cannot be reliably evaluated on a separate basis." This focus is underscored by changes proposed to the definition of a "nonroutine contribution" to a business activity--which, as a practical matter, must be made by both controlled parties for RPSM to be applicable. The revision would add to the existing concept of a contribution that cannot be fully accounted for by reference to market returns, one "that is so interrelated with other transactions that it cannot be reliably evaluated on a separate basis." (34)

Given the relentlessly increasing technological component to services, this new category of integrated transactions for which RPSM might be appropriate could lead to increased usage--or IRS imposition--of RPSM. The examples given are not extreme: One company develops a database and software that are promoted by an affiliate that develops a related communications network (Example 1); a local mining/extraction company is provided with management services and exploration services and equipment by U.S. affiliates (Example 2). (35) Indeed, although Example 2 is short on facts, it suggests a very low threshold for nonroutine contributions.

RPSM is a complicated method and its risk-sharing principle may be problematic for some multinational groups. Aspects often anathema to the IRS are the need to use foreign taxpayer data (and allocations) and foreign comparables. While RPSM could lead to a more equitable, if rather formulaic, approach among countries, one can expect to encounter practical problems in its implementation or acceptance by the IRS and tax agencies in other countries.

The Sleeping Tiger: Imputed Contracts

As part of the general comparability rules, the current section 482 regulations provide that written contracts between controlled parties (including the consequent allocation of risks) will be respected if the terms are consistent with the economic substance of the underlying transactions. If not, or if there is no written agreement, the IRS may impute terms consistent with the transactions' economic substance. (36)

Three new examples in the regulations appear to expand considerably the scope and threat of this provision. (37) First, they suggest a wide range of ways an agreement might be effectively rewritten by the IRS to hew to the economic substance of the transactions: (i) imputing a separate service agreement, possibly with a contingent payment provision, for previously uncompensated services; (ii) imputing a long-term contract that conveys profit opportunities to the service-provider (the only approach mentioned in the current regulations); (iii) requiring compensation for a change in contractual relationships; or (iv) imputing a transfer of intangible rights. Second, the examples can be read to suggest that the corrective imputed contract could make adjustments in current and future years for erroneous methodology in past years (most notably, types (i) and (iii))--causing some commentators to characterize these changes as a repeal of the statute of limitations. Finally, the examples stress the contractual and economic relationship between the parties more than the features of individual transactions. Particular exposure may lurk in changes to relationships between controlled parties (e.g., if a distributor is converted into a commissionaire or if other risks are rearranged).

The increased emphasis on this IRS tool, which has the appearance of hindsight carte blanche, is unnerving. Transfer pricing is at best a rough science, and threatening the fragile certainty of compliant taxpayers is not welcome. While illustration of possible approaches is useful (the statute-of-limitations issue aside), it would help if the IRS restricted this tool to abusive situations or at least to ones where the inconsistency is significant. The IRS should also temper its ability to use hindsight by subjecting itself to the same standard that the current regulations apply to taxpayers in determining which taxpayer bears risk: "An allocation of risk between controlled taxpayers after the outcome of such risk is known or reasonably knowable lacks economic substance." (38) By the same token, taxpayers should take heed to specify respective risk-bearing in their intercompany contracts and adhere to it.

Getting a Grip on Integrated Transactions

As discussed in connection with SCBM, RPSM, and imputed contracts, the regulations are particularly sensitive to transactions that combine different elements. Prop. Reg. [section] 1.482-9(m) highlights the issue.

First, the new section notes that it may not be necessary to separately evaluate the various elements of an integrated transaction if sufficiently similar features are present in the comparable transactions used to evaluate the transaction as a whole. This rule replaces the provision in the current regulations that a separate allocation for services is not to be made if the services are merely ancillary and subsidiary to the transfer of property. (39) While conceptually sound, the new rule is more complicated to assess and apply. It may be harder to determine from publicly available information that the comparables perform similar services than it would have been to conclude that the services are ancillary and subsidiary.

Second, the provision refers to services transactions that may (i) result in the transfer of intangible property, (ii) have an effect similar to the transfer of intangible property, or (iii) include an element that constitutes the transfer of intangible property. If the element relating to intangible property is "material," that element must be corroborated or determined under the intangibles rules of Treas. Reg. [section] 1.482-4. To the extent this requires the elements of the transaction to be split apart and analyzed separately, the provision is theoretically acceptable. The potential problems reside primarily in the vagueness of the definitional aspects and the burdensomeness of the determination. (40) It would be helpful, for instance, to illustrate the difference between use of intangibles in rendering services (e.g., software used by a data processing service provider) and transferring intangibles that the recipient can exploit. (41)

Outside of these two rules, the regulations default to whichever approach--including separate evaluation of the component parts--will provide "the most reliable measure of an arm's length result."

At bottom, the factual tension here appears unavoidable, though some type of de minimis rule would be helpful.

What's in the Frame? The Revised Intangibles Rules

The reframed intangibles rules may not work much substantive change by reconfiguring the current owner/assister approach as an owner/contributor approach. The IRS's objective is to avoid misapplication of the current rules to reach "all or nothing" results that improperly attribute all the income from an intangible to the section 482 "owner," rather than dividing it between those who hold legal rights with respect to the intangible and those who otherwise contribute to its value. (42) Apparently, the goal is to eliminate the third "cheese example" in the current regulations, (43) which treats a long-term exclusive licensee of a trademark as the owner of the trademark by contract, entitled to all of the income therefrom. If that example were wrong because it effectively presumed there was no value to the retained rights of the trademark's legal owner, one would think it could have been corrected even under the current framework, which permits multiple owners of an intangible.

Another implicit IRS objective is to reduce the offshore migration of intangibles. This seems at bottom a valuation issue, for example, enforcing the commensurate-with-income provisions when potentially valuable intangibles are licensed abroad, or the enhancement compensation approach when they are developed abroad but significantly "assisted" here. (44) The IRS's underlying fear that this migration of value was occurring by the assister's use of the cost safe harbor for services should be significantly mitigated by the new SCBM approach and its limitations. Perhaps it is felt that clarifying the need to value each party's contribution to the intangible rights of the other will be perceived as adding teeth to the valuation exercise, or that more clearly characterizing each party's interest as a type of intangible will support higher, commensurate-with-income returns (or profit-split approaches) rather than routine service-provider returns.

In any event, the new rules require a new look at transactions and a better understanding of the IRS objectives. One can envision considerable complexity in trying to identify, isolate, and value contributions made by group members to widely used multi-faceted intangibles, such as marketing intangibles.

Contingent Payment Arrangements: A New Thing

The regulations explicitly recognize that a contingent payment arrangement may be an appropriate, arm's-length way to compensate a related party for services. (45) (It is not actually a TPM, but has a similar effect.) Under a contingent payment arrangement, payments may not occur until periods after the services are rendered. This type of arrangement may be useful for taxpayers performing independent of contract R&D services that might otherwise necessitate a high current markup. It could serve as a partial alternative to an intangibles cost-sharing arrangement involving high-value, high-risk services, importing a commensurate-with-income flavor for services.

The key to acceptable arrangements of this type is demonstrating what uncontrolled taxpayers engaged in similar transactions under similar circumstances would do, including a basis of payment that reflects respective benefits and risks. The risk-based assessment is appropriate. The IRS may consider other alternatives reasonably available to the parties (e.g., a royalty structure) to help it determine whether the payment basis is reasonable.

A taxpayer that wants to utilize this rule must reflect the arrangement in a written contract prior to the start of the pertinent activities. The IRS, on the other hand, may impute contingent payment terms after the fact if the economic substance of a transaction is consistent with such terms (see earlier discussion of imputed agreement).

Another New Concept: Passive Association Non-Benefit

In defining services transactions, the regulations state that a controlled taxpayer generally will not be considered to obtain a benefit--and thus need not (and may not) pay for it where that benefit merely results from its status as a member of a controlled group, rather than from some activity of another member. (46) The same rule, termed an "incidental benefit," can be found in the OECD Guidelines. (47)

An example given in the regulations concerns a small acquired company that obtains a larger, more complex contract than previously undertaken, even though the new parent was not involved in the solicitation, negotiation, or anticipated execution of the contract, nor were its marketing intangibles used. If the parent executed a beneficial performance guarantee with respect to the project or helped negotiate the contract, however, an intercompany benefit (i.e., service) would be considered to have been obtained. (48)

The OECD Guidelines give additional examples. No service is considered rendered if an affiliate gets a higher credit rating solely by reason of its affiliation, whereas a compensable service would have been rendered if the higher credit rating results from another member's guarantee. A service (i.e., a non-incidental benefit) is received if an affiliate benefits from the group's reputation deriving from global marketing and public relations campaigns. (49)

This concept is potentially helpful in reducing the need to quantify certain intangible benefits of group membership, though the situations may be rare indeed where one can prove the absence of any benefit-creating activity. The offsetting, implicit need to value and pay for all other group membership benefits may be more troubling.

Random Musings

Loan Guarantees

Implicit in their explicit exclusion from SCBM, as well as the kitchen-sink approach of the regulations, is that loan guarantees are services. This would be consistent with the informal IRS position in this regard (50)--but for the crucial difference that the ability to effectively ignore such guarantees under the cost safe harbor is gone. In view of different characterizations in other contexts, (51) it would be helpful for the IRS to confirm the services characterization and to provide some guidance on the troublesome issue of valuing guarantees under the arm's-length benefit-based standard. (52)

Stock-Based Compensation

The IRS recently finalized controversial regulations that require stock-based compensation to be included in the cost pool for qualified cost-sharing arrangements for developing intangibles. (53) Although the preamble to the preceding proposed regulations stated that the IRS was considering a similar inclusion in determining costs for services, (54) there is no mention of this in the section 482 service regulations. The regulations do specify a broad definition of costs--"full consideration for all resources expended, used or made available to achieve the specific objective for which the service is rendered" (55)--to replace language simply referring to costs or deductions directly or indirectly related to the service performed. The regulations also provide that GAAP or federal income tax accounting rules may provide a useful starting point but will not be conclusive; it is worth noting that the GAAP treatment of stock options is currently undergoing intense scrutiny and probable revision, and has been a controversial point in the cost-sharing debate.

In view of the fuss that it has made in this regard, the IRS should clarify whether the new broader concept of cost in the regulations is intended to include stock-based compensation. (56) Arguments could be made that inclusion of such costs here is even more problematic than under the cost-sharing rules. (57)

Commissionaires and Limited Risk Distributors

An interesting point under the regulations' gross services margin method (analogous to the resale price method for tangible property) is that if a related party performs an agent service or intermediary function comparable to a distributor that takes title to goods and resells them, the gross profit margin of such a buy-sell distributor on uncontrolled sales may be used as the comparable margin, subject to adjustment for any material differences. (58) An example under this provision suggests a hard look at the similarity of functions and risks in the two types of relationships, and the inference is that they may not be very different. (59)

Conclusions

The IRS is to be commended for taking a big step toward harmonizing its services rules with international standards. (60) This move comes, however, at the price of extra work, complexity, and effective loss of the highly practical cost sale harbor. The attempted theoretical perfection of the regulations portends major practical problems and uncertainties. Taxpayers may want to reduce opportunities for IRS second guessing by more tightly documenting intercompany relationships. Given the prevalence of intercompany services, the IRS should seriously reconsider more widely available and administrable safe harbors, even ones with modest markups to address its revenue erosion concerns.

(1) 68 Fed. Reg. 53448 (Sept. 10, 2003), Prop. Reg. [subsection] 1.482-1, -4, -6, and -9.

(2) The services provisions of the regulations are proposed to be effective for taxable years beginning after their finalization, which will not occur until at least mid-2004. Prop. Reg. [section] 1.482-9(n). The effective date for the changes to the intangibles provisions is not specified, perhaps deferring a decision on how to handle ongoing transfers.

(3) Treas. Reg. [section] 1.482-2(b)(3).

(4) Prop. Reg. [section] 1.482-9(f). Although characterized as a "method," the new provision works like a sale harbor, in that the IRS cannot reallocate income or expenses with respect to a covered transaction if the actual markup is within specified parameters, without requiring the taxpayer to demonstrate that the actual markup is, in fact, arm's length.

(5) This requirement does not apply if the U.S. controlled group's gross income is less than $200 million or if the aggregate cost of SCBM-covered services is less than $10 million.

(6) Prop. Reg. [subsection] 1.482-4(f)(4)(ii) (Exs. 2, 3, 5 & 6) and 1.482-9(g)(2) (Exs. 1 & 2).

(7) Prop. Reg. [section] 1.482-6(c)(3)(B).

(8) Prop. Reg. [section] 1.482-9(g)(1).

(9) Prop. Reg. [section] 1.482-1(d)(3)(ii)(C).

(10) Prop. Reg. [section] 1.482-9(m).

(11) SCBM is not available.

(12) Prop. Reg. [subsection] 1.482-4(f)(3) & (4).

(13) The Preamble (at 53456) confirms this: "The Treasury Department and the IRS intend the broad scope of the term activity to allow transactions that are not subject to the existing section 482 regulations applicable to other types of transactions (e.g., transfers of tangible or intangible property, rentals, or loans) to be analyzed under proposed [section] 1.482-9."

(14) Id.

(15) But see the discussion of contingent payment arrangements.

(16) Organisation for Economic Cooperation and Development, Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, Ch. VII (Special Considerations for Intra-Group Services) (March 1996) (OECD Guidelines).

(17) "Tax Treaty Characterization Issues Arising From E-Commerce," Report to Working Party No. 1 of the OECD Committee on Fiscal Affairs (February. 1, 2001). See also Comments of American Bar Association Section of Taxation (January 3, 2002), reproduced in 10 Tax Mngmt Transfer Pricing Rep. 722 (January 9, 2002).

(18) Preamble at 53452. Not mentioned is either the explosive growth of the U.S. services sector (and the consequent revenue at stake) or the potential for adverse selection under the elective approach of the current regulations, i.e., using cost for outbound services but arm's length for inbound services.

(19) Prop. Reg. [section] 1.482-9(f)(5) (Ex. 7).

(20) Steven Musher, IRS Deputy Associate Chief Counsel (International), quoted in 12 Tax Mngmt Transfer Pricing Rep. 348 (September 17, 2003); September 12, 2003, Remarks by Rocco Femia, Treasury Department Office of International Tax Counsel, reported in 178 DTR G-7 (September 15, 2003).

(21) Wood & Canale, A Shot Across the Bow in an Unsafe Harbor: Proposed Rules on Related-Party Services and Intangible Property Transactions, 12 Tax Mngmt Transfer Pricing Rep. 498, 503 (October 1, 2003).

(22) Example 7 in Prop. Reg. [section] 1.482-9(f)(5) does not address this relationship, although the Preamble (at 53453) states that the SCBM rules are not in lieu of the interquartile range under other TPMs. Even if both ranges were based on the same comparables data, CPM must surmount the best-method rule.

(23) Prop. Reg. [subsection] 1.482-9(f)(1), -9(e)(2)(ii) & -9(e)(1).

(24) Preamble at 53454.

(25) Prop. Reg. [section] 1.6662-6(d)(2)(ii)(B).

(26) Prop. Reg. [section] 1.482-9(j).

(27) Paragraph 7.36 of Chapter VII of the OECD Guidelines reflects these considerations.

(28) TAM 8806002 (Sep. 24, 1987).

(29) Preamble at 53456.

(30) Prop. Reg. [section] 1.482-9(k)(1).

(31) OECD Guidelines, Ch, VII, [paragraphs] 7.16-7.17.

(32) Cost-sharing arrangements for services are permitted under the OECD Guidelines (Chapter VIII, [paragraph] 8.7 (Cost Contribution Arrangements)). Theoretically, the "unspecified method" route under Prop. Reg. [section] 1.482-9(h) would be available, but involves considerable hurdles and uncertainty.

(33) Preamble at 53456.

(34) Prop. Reg. [section] 1.482-6(c)(3)(i)(B).

(35) Prop. Reg. [section] 1.482-9(g)(2).

(36) Prop. Reg. [section] 1.482-1(d)(3)(ii)(B).

(37) Prop. Reg. [section] 1.482-1(d)(3)(ii)(C) (Exs. 3-5). See also Prop. Reg. [subsection] 1.482-9(i)(3) and -9(i)(4) (Exs. 1 & 2).

(38) Treas. Reg. [section] 1.482-1(d)(3)(iii)(B).

(39) Treas. Reg. [section] 1.482-2(b)(8).

(40) Example 4 illustrates the potential for confusion. It provides that the memorialization in technical documentation of know-how developed by Company X while rendering R&D services to Company Y constitutes the transfer of intangible property, a material element that must be corroborated or determined under the intangibles rules. But either the independent research services themselves (as opposed to their documentation) created and transferred know-how--the value of which should be reflected in the arm's-length price for that type of activity--or, if it was contract research, the know-how developed would belong to Company Y ab initio, so there would be no transfer.

(41) See Commentary on Article 12, OECD Model Tax Convention on Income and on Capital [paragraph] 11 (1997); TEI Comments on Section 482 Services Regulations (July 24, 1996), 48 The Tax Executive 401, 402 (Sept-Oct. 1996).

(42) Preamble at 53449.

(43) Treas. Reg. [section] 1.482-4(f)(3)(iv) (Ex. 4).

(44) See, e.g., the second "cheese example" (Treas. Reg. [section] 1.482-4(f)(3)(iv) (Ex. 3)) and Treas. Reg. [section] 1.482-1(d)(3)(ii)(C) (Ex. 3).

(45) Prop. Reg. [section] 1.482-9(i).

(46) Prop. Reg. [section] 1.482-9(1)(3)(v).

(47) OECD Guidelines, Ch. VII, [paragraph] 7.13.

(48) Prop. Reg. [section] 1.482-9(1)(4) (Exs. 15-17).

(49) This is similar to Example 1 in the Regulations (relating to Olympic sponsorship).

(50) TAM 7822005 (Mar. 5, 1978); 1995 FSA LEXIS 135 (May 1, 1995).

(51) See, e.g., FSA 200147033 (Aug. 14, 2001) and Bank of America v. United States, 680 F.2d 142 (Ct. Cl. 1982) (treating guarantee fees as analogous to interest for sourcing purposes).

(52) See Ryan, Erivona, & Chamberlain, A Transfer Pricing Framework for Loan Guarantee Fees, 11 Tax Mngmt Transfer Pricing Rep. 850 (Feb. 5, 2003).

(53) Treas. Reg. [section] 1.482-7(d)(2).

(54) 67 Fed. Reg. 48997, 49000 (Jul. 29, 2002).

(55) Prop. Reg. [section] 1.482-9(j).

(56) Wood & Canale, supra note 21 at 501 (indicating IRS confirms inclusion).

(57) Arguments would include (i) far more pervasive potential application, (ii) not effectively elective, (iii) employee allocation issues, (iv) more direct applicability of comparability standards, (v) arm's-length emphasis, and (vi) not primarily a safe-harbor-type context. See Lewis & Kochman, The Final Word on Stuck Options in Cost Sharing Arrangements??, 32 Tax Mngmnt Intl Journal 651, 658 (Dec. 12, 2003).

(58) Prop. Reg. [section] 1.482-9(c)(3)(ii)(D).

(59) Prop. Reg. [section] 1.482-9(c)(4) (Ex. 2).

(60) Considerable challenges and potential disputes remain in this regard. As so visibly put in Zollo, Bowers & Cowan, Transfer Pricing for Services: The Next Wave, Taxes 17 (March 2003), "not every country's sleeve is the same length."

PATRICIA GIMBEL LEWIS is a partner in the Washington D.C., law firm of Caplin & Drysdale, Chartered. She received J.D. and M.B.A. degrees from Harvard University in 1971, with honors, and her undergraduate degree from Wellesley College. Mrs. Lewis was a member of the 1994-1996 IRS Commissioner's Advisory Group, and co-chaired the Taxation Section of the District of Columbia Bar from 1992 to 1995. Mrs. Lewis's prior articles for The Tax Executive include: Second First??? Transfer Pricing Issues in Secondment of Personnel (2002); Mining for Nuggets in the IRS APA Report (2000); Now What? Collateral Consequences of Transfer Pricing Adjustments (1995); and Strategic Choices of Transfer-Pricing Controversies (1992). Mrs. Lewis expresses her appreciation to her colleagues Rebecca I. Rosenberg and Roy A. Moss for their assistance in connection with the preparation of this article.