TEI comments on proposed section 482 services regulations: December 22, 2003.

On December 22, 2003, Tax Executives Institute submitted comments to the Internal Revenue Service relating to the propossed section 482 services regulations. The comments were prepared under the aegis of TEI's International Tax Committee, whose chair is Bruce R. Maggin of IBM Corporation.

On September 5, 2003, the Internal Revenue Service issued proposed regulations providing guidance on the treatment of controlled services transactions under section 482 of the Internal Revenue Code and the allocation of income from intangibles, particularly with respect to contributions by a controlled party to the value of an intangible that is owned by another controlled party. The proposed regulations were published in the September 10, 2003, issue of the Federal Register (68 FED. REG. 53448). A hearing is scheduled for January 14, 2004.

Background

Tax Executives Institute is the preeminent association of business tax executives in North America. Our more than 5,400 members represent 2,800 of the leading corporations in the United States, Canada, and Europe. TEI represents a cross-section of the business community, and is dedicated to developing and effectively implementing sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply in a cost-efficient manner.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations under section 482, relating to the treatment of controlled services transactions and the allocation of income from intangibles.

Executive Summary

The release of proposed regulations in September represents the first attempt to revamp the section 482 services regulations since the 1960s. Much has changed in the world of cross-border transactions in the past 35 years and the Department of Treasury and Internal Revenue Service are to be commended for attempting to bring the rules more in line with today's global economy. Transfer pricing is not done in a vacuum and the proposed regulations recognize that the U.S. rules must comport with international guidelines. Thus, the proposed regulations seek to harmonize the transfer pricing rules for services with guidelines issued by the Organisation for Economic Cooperation and Development in several areas, including the definition of benefit, the exclusion of shareholder services, the requirement to use a standard pricing method, and the need to charge a profit element in many circumstances.

TEI is concerned, 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). The treatment of non-integral services under current Treas. Reg. [section] 1.482-2(b)(3)--which permits a taxpayer to charge services at cost where they are not an integral part of the business activity of either the member rendering the services or the member receiving the benefit of the services--is a practical approach to an area that is incredibly difficult to track. It has served taxpayers and the government well for nearly four decades.

Although Treasury and the IRS have attempted to provide an alternative in the SCBM method, the proposed regulations will permit far fewer services to be charged at cost, thereby increasing complexity and adding compliance burdens and expense. With the introduction of comparability standards and range rules for low-margin services, the sheer volume of transactions required to be analyzed under the proposed regulations will undoubtedly increase. In addition, the proposed rules are likely to cause additional controversy, not only with the IRS but with foreign jurisdictions, thereby increasing the potential for double taxation. For example, requiring a cost-plus approach for centralized services may run afoul of other jurisdictions that favor--and often require--a charge for such services at cost. Finally, the cost rates used in many of the examples may create de facto standards for auditing management and other services. In sum, the SCBM method is neither simple nor safe to use.

For these reasons, TEI urges Treasury and the IRS to retain the cost safe harbor. The vast majority of back-office services are routine, low-margin services for which charging cost is reasonable and appropriate. These services support the core profit-making activities of the taxpayer, but are not themselves integral to such activities. These services include finance, treasury, comptrollers or controllers, accounting, legal, tax, human resources, and procurement. To the extent that intangibles assist in providing these services, they typically make the service more efficient, not more valuable. TEI believes that the cost safe harbor should be retained, at least with respect to certain enumerated services.

In its analysis of the proposed regulations, TEI also offers the following conclusions and recommendations:

* Changes are needed in the area of centralized services to aid taxpayers seeking to comply with the requirements of both the United States and foreign jurisdictions. Possible changes include the explicit provision for a cost-sharing model similar to the qualified cost-sharing arrangement for intangible property development under Treas. Reg. [section]1.482-7 and to the concept of the cost contribution arrangement under guidelines issued by the OECD.

* The concept of legal ownership in the intangibles regulations is at odds with longstanding tax principles of beneficial ownership. The proposed regulations should be clarified by eliminating the concept of "legal ownership" from the transfer pricing analysis.

* The examples in Prop. Reg. [subsection] 1.482-1(d)(3)(ii)(C), 1.482-9(i)(3), and -9(i)(4) should clarify that an adjustment cannot be made in later years for transfer pricing errors that occurred in years for which the statute of limitations has closed.

* The SCBM method is far from simple since it effectively requires taxpayers to perform a full transfer pricing analysis for routine, low-margin services. To avoid adverse effects on U.S. businesses, the final regulations should provide a true cost safe harbor method for these services. In addition, examples of what constitutes "low-margin" services should be provided.

* Taxpayers should be protected from penalties if they have reasonably applied SCBM. The definition of "total service costs" should permit taxpayers to rely on generally accepted accounting or tax accounting principles in determining such costs. The terms "significantly," "material," and "de minimis" should be defined. The 50-percent recipient test in Prop. Reg. [section] 1.482-9(f)(4)(ii) should be eliminated.

* The exclusions from use of SCBM set forth in Prop. Reg. [section]1.4829(f)(4)(v)(E) should be narrowed and clarified. The final regulations should provide a safe harbor that a parent-subsidiary charge for a guarantee at cost-only is one measure of an arm's-length charge. Finally, SCBM should be revised to permit the safe harbor to apply to inbound transactions.

* 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, however, it could create an incentive to consolidate the services elsewhere or discourage foreign-owned multinationals from placing general support services operations in the United States.

* The proposed services regulations should not be finalized before taxpayers have had an opportunity to review and comment upon the proposed cost-sharing regulations when they are issued.

* The final regulations should address the grandfathering of existing compliance approaches. In particular, multinationals should be permitted a transition period in which to comply with the final regulations.

GENERAL COMMENTS

I. Scope of the regulations

A. The Need for Cost Sharing

The proposed regulations add a new Prop. Reg. [section] 1.482-9 to deal with "coutrolled services transactions," which are broadly defined in subsection (1) as any activity by a controlled taxpayer that results in a benefit to one or more controlled taxpayers. The term "activity" is defined to include the use by the renderer (or making available to the renderer) of any property or other resources of the renderer. An activity provides a benefit if it results in a reasonably identifiable increment of economic or commercial value that enhances the recipient's commercial position (or is reasonably anticipated to de so). An activity confers 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.

In adopting a "specific benefit" approach, the proposed regulations revamp the "benefit" test of the current regulations, which focused on the service provider, rather than the recipient, i.e., on whether an uncontrolled taxpayer in circumstances similar to the renderer would charge for the service. The Preamble specifically rejects the general benefit theory, which "requires that expenses incurred for the benefit of the group as a whole be allocated to members on the same ratable basis even if there is no specific, identifiable benefit received by the affiliates currently." (1) TEI questions whether this level of review is warranted.

For sound business reasons, many multinational taxpayers choose to consolidate the performance of certain services that benefit all, or nearly all, group members. These "headquarters" or centralized services may include accounting, financial, legal, management, marketing, internal audit, and computer or information technology activities. These services are hot always performed at the corporate headquarters, but may be performed at a regional headquarters or a shared services center. Thus, these "stewardship" expenses may well be performed in an entity other than a parent.

There are potentially hundreds of members of the corporate group that may benefit from broadly targeted centralized headquarters services. In many cases, the consolidation of such services is headquarters-driven with most of the benefits realized by the corporate headquarters. The consolidation streamlines information reporting and provides management with real-time access to information necessary for making global business decisions. In these circumstances, there is little, if any, benefit passed on to the affiliate. (2)

The general benefit approach is based on a presumption that the arm's-length charge for services performed by a corporate group's headquarters staff on behalf of the group as a whole may be shared by all of the group's members. This approach to identifying group-wide controlled services transactions has been--like the current regulations' cost safe harbor approach to valuing such transactions--an invaluable aid to multinational companies seeking to comply with transfer pricing requirements. While the IRS and Treasury have tried to offer a substitute for the cost sale harbor, the failure to provide a workable substitute for the general benefit approach will leave taxpayers with endless valuation and cost accounting projects that will likely yield little difference in results for both taxpayers and the IRS.

To justify a broad allocation of the charges associated with corporate services under the revised definition of "benefit" in Prop. Reg. [section] 1.482-9(1)(3), a taxpayer will first have to identify each individual corporate group member that benefits from--and will be willing to pay for--each individual service provided by a corporate headquarters staff. Depending on the size of the group, this first step could produce an unwieldy matrix of thousands of controlled services transactions. Next, the taxpayer will have to analyze each individual transaction using one of the proposed regulations" six valuation methods. Where cost-based valuation methods must be used--which will likely be the case for the majority of taxpayers that do not provide comparable services to unrelated parties--Prop. Reg. [section] 1.482-9(k) will restrict the use of any allocation-of-cost approach based on a "generalized or non-specific benefit." Thus, without an alternative to the general benefit approach and a workable method for broadly allocating centralized headquarters services, taxpayers must painstakingly identify the particular costs attributable to particular centralized services provided to particular members of the corporate group. For the vast majority of multinational corporate groups, this is simply not realistic or workable.

The OECD clearly recognizes that multinational corporate groups cannot undertake the type of extensive transaction-by-transaction analysis required by the proposed regulations for headquarters services. Specifically, there are situations involving centralized headquarters services "where a separate recording and analysis of the relevant service activities for each beneficiary would involve a burden of administrative work that would be disproportionately heavy in relation to the activities themselves." The OECD's proposed solution in these cases is both reasonable and appropriate:

   In such cases, the charge
   could be determined by reference
   to an allocation among
   all potential beneficiaries of
   the costs that cannot be allocated
   directly, i.e., costs
   that cannot be specifically
   assigned to the actual beneficiaries
   of the various
   services.

Organisation for Economic Cooperation and Development, TRANSFER PRICING GUIDELINES FOR MULTINATIONAL ENTERPRISES AND TAX ADMINISTRATIONS [paragraph] 7.24 (March 1996) (hereinafter referred to as the "OECD Guidelines").

While the Treasury and IRS have taken several steps to harmonize the regulations with the OECD Guidelines in some areas, further changes are needed in the area of centralized services to facilitate taxpayer compliance both with U.S. requirements and with the requirements of foreign jurisdictions that follow the OECD. (3) Possible changes include the explicit provision for a cost-sharing model similar to the concept of the cost contribution arrangement (CCA) under chapter VIII the OECD Guidelines and analogous to a qualified cost-sharing arrangement (QCSA) for intangible property development under Treas. Reg. [section] 1.482-7.

The OECD Guidelines contemplate that taxpayers may share in the provision of services at cost. Specifically, the Guidelines state at paragraph 8.3 "[a] CCA is a framework agreed among business enterprises to share the costs and risks of ... services and to determine the nature and extent of the interests of each participant in those ... services." Additionally, at paragraph 8.7, the Guidelines note that, "[w]hile CCAs for research and development of intangible property are perhaps most common, CCAs need not be limited to this activity. CCAs could exist for any joint funding or sharing of costs and risks, for developing or acquiring property or for obtaining services." (Emphasis added.)

Because participants in a QCSA are deemed to be the owners of developed intangibles in proportion to their respective contributions/benefits, the typical issues surrounding property transfers and profit determination de not exist. These same concerns are highlighted in the services context as well. Intangibles can have value in excess of their development costs. Conversely, intra-group services commonly generate benefits in the form of cost reductions rather than profit generation. The profit associated with intra-group services, on average, should be less than the profit associated with the development of intangibles. Thus, if cost sharing is acceptable for the development of intangibles, it should be equally acceptable with respect to services.

Like both the QCSA and CCA approaches, a simplified method for sharing headquarters services charges will reflect the economic realities of multinational corporate groups. Moreover, the rules governing a cost-sharing arrangement can be crafted to be consistent with the substantive framework of the proposed regulations. Specifically,

* The pool of charges to be shared should be restricted to only those costs reasonably expected to result in benefits to the participating members;

* Where necessary to achieve arm's-length results, certain types of centralized services that do not belong in the class of "low-margin" services could be charged to the cost-sharing pool with an appropriate profit markup;

* Through the use of reasonable methods of allocation similar to those upon which QCSAs and CCAs rely, each participant should be responsible for a share of the overall pool of centralized services charges in proportion to the participant's anticipated share of benefits received from the arrangement. Examples would be helpful.

Adopting a cost-sharing approach will accomplish at least two important goals: (i) the adoption of a transfer pricing methodology providing for a reasonable allocation of centralized services charges to appropriate recipients, and (ii) greater consistency between the U.S. transfer pricing laws and the OECD Guidelines followed by many of our treaty partners. This minimizes the risk of double taxation and limits the number of Competent Authority proceedings.

B. Imputed Contracts and the Statute of Limitations

Under current Treas. Reg. [section] 1.482-3(d)(3)(ii)(B), written contracts between controlled parties will generally be respected as long as the terms are consistent with the economic substance of the parties' conduct. If not, the IRS may impute terms consistent with the economic substance of the underlying transactions. Two examples in the proposed regulations considerably expand this authority, permitting the IRS to rewrite agreements if the taxpayer rendering services to a related party is not adequately compensated when it renders the services. See Prop. Reg. [sub section] 1.482-1(d)(3)(ii)(C) (Exs. 3-4).

Significantly, the examples indicate that the IRS is not limited to making transfer pricing adjustments for the years that are under audit. Rather, the IRS may choose to make an adjustment in the current or future years to correct an "erroneous" methodology in past years, suggesting that the agency may vitiate the operation of the statute of limitations. (4) TEI bas grave concerns about the far-reaching effect of these examples and questions whether the Treasury and IRS have the authority to promulgate regulations that seemingly abrogate the stature of limitations.

TEI is concerned with how agents will interpret these examples. If the IRS can look back 6 years, why not 16 or 26 years? In year 7, 17, or 27, it will be difficult--if not impossible--to reliably determine whether there were indeed incremental marketing expenditures, whether there is a premium return resulting therefrom, and which party is benefitting. If, in the examples, the IRS had audited years 1 through 6 and found operating margins below the arm's-length range, it would undoubtedly have proposed adjustments for those years. If left unchanged, the examples may well serve as a fall back for cases in which the IRS missed making adjustments in years 1 through 6 and the statute of limitations for those years has closed. (5)

Statutes of limitations, the Supreme Court has said, "are designed to promote justice by preventing surprises through the revival of claims that have been allowed to slumber until evidence has been lost, memories have faded, and witnesses have disappeared. The theory is that even if one has a just claim, it is unjust not to put the adversary on notice to defend within the period of limitation and that the right to be free of stale claims in time comes to prevail over the right to prosecute them." Rothensies v. Electric Storage Battery Co., 329 U.S. 296, 301 (1946) (quoting Order of RR Telegraphers v. Railway Express Agency, Inc., 321 U.S. 342, 348-49 (1944)). Accord Hull v. United States, 146 F.3d 235 (4th Cir. 1998) ("Concerns of fairness to both the government and taxpayers dictate that both abide by the same rules ..."). In tax cases, statutes of limitations are "an almost indispensable element of fairness as well as of practical administration of income tax policy." Rothensies, 329 U.S. at 300. The Court has noted:

   [Congress has regarded it as]
   ill-advised to have an income
   tax system under which there
   would never come a day of
   final settlement and which
   required both the taxpayer
   and the Government to stand
   ready forever and a day to
   produce vouchers, prove
   events, establish values and
   recall details of all that goes
   into an income tax contest.

Id. Whether intended or not, the proposed regulations undermine this important policy.

TEI believes that the public policy reasons underlying a statute of limitations are too important to be abrogated to correct old transfer pricing. Thus, if the parties did not establish an arrangement where the U.S. taxpayer would be compensated in subsequent years and the statute of limitations has run, the IRS should not be permitted to "correct" the transfer prices for the closed years by taxing the U.S. taxpayer on a premium return in the subsequent years. Moreover, it is questionable whether a tax regulation that effectively avoids the statute of limitations is valid and consistent with the Code.

The examples should be modified to clarify that the statute of limitations must be open in years 1 through 6 or another example should be included showing that an adjustment cannot be made when the statute has closed for the prior years.

C. Total Services Costs

TEI is concerned that the proposed regulations for services are generally based on rules appropriate for manufacturers, whose methods often cannot be easily adapted to the services sector. For example, the concept of "total services costs"--which is defined under Prop. Reg. [section] 1.482-9(j) as all costs that can be directly identified with the act of rendering the services and all other costs reasonably allocable to the services--is not commonly used in the service sector. Unlike cost of goods so]d for the manufacturing sector, the term has no generally accepted meaning. Because markups on total services costs are often not reported in published financial statements or even used in internal management reporting, the identification of comparables is extremely difficult. Thus, the term provides little guidance to service organizations.

In addition, the proposed regulation provides that generally accepted accounting or tax principles may provide a useful starting point for determining "total services costs," but will not be conclusive. TEI recommends that the final regulations clearly permit taxpayers to rely on these principles in determining such costs, with any exceptions explicitly enumerated. (This is an essential element of a simple method.) Book reporting should be conclusively accepted for cost determinations, particularly in light of the very general definition set forth in Prop. Reg. [section] 1.482-9(j).

II. Safe Harbors

A. Introduction

Treas. Reg. [section] 1.482-2(b)(3) provides the general rule that an arm's-length charge for services rendered shall be the amount that 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 relevant facts." The current regulations further provide that--except where the services are an "integral part" of the business activity of either the member rendering the services or the member receiving the services--the arm's-length charge "shall be deemed equal to the costs or deductions incurred with respect to such services by the member or members rendering such services unless the taxpayer establishes a more appropriate charge...." This cost safe harbor provides a simple and reliable pricing method, limited in application to those inter-company services that cannot be considered integral to the business or business activity of either the service provider or recipient. This is administratively beneficial for both taxpayers and for tax authorities, because 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. By definition, the non-integral services are outside the companies" principal area of business and thus outside the scope of their available pricing knowledge and competency.

The cost sale harbor in the 1968 Treasury Regulations was apparently intended to apply to simple and routine services where the intangible content is insubstantial. Because of some ambiguities in several aspects of these regulations, the cost safe harbor may sometimes have been applied, perhaps improperly, to high-margin services that satisfy the qualitative aspects of the cost safe harbor, though not necessarily its intent.

According to the Preamble to the proposed regulations, the Simplified Cost-Based Method (SCBM) is designed to forestall perceived abuses while providing a method with fewer compliance and administrative requirements than the other methods to value the transfer price of controlled services. Although characterized as a "method," Prop. Reg. [section] 1.482-9(f) is more akin to a safe harbor. It permits services that meet certain requirements to be priced by reference to the markup on total services costs of uncontrolled taxpayers that engage in similar business activities under similar circumstances. Thus, the proposed regulations introduce a comparability feature to the analysis. (6) To qualify for SCBM, the following criteria must be met:

* 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 G&A) from controlled parties;

* There is a written contract in place describing the services and their pricing;

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

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

TEI believes that SCBM does not comport with current business practices. Moreover, contrary to its well-intentioned goal, SCBM will increase the administrative and compliance burdens of taxpayers that adopt it.

B. SCBM's Inaccurate Assumptions

TEI submits that SCBM misapprehends the nature of service activities between controlled entities. The main driver in replacing the cost safe harbor with SCBM seems to be the government's belief that all controlled services--including so-called back-office and support services--can be provided by an uncontrolled party intending to profit from rendering such services and by setting a transfer price accordingly. While most services can theoretically be obtained from third parties, in reality, most back-office services between controlled entities are frequently done within the controlled group to consolidate services within a particular affiliate to save costs (e.g., via location savings and economies of scale) or to concentrate expertise (e.g., centers of excellence). These service groups are managed to maximize service and minimize cost. Indeed, the service groups are usually not operated to make a profit and are ancillary to the taxpayer's profit-making business activities. Many services are provided by related parties rather than outside vendors to ensure confidentiality and data security. For these reasons, with respect to the majority of back-office services, the regulations seek comparability where it is unlikely to exist.

Concededly, it may be inappropriate for controlled parties to charge cost for high-value services that are significantly enhanced by the use of valuable intangibles, but many back-office services do not involve the use of such intangibles. By placing too much emphasis on the use of intangibles, the proposed regulations seem to view every service performed with the use of an intangible as inherently valuable. This is simply not the case.

A taxpayer's use of technology--or experienced personnel to provide non-integral services--should not subject the intangibles to these proposed regulations or prevent the services from being charged out at cost. For most back-office or support functions, retaining cost as the transfer price is not only appropriate, but more realistic than imposing a profit where none is anticipated. Requiring a markup (or at least assuming that there is a comparable markup) in every case unrealistically imposes a profit on activities not intended to be profitable. Indeed, imposing a profit on many routine support activities is just as inappropriate as only charging cost when truly valuable intangibles are transferred between controlled taxpayers.

TEI submits that support services may properly be billed at cost. Consolidation and centralization of support services is done for purposes of efficiency and coordination, not because the provider is particularly capable of performing the service. In many cases, employees of the recipients are transferred to the location of the provider to assist in performing the services with the particular location being based on factors such as available space. Therefore, these arrangements are properly viewed as a pooling of resources in a centralized location, rather than a business relationship with a profit motive.

C. SCBM's Administrative Burdens

SCBM will be difficult to use and will impose significant burdens on both taxpayers and the government. The cost safe harbor in Treas. Reg. [section] 1.482-2(d) is simple to administer and possesses the certainty of a typical sale harbor. Unlike the cost safe harbor, a taxpayer using SCBM will face a significantly increased administrative burden to comply with its requirements. Because of the subjective nature of this new method, the work necessary for a taxpayer to comply with this method (and for the IRS to audit it) will be significantly higher than the work required to use the cost safe harbor. Moreover, the new method will produce substantial uncertainty. The following points illustrate these concerns.

(1) The Availability of Comparables. To use SCBM, a taxpayer must compare the controlled services with comparable uncontrolled services. Appropriate comparables for many back-office services, however, simply do not exist. For example, a parent company may provide accounting services to its affiliates. Because the accounting services are centralized, the parent is able to improve efficiency and reduce expenses by achieving economies of scale. In addition, by offering the services, the parent can ensure that its various subsidiaries use common accounting practices. Although such services may be offered by unrelated accounting firms, ascertaining an uncontrolled markup will in many instances involve comparing service providers with fundamental quantitative and qualitative differences.

An accounting firm's core business is providing accounting services. As a result, the accounting firm typically prices its services to make a profit. Depending on a variety of circumstances (e.g., other services provided to a client, the nature of the services, the type of staff used, seasonality, and time demands), the accounting firm's profit margin may vary widely. Thus, while some comparison to unrelated entities is possible, analyzing the whole range of accounting services provided to an affiliate (e.g., payables or financial statement processing) will prove cumbersome and subject to many assumptions. Significant adjustments will be required to bring the comparables in line with a taxpayer's facts, if this can be done al all. Moreover, the parent designs its service, staffing, and cost model to support the overall needs of the primary business of the parent, not to make a profit. See, e.g., Treas. Reg. [section]. 1.482-2(b)(7)(v) (Ex. 14) (accounting services are supportive in nature and are not an integral part of the companies' operations).

Moreover, eight of ten examples set forth in Prop. Reg. [section] 1.482-9(f)(5) refer to the "interquartile range of arm's length markups" and treat the median of that range as the arm's length markup of that range. Nowhere in the Treasury Regulations, however, is a taxpayer required to use the median range. Assuming this was not the drafters' intent, we suggest another example be added that does not rely on the median point as the arm's-length markup required.

(2) The Lack of Certainty. Tax regulations in general--and particularly a "simplified" method--should provide standards to permit taxpayers to use a methodology with a degree of certainty. The cost safe harbor provides that requisite level of clarity, whereas the proposed SCBM does not. To use SCBM, a taxpayer must determine an arm's-length markup for each service it offers by gathering comparability information from uncontrolled entities. The markup's appropriate ness will not be finally settled until it is endorsed or redetermined by the IRS on audit. One of the principal benefits of the cost safe harbor is that such laborious analyses are not required. Even if the "best method" rule does not apply to SCBM, taxpayers must nonetheless undertake an analysis near]y as comprehensive as that required under a best method analysis. This is an inefficient process for determining whether it is appropriate to charge out at cost for routine, low-margin services. To avoid adverse effects on U.S. businesses, the final regulations should provide a true cost safe harbor method for routine, low-margin services. In addition, the government should provide a list that could be updated periodically of what it considers "low-margin" services. Al a minimum, the final regulations should include a presumption that the cost safe harbor remains appropriate for these services, unless the IRS can clearly demonstrate that an intangible within the meaning of Treas. Reg. [section] 1.482-4(b) is being transferred. Such a presumption maintains the simplicity and certainty of the cost safe harbor, but permits the IRS to challenge those exceptional situations where a taxpayer's use of the cost sale harbor may be abusive.

(3) The Written Contract Requirement. Under SCBM, the taxpayer and its controlled affiliate must have a written contract describing the services at the time the services are provided. Many taxpayers' standard inter-affiliate service agreements, however, currently provide for billing al cost. If this requirement is retained, taxpayers will have to amend their agreements to qualify for SCBM. For most back-office services, this will be a tremendously burdensome administrative task with little perceived benefits to the federal fisc.

(4) Exposure to Penalties. Prop. Reg. [section] 1.482-9(j) provides that, to use SCBM, taxpayers must charge at least "total services costs." Similar to the current regulations, Prop. Reg. [section] 1.482-9(f)(2)(v)(B) provides a reasonableness test for evaluating the allocation of costs. Several examples suggest, however, that relatively minor audit disputes over allocation methodology may result in adjustments and essentially denial of the method. See Prop. Reg. [section] 1.482-9(f)(5) (Exs. 8 & 9). (7) Because taxpayers may net learn until audit that the IRS believes they have incorrectly applied SCBM, they will net have prepared the full (contemporaneous) documentation necessary to satisfy the section 6662 requirements. To protect themselves, taxpayers must still prepare that documentation even when in good faith they believe they have correctly applied the method.

Taxpayers should be protected from penalties if they have reasonably applied SCBM in good faith. TEI recommends that a substantial compliance exception to the section 6662 requirements be provided when a taxpayer has acted in good faith in applying SCBM. This good faith requirement should be deemed satisfied if the taxpayer shows how it determined that the service was eligible for the method.

D. The Increased Risk of Double Taxation

Prop. Reg. [section] 1.482-9(f)(2)(iii) provides that the arm's-length markup of costs must net exceed 10 percent. Under subparagraph (iv), if the taxpayer services at cost, then the IRS may make an adjustment only if the arm's-length markup at least six percent. This limitation declines ratably to zero according to a sliding scale. Thus, except for those services with markups of six percent or less, taxpayers will likely be required to charge a markup on controlled services.

In defining tax deductible costs, many countries allow little or no markup on routine services and often will net permit any markups to be deducted. (8) Thus, the proposed regulations will likely lead to double taxation and could well cause an increase in Competent Authority cases under U.S. tax treaties, as well as the Advance Pricing Agreement program. This increase will add even more burden to the already overextended Competent Authority and APA groups and further slow down the processing and resolution of cases.

E. Similar and Ancillary Services

Prop. Reg. [section] 1.482-9(f)(4)(i) states that SCBM may net be used when the renderer, the recipient, or another controlled taxpayer in the same controlled group renders, or has rendered, similar services to one or more uncontrolled taxpayers (unless such services are rendered on a de minimis basis). TEI believes that this exclusion is overbroad and vague. First, the inclusion of the phrase "or another controlled taxpayer in the same controlled group" will operate to prohibit the entire controlled group from using SCBM for certain services where one member provides similar services to uncontrolled parties.

For example, it will prevent Member A from pricing a particular service to other controlled members under SCBM where Member B provides similar services to uncontrolled parties as an accommodation. The basis and necessity for this restriction are unclear. The restriction apparently assumes that Member A will benefit from Member B's having provided similar services to uncontrolled parties. If that is the case, the restriction inappropriately presumes that affiliated entities will net respect the concept of corporate separateness. Affiliates must respect corporate entities net only for tax purposes, however, but also for legal and regulatory purposes. TEI recommends that the exclusion be limited to prevent application of SCBM only in cases where the renderer or the recipient is engaged in the trade or business of rendering similar services to one or more uncontrolled entities. While services provided to uncontrolled parties may indicate that the services are integral to the provider's business, in some situations the services are ancillary and provided merely as an accommodation. Where taxpayers can demonstrate the lack of a profit motive in providing services to uncontrolled parties, SCBM--or some other alternative--should be available to the taxpayer to price its controlled services.

Other provisions of Prop. Reg. [section] 1.482-9(f)(4)(i) are vague and difficult to apply. First, the broad reference to services "having been rendered" to uncontrolled taxpayers provides no temporal boundaries. For example, it is net clear whether one is only disqualified when a controlled party has performed such services relatively recently (e.g., in the last three years), or whether disqualification may also occur when such services were performed decades earlier. It is also unclear whether a taxpayer is disqualified if a current controlled taxpayer performed services for uncontrolled taxpayers prier to becoming a controlled taxpayer. TEI's view is that disqualification is appropriate only where such services have been provided to uncontrolled parties in the current tax year.

Adding to this ambiguity, the proposed regulations provide an exception for services rendered on a de minimis basis. The term "de minimis" is undefined and extremely subjective. The term should be more clearly defined in the final regulations. For example, it is net unusual for a seller of a business to provide services--e.g., relating to information technology, tax compliance, accounting support, and employee benefits--to a third-party buyer during a transition period until the buyer establishes its own departments to perform comparable functions. The provision of such services should be considered de minimis.

F. The 50-Percent Recipient Test

Prop. Reg. [section] 1.482-9(f)(4)(ii) provides that, where services are rendered to a recipient who received services from controlled taxpayers in significant amounts, services to that recipient cannot be priced using the SCBM. Amounts paid or accrued by the recipient with respect to controlled services are considered significant if they constitute at least 50 percent of the recipient's total costs for the taxable year. TEI recommends that this test be eliminated.

First, there is seemingly no logical nexus in the rule. Just because a taxpayer receives a larger volume of services does not mean those services are improperly priced. The more costs and services are centralized, the greater the amount of a "critical mass" savings enjoyed by the taxpayer's business. This structure represents prudent business planning and is not tax motivated. The more successful the taxpayer is at centralizing services, however, the more likely the taxpayer will not be allowed to use SCBM. Tax regulations should not encourage taxpayers to structure their business in a less efficient way in order to secure a more predictable tax result.

G. The Effect of SCBM on U.S. Tax Revenues

Under the current rules, cost remuneration makes the choice of where to locate services inherently tax neutral. Wherever the services are performed, each member will pay only its allocable share of costs. In other words, whether the services are performed in the United States or elsewhere should not affect a group's final U.S. taxable income.

The proposed regulations assume that these services are performed in the United States. If taxpayers may no longer charge out these services at cost, however, it could create an incentive to consolidate the services elsewhere, charging them back to the United States at a markup under the proposed regulations. It may also discourage foreign-owned multinationals from placing general support services operations in the United States. Thus, the proposed regulations may perversely create a tax-driven motive to move services--and jobs--offshore. This is not a trend that should be encouraged.

H. Exclusions

(1) In General. The Preamble to the proposed regulations states that SCBM should not be available for high-margin services but does not define what constitutes a "high-margin" service. TEI submits that, although many services require highly skilled service providers, such services are high-margin only if the service provider incurs financial risks with respect to the underlying activity and thus should be compensated on a basis other than cost.

The exclusions from using SCBM set forth in Prop. Reg. [section] 1.4829(f)(4)(v) are overbroad and should apply only when the service provider incurs financial or business risks with respect to the underlying activity. For example, the Treasury and IRS appear concerned that controlled taxpayers performing services (such as research and development or contract manufacturing) must charge appropriate markups. These activities are often undertaken, however, by the service provider with no risk. The provider will be compensated at cost (and a markup, as appropriate), regardless of the success of its efforts.

(2) Financial and Other Guarantees. The proposed regulations do not permit the use of SCBM in respect to financial and similar guarantees (such as performance guarantees). This implies that taxpayers must apply a different--but unspecified--methodology to determine the correct arm's-length pricing for related group guarantees. This represents a significant change from the current regulations, under which the cost method may apply to related group guarantees, provided such guarantees are not integral to the business of either the service provider or recipient (or the taxpayer cannot otherwise establish the appropriate markup). See, e.g., Private Letter Ruling 7822005.

Finding comparables for related-group guarantees will prove extremely difficult. As an economic matter, a guarantor of a related-party obligation generally does not perform a function that is generally subject to separate economic valuation between the related-group members. A guarantee's value usually lies in extending the value of a parent company credit rating to other group members, but that credit rating, in turn, generally depends on the assets and liabilities of the entire controlled group (including the guaranteed member).

Moreover, unrelated parties generally do not engage in transactions comparable to most related group guarantees, such as offering guarantees of a company's public debt issuances or derivative transactions. Therefore, comparable uncontrolled transaction data generally do not exist. Finally, certain guarantees primarily benefit the parent corporation rather than any subsidiary. In such circumstances, guarantees are more appropriately considered stewardship related and should not be chargeable at all to subsidiaries.

TEI recommends that the final regulations acknowledge the distinction between stewardship-related guarantees and those that do not benefit the parent primarily. In addition, for guarantees warranting a parent-subsidiary charge, the final regulations should provide that such a charge for a guarantee at cost-on]y may generally be considered arm's length.

(3) Inbound Transactions. Prop. Reg. [section] 1.482-9(f)(2)(v)(A) provides that "nothing in paragraph (f) [relating to the SCBM method] shall limit the IRS's authority to make an allocation" where the amount charged by the taxpayer is less than the total services cost with respect to the services, or the markup exceeds the arm's-length markup on total services costs. The limitation on the IRS's authority to make adjustments under SCBM thus does not apply when the correct price is below the amount charged. In effect, the sale harbor is not available for charges from a foreign parent to a U.S. subsidiary. TEI recommends that this omission be remedied in the final regulations.

I. Withholding Taxes

Some treaties with the United States provide that payments received by a U.S. corporation for services performed in this country for a foreign affiliate located in a treaty country are usually not subject to withholding tax by that country. These payments generally fall under the Business Profits provision of the treaty. The proposed regulations presume that these services may also involve the provision of hidden intangibles. Such a characterization could result in the foreign country asserting that these payments are not included under the Business Profits section of the treaty, but rather are covered under the Royalty section (which normally covers items such as secret processes and commercial and scientific information). The Royalty section may not require a Permanent Establishment in order for the payment to be taxable, permitting withholding taxes on such payments. This would have the effect of both increasing the incidence of double taxation and decreasing income tax collections in the United States. (9)

III. Allocation of Income with Respect to Intangibles

A. Interaction with Cost Sharing Regulations

Prop. Reg. [section] 1.482-9(f)(4) provides that research, development, experimentation, engineering, and scientific activities are excluded from the use of SCBM. Prop. Reg. [section] 1.482-9(m)(3) also states that "[s]ervices provided by a controlled participant under a qualified cost sharing arrangement are subject to 1.482-7 [the qualified cost sharing regulations]." The Treasury Department and IRS have announced an intention to issue new proposed regulations related to cost sharing in the near future. The lack of such regulations creates a great deal of taxpayer uncertainty regarding how research and development, marketing, or other activities that are performed pursuant to a qualified cost sharing agreement will be treated for transfer pricing purposes. TEI urges the Treasury and IRS not to promulgate the final services regulations without first permitting taxpayers to review and comment upon the proposed cost sharing regulations since the two areas are inextricably linked.

B. The Single Owner, Bifurcated Owners, and Economic Owner/ Developer Concepts

The current regulations generally treat the owner of legally protected intangible property as the tax owner, applying the "developer/assister" rule to determine the owner of property that is not legally protected. As evidenced by the recent DHL Corp. v. Commissioner case, (10) there has long been confusion about the application of the existing regulations concerning the ownership and allocation of income from intangibles and the interaction of the transfer pricing regulations for intangibles with the regulations governing services. Historically, there has been tension between the "legal" owner of an intangible and its "economic developer."

In an attempt to clarify how the income from intangibles should be allocated, Prop. Reg. [sub section] 1.482-4(f)(3) and 1.482-4(f)(4) eliminate the "bifurcation of ownership" approach in current Treas. Reg. [section] 1.482-4(f)(3), replacing it with a single-owner approach along with the concept of "contribution to the development or enhancement of the intangible." In doing so, Prop. Reg. [section] 1.482-4(f)(3) defines the "sole owner" of an intangible as the "legal owner"--"unless such ownership is inconsistent with the economic substance of the underlying transaction." (Emphasis added.) The proposed regulations essentially divide an intangible into pieces (such as a registration, a license, etc.,), stating that each piece can have an "owner" that is entitled to share in the economic returns.

It appears from this language that the Treasury Department is acknowledging the economic substance of a transaction as opposed to pure legal ownership. Other aspects of the regulations, however, suggest otherwise. For example, the Treasury Department prefaces this section by identifying the legal owner as the "sole owner" of the intangible. Does this mean a licensee must pay a fee, such as a royalty, to a registered owner of a legally protected intangible even if the licensee is solely responsible for developing the commercial value of the intangible? Must the registered owner then reimburse the licensee (the "contributor") for developing the commercial value?

The concept of legal ownership is at odds with longstanding tax principles of beneficial ownership. TEI asserts that, for purposes of examining the allocation of income among members of a controlled group, the determination of a legal owner is not relevant to a transfer pricing analysis. To illustrate the difficulty in allocating the income associated with an intangible based on legal ownership, consider the example of a large multinational corporation in which the legal owner of an intangible may have very little to do with the economic substance of the creation or enhancement of the intangible. The parent company may choose to centrally register patents and trademarks for purposes of administration and consistency, thus making the parent company the legal owner of an intangible. All the value associated with the underlying intangible may, however, be created by a foreign subsidiary that undertook all the financial and business risks (through funding research and development, marketing and advertising efforts, etc.). In this case, the parent company is merely performing an administrative service by registering and managing a patent or trademark portfolio.

In the alternative, a parent company may choose to register an intangible in the name of each foreign subsidiary to simplify the local defense or prosecution of legal claims even where the underlying technology or marketing intangible is developed by the parent. Thus, the determination of legal ownership may have no relationship to the economic substance of the transaction. It is not clear from the proposed regulations how a taxpayer should approach implementing transfer pricing compliance when the legal owners and economic developers are not the same.

TEI agrees with the emphasis on economic substance. If arm's-length principles are to be applied consistently, the income from an intangible should appropriately correspond to the underlying economic substance of the transaction rather than to its mere form. In other words, where the economic developer and legal owner of an intangible are different, the economic substance of the transaction should govern the allocation of income. Furthermore, this type of "economic developer" approach is consistent both with the principles of cost sharing (in which there may be multiple economic owners but only one legal owner) contained in Treas. Reg. [section] 1.482-7 and with the OECD Guidelines. See OECD Guidelines, Ch. 6. TEI believes the proposed regulations should be clarified by eliminating the concept of "legal ownership" from a transfer pricing analysis.

C. Existing Compliance Structures

In an attempt to clarify how the income from intangibles should be allocated, the proposed regulations redefine the intangible ownership principles now contained in Treas. Reg. [section] 1.482-2(f)(3). Many taxpayers have relied upon the existing regulations in developing a transfer pricing compliance approach for intangibles and various services. In many cases, this reliance may have involved making a determination about what type of activities creates an intangible and what type constitutes a service under the existing regulations. Furthermore, this reliance may have affected how the controlled parties defined legal ownership of various intangibles. The regulations should address how existing compliance approaches will be grandfathered when the rules become final. In particular, multinationals should be given a lengthy penalty-free period to achieve compliance with the final regulations.

D. Materiality Thresholds

Treas. Reg. [section] 1.482-4(b) states that, "[f]or purposes of section 482, an intangible is an asset that comprises any of the following items and has substantial value independent of the services of any individual ..." (Emphasis added.) The proposed regulations add several additional thresholds of materiality for transfer pricing purposes in respect of intangibles. Presumably, these additional measures, when quantified, are greater in value than the substantial value now necessary to find the presence of an intangible asset. Beyond that, it is unclear the extent to which the additional terms refer to the same or different measures of intangible value. Specifically, Prop. Reg. [section] 1.4829(f)(4)(iii) provides that SCBM cannot be used if intangibles contribute significantly to the value of the services provided. Since the consequences of erroneously applying SCBM can be economically unfavorable, taxpayers must know how to quantify the term significantly in this context. We suggest that the term be defined as more than 20 percent of the value of the services provided.

Additionally, when addressing integrated transactions that are structured as controlled services transactions, the proposed regulations use the terms de minimis and material to define the point at which the intangibles component becomes meaningful enough to warrant a separate analysis. Again, taxpayers will find it difficult to apply the proposed regulations if such key terms are not precisely defined. Thus, TEI recommends that the final services regulations harmonize these provisions, indicating the relative measure of intangible value referred to by each.

E. Deemed Transfers of Intangibles

Section 482 provides authority for the IRS to allocate income and deductions among taxpayers, including income attributable to any transfer or license of intangible. In the latter case, the statute provides that the income with respect to such transfer or license must be "commensurate with the income" attributable to the intangible. Under the proposed regulations, transactions that are not a transfer or license of a property right may now be characterized as such. TEI questions whether Treasury and the IRS have the authority to apply the section 482 commensurate-with-income standard for actual transfers of property to deemed intangible property transfers.

F. Concluding Comments

As technology evolves, the use of intangibles in the provision of services will expand. If the proposed regulations' view is adopted, few transactions will be viewed as "pure" service transactions; the extent of such transactions will shrink further as technology develops. Taxpayers should be free to render services in the manner most appropriate to their business requirements. Thus, general tax principles should govern the characterization of a transaction for transfer pricing purposes.

IV. Transfer Pricing Methods

A. Comparable Uncontrolled Services Price Method

Prop. Reg. [section] 1.482-9(b)(1) sets forth the comparable uncontrolled services price (CUSP) method of determining transfer prices. Under CUSP, the arm's-length nature of intercompany services is evaluated using the prices charged in an uncontrolled services transaction for services that are "identical to, or have a high degree of similarity to," the uncontrolled services. This standard is arguably higher than the standard set forth in the 1994 regulations, which under Treas. Reg. [section] 1.482-1(d)(2) requires only that the uncontrolled transaction be "sufficiently similar" to the controlled transaction. TEI suggests that the final regulations clarify that controlled services also need be only "sufficiently similar" to uncontrolled services.

B. Cost of Services Plus Method

The cost-plus method is recognized in many jurisdictions as the most reasonable method to derive an arm's-length consideration for services among members of a controlled group when there is no comparable uncontrolled price. See OECD Guidelines, [sub section] 7.31, 7.35 & 7.36. A broad use of this method avoids potential double taxation with other countries and should be encouraged by the regulations. In TEI's July 24, 1996, comments on the services regulations, we strongly recommended that the cost sale harbor be retained. The vast majority of back-office services are routine, low-margin services for which charging cost is reasonable and appropriate. These services support the core profit-making activities of the taxpayer, but are not themselves integral to such activities. These services can include finance, treasury, comptrollers or controllers, accounting, legal, tax, business resources, and procurement. We continue to believe that the cost sale harbor is a practical approach to an area that is incredibly difficult to track. If the cost sale harbor is eliminated, however, the final regulations should provide a workable alternative for low-value services (perhaps cost plus no greater than 5 percent). Such a cost-plus sale harbor would remove the administrative burden of preparing documentation and costly studies.

TEI also recommends that the final regulations remove the statement in the Preamble and in Prop. Reg. [section] 1.482-9(d) that the "cost of services plus method is ordinarily used in cases where the controlled service renderer provides the same or similar services to both controlled and uncontrolled parties." The final rules should also clarify that the cost of services plus method may be the "best method" even though the service provider does net provide such services to uncontrolled parties.

U.S.-based multinational corporations may operate foreign subsidiaries that charge back costs to the U.S. parent company under a cost-plus method. For example, a U.S. parent company may have an R&D center in India operated through its wholly owned India subsidiary. This relationship may be described in an intercompany services agreement with a cost-plus markup as the sole profit-making source for the R&D center with the India operation acting exclusively as a service provider without assuming any of the economic risks or retaining any rights to the R&D deliverables. While the expertise of the R&D personnel in India may be an important resource for the U.S. parent company, the India R&D center operates with very low risk because its costs are covered under the intercompany services agreement (including a markup). It may be desirable for such a U.S.-based company to centralize the legal ownership of its global technology in the United States. Several U.S. parent-foreign subsidiary examples should be added to demonstrate the cost of services plus method (as well as the simplified cost-based method) to address such situations and to provide a balance with the examples involving foreign parent-U.S, subsidiary relationships.

Finally, although we continue to believe that cost is a better approach, the final regulations should provide that general comparability is all that is required for low-value services where there are no uncontrolled service transactions. Anything more than this brings the method much closer to the SCBM method and loses much of its administrability. The regulations should be "user friendly" to avoid placing U.S. multinationals at a competitive disadvantage with their foreign counterparts by, for example, increasing the cost of U.S.-based intercompany services operations and endangering the deductibility of these services in foreign jurisdictions.

C. Profit Split Methods

The proposed regulations extend the use of the existing comparable profit split and residual profit split methods to controlled services transactions. TEI takes issue with how the residual profit split method is misapplied to oil and gas services in Example (2) of Prop. Reg. [section] 1.4829(g) (11)

These profit split methods evaluate whether the allocation of combined profit or loss is arm's length by reference to the relative value of each controlled taxpayer's contributions to the combined operating profit or loss. Consistent with the current regulations, the relative value of the contributions is based on functions performed, risks assumed, and resources employed by each controlled taxpayer. The proposed regulations provide that the profit split method 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.

Prop. Reg. [section] 1.482-9(g) illustrates the application of this method in two examples. While TEI has no objection to the first example, it believes that Example (2) of Prop. Reg. [section] 1.482-(g)(2) misapplies the residual profit split method to the off and gas industry and may in certain circumstances be in direct conflict with the best method rule of the Treasury Regulations. (12)

The example states that the facts and circumstances demonstrate that Company A, B, and C all make nonroutine contributions; because the transactions between the three companies are highly integrated, it is difficult to reliably evaluate them on a separate basis. Thus, the IRS determines that a residual profit split method will provide the most reliable measure of the arm's-length results of the services performed by all three related taxpayers. The example concludes by stating that Company C provided nonroutine contributions in the form of drilling rights and thus residual profits are allocated to Company C based on this contribution.

TEI is troubled by this example. First, it does net state which party bears the economic risk of the activities, which is crucial in determining how each party should be compensated. In addition, all the services described in Example 2 are done routinely by third-party service companies. In fact, it is the norm for exploration services, including the supply of equipment, to be provided to oil companies by outside service contractors. Similarly, there are numerous contractors that will provide companies with management services relating to foreign exploration. Comparables can easily be found for each of these services. This example misapprehends the business of the taxpayer and the off exploration process in particular. Whether or net there is integration, these services can easily be evaluated on a separate basis because of the large number of comparable uncontrolled transactions. Therefore, under the best method rule, the comparable uncontrolled services price method described in Prop. Reg. [section] 1.482-9(b) should be applied in this case. (13)

Example (2)'s conclusion that Company C's drilling rights constitute nonroutine contributions of services also has disturbing implications that contravene longstanding and well-established law concerning the income tax treatment of oil and gas rights. Foreign drilling rights granted by a foreign sovereign generally are treated for income tax purposes as an economic interest in the oil and gas in place and an interest in real property. See Treas. Reg. [section] 1.611-1(b)(1); Rev. Rul. 68-551, 1968-2 C.B. 261; Rev. Rul. 73-470, 1973-2 C.B. 88; Rev. Rul. 68-226, 1968-1 C.B. 362.; General Counsel Memorandum 32336 (June 29, 1962). They are not treated as services.

TEI believes that this example should be clarified to reflect both the longstanding practices of the industry and the well-settled law applicable to those practices.

Conclusion

Tax Executives Institute appreciates this opportunity to present its views on the proposed regulations under section 482, relating to the treatment of controlled services transactions and the allocation of income from intangibles. If you have any questions, please de net hesitate to call Bruce R. Maggin, chair of TEI's International Tax Committee, at 914.765.4083, or Mary L. Fahey of the Institute's professional staff at 202.638.5601.

(1) Technical Advice Memorandum 8806002 (Sept. 24, 1987).

(2) If the cost-sharing project is implemented to permit the affiliate to provide more information to the corporate headquarters, it is questionable whether any benefit is realized at the affiliate level. Thus, although it is arguable that whether any charge back should be required, if one is required, cost is the appropriate charge.

(3) See Convention between the Government of the United States of America and the Government of Japan for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income, n. 3 (Nov. 6, 2003) ("[T]he Contracting States shall undertake to conduct transfer pricing examinations of enterprises ... in accordance with the Transfer Pricing Guidelines" of the OECD.).

(4) In Examples 3 and 4 of Prop. Reg. [section] 1.482-1(d)(3)(ii), the IRS failed to make adjustments in years 1 through 6 during which a U.S. subsidiary of a foreign parent "undertakes incremental marketing activities." In the first case, the subsidiary is the U.S. distributor of products purchased from its parent and the incremental marketing activities are "in addition to the activities similar to those observed in the independent distribution activities in the U.S. market." In the second case, the subsidiary is engaged in U.S. manufacturing and distribution using the manufacturing and marketing intangibles (including the parent's trademark), and the incremental marketing activities are "in addition to the activities required under the terms of the license agreement." In bath cases, by year 7, goods bearing the trademark of the foreign parent generate a premium return in the U.S. market. In the first case, the foreign parent does net compensate the U.S. subsidiary for performing these incremental activities and increases the transfer prices of its products to capture the premium return. In the second case, in year 7, the foreign parent agrees to reimburse the U.S. subsidiary for the cost of its incremental marketing activities, but otherwise captures the premium return through an increase in royalties. Bath examples conclude that starting in year 7, the IRS may impute one or more agreements that would afford the U.S. subsidiary an appropriate portion of the premium return from the trademark of the foreign parent. Thus, whether the statute of limitations is open in years 1 through 6 is irrelevant. See also Prop. Reg. [sub section] 1.4829(i)(3) and -9(i)(4) (Exs. 1 & 2) (relating to contingent-payment compensation).

(5) See Robert T. Cole, A Road Map for the IRS to Avoid the Statute of Limitations in Transfer Pricing, 32 TAX MGMT. INT'L J. (No. 12) 673 (Dec. 12, 2003).

(6) According to the Preamble, the conditions for application of SCBM will be a substitute for the traditional "best method" analysis under Treas. Reg. [section] 1.482-1(c).

(7) The use of the term "reasonable" in the proposed regulations is vague and loosely applied, implying that any time an agent disagrees with a taxpayer, the taxpayer has been unreasonable. This is particularly true in Examples 8 and 9 of Prop. Reg. [section] 1.482-9(f)(5), which conclude that because the result changed, the taxpayer was net rreasonable." Yet, the difference in amounts allocated could have resulted from many things that have nothing to de with the reasonableness of the method used. For example, an adjustment could have been made elsewhere in the audit that caused a previously expensed item to be capitalized. If the expensed item were included in the pool of expenses allocated, the allocation would change. Similarly, if the taxpayer inadvertently included an entertainment expense that was non-deductible in the pool of expenses to be allocated and it is discovered and disallowed on audit, it would likewise change the allocation. Simply because the allocated amounts are changed as a result of the audit does net automatically make the taxpayer's method "not reasonable," as these two examples imply.

(8) Some countries also require the approval of contracts by a government agency before payments can be remitted. Requiring a markup on routine services in these countries may increase the difficulty of obtaining these payments.

(9) This problem may also occur in countries without income tax treaties with the United States. In certain cases, foreign tax authorities treat such services as subject to withholding fax, regardless of the fact that they are based upon cost recovery and are performed outside the country. Requiring these services to be charged based upon a method other than cost will further confound an already difficult situation.

(10) 285 F.3d 1210 (9th Cir. 2002) (reversing the Tax Court's interpretation of the developer/assister rule).

(11) This method may well be appropriate in other areas. See Prop. Reg. [section] 1.4829(g), Ex. 1.

(12) In this example, Company A, a U.S. corporation is a large multinational engaged in oil and gas exploration, development, and extraction. In performing these functions, it uses teams of specialists drawn from its employees and employees of two of its wholly-owned subsidiaries, Company B and Company C. Company B is a U.S. corporation engaged in the business of providing general construction contracting services and Company C is a mining/ extraction subsidiary located in Country C. Through its relationship with the Country C government, Company C obtains drilling rights on land for which it already owns mining rights. Because it lacks expertise and personnel to perform oil exploration, Company C enters into an agreement with Companies A and B to have them provide Services to facilitate exploration on the tract. Specifically, Company A provides management services and Company B provides all the necessary labor and equipment for the exploration. All three companies provide their own administrative support for their respective functions.

(13) Applying a profit split method to international oil exploration services is also incompatible with the way exploration services are provided by uncontrolled companies. International exploration service companies are net wining to accept the risk associated with finding oil and gas. It is generally understood that there is a no greater than a 1 in 10 chance that foreign off exploration will result in a commercial discovery in areas where there is net already oil production. For this reason, a service provider in this business will only provide such services on a fee basis (e.g., per man hours or per day on a "turnkey" project that can include management and the operation of equipment).