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.

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.

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 comprehensive manner.

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.

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.

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.

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.

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.