||January 16, 2007
This Notice Clarifies and Modifies Certain Provisions
of the Temporary and Proposed Regulations
Under Section 482 of the Code
Relating to Controlled Services Transactions,
and Section 6662 of the Code Relating to
Transfer Pricing Documentation Penalties
On August 4, 2006, the Treasury Department and the IRS published T.D.
9278, 2006-34 I.R.B. 256, containing temporary and proposed regulations that
address controlled services under section 482 (71 Fed. Reg. 44466). This
notice makes several clarifications concerning provisions in the temporary
and proposed regulations, primarily relating to the services cost method.
In addition, this notice makes certain modifications to the effective date
of the temporary regulations.
The temporary and proposed regulations provided for a new transfer pricing
method applicable to certain controlled services transactions, the services
cost method (SCM). Under specified circumstances, the SCM allows the arm’s
length charge for a controlled services transaction to be determined by reference
to total services costs, without a markup. Two categories of covered services
are potentially eligible for this method, specified covered services and low
margin covered services, both defined in Temp. Treas. Reg. § 1.482-9T(b)(4).
To demonstrate that a particular controlled service qualifies for the SCM,
the taxpayer must reasonably conclude, in its business judgment, that the
service does not contribute significantly to key competitive advantages, core
capabilities, or fundamental risks of success or failure in one or more trades
or businesses of the renderer, the recipient, or both. Temp. Treas. Reg.
§ 1.482-9T(b)(2) (business judgment rule). Specified covered services
are those controlled services that the Commissioner identifies by means of
a revenue procedure. Low-margin covered services are controlled services
transactions for which the arm’s length mark-up, determined by reference
to comparable uncontrolled transactions, equals 7% or less.
The Treasury Department and the IRS issued a proposed revenue procedure
that identified specified covered services. See Announcement
2006-50, 2006-34 I.R.B. 321 (August 21, 2006). That proposed revenue procedure
identified forty-eight activities or groups of activities that constitute
specified covered services. Contemporaneously with the issuance of this notice,
the IRS intends to issue a final revenue procedure on this topic before December
31, 2006. The revenue procedure may be further updated, as appropriate, including
in connection with the conclusion of the one-year transition period provided
by this notice and in the course of finalization of the temporary regulations
in response to comments.
The temporary and proposed regulations also added a provision in Temp.
Treas. Reg. § 1.482-9T(b)(5) concerning shared services arrangements
(SSAs). Provided that the taxpayer satisfies the conditions for use of an
SSA, which includes reasonably concluding that the SSA utilizes the most reliable
measure of the participants’ respective shares of the reasonably anticipated
benefits from the covered services, the IRS will not make an adjustment to
the taxpayer’s allocation. An SSA must be structured such that: (1)
it includes two or more participants; (2) each participant reasonably anticipates
a benefit from one or more covered services specified in the SSA; and (3)
each covered service confers a benefit on at least one participant in the
SSA. See Temp. Treas. Reg. § 1.482-9T(b)(5).
Services eligible to be included in an SSA are limited to services that qualify
for the SCM. Temp. Treas. Reg. § 1.482-9T(b)(5)(i).
The temporary and proposed regulations are generally effective for taxable
years that begin after December 31, 2006. Temp. Treas. Reg. § 1.482-9T(n).
A taxpayer may elect to apply the temporary regulations to open tax years
that begin after September 10, 2003.
SECTION 3. CLARIFICATIONS, PARTIAL MODIFICATION OF EFFECTIVE DATE
Numerous public comments were submitted concerning both Announcement
2006-50 and the temporary and proposed regulations. In response to these
comments, this notice describes modifications to the list of specified covered
services, as adopted in the final revenue procedure. The notice also modifies
the effective date of the temporary regulations in several respects, as described
below. Lastly, the notice makes several clarifications concerning the intended
application of the regulations, as described below. These clarifications
will be considered during the process of finalizing the temporary regulations.
In the interim, and pending the issuance of final regulations under Treas.
Reg. § 1.482-9, and other related provisions, taxpayers may rely
on the guidance contained in this notice.
§ 3.01 Partial Modification of Effective Date —
The temporary and proposed regulations are effective for tax years beginning
after December 31, 2006 (with retroactive application for tax years beginning
after September 10, 2003, at the election of the taxpayer). See Temp.
Treas. Reg. § 1.482-9T(n). Several commentators requested that
the effective date of the entire regulations be moved back one year, which
in their view would provide taxpayers sufficient time to modify accounting
systems and to take other steps, including preparation of contractual agreements
and other transfer pricing documentation, deemed necessary to comply fully
with the temporary regulations.
In response to these comments, this notice partially modifies the effective
date of Temp. Treas. Reg. § 1.482-9T(b) of the temporary regulations.
Subject to the exceptions described below, the effective date of the temporary
regulations, as they pertain to the identification of controlled services
eligible to be priced at cost, is moved back one year. The temporary regulations
will thus apply to taxable years after December 31, 2007, for all provisions
related to the SCM in Temp. Treas. Reg. § 1.482-9T(b). The only
SCM provision that has immediate effect, i.e., for taxable
years beginning after December 31, 2006, is the business judgment rule in
Temp. Treas. Reg. § 1.482-9T(b)(2).
The net effect of this modification is that, for taxable years with
beginning dates from January 1, 2007 to December 31, 2007, taxpayers may apply
the existing regulations in Treas. Reg. § 1.482-2(b) for purposes
of identifying controlled services that are eligible to be priced on a cost
basis, without a markup. For such taxable years, services that are priced
on a cost basis must be “non-integral” within the meaning of existing
Treas. Reg. § 1.482-2(b)(7), and they must also satisfy the SCM
business judgment test in Temp. Treas. Reg. § 1.482-9T(b)(2). Other
SCM related provisions, including the documentation provision in Temp. Treas.
Reg. § 1.482-9T(b)(3)(i) and the excluded transactions in Temp.
Treas. Reg. § 1.482-9T(b)(3)(ii), are inapplicable to transactions
during this one-year period. Consequently, in this context, the existing
documentation standards applicable to controlled services will apply to transactions
during this one-year period. Alternatively, for tax years beginning between
January 1, 2007 and December 31, 2007, taxpayers may elect to apply the SCM
as set forth in Temp. Treas. Reg. § 1.482-9T(b), without taking
into account any of the modifications described above.
The provisions of Temp. Treas. Reg. § 1.482-9T(b) will be
effective in all respects for taxable years beginning after December 31, 2007.
§ 3.02 Services Cost Method Applies Only at Option
Several commentators requested confirmation that application of the
SCM was a matter within the control of the taxpayer, assuming that the underlying
transactions qualified for the SCM. Commentators observed that the temporary
regulations could be interpreted as requiring a taxpayer
to apply the SCM, if all the conditions for that method were satisfied. In
the view of commentators, this would conflict with the ability of a taxpayer
to apply the best method rule, including by applying a transfer pricing method
other than the SCM.
This notice confirms that under the temporary regulations the SCM is
elective by taxpayers. A statement in its books and records evidencing the
taxpayer’s intent to apply the SCM is required as a necessary condition
to applicability of the SCM. Temp. Treas. Reg. § 1.482-9T(b)(3)(i)
(second sentence). This notice also confirms that there is no requirement
for a taxpayer to attach such statement to its tax return, as typically is
the case with elections that are to be flagged to the IRS’ attention.
§ 3.03 Listing of Specified Covered Services in
Several commentators contended that the proposed list of specified covered
services in Announcement 2006-50 was too narrow to be of practical use. Some
commentators suggested that the list should refer to departments or to accounting
classifications, rather than to specific activities or groups of activities.
One commentator suggested that all activities in particular departments should
be identified as eligible for the SCM. Other commentators supported the general
approach taken in Announcement 2006-50, but suggested that the list include
certain additional activities, so as to describe the back office in a more
The SCM is intended to provide a practical and administrable means of
identifying low-margin services that may be evaluated by reference to total
services cost without a markup. The SSA provision affords taxpayers the flexibility
to analyze specified covered services and low margin covered services that
produce benefits to multiple recipients, under a joint-benefit approach.
Flexible grouping rules are adopted for purposes of the SCM and the SSA provisions.
Temp. Treas. Reg. § 1.482-9T(b)(4) (first sentence parenthetical)
and (b)(5)(iii)(B). In the view of the Treasury Department and the IRS, these
provisions afford flexibility to analyze covered services in a way that does
not impose inappropriate compliance burdens. Accordingly, the Treasury Department
and the IRS decline to adopt a departmental approach to identification of
specified covered services eligible for the SCM.
In response to public comments, however, the Treasury Department and
the IRS have concluded that certain modifications to the list of specified
covered services in Announcement 2006-50 are appropriate. Several further
categories will be added, and further activities will be specified within
the categories. In addition, the individual categories of specified covered
services will also include “other similar activities.” This reflects
the conclusion of the Treasury Department and the IRS that the list of specified
covered services should be structured and interpreted in a practical, common-sense
manner. The changes described in this paragraph are reflected in Rev. Proc.
2007-13, which is published contemporaneously with this notice.
§ 3.04 Business Judgment Rule
In finalizing the regulations, the Treasury Department and the IRS will
incorporate provisions consistent with the following interpretations of the
business judgment rule.
(1) Applies by Reference to Controlled Group
In evaluating whether a controlled services transaction qualifies for
the SCM, the temporary regulations provide that the business judgment rule
should be applied by reference to “one or more trades or businesses of
the renderer, recipient, or both.” Temp. Treas. Reg. § 1.482-9T(b)(2)
(emphasis added). Commentators observed that this rule may yield incorrect
results in some cases, for example, where a dedicated services subsidiary
performs primarily low margin covered services or specified covered services,
and few other activities. The activities performed by such an entity would
potentially be ineligible for the SCM under the business judgment rule, because
they would constitute the entity’s core capability.
This notice provides that taxpayers are to apply the business judgment
rule by reference to one or more trades or businesses of the controlled
group, as defined in Treas. Reg. § 1.482-1(i)(6), instead
of “the renderer, recipient, or both,” as stated in Temp. Treas.
Reg. § 1.482-9T(b)(2).
(2) Evaluates Contributions to Operating Profit
This notice provides that the business judgment rule in Temp. Treas.
Reg. § 1.482-9T(b)(2) should take into account whether a particular
activity contributes to the operating profit of one or more controlled parties,
as that term is defined in Treas. Reg. § 1.482-5(d)(3). For example,
the activities performed by a corporate tax department should not be disqualified
from the SCM, given that these activities primarily affect foreign income
taxes (as defined in § 1.901-2(a)) and domestic income taxes, which
are not classified as operating expenses. See Treas.
Reg. § 1.482-5(d)(3).
(3) Taxpayer’s Reasonable Business Judgment
Several commentators expressed concern over how the business judgment
rule would be administered. They raised questions concerning how to evidence
the necessary business judgment, for example, whether an executive’s
representation must be preferred to the tax director’s. Commentators
also requested that statements from the preamble to the temporary regulations
be incorporated in final regulations.
The Treasury Department and the IRS reiterate that the temporary regulations
already incorporate a high threshold for application of the business judgment
rule to exclude services otherwise eligible for the SCM. The exclusion is
inapplicable so long as the taxpayer reasonably concludes in its business
judgment that the covered services do not contribute significantly to key
competitive advantages, core capabilities, or fundamental risks of success
or failure in one or more trades or businesses of the controlled group.
The test is satisfied by a reasonable exercise of the taxpayer’s
business judgment, not a reasonable exercise of the IRS’s judgment in
examining the taxpayer. In the view of the Treasury Department and the IRS,
the gloss in the preamble to the temporary regulations, such as that this
is a business judgment preeminently within the business person’s own
expertise, flows directly from the regulations’ specification that the
matter lies in the taxpayer’s reasonable business judgment. The evidence
necessary to establish the taxpayer’s reasonable business judgment is
determined under all the facts and circumstances. No source, executive or
otherwise, is generally more probative than another.
§ 3.05 Shared Services Concept Applicable to non-SCM
In general, commentators supported the SSA provision as a useful mechanism
for allocation of costs from shared or centralized services. Commentators
called into question, however, the need to restrict SSAs to covered services
eligible to be analyzed under the SCM. In the view of the commentators, extending
the SSA concept to all controlled services would produce accurate results
and would also be consistent with the OECD Transfer Pricing Guidelines
for Multinational Enterprises and Tax Administrations, in particular,
the provisions pertaining to cost contribution arrangements.
This notice confirms that taxpayers may also make allocations of arm’s
length charges for services ineligible for the SCM that yield a benefit to
multiple members of a controlled group. In such a case, however, the flexible
rules under the SCM for establishing the joint benefits and selecting the
allocation key are inapplicable. Instead, the more robust analysis under
the general transfer pricing rules applies for purposes of determining the
appropriate arm’s length charges, benefits, allocation keys, etc.
§ 3.06 Documentation Provisions
This notice clarifies that the documentation for services analyzed under
the SCM, described in Temp. Treas. § 1.482-9T(b)(3)(i) (adequate
books and records) need not be generated contemporaneously with the filing
of the income tax return.
In addition, for tax years beginning after December 31, 2006, and on
or before December 31, 2007, the written contract specified by Temp. Treas.
Reg. § 1.482-9T(i)(2) need not be entered into prior to, or contemporaneous
with the start of the activity or group of activities. Instead, the written
contract need only be prepared prior to, or contemporaneous with the filing
of the income tax return.
§ 3.07 Penalty Relief for Certain Controlled Services
During a one-year transition period, the Treasury Department and the
IRS intend that taxpayers’ reasonable efforts to comply with the temporary
regulations, as modified by this notice, will avoid the imposition of penalties
for controlled services transactions, except for those evaluated under Treas.
Reg. § 1.482-2(b), as modified by section 3.01 of this notice.
Accordingly, this notice provides that penalties, including but not
limited to penalties within the meaning of section 6662(e) and (h) of the
Code, will not apply to controlled services transactions (except for those
evaluated under Treas. Reg. § 1.482-2(b)(3), as modified by section
3.01 of this notice), for taxable years beginning after December 31, 2006
and on or before December 31, 2007, provided that the taxpayer makes reasonable
efforts to comply with documentation provisions in I.R.C. § 6001
and Treas. Reg. § 1.6662-6(d)(2)(iii).
In determining whether a taxpayer’s efforts are reasonable, the
Service will take into consideration that a taxpayer may not yet have all
of its intercompany agreements in place and may be implementing changes to
its accounting systems during this one-year transition period. If, however,
the taxpayer fails to provide the Service with any transfer pricing documentation
in connection with its controlled services transactions within the applicable
time period, such actions will be deemed unreasonable.
This relief from penalties is intended to provide a reasonable transition
period during which taxpayers may analyze the temporary and proposed regulations,
execute any required contractual agreements, and prepare transfer pricing
documentation for transactions subject to the regulations. This clarification
does not limit the ability of the Commissioner to make section 482 allocations
with respect to charges for services transactions that take place during this
period or to apply penalties to controlled services transactions that are
evaluated under Treas. Reg. § 1.482-2(b), as modified by section
3.01 of this notice.
SECTION 4. REQUEST FOR COMMENTS
The Treasury Department and the IRS request further comments from interested
persons on the rules announced in this notice. In addition, the revenue procedure
issued contemporaneously with this notice is intended to be an evolving list
of services that are eligible for the SCM. The Treasury Department and the
IRS contemplate issuing updates as appropriate, including a further revision
of the revenue procedure to coincide with the end of the one-year transition
period and in response to comments received on the temporary regulations.
Comments are solicited on the categories and listed activities in the revenue
procedure, possible additions, and other revisions. For example, comments
are solicited whether warehousing and other functions that support distribution
should be eligible for the SCM in light of Temp. Treas. Reg. § 1.482-9T(b)(3)(ii)(E)
(reselling, distribution ineligible for SCM).
Written comments may be submitted to CC:INTL:6 (Notice 2007-5), room
4607, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington,
DC 20224. Submissions may be hand delivered Monday through Friday between
the hours of 8 a.m. and 5 p.m. to: CC:INTL:6 (Notice 2007-5) Courier’s
desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Washington,
DC 20224. Alternatively, taxpayers may submit comments electronically via
the following e-mail address: Notice.Comments@irscounsel.treas.gov.
Please include “Notice 2007-5” in the subject line of any electronic
SECTION 5. DRAFTING INFORMATION
The principal authors of this notice are Thomas A. Vidano and Carol
B. Tan of the Office of Associate Chief Counsel (International). For further
information regarding this notice, contact Thomas A. Vidano or Carol B. Tan
at (202) 622-5265 (not a toll-free call).
Internal Revenue Bulletin 2007-03
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