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Internal Revenue Bulletin - November 3, 2003 - REG-146893-02; REG-115037-00 Internal Revenue Bulletin: 2003-44 November 3, 2003 REG-146893-02; REG-115037-00 Notice of Proposed Rulemaking and Notice of Public Hearing: Treatment of Services Under Section 482; Allocation of Income and Deductions From Intangibles Table of Contents
This document contains proposed regulations that provide guidance regarding the treatment of controlled services transactions
under section 482 and the allocation of income from intangibles, in particular with respect to contributions by a controlled
party to the value of an intangible that is owned by another controlled party. These proposed regulations potentially affect
controlled taxpayers within the meaning of section 482. The proposed regulations provide updated guidance that is necessary
to reflect economic and legal developments since the issuance of the current guidance. This document also provides a notice
Written or electronic comments must be received December 9, 2003. Outlines of topics to be discussed at the public hearing
scheduled for January 14, 2004, at 10 a.m. must be received by December 23, 2003. ADDRESSES:
Send submissions to CC:PA:LPD:PR (REG-146893-02 and REG-115037-00), room 5203, Internal Revenue Service, POB 7604, Ben Franklin
Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 4
p.m. to: CC:PA:LPD:PR (REG-146893-02 and REG-115037-00), Courier's desk, Internal Revenue Service, 1111 Constitution Avenue,
NW, Washington, DC 20044. Alternatively, taxpayers may submit electronic comments directly to the IRS Internet site at www.irs.gov/regs. The public hearing will be held in the auditorium, Internal Revenue Building, 1111 Constitution Avenue, NW, Washington,
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, J. Peter Luedtke or Helen Hong-George, (202) 435-5265; concerning submissions of comments,
the hearing, and/or to be placed on the building access list to attend the hearing, Sonya M. Cruse, (202) 622-7180 (not toll-free
Background Section 482 of the Internal Revenue Code generally provides that the Secretary may allocate gross income, deductions and credits
between or among two or more taxpayers owned or controlled by the same interests in order to prevent evasion of taxes or to
clearly reflect income of a controlled taxpayer. Comprehensive regulations under section 482 published in the Federal Register (T.D. 6952, 1968-1 C.B. 218 [33 FR 5849]) on April 16, 1968, provided guidance with respect to a wide range of controlled
transactions, including transfers of tangible and intangible property and the provision of services. Revised and updated
transfer pricing regulations were published in the Federal Register (T.D. 8552, 1994-2 C.B. 93 [59 FR 34971], T.D. 8632, 1996-1 C.B. 85 [60 FR 65553], and T.D. 8670, 1996-1 C.B. 99 [61 FR 21955])
on July 8, 1994, December 20, 1995, and May 13, 1996. A. Services Transactions While comprehensive in other respects, the regulations issued in the mid-1990s did not modify substantively the 1968 regulations
relating to controlled services transactions. The current services regulations at §1.482-2(b) provide generally that where
one member of a controlled group performs services for the benefit of another member without charge, or at a charge that is
not equal to an arm's length charge, the Commissioner may make appropriate allocations to reflect an arm's length charge for
such services. The determination of the arm's length charge depends on whether the services transaction is an “integral part”
of the business of the renderer or recipient of the services. The current services regulations provide several overlapping
quantitative and qualitative tests to determine whether a services transaction is integral.
Under the current services regulations, the arm's length charge for non-integral services is deemed to be equal to the “costs
or deductions” incurred with respect to the services, unless the taxpayer establishes that another charge is more appropriate.
General guidance is provided regarding the definition of cost and the appropriate allocation of costs to particular services.
The arm's length charge for integral services under the current services regulations is “the amount which 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.” No guidance is provided regarding the methods that may be used to determine
whether a charge is consistent with an arm's length charge.
B. Income Attributable to Intangibles The Treasury Department and the IRS issued final regulation §1.482-4(f)(3) as part of the 1994 regulations. The preamble
to those regulations states that the rules of §1.482-4(f)(3) were necessary in order “to identify the controlled taxpayer
that should recognize the income attributable to intangible property.” Section 1.482-4(f)(3) identifies that party by providing
rules to determine the owner, for section 482 purposes, of the rights to exploit an intangible to which income was attributable.
Under those rules, the legal owner of an intangible, the taxpayer with a right to exploit the intangible, and even a taxpayer
that contributes to the development or enhancement of the intangible could be deemed “owners” of that intangible, entitled
to a portion of the income attributable to the intangible.
Explanation of Provisions A. Overview These proposed regulations provide updated guidance under section 482 that replaces existing guidance under §1.482-2(b) relating
to controlled services transactions and existing guidance under §1.482-4(f)(3) relating to the allocation of income attributable
to intangible property. These proposed regulations also make conforming and other changes to provisions of the current regulations
under sections 482 and 6662 that are related to this guidance.
1. Services Transactions These proposed regulations provide updated guidance under section 482 relating to controlled services transactions. The Treasury
Department and the IRS believe that such guidance is necessary to reflect economic and legal developments since the issuance
of the 1968 regulations. In the last 35 years, cross-border services have become an increasingly large and important segment
of the U.S. and global economies. In particular, cross-border services transactions make up an increasingly significant segment
of cross-border transactions among members of controlled groups.
Legal developments in the transfer pricing area since 1968 include the amendment of section 482 in 1986 to provide for the
commensurate with income standard in the context of transfers of intangible property and the issuance in the mid-1990s of
updated transfer pricing regulations addressing transactions other than services transactions. In addition, also in the mid-1990s,
the OECD published updated transfer pricing guidelines for use by countries in the resolution of transfer pricing cases in
mutual agreement proceedings under tax treaties.
These proposed regulations provide generally that the arm's length amount charged in a controlled services transaction must
be determined under one of the transfer pricing methods provided for or referenced in the proposed regulations. The guidance
regarding transfer pricing methods provided for in the proposed regulations generally is consistent with the current regulatory
guidance regarding the transfer pricing methods applicable to transfers of tangible or intangible property and is consistent
with international standards in this area. In addition, the proposed regulations provide a new cost-based method that may
be used to price low-margin controlled services transactions that meet certain quantitative and qualitative conditions and
requirements. This simplified cost-based method generally requires a less robust analysis of services transactions within
its scope than would be required under the other pricing methods. The simplified method is intended to preserve aspects of
the current rules that provide appropriately reduced administrative and compliance burdens for low-margin services while bringing
the current rules more into line with the arm's length standard and eliminating aspects of the current rules that have proved
problematic. The proposed regulations provide updated guidance consistent with international standards in this area on the threshold issue
of whether activities constitute the rendering of services for the benefit of another member of a controlled group. The proposed regulations provide guidance to better coordinate and harmonize the rules applicable to services transactions
with the rules for other types of transactions under section 482, in particular transfers of intangible property. The Treasury
Department and the IRS believe that such guidance is necessary to mitigate the extent to which the form or characterization
of a transfer of intangibles as the rendering of services can lead to inappropriate results. The Treasury Department and
the IRS believe that the transfer pricing rules should reach similar results in the case of economically similar transactions,
regardless of the characterization or structuring of such transactions. Thus, several provisions of the proposed regulations
are intended to minimize or to eliminate the differences between the transfer pricing analysis of services transactions related
to intangibles and the analysis of transfers of intangible property. In particular, the proposed regulations provide that
the arm's length result for a services transaction that effects the transfer of intangible property must be determined or
corroborated by an analysis under the transfer pricing rules for transfers of intangible property. In addition, the proposed
regulations limit the use of the simplified cost-based method in the case of services that involve the use of valuable intangibles.
The proposed regulations also provide guidance regarding the use or imputation of contingent-payment arrangements in the
context of services transactions, and provide generally applicable guidance on the application of the residual profit split
method to make that method more suitable to the analysis of services transactions where appropriate. The cumulative effect
of these provisions is to make available in connection with the transfer pricing of controlled services relating to intangibles
the analytical tools that are available in connection with the transfer pricing of transfers of intangible property, including
the possibility of analyzing transactions as multi-year arrangements in which the consideration for services rendered in one
tax accounting period may be due in later periods.
2. Income Attributable to Intangibles These proposed regulations also update guidance under existing §1.482-4(f)(3) relating to the allocation of income attributable
to intangible property. The taxpayers and other commentators have criticized the framework of §1.482-4(f)(3). In particular,
commentators have questioned the use of ownership for purposes of section 482, as distinct from legal ownership or ownership
for tax purposes more generally, as an analytical tool for determining the appropriate allocation of income attributable to
an intangible. The Treasury Department and the IRS believe that existing §1.482-4(f)(3), when properly applied, generally
reaches appropriate results in allocating income attributable to intangible property. However, the Treasury Department and
the IRS are concerned that the regulation may be misapplied to reach “all or nothing” results based on a determination of
ownership in cases where an arm's length analysis in accordance with the section 482 regulations would require that the income
attributable to an intangible be divided among the controlled taxpayers that made significant contributions to develop or
enhance that intangible, and that hold legal rights with respect to that intangible.
As a result, the Treasury Department and the IRS believe that the analytical framework of §1.482-4(f)(3) should be modified.
The rules for determining the ownership of an intangible generally should be distinct from the rules for determining the
allocation of income from an intangible. The income attributable to an intangible should be allocated among controlled taxpayers
under the arm's length standard, in accordance with each party's contributions to the development or enhancement of that intangible
and its ownership interests (if any). This analysis generally will preclude “all or nothing” results. The proposed modifications
to §1.482-4(f)(3) are possible because of proposed changes to the treatment of controlled services transactions, in particular
the conditions and requirements on the use of the simplified cost-based method and the provisions intended to better coordinate
and harmonize the rules applicable to services transactions with the rules for transfers of intangible property (including
guidance on services that effect transfers of intangible property and guidance on the residual profit split method and contingent
payment arrangements).
B. Services Transactions—§1.482-9 1. General Rule—§1.482-9(a) Consistent with the rules governing transfers of tangible and intangible property under existing §§1.482-3 and 1.482-4, respectively,
proposed §1.482-9(a) provides that the arm's length amount charged in a controlled services transaction must be determined
under one of the methods described or referenced in the proposed regulations. Also consistent with the rules governing transfers
of tangible and intangible property, the proposed regulations provide guidance concerning selection and application of the
appropriate method by explicitly incorporating the general rules in §1.482-1 (including the best method rule of §1.482-1(c),
the comparability analysis of §1.482-1(d), and the arm's length range of §1.482-1(e)) of the existing regulations.
The proposed regulations specify six methods applicable to controlled services transactions. Proposed §1.482-9(a) sets out
four new methods applicable to services: the comparable uncontrolled services price method, the gross services margin method,
the cost of services plus method, and the simplified cost-based method. The first three methods are direct analogs of methods
provided for transfers of tangible property under existing §1.482-3, tailored to account for particular circumstances in services
transactions. The fourth method, the simplified cost-based method, is set forth in proposed §1.482-9(f). Proposed §1.482-9(a)
also specifies that the comparable profits method under existing §1.482-5 and the profit split methods under existing §1.482-6,
as modified by proposed §1.482-9(e) and (g) respectively, are applicable to services. Finally, proposed §1.482-9(a)(7) indicates
that unspecified methods also may be used in appropriate circumstances, as prescribed by proposed §1.482-9(h).
Proposed §1.482-9(a)(1) provides that the general rules under §1.482-1 of the existing regulations, including the best method
rule of existing §1.482-1(c), the comparability standards of existing §1.482-1(d), and the rules regarding determination of
an arm's length range under existing §1.482-1(e), generally apply to the determination of an appropriate arm's length charge
for controlled services transactions. The best method rule under existing §1.482-1(c) provides that an arm's length result
must be determined under the method that, given the facts and circumstances, provides the most reliable measure of an arm's
length result. Existing §1.482-1(c)(2) provides two primary factors to consider in determining which method is the most reliable:
the degree of comparability between the controlled transactions and any uncontrolled comparables, and the quality of data
and assumptions used in the analysis. The proposed regulations incorporate the comparability factors in existing §1.482-1(d) because these factors generally are
relevant under all methods. In addition, the description of each of the methods set out in the proposed regulations provides
other comparability factors that may be of particular importance in the context of that method as applied to a controlled
services transaction.
2. Comparable Uncontrolled Services Price Method—§1.482-9(b) Proposed §1.482-9(b) sets forth the comparable uncontrolled services price method. This method evaluates whether a controlled
services transaction satisfies the arm's length standard by comparing the price of a controlled services transaction with
the price charged in a comparable uncontrolled services transaction. This method is analogous to the comparable uncontrolled
price method of §1.482-3(b) in the context of transfers of tangible property. Proposed §1.482-9(b)(1) provides that this
method ordinarily is used where the controlled services are identical to or have a high degree of similarity to the services
in the uncontrolled transaction.
The proposed regulations provide that all of the comparability factors described in existing §1.482-1(d) must be considered,
but emphasize that similarity in the nature of the services and valuable intangibles used, if any, in providing the services
are the most important factors in determining comparability under this method. Consistent with the best method rule, proposed
§1.482-9(b)(2)(ii) provides that the comparable uncontrolled services price method generally provides the most direct and
reliable measure of an arm's length result if an uncontrolled transaction either has no differences from the controlled services
transaction or has only minor differences that have a definite and reasonably ascertainable effect on price, and appropriate
adjustments may be made for such differences. Proposed §1.482-9(b)(4) provides several examples that illustrate the application
of the comparable uncontrolled services price method to cases in which the comparable uncontrolled transactions are internal
or external. The Treasury Department and the IRS recognize that, under certain circumstances, uncontrolled parties may use proprietary
pricing models or other indirect methods to establish the price charged to uncontrolled parties in a services transaction.
Proposed §1.482-9(b)(5) provides that such data may be used as indirect evidence of a comparable uncontrolled services price
if certain requirements are met. This provision is analogous to the provision regarding indirect evidence of comparable uncontrolled
prices in §1.482-3(b)(5) in the context of transfers of tangible property. 3. Gross Services Margin Method—§1.482-9(c) Proposed §1.482-9(c) sets forth the gross services margin method. This method evaluates the arm's length price charged in
a controlled services transaction by reference to the gross services profit margin realized in uncontrolled transactions that
involve similar services. Similar to the resale price method provided for in §1.482-3(c) in the context of transfers of tangible
property, the charge under this method is calculated based on the price paid in an underlying and related uncontrolled transaction
undertaken by the controlled group.
Proposed §1.482-9(c)(1) provides guidance regarding the circumstances in which this method ordinarily would be used. This
method ordinarily is used in cases where a controlled taxpayer performs functions or services in connection with a “related
uncontrolled transaction” between a member of the controlled group and an uncontrolled taxpayer. For example, this method
may be used where a controlled taxpayer renders services (agent services) to another member of the controlled group in connection
with a transaction between that other member and an uncontrolled taxpayer. This method also may be used in cases where a
controlled taxpayer contracts to provide services to an uncontrolled taxpayer (intermediary function) and another member of
the controlled group actually performs the services provided.
Proposed §1.482-9(c)(2)(i) provides that the gross services margin method evaluates whether the price charged or amount retained
by a controlled taxpayer is arm's length by determining the “appropriate gross services profit” of the controlled taxpayer.
If one controlled taxpayer renders services to another member of a controlled group with respect to a transaction between
that other member of the controlled group and an uncontrolled taxpayer, the price charged to the other member under the gross
services margin method is the appropriate gross services profit of the controlled taxpayer that performed the agent services.
In cases where one controlled taxpayer contracts to provide services to an uncontrolled taxpayer and another member of the
controlled group actually performs those services, the price charged to the controlled intermediary under the gross services
margin method is determined by subtracting from the “applicable uncontrolled price” the appropriate gross services profit
of the intermediary controlled taxpayer.
Proposed §1.482-9(c)(2)(ii) and (iii) define the terms “related uncontrolled transaction,” “applicable uncontrolled price”
and “appropriate gross services profit,” which are necessary to determine the arm's length price under proposed §1.482-9(c)(2)(i).
The related uncontrolled transaction is a transaction between a member of the controlled group and an uncontrolled taxpayer
as to which a controlled taxpayer performs agent services or an intermediary function. The applicable uncontrolled price
is the final sales price paid by the uncontrolled party in the related uncontrolled transaction. Proposed §1.482-9(c)(2)(iii)
provides that the appropriate gross services profit is calculated by multiplying the applicable uncontrolled price by the
gross services profit margin earned in comparable uncontrolled services transactions. The gross services profit margin takes
into account all functions performed by other members of the controlled group and any other relevant factors. The proposed regulations incorporate the general comparability factors of existing §1.482-1(d) in determining comparability
under this method. Proposed §1.482-9(c)(3)(ii)(A) emphasizes that comparability under the gross services margin method is
particularly dependent on similarity of functions performed, risks borne, intangibles used (if any), and contractual terms,
as all these factors may materially affect the gross services profit margin. In determining comparability, the proposed regulations state that where the controlled taxpayer provides services similar
to a sales or purchasing agent, this method is less dependent on close similarity in the underlying property transferred or
the services provided to the uncontrolled party. However, substantial differences in the nature of the property transferred
or the services provided to the uncontrolled party may indicate significant differences in the functions performed by the
controlled taxpayer. Thus, it ordinarily would be expected that the controlled and uncontrolled transactions would involve
agent or intermediary services involving the transfer of goods within the same product categories, or the provision of services
of the same general type. In addition, the proposed regulations provide that if the functions performed by a controlled taxpayer are similar to those
performed by an uncontrolled taxpayer, then the gross profit margin earned by the uncontrolled taxpayer may be used as a comparable
gross services profit margin regardless of the structure of the uncontrolled services transaction. For example, proposed
§1.482-9(c)(3)(ii)(D) provides that if a controlled taxpayer that functions as a sales or purchasing agent for transfers of
tangible property is comparable to a distributor that takes title to goods and resells them (i.e., a buy-sell distributor), then the gross profit margin earned by the uncontrolled distributor on sales, stated as a percentage
of the uncontrolled price paid for the goods, may be used as the comparable gross services profit margin.
Proposed §1.482-9(c)(4) provides examples that illustrate various aspects of the application of the gross services margin
4. Cost of Services Plus Method—§1.482-9(d) Proposed §1.482-9(d) sets forth the cost of services plus method. This method evaluates whether the amount charged in a controlled
services transaction is arm's length by reference to the gross services profit markup in comparable uncontrolled services
transactions. The proposed regulations provide that this method is most reliably applied when the renderer in the controlled
services transaction provides the same or similar services to both controlled and uncontrolled parties. The cost of services plus method under proposed §1.482-9(d) is similar to the cost plus method applicable to transfers of
tangible property under existing §1.482-3(d). The proposed regulations, however, incorporate certain modifications that are
necessary because the manner in which the costs of providing services are presented for financial accounting purposes is less
uniform than the manner in which costs of goods sold are presented for such purposes. The proposed regulations refer to the
costs to be taken into account in evaluating controlled services transactions as “comparable transactional costs.” Proposed
§1.482-9(d)(2)(ii) defines comparable transactional costs to include all costs of providing the services that are taken into
account as the basis for determining the gross services profit markup in comparable uncontrolled services transactions. The
Treasury Department and the IRS intend this definition to be flexible to ensure that reasonably equivalent categories of costs
will be used to determine gross services profit in particular cases. Consequently, the proposed regulations provide that
in some circumstances comparable transactional costs may constitute a subset of the total services costs (as defined in proposed
§1.482-9(j)). Generally accepted accounting principles or income tax accounting rules (where income tax data for comparable
transactions are available) may provide a useful starting point but will not be conclusive. The proposed regulations incorporate the general comparability factors of existing §1.482-1(d) and provide several specific
rules to ensure appropriate results under this method. For example, proposed §1.482-9(d)(3)(ii)(A) provides that in determining
functional comparability between the tested transaction and uncontrolled transactions, it may be necessary to consider the
charge determined under the cost of services plus method expressed in the form of a markup on total services costs of the
controlled taxpayer and uncontrolled parties. The Treasury Department and the IRS believe that this confirming analysis will
prevent inappropriate results where the uncontrolled transactions incorporate functional differences that are reflected in
costs that are not included in comparable transactional costs. In addition, proposed §1.482-9(d)(3)(ii)(B) states that reliability
under this method will be reduced if a significant amount of the controlled taxpayer's comparable transactional costs consists
of costs incurred in a tax accounting period other than the period under review. The Treasury Department and the IRS believe
that in such cases application of this method may produce unreliable results.
The proposed regulations further provide that if, in applying this method, the controlled taxpayer and the comparable parties
do not state their respective costs of providing the services on an equivalent basis, adjustments will be necessary to ensure
reliability of the results. Proposed §1.482-9(d)(3)(iii)(B) notes that where such adjustments are not possible, the reliability
of the results determined under this method will be reduced.
Proposed §1.482-9(d)(4) provides examples that illustrate various aspects of the application of the cost of services plus
5. Comparable Profits Method—§1.482-9(e) The proposed regulations specify that the comparable profits method may be applied to controlled services. The comparable
profits method evaluates whether the amount charged in a controlled services transaction is arm's length based on analysis
of objective measures of profitability (profit level indicators) derived from financial information regarding uncontrolled
taxpayers that engage in similar business activities under similar circumstances. The proposed regulations provide that the guidance in existing §1.482-5 generally is applicable to controlled services transactions.
Proposed §1.482-9(e) provides specific guidance that tailors the application of §1.482-5 in cases in which the tested party
under existing §1.482-5(b)(2) is the renderer of the services under review. In all other cases, including cases in which
the tested party is the recipient of controlled services, the provisions of existing §1.482-5 apply without regard to §1.482-9(e).
Proposed §1.482-9(e) permits the application of the various profit level indicators provided in existing §1.482-5(b)(4)(ii)
to controlled services transactions. As noted in existing §1.482-5(b)(4), whether the use of a particular profit level indicator
is appropriate depends upon a number of factors, including the extent to which the profit level indicator is likely to produce
a reliable measure of the income that the tested party would have earned had it dealt with controlled taxpayers at arm's length.
In this regard, caution should be exercised in applying these profit level indicators to controlled services transactions.
For example, application of the rate of return on capital employed profit level indicator may produce unreliable results
because the reliability of this profit level indicator decreases as operating assets play a lesser role in generating operating
profits for both the tested party and the uncontrolled comparable. In addition, reliability under this profit level indicator
depends on the extent to which the composition of the tested party's assets is similar to that of the uncontrolled comparable.
With respect to financial ratios, the lack of uniformity regarding the presentation for financial accounting purposes of costs
of providing services (as noted in the description of cost of services plus method above) and the limited availability of
detailed information regarding the cost accounting practices of uncontrolled parties suggest that the reliability of the profit
level indicators that depend on segmentation of such costs may be reduced. Existing §1.482-5(c)(3) states that the reliability
of results derived from the comparable profits method is affected by the quality of the data used to apply this method. Due
to the lack of uniformity regarding the presentation for financial accounting purposes of costs of providing services, it
may be difficult to determine, for example, whether costs included in costs of goods sold or operating expenses reported by
uncontrolled taxpayers are in fact comparable to the corresponding costs incurred by the controlled taxpayer in the relevant
business activity. Consequently, an arm's length charge determined by use of the ratio of gross profit to operating expenses
as a profit level indicator may not be reliable.
Proposed §1.482-9(e)(2)(ii) describes a new profit level indicator that may be more reliable in the context of controlled
services transactions. The proposed regulations define this profit level indicator as the ratio of operating profits to total
services costs (defined in proposed §1.482-9(j)), or the markup on total costs (also referred to as the “net cost plus”).
This new profit level indicator evaluates operating profits based on a markup on all costs related to the provision of services.
This new profit level indicator is more likely to result in a cost base used to determine the controlled taxpayer's comparable
operating profit that is comparable to the cost base used by uncontrolled parties to calculate their operating profits in
The proposed regulations state that the degree of consistency in accounting practices between the controlled services transaction
and the uncontrolled transaction will affect the reliability of the results under this method. If appropriate adjustments
to account for such differences are not possible, the reliability of the results determined under this method will be reduced.
Proposed §1.482-9(e)(3) provides examples that illustrate various aspects of the application of the comparable profits methods
to controlled services transactions.
6. Simplified Cost-Based Method—§1.482-9(f) a. Overview The proposed regulation provides for a new simplified cost-based method for low-margin services, such as routine back-office
services. This simplified method is intended by the Treasury Department and the IRS to serve the same purpose as the current
regulations relating to the pricing of non-integral services by providing reduced compliance and administrative burdens with
respect to the transfer pricing of low-margin services. Such reduced burdens allow both taxpayers and the IRS to direct their
resources appropriately to other issues. The Treasury Department and the IRS believe, however, that certain aspects of the
rules in the current regulations intended to deal with low-margin services are problematic and therefore should be modified.
In particular, the current regulations in some cases have been interpreted or applied to reach inappropriate results from
a policy perspective by allowing high-margin controlled services to be priced at cost. Further, the qualitative and subjective
tests in the current regulations for determining whether a controlled service may be priced at cost have been difficult to
apply and have led to disputes. Therefore, while the simplified method is intended to maintain reduced compliance and administrative burdens with respect
to the pricing of low-margin services, it differs from the current rules regarding the pricing of low-margin services in significant
respects. In particular, the simplified method is based on comparability principles, and the administrative benefits of the
simplified method decrease as the margins attributable to the service at issue increase. Thus, the simplified method is more
consistent with the arm's length standard and will limit significantly the potential for arbitrariness and controversy that
makes the current rules problematic.
b. General Description of Method—§1.482-9(f)(1) The simplified method allows services that meet certain requirements and conditions to be priced by reference to the markup
on total services costs of uncontrolled taxpayers that engage in similar business activities under similar circumstances.
The markup on total services costs under the simplified cost-based method corresponds to the profit level indicator of the
ratio of operating profit to total services costs, or net cost plus, which is provided for under the comparable profits method
for services in proposed §1.482-9(e). Proposed §1.482-9(f)(1)(i) provides that if a controlled services transaction that
meets the conditions and requirements of proposed §1.482-9(f) is priced under the simplified method, that method will be considered
the best method for purposes of §1.482-1(c). In effect, the conditions and requirements for the application of the simplified
method are a substitute for a traditional best method analysis.
c. Limitation on Allocations by the Commissioner— §1.482-9(f)(2) The distinguishing feature of the simplified method is a limitation on the ability of the Commissioner to make allocations
that he could otherwise make under the general transfer pricing rules. Proposed §1.482-9(f)(2)(i) provides generally that
the Commissioner may make an allocation under the simplified method only if the arm's length markup on total costs, as determined
by the Commissioner under the general transfer pricing rules, exceeds the markup charged by the taxpayer by at least a specified
number of percentage points. This “applicable number of percentage points” is six if the amount charged by the taxpayer is
equal to total costs, and it declines ratably to zero by one percentage point for every increase of two percentage points
in the markup on total costs charged by the taxpayer. Thus, for example, if a taxpayer prices controlled services at cost
under this method, the Commissioner may make an allocation only if the arm's length markup on total costs is at least 6 percent.
As the markup charged by the taxpayer on the controlled services approaches 10 percent, the applicable number of percentage
points declines ratably to zero. This ensures that only relatively low-margin services benefit from the simplified method.
Proposed §1.482-9(f)(2)(iii) also provides an upper bound for the application of the simplified method of 10 percent. Thus,
in no event would the Commissioner be limited under this method in making an allocation if the arm's length markup on total
costs exceeds 10 percent. Proposed §1.482-9(f)(2)(iv) provides equations and a table with respect to these rules, and proposed
§1.482-9(f)(5) provides several examples that describe and illustrate the application of these rules.
The Treasury Department and the IRS intend these quantitative rules, applied in conjunction with the other requirements for
and conditions on the application of the simplified method, to provide objective, administrable guidance for determining whether
controlled services may be priced under the simplified method rather than subject to a full transfer pricing analysis, including
an analysis under the best method rule. Further, because the benefits of the simplified method decline as the margin attributable
to the service increases, the pricing of a relatively high-margin controlled service under the simplified method converges
with that under a full transfer pricing analysis. The objective of these quantitative rules is to provide a sufficient range
with respect to the pricing of low-margin services to maintain appropriately reduced compliance and administrative burdens
with respect to such services, while safeguarding against the inappropriate application of the simplified method to services
that should be subject to a more robust arm's length analysis.
The simplified method does not grant authority to the Commissioner to make allocations that could not be made under the general
transfer pricing rules. Thus, the qualitative rules of the simplified method apply in conjunction with, and not in lieu of,
the interquartile range that may be available under certain other transfer pricing methods. For example, if the markup charged
by the taxpayer on a controlled services transaction exceeds the arm's length markup by more than the applicable number of
percentage points but is within the interquartile range of results under a best method analysis, the Commissioner may not
make an allocation with respect to the underlying service. This interaction between the upper bound and the interquartile
range further ensures that the benefits of the simplified method are focused on relatively low-margin services because the
arm's length range can be expected to provide a wider tolerance band than the applicable number of percentage points as the
markup on total services costs approaches 10 percent.
These limitations on the Commissioner's authority to make an allocation apply only if the markup charged in the controlled
transaction is less than the arm's length markup. If instead the markup charged in the controlled transaction exceeds the
arm's length markup, proposed §1.482-9(f)(2)(v) provides that the limitation on the Commissioner under the simplified method
does not apply to prevent the Commissioner from making an allocation. Further, proposed §1.482-9(f)(2)(v)(A) provides that the limitation on the Commissioner does not apply to prevent an allocation
if the amount charged by the taxpayer is less than the “total services costs” in the controlled services transaction. The
Treasury Department and the IRS believe that it is appropriate to subject controlled services that are priced at less than
cost to a full transfer pricing analysis. Finally, proposed §1.482-9(f)(2)(v)(B) provides that the Commissioner's authority to determine the cost base is not limited
if the taxpayer's method of determining, allocating and apportioning costs is not consistent with the methods used by similar
uncontrolled taxpayers in similar circumstances. This authority, which is similar to the Commissioner's authority under existing
§1.482-2(b)(4) to make appropriate allocations of costs, constitutes an important safeguard on the reliability of the results
determined under the simplified cost-based method. Consistent with the purpose of the simplified method — to provide certainty
concerning the pricing of low-margin controlled services, and to reduce the number of disputes where taxpayers make a good
faith effort to price qualifying services under this method — the Treasury Department and the IRS anticipate that the Commissioner
will exercise this authority to correct an erroneous allocation only where that allocation has a significant impact on the
amount of consideration in the controlled transaction.
In all cases in which the Commissioner's authority to make an allocation is not limited by the simplified method, allocations
nevertheless must be consistent with the arm's length standard and otherwise appropriate under the generally applicable transfer
pricing rules. Proposed §1.482-9(f)(5) provides examples that illustrate the application of the rules in proposed §1.482-9(f)(2).
d. Conditions on Use of Simplified Method—§1.482-9(f)(3) There are two conditions on the application of the simplified method. Proposed §1.482-9(f)(3) provides that taxpayers must
maintain adequate books and records with respect to the determination and allocation of total costs, and subject to a de minimis exception must have a written contract in place that provides for current compensation for the services. The written-contract
requirement ensures that the controlled taxpayers allocate risks attributable to the services transaction before the relevant
services are rendered, and ensure in particular that the service renderer does not bear risks in a manner that would be inconsistent
with the charging of a relatively low margin on total costs. The Treasury Department and the IRS believe that many large
and mid-size taxpayers already have in place such basic agreements for controlled services transactions, or can execute such
contracts without incurring undue expense. Thus, the written-contract requirement is not intended to impose significant compliance
burdens on such taxpayers, or to limit their ability to use this method in appropriate cases.
The Treasury Department and the IRS recognize that the written-contract requirement could impose an undue burden on smaller
taxpayers or on taxpayers that choose to apply the simplified method to a limited amount of services. Accordingly, the proposed
regulations provide that the written-contract requirement does not apply to taxpayers that are members of a U.S. controlled
group with an annual gross income of less than $200 million, or to taxpayers that apply the simplified method to services
whose aggregate costs are less than $10 million. In order to apply the simplified method in the absence of a written contract,
however, the conduct of the parties to the services transaction must be consistent with an agreement that provides for current
compensation of the services.
e. Transactions Not Eligible for Simplified Method—§1.482-9(f)(4) The Treasury Department and the IRS intend the simplified method to apply only to low-margin controlled services for which
total costs constitute an appropriate reference point for determining profitability. The arm's length charge for other controlled
transactions is more appropriately determined under another transfer pricing method, subject to the best method rule. The
proposed regulations identify categories of transactions that are not eligible to be priced under this method. The Treasury
Department and the IRS believe that the simplified method should not be available for such transactions because they tend
to be high-margin transactions, transactions for which total costs constitute an inappropriate reference point for determining
profitability, or other types of transactions that should be subject to the more robust arm's length analysis, including an
analysis under the best method rule. The Treasury Department and the IRS anticipate that, in general, controlled services
that are priced at cost under an application of the existing regulations that is consistent with the intent of those regulations
should qualify to be analyzed under the simplified method.
Proposed §1.482-9(f)(4)(i) provides that controlled services that are similar to those provided to uncontrolled parties by
either the renderer or the recipient are not eligible for the simplified cost-based method. This rule is similar to the rule
of existing §1.482-2(b)(7)(i), which has not led to compliance or administrative difficulties because taxpayers generally
will have access to internal information concerning the comparable uncontrolled price of such services.
Proposed §1.482-9(f)(4)(ii) provides that controlled services provided to a recipient that receives controlled services in
significant amounts are not eligible to be evaluated under the simplified method. This rule is similar to the rule in existing
§1.482-2(b)(7)(iv) but has been simplified and narrowed in scope, and therefore should apply in fewer cases. The Treasury
Department and the IRS believe that services routed through conduits or intermediaries should be subject to a full transfer
Proposed §1.482-9(f)(4)(iii) provides that controlled services that involve the use of valuable or unique intangibles are
ineligible for the simplified method if such intangibles contribute significantly to the value of the services and the costs
associated with such intangibles are not reflected in the costs relating to the rendering of the services. The Treasury Department
and the IRS believe that such services are likely to have values substantially in excess of their cost and therefore categorically
should be subject to a full transfer pricing analysis. The Treasury Department and the IRS anticipate that there will be
significant overlap between this rule and the 10 percent rule in proposed §1.482-9(f)(2)(iii); that is, the arm's length markup
on total costs with respect to such services is likely to exceed 10 percent.
Proposed §1.482-9(f)(4)(iv) provides that controlled services that are combined with other types of controlled transactions,
such as a transfer of tangible or intangible property, are not eligible for the simplified method to the extent of those other
transactions. The Treasury Department and the IRS intend the application of the simplified method to be limited to low-margin
services transactions. Proposed §1.482-9(f)(4)(v) identifies several specific types of transactions that are not eligible for the simplified method.
The first four types — manufacturing, production, extraction, and construction services — are identical to types of transactions
excluded from eligibility for pricing at cost under existing §1.482-2(b)(7)(ii)(A). Such services generally constitute core
profit-making functions of an enterprise. The Treasury Department and the IRS therefore believe that such services should
continue to be subject to a full transfer pricing analysis. Also not eligible for the simplified method are reselling, distribution, or similar activities conducted under a commission
or other arrangement, as well as financial transactions, including guarantees, and insurance or reinsurance. The Treasury
Department and the IRS believe that it is not appropriate to apply the simplified method to such transactions because total
costs generally constitute an inappropriate reference point for