Section 482 service regulations.
This letter responds to your request for TEI's recommendations concerning the forthcoming section 482 regulations relating to the performance of intercompany services. TEI is pleased to have the opportunity to assist the IRS in this important project. Although an IRS representative recently announced that the proposed regulations were not a priority item for this year, we assume the request for comments signals an intent not to relegate the proposed section 482 service regulations to the "bottom of the pile."
The Statutory Scheme
Section 482 of the Internal Revenue Code authorizes the Secretary of the Treasury to "distribute, apportion, or allocate gross income, deductions, credits or allowances" among related parties if he determines it necessary to prevent the "evasion of taxes or clearly to reflect the income" of the entities. Ten years ago, Congress amended section 482 to impose a commensurate-with-income standard on transfers of intangible property, which is defined by specific reference to section 936(h)(3)(B). See [sections] 1231(e)(1), Tax Reform Act of 1986, Pub. L. No. 99-514, amending I.R.C. [sections] 482. Section 936(h) provides an extended list of intangible property "which has substantial value independent of the services of any individual." This list includes any (i) patent, invention, formula, process, design, pattern, or know-how; (ii) copyright, literary musical, or artistic composition; (iii) trademark, trade name, or brand name; (iv) franchise license or contract; (v) method, program, system, procedure, campaign survey, study, forecast, estimate, customer list, or technical date; or (vi) any similar item.
In reviewing any proposed amendment of Treas. Reg. [sections] 1.4822(b), the IRS should keep three principles in mind:
* The rules for services and the rules for intangible property are mutually exclusive because intangibles are defined in the Code as property rights having "substantial value independent of the services of any individual." Any revised regulations should reflect this distinction.
* Any new regulations should be consistent with the revised transfer pricing guidelines issued by the Organisation for Economic Co-operation and Development (OECD).(1) U.S. multinational corporations do not operate in a vacuum. Deviations from the OECD's Guidelines would create problems with the United States' trading partners, have an anti-competitive effect for multinational corporations, and pose an increased risk of double taxation.
* The current safe harbors should be retained.
It is against this backdrop that TEI offers the following comments.
The Current Regulations
The obvious place to begin in revising the service regulations is with the current regulatory scheme. There are several parts of the current service regulations that have worked well for almost three decades:
* The use of cost as the arm's-length charge for the rendition of non-integral services under Treas. Reg. [subsections] 1.482-2(b)(3) & (b)(7);
* No required allocation of the cost of services producing an indirect or remote benefit under Treas. Reg. [sections] 1.4822(b)(2)(i); and
* No required allocation of the cost of services that are duplicative under Treas. Reg. [sections] 1.4822(b)(2)(ii).
TEI strongly believes these provisions should be retained in the revised regulations. If substantive changes are made in these rules, existing service arrangements or practices should be respected.
A. Treatment of Non-Integral Services. Treas. Reg. [sections] 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 regulations further provide that -- except where services are an "integral" part of the business activity of either the member rendering the services or the member receiving the benefit of 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...." Subparagraph (7) sets forth four alternative tests for determining when services are deemed to be integral:
* If either the provider or the recipient is in the trade or business of rendering similar services to unrelated parties.
* If the provider performs the services for related parties as one of its principal activities. There is a presumption that the provision of services is not a principal activity if the cost does not exceed 25 percent of the renderer's total costs or deductions for the taxable year.
* If the provider is "peculiarly capable" of rendering the services and the services are a principal element in the operations of the recipient.
* If the recipient receives the benefit of a substantial amount of services from one or more related parties during the taxable year. Services are "substantial" if the cost of providing such services exceeds 25 percent of the recipient's total costs or deductions during the taxable year.
The current regulatory treatment of non-integral services is a practical approach to an area that is incredibly difficult to track. The cost chargeback is also consistent with the transfer-pricing policies of many U.S. trading partners. See, e.g, Canada's Information Circular No. 87-2 (Feb. 27, 1987) (forbidding the mark-up of costs on many centralized functions). TEI strongly recommends that the cost chargeback for non-integral services be retained in any revised regulations. The 25-percent floor for principal activity or substantial services should also be included in the revised regulatory scheme. Indeed, economic changes in recent years suggests that the IRS should consider raising the 25-percent floor. As competition increases, profit margins for many multinationals are decreasing. Thus, a higher percentage may be warranted.
We recommend one minor modification of the first integral services test. There is no sound policy reason for finding a service "integral" when the recipient is in the trade or business of rendering similar services. The revised regulations should apply the integral services test solely in respect of the provider of the service.
B. Indirect or Remote Benefits. Treas. Reg. [sections] 1.482-2(b)(2)(i) provides that allocations of an arm's-length charge may be made with respect to services undertaken for the joint benefit of the members of a group of controlled entities. The regulations further provide that no allocations need be made "if the probable benefits to the other members were so indirect or remote that unrelated parties would not have charged for such services." An example of an indirect or remote benefit is an advertisement for travel on one member (an international airline) that may benefit affiliated hotels, but does not single out any specific hotel.
Paragraph 7.13 of the OECD Guidelines contains a similar exception, providing that "an associated enterprise should not be considered to receive an intra-group service when it obtains incidental benefits attributable solely to its being a part of a larger concern, and not to any specific activity being performed." As an example, the Guidelines cite a higher credit-rating attained solely by reason of the member's affiliation with the group (referred to as a "passive association").
TEI recommends that the exception for indirect or remote benefits be retained in the revised regulations. Moreover, the regulations should include an additional example similar to the OECD credit-rating example.
C. Duplicative Services. Treas. Reg. [sections] 1.482-2(b)(2)(ii) provides that allocations will generally not be made if the service is merely a duplication of a service that the related party has independently performed or is performing for itself. Paragraph 7.11 of the OECD Guidelines similarly provides that "no intra-group service should be found for activities undertaken by one group member that merely duplicate a service that another group member is performing for itself, or that is being performed for such group member by a third party." This exception for duplicate services reflects a common-sense approach and should be retained.
Revisions to the Current Regulations
A. Definition of Services. The current regulations contain no definition of the term "services" nor do they set forth any examples involving a "pure" service provider. Guidance in this area is needed. For example, in the past, financial service companies provided services through employees who would analyze an issue and produce a written report for the customer. Through technology, the service provider has often eliminated its "human" activity and provides the service by giving the customer direct remote access to a computer program running on the provider's computer.
In addition, manufacturing companies sometimes provide services through employees who assist in troubleshooting production problems. Or companies may provide services through employees who are temporarily transferred to a foreign service recipient. Services under these "seconding" arrangements typically involve full-time employment for the service recipient, where the arrangement is used as a matter of convenience to allow the employee to remain a participant in U.S.-based benefit plans.
The distinction between a transfer of services or the use of an intangible is often difficult to define, particularly in respect of common business arrangements. Moreover, such arrangements may be extremely difficult to value.
TEI believes that the above-described transactions constitute a transfer of services or "show-how," rather than the use of an intangible or the transfer of know-how. Examples reflecting this distinction -- and illustrating where the line between services and intangibles is drawn -- should be included in the revised regulations.
B. Safe Harbor. When the services rendered are the type that the provider is uniquely qualified to furnish, a transfer of intangible assets may concomitantly occur at the same time. See, e.g., Hospital Corporation of America v. Commissioner, 81 T.C. 520, 599 (1983) (holding that an intangible had been transferred and a section 482 allocation was therefore proper where the taxpayer's experience and expertise in hospital administration formed the basis for a contract for services to be performed in Saudi Arabia). A bright-line test should be adopted to permit taxpayers to determine whether an intangibles transfer has occurred and, if so, what portion of the transaction should be attributed to that transfer. TEI recommends the creation of a safe harbor based on a comparison of the cost of the services with their value (perhaps on an arm's-length basis) to the recipient. A very high ratio of value to cost, e.g., may imply a transfer of intangibles; a low ratio (e.g., less than 2:1) may be deemed a pure transfer of services.
C. General Benefits. Under Paragraph 7.6 of the OECD Guidelines, the question whether an intra-group service has been rendered depends on the benefit that the recipient is intended to receive. Whether a benefit is received generally rests on whether an unrelated party would be willing to pay for the services. Under Treas. Reg. [sections] 1.482-2(b)(2), however, expenses incurred by a parent that benefit the group generally must be allocated on some basis, even if no benefit for a particular subsidiary can be found. TEI suggests that these benefits should be considered "remote" and that the U.S. rules should be harmonized with the OECD.
D. Use of the Cost-Plus Method. A U.S. parent may pay for marketing support in a foreign location. For example, all the expenses of a foreign sales representative may be reimbursed by a U.S. entity on the grounds that the representative's efforts will lead to orders placed with the U.S. factory.
In addition, some countries do not permit a U.S. parent to establish a liaison office, but rather require the parent to establish a subsidiary to provide what would otherwise be liaison activities. In order to pay the local expenses, a cost-plus arrangement is often used. Such an arrangement may also be used in respect of European re-invoicing centers.
The OECD Guidelines state a preference for a "direct-charge" method (i.e., charging for specific services) of determining an arm's-length charge for services between related entities. The Guidelines note, however, that a direct-charge method is generally difficult to apply in practice and that multinational enterprises may use cost allocation and apportionment methods (referred to as "indirect-charge methods").(2) The Guidelines thus recognize the practical difficulties that arise when intra-company services are rendered across international borders.
In many cases, the services offered in the foregoing examples are non-integral and charges for them should be allocated on a cost basis under Treas. Reg. [sections] 1.482-2(b)(3). In respect of integral services, TEI supports the general cost-plus approach to valuing services based on the anticipated benefits where the provider is not in the trade or business of providing such services. In these circumstances, cost-plus should provide a fair return to the service provider. The revised regulations should be consistent with the OECD Guidelines and include examples of situations in which a cost-plus method (with, say, a 5- or 10-percent mark-up) may be used. The examples could include not only supplier liaison and marketing services, but also miscellaneous administrative services such as billing, re-invoicing, and payroll services.
E. Stewardship Activities. In Private Letter Ruling 8806002 (Sept. 24, 1987), the IRS narrowly defined "stewardship expenses" to include only expenses related to duplicative functions, general review and periodic supervisory visits, the cost of meeting the reporting requirements of the parent, and the expenses for refinancing the parent's ownership in the subsidiary. In contrast, Paragraph 7.9 of the OECD Guidelines is broader in scope and now defines "stewardship activities" to include the types of services that a coordination centre may provide. TEI strongly believes that the OECD Guidelines provide a reasonable interpretation of the benefit test that should be adopted in any revised regulations. The regulatory definition of stewardship activities should thus conform to the OECD model.
F. Shareholder Activities. Paragraph 7.9 of the OECD Guidelines also deals with activities that are performed solely because of an entity's interest as a shareholder in other members of the groups. Broader than stewardship activities, these "shareholder activities" do not justify a charge to the recipient companies because an independent enterprise is not willing to pay for the activity. Paragraph 7.10 provides the following examples of such activities:
* Costs of activities relating to the juridical structure of the parent company, such as shareholder meetings, issuance of shares, and costs of the supervisory board;
* Costs relating to reporting requirements of the parent company including the consolidation of reports; and
* Costs of raising funds for the acquisition of a company by the parent.
TEI believes that the distinction between "stewardship" and "shareholder" activities is helpful and should be included in the revised regulations.
Tax Executives Institute appreciates this opportunity to present our views on revisions to the section 482 regulations relating to the transfer of intercompany services. If you have any questions, please do not hesitate to call Joseph S. Tann, Jr., chair of TEI's International Tax Committee, at (312) 750-5074, or Mary L. Fahey of the Institute's professional staff at (202) 638-5601.
(1) Citations are generally to the services and intangible property portions of the OECD's Transfer Pricing Guidelines for Multinational Enterprises and Tax Administration reprinted the BNA Daily Tax Report (No. 70) L-ll (April 11, 1996) (hereinafter cited as the "OECD Guidelines"). (2) OECD Guidelines [paragraphs] 65, 67, and 68.
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|Author:||Skinner, Jack R.|
|Date:||Sep 1, 1996|
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