[Federal Register Volume 68, Number 175 (Wednesday, September 10, 2003)]
[Proposed Rules]
[Pages 53448-53482]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 03-22550]



[[Page 53447]]

-----------------------------------------------------------------------

Part III





Department of the Treasury





-----------------------------------------------------------------------



Internal Revenue Service



-----------------------------------------------------------------------



26 CFR Parts 1 and 31



Treatment of Services Under Section 482; Allocation of Income and 
Deductions From Intangibles; Proposed Rule

  Federal Register / Vol. 68, No. 175 / Wednesday, September 10, 2003 / 
Proposed Rules  

[[Page 53448]]


-----------------------------------------------------------------------

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 31

[REG-146893-02, REG-115037-00]
RIN 1545-BB31, 1545-AY38


Treatment of Services Under Section 482; Allocation of Income and 
Deductions From Intangibles

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

-----------------------------------------------------------------------

SUMMARY: 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 of public hearing on these proposed regulations.

DATES: 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-115037-02), 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, DC.

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 numbers).

SUPPLEMENTARY INFORMATION:

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 (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 (59 FR 34971, 60 FR 
65553 and 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 Sec.  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 Sec.  
1.482-4(f)(3) as part of the 1994 regulations. The preamble to those 
regulations states that the rules of Sec.  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 Sec.  1.482-2(b) relating to 
controlled services transactions and existing guidance under Sec.  
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

[[Page 53449]]

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 
Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  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--Sec.  1.482-9

1. General Rule--Sec.  1.482-9(a)
    Consistent with the rules governing transfers of tangible and 
intangible property under existing Sec. Sec.  1.482-3 and 1.482-4, 
respectively, proposed Sec.  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 Sec.  1.482-1 
(including the best method rule of Sec.  1.482-1(c), the comparability 
analysis of Sec.  1.482-1(d), and the arm's length range of Sec.  
1.482-1(e)) of the existing regulations.
    The proposed regulations specify six methods applicable to 
controlled services transactions. Proposed Sec.  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

[[Page 53450]]

simplified cost-based method. The first three methods are direct 
analogs of methods provided for transfers of tangible property under 
existing Sec.  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 Sec.  1.482-
9(f). Proposed Sec.  1.482-9(a) also specifies that the comparable 
profits method under existing Sec.  1.482-5 and the profit split 
methods under existing Sec.  1.482-6, as modified by proposed Sec.  
1.482-9(e) and (g) respectively, are applicable to services. Finally, 
proposed Sec.  1.482-9(a)(7) indicates that unspecified methods also 
may be used in appropriate circumstances, as prescribed by proposed 
Sec.  1.482-9(h).
    Proposed Sec.  1.482-9(a)(1) provides that the general rules under 
Sec.  1.482-1 of the existing regulations, including the best method 
rule of existing Sec.  1.482-1(c), the comparability standards of 
existing Sec.  1.482-1(d), and the rules regarding determination of an 
arm's length range under existing Sec.  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 Sec.  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 Sec.  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 Sec.  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--Sec.  1.482-9(b)
    Proposed Sec.  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 Sec.  1.482-
3(b) in the context of transfers of tangible property. Proposed Sec.  
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 Sec.  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 Sec.  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 
Sec.  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 Sec.  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 Sec.  1.482-3(b)(5) in 
the context of transfers of tangible property.
3. Gross Services Margin Method--Sec.  1.482-9(c)
    Proposed Sec.  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 
Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  1.482-9(c)(2)(iii) provides that the appropriate gross 
services profit is calculated by multiplying the applicable

[[Page 53451]]

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 Sec.  1.482-1(d) in determining comparability under 
this method. Proposed Sec.  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 Sec.  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 Sec.  1.482-9(c)(4) provides examples that illustrate 
various aspects of the application of the gross services margin method.
4. Cost of Services Plus Method--Sec.  1.482-9(d)
    Proposed Sec.  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 Sec.  1.482-9(d) is 
similar to the cost plus method applicable to transfers of tangible 
property under existing Sec.  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 Sec.  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 Sec.  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 Sec.  1.482-1(d) and provide several specific rules 
to ensure appropriate results under this method. For example, proposed 
Sec.  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 Sec.  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 Sec.  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 Sec.  1.482-9(d)(4) provides examples that illustrate 
various aspects of the application of the cost of services plus method.
5. Comparable Profits Method--Sec.  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 
Sec.  1.482-5 generally is applicable to controlled services 
transactions. Proposed Sec.  1.482-9(e) provides specific guidance that 
tailors the application of Sec.  1.482-5 in cases in which the tested 
party under existing Sec.  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 Sec.  1.482-5 apply without regard to Sec.  1.482-9(e).

[[Page 53452]]

    Proposed Sec.  1.482-9(e) permits the application of the various 
profit level indicators provided in existing Sec.  1.482-5(b)(4)(ii) to 
controlled services transactions. As noted in existing Sec.  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 Sec.  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 Sec.  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 Sec.  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 similar business activities.
    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 Sec.  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--Sec.  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--Sec.  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 Sec.  1.482-9(e). Proposed 
Sec.  1.482-9(f)(1)(i) provides that if a controlled services 
transaction that meets the conditions and requirements of proposed 
Sec.  1.482-9(f) is priced under the simplified method, that method 
will be considered the best method for purposes of Sec.  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-- Sec.  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 Sec.  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

[[Page 53453]]

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 Sec.  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 
Sec.  1.482-9(f)(2)(iv) provides equations and a table with respect to 
these rules, and proposed Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  1.482-9(f)(5) provides examples that illustrate the 
application of the rules in proposed Sec.  1.482-9(f)(2).
    d. Conditions on Use of Simplified Method--Sec.  1.482-9(f)(3). 
There are two conditions on the application of the simplified method. 
Proposed Sec.  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--Sec.  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

[[Page 53454]]

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 Sec.  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 Sec.  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 Sec.  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 Sec.  
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 pricing analysis.
    Proposed Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  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 determining profitability with 
respect to such transactions.
    Finally, research and development, experimentation, engineering or 
scientific services are excluded from the simplified method. The 
Treasury Department and the IRS believe that such services may in a 
significant number of cases involve valuable intangibles and therefore 
should be subject to a full transfer pricing analysis.
    No inference is intended regarding either the arm's length markup 
on total services costs with respect to any of the excluded categories 
or types of transactions or the appropriate transfer pricing method for 
analyzing any particular transaction. In particular, no inference is 
intended that the arm's length markup for such transactions in a 
particular case will exceed 10 percent of total costs. Rather, these 
transactions are ineligible for the simplified cost-based method 
because the Treasury Department and the IRS have concluded that a full 
transfer pricing analysis is appropriate.
    f. Coordination With Documentation and Penalty Rules--Sec.  1.6662-
6(d)(2)(ii)(B) and (iii)(B). Section 6662 imposes certain accuracy-
related penalties on substantial valuation misstatements as described 
in section 6662(e)(1)(B) and gross valuation misstatements as described 
in section 6662(h)(2)(A). These accuracy-related penalties include two 
categories of transfer pricing penalties, referred to as the 
transactional and net section 482 transfer price adjustment penalties. 
These penalties are not applicable if the taxpayer prepares 
contemporaneous documentation indicating that the taxpayer reasonably 
selected and applied a transfer pricing method, and provides that 
documentation to the Commissioner upon request.
    Existing Sec.  1.6662-6(d)(2) provides that an amount is excluded 
from the calculation of a net section 482 transfer price adjustment for 
purposes of applying the section 6662 penalty if the taxpayer 
establishes that both the specified method and documentation 
requirements are met with respect to that amount. Existing Sec.  
1.6662-6(d)(2)(ii) provides that the specified method requirement is 
met if the taxpayer selects and applies a specified method in a 
reasonable manner. A taxpayer meets this burden only if, given the 
available data and the applicable pricing methods, the taxpayer 
reasonably concluded that the method (and its application of that 
method) provided the most reliable measure of an arm's length result 
under the principles of the best method rule. Existing Sec.  1.6662-
6(d)(2)(iii) provides rules with respect to the documentation 
requirement, and in particular contains a descriptive list of 
categories of documents that must be maintained and provided in order 
to meet the requirement. A taxpayer is not subject to the section 482 
transactional penalty if it meets the requirements of Sec.  1.6662-
6(d).
    A significant purpose of the simplified cost-based method is to 
maintain appropriately reduced compliance and administrative burdens 
with respect to low-margin services. Consistent with that purpose, 
proposed Sec.  1.6662-6(d)(2)(ii)(B) provides that, for purposes of the 
specified method documentation requirement, a taxpayer's selection and 
application of the simplified method will be considered reasonable if 
the taxpayer reasonably concluded that the relevant transaction meets 
the conditions and requirements for application of that method, 
including the rule in proposed Sec.  1.482-9(f)(2)(iii) that provides 
that the simplified method shall not apply if the arm's length markup 
exceeds 10 percent of total costs. In addition, the proposed 
regulations clarify the description of the documents that must be 
maintained and

[[Page 53455]]

provided in order to satisfy the documentation requirement. While these 
clarifications apply generally, they are particularly relevant where 
the simplified method is applied.
7. Profit Split Method--Sec. Sec.  1.482-9(g) and 1.482-6(c)(3)(i)(B)
    The proposed regulations provide guidance regarding the application 
of the comparable profit split and the residual profit split methods to 
controlled services transactions. Generally, both profit split methods 
evaluate whether the allocation of the combined operating profit or 
loss attributable to one or more controlled transactions is arm's 
length by reference to the relative value of each controlled taxpayer's 
``contributions'' to the combined operating profit or loss.
    The proposed regulations provide that the guidance regarding the 
profit split methods in existing Sec.  1.482-6, as amended by proposed 
Sec.  1.482-6(c)(3)(i)(B) and other conforming changes, generally is 
applicable to controlled services transactions. Proposed Sec.  1.482-
9(g) also provides specific guidance on the application of Sec.  1.482-
6 in the context of controlled services transactions. In particular, 
proposed Sec.  1.482-9(g)(1) provides that a profit split method may be 
appropriate when the controlled services transaction involves either 
high-value services or transactions that are highly integrated and 
cannot be reliably evaluated on a separate basis.
    Proposed Sec.  1.482-6(c)(3)(i)(B) amends the residual profit split 
method in existing Sec.  1.482-6(c)(3). In general, existing Sec.  
1.482-6(c)(3) provides that the residual profit split method allocates 
the combined operating profit or loss from the relevant business 
activity between controlled taxpayers according to a two-step process. 
Operating income first is allocated to each controlled taxpayer to 
provide a market return for its routine contributions to the relevant 
business activity. The residual profit then is divided among the 
controlled taxpayers based upon the relative value of each taxpayer's 
contributions of intangible property. The proposed regulations amend 
existing Sec.  1.482-6(c)(3)(i)(B) by providing that residual profits 
will be divided based on the relative value of each taxpayer's 
``nonroutine contributions,'' which may include contributions of 
intangible property. Proposed Sec.  1.482-6(c)(3)(i)(B) defines 
nonroutine contributions as contributions by controlled taxpayers that 
cannot be accounted for by reference to market returns, or that are so 
interrelated with other transactions that the contributions cannot be 
reliably evaluated on a separate basis. The proposed regulations thus 
make the residual profit split method more suitable in the context of 
services transactions and highly integrated transactions where data 
relating to comparable transactions are unavailable, whether or not 
these transactions involve the technical transfer or use of intangible 
property.
    Proposed Sec.  1.482-9(g)(2) provides examples that illustrate the 
application of the residual profit split method to controlled services 
transactions.
8. Unspecified Methods--Sec.  1.482-9(h)
    Proposed Sec.  1.482-9(h) provides that in addition to the 
specified methods in Sec.  1.482-9(a), an unspecified method may be 
used to determine an arm's length charge if such a method will provide 
the most reliable measure of an arm's length result under the best 
method rule. Proposed Sec.  1.482-9(h) emphasizes that an unspecified 
method should take into account that under the arm's length standard 
uncontrolled taxpayers must compare the terms of a transaction to the 
realistic alternatives to entering into that transaction. Therefore, an 
unspecified method should provide information on the prices or profits 
that the controlled taxpayer might have realized by choosing a 
realistic alternative to the controlled transaction.
    9. Contingent-Payment Contractual Terms--Sec.  1.482-9(i)
    Proposed Sec.  1.482-9(i) provides guidance on the treatment of 
contingent-payment arrangements. The Treasury Department and the IRS 
recognize that controlled taxpayers may allocate the risks associated 
with rendering services in a variety of ways, including by specifying 
that compensation for the services will be paid only in the event that 
the services yield certain results. For example, taxpayers may enter 
into a contingent-payment arrangement that provides that the renderer 
of research and development services will receive compensation only if 
the research and development results in sales of a commercially viable 
product. Proposed Sec.  1.482-9(i) provides specific guidance 
concerning the evaluation of such contractual arrangements in the 
context of controlled services.
    Proposed Sec.  1.482-9(i)(1) provides that the arm's length charge 
in a controlled services transaction is determined taking into account 
any contingent-payment terms. Proposed Sec.  1.482-9(i)(2) provides 
that a contingent-payment arrangement is recognized if the arrangement 
is set forth in a written contract entered into prior to the start of 
the activity; the contract explicitly states that payment is contingent 
upon the happening of a future benefit for the recipient directly 
related to the outcome of the controlled services transaction; and the 
contract provides for payment on a basis that reflects the recipient's 
benefit from the services rendered and the risks borne by the renderer. 
If these three conditions are satisfied, the arm's length result for 
the controlled services transaction ordinarily would not require a 
payment to the renderer if the contingency does not occur. If, on the 
other hand, the contingency occurs, an arm's length result would 
require payment reflecting the recipient's benefit and the risks borne 
by the service renderer.
    The proposed regulations incorporate the principles of existing 
Sec.  1.482-1(d)(3) and provide that a contingent-payment arrangement 
must be reasonable and consistent with the economic substance of the 
parties' conduct, based on all facts and circumstances. Existing Sec.  
1.482-1(d)(3)(ii)(B) provides that in evaluating reasonableness and 
economic substance, all facts and circumstances are relevant, but the 
actual conduct and the respective legal rights of the parties will be 
given greatest weight in the analysis. Proposed Sec.  1.482-9(i)(3) 
confirms explicitly that the Commissioner's authority under existing 
Sec.  1.482-1(d)(3)(ii)(B) to impute contractual terms in appropriate 
cases extends to imputation of contingent-payment terms where such 
terms are consistent with the economic substance of the controlled 
services transaction.
    Proposed Sec.  1.482-9(i)(4) provides that the arm's length charge 
in a contingent-payment arrangement is evaluated in accordance with 
section 1.482-9 and other applicable rules under section 482. In the 
case of an arrangement for the manufacture, construction, or 
development of tangible or intangible property owned by the recipient, 
the arm's length charge determined under the rules of Sec. Sec.  1.482-
3 and 1.482-4 for the transfer of similar property may be considered.
    Examples are provided in proposed Sec.  1.482-9(i)(5) and under 
existing Sec.  1.482-1(d)(3) to illustrate the application of these 
rules.
10. Total Services Costs--Sec.  1.482-9(j)
    Proposed Sec.  1.482-9(j) defines the term ``total services 
costs,'' which is used to determine the arm's length charge under the 
simplified cost-based method, the comparable profits method in cases 
where the ratio of operating profits to total services costs is used as 
the profit level indicator, and in the cost of services plus method in 
cases where an analysis of the result expressed as ratio

[[Page 53456]]

of operating profits to total services costs is necessary. Total 
services costs include all costs that can be directly identified with 
the act of providing the services, as well as all other costs 
reasonably allocable to the services as determined under proposed Sec.  
1.482-9(k). The Treasury Department and the IRS intend the costs 
included to be comprehensive and to comprise full consideration for all 
resources expended, used, or made available to render the service. 
Generally accepted accounting principles or income tax accounting rules 
may provide a useful starting point for determination of total services 
costs, but neither will have conclusive effect. Consistent with the 
current regulations under the comparable profits method, proposed Sec.  
1.482-9(j) excludes certain costs from total services costs, such as 
interest expense and other expenses not related to the controlled 
services transactions.
11. Allocation of Costs--Sec.  1.482-9(k)
    Existing Sec.  1.482-2(b)(3) through (6) provide that costs may be 
allocated and apportioned to a services transaction under ``a method of 
allocation and apportionment which is reasonable and in keeping with 
sound accounting practices.'' Proposed Sec.  1.482-9(k) retains the 
flexible approach of the current rule by allowing any reasonable method 
of allocation and apportionment of costs where such allocation and 
apportionment is relevant to determining an arm's length charge for 
services. In establishing the appropriate method, the proposed 
regulations state that consideration should be given to all bases and 
factors, including the general practices used by taxpayers to apportion 
costs for other purposes. The proposed regulations provide, however, 
that such general practices need not be accorded conclusive weight by 
the Commissioner.
    Proposed Sec.  1.482-9(k)(3) provides examples that illustrate the 
rules regarding the allocation and apportionment of costs.
12. Controlled Services Transactions--Sec.  1.482-9(l)
    Proposed Sec.  1.482-9(l) provides guidance regarding the threshold 
question of whether an activity by one member of a controlled group 
constitutes a controlled services transaction, the arm's length charge 
for which must be determined under proposed Sec.  1.482-9(l). This 
guidance updates and substantially modifies the guidance in existing 
Sec.  1.482-2(b)(3), and brings such guidance more into line with 
international standards in this area.
    a. General Rule--Sec.  1.482-9(l)(1). Proposed Sec.  1.482-9(l)(1) 
provides generally that a controlled services transaction includes any 
activity by one controlled taxpayer that results in a benefit to one or 
more other controlled taxpayers. The terms ``activity'' and ``benefit'' 
are further defined and described in proposed Sec.  1.482-9(l)(2) and 
(3).
    b. Activity--Sec.  1.482-9(l)(2). Proposed Sec.  1.482-9(l)(2) 
defines an activity to include the use by the renderer, or the making 
available to the recipient, of any property or other resources of the 
renderer. The Treasury Department and the IRS intend the broad scope of 
the term activity to allow transactions that are not subject to the 
existing section 482 regulations applicable to other types of 
transactions (e.g., transfers of tangible or intangible property, 
rentals, or loans) to be analyzed under proposed Sec.  1.482-9.
    c. Benefit--Sec.  1.482-9(l)(3)--i. General Rule--Sec.  1.482-
9(l)(3)(i). Proposed Sec.  1.482-9(l)(3) specifies rules for 
determining whether an activity results in a benefit to one or more 
other members of the controlled group. Proposed Sec.  1.482-9(l)(3)(i) 
provides that, in general, an activity is considered to provide a 
benefit to the recipient if the activity directly results in a 
reasonably identifiable increment of economic or commercial value that 
enhances the recipient's commercial position, or that may be reasonably 
anticipated to do so. In cases where an activity may be reasonably 
anticipated to have a particular result or outcome, but that result or 
outcome in fact does not occur, the determination of whether a benefit 
is present is evaluated by reference to what it was reasonable to 
expect at the time the activity was performed.
    Proposed Sec.  1.482-9(l)(3)(i) further provides that an activity 
is generally considered to confer a benefit if an uncontrolled taxpayer 
in circumstances comparable to those of the recipient would be willing 
to pay an uncontrolled party to perform the same or similar activity, 
or if such uncontrolled taxpayer would be willing to perform for itself 
the same or similar activity. This proposed rule would replace the rule 
of existing Sec.  1.482-2(b)(2)(i), which provides that the relevant 
determination is whether an uncontrolled taxpayer in circumstances 
similar to the renderer would charge for the service. The Treasury 
Department and the IRS believe that the approach of the proposed 
regulations is more consistent with the arm's length standard and is 
more in line with international standards in this area. In addition, 
this approach should be substantially easier to administer than the 
standard under existing Sec.  1.482-2(b)(2)(i), which in some cases has 
been interpreted as requiring a difficult analysis of the subjective 
intent of the renderer. While the focus of this aspect of the proposed 
regulations is on the recipient, the determination of the arm's length 
charge may require a focus on the recipient, the renderer, or both, 
depending on the applicable method.
    The proposed regulations and the examples set forth under Sec.  
1.482-9(l)(4) do not adopt a so-called ``general benefit'' approach, 
under which certain activities in a corporate group were presumed to 
generate a benefit to the controlled group as a whole. This general 
benefit approach in some cases has been used to justify a charge to a 
group member for centralized activities performed by a corporate parent 
or service center, whether or not that particular member actually 
receives a benefit from those activities. The Treasury Department and 
the IRS believe that the general benefit concept is inconsistent with 
the arm's length standard. In the controlled group context, the benefit 
analysis appropriately focuses on whether one or more controlled 
parties receive an identifiable benefit from an activity performed by 
another member of the group. Although the proposed regulations do not 
adopt the general benefit approach, in certain cases the allocation or 
sharing among group members of expenses or charges relating to 
corporate headquarters-level activities or other centralized service 
activities may be consistent with the rules of the proposed 
regulations.
    Proposed Sec.  1.482-9(l)(3)(i) clarifies that a benefit is 
received by the owner of an intangible when another controlled taxpayer 
performs an activity that contributes to the development or enhancement 
of the value of that intangible. This provision is consistent with 
proposed Sec.  1.482-4(f)(3) and (4).
    ii. Indirect or Remote Benefits and Duplicative Activities--Sec.  
1.482-9(l)(3)(ii) and (iii). Proposed Sec.  1.482-9(l)(3)(ii) and (iii) 
retain, with modifications, two concepts that also appear in the 
existing regulations. First, an activity does not result in a benefit 
to the extent that the activity produces only indirect or remote 
benefits. Second, an activity does not produce a benefit where the 
underlying activity is duplicative of an activity performed by the 
putative recipient.
    Under proposed Sec.  1.482-9(l)(3)(ii), an activity produces an 
indirect or remote benefit only if that activity is one for which an 
uncontrolled taxpayer

[[Page 53457]]

operating under similar conditions would not be willing to pay, or 
would not itself undertake. Consistent with the general approach in 
proposed Sec.  1.482-9(l)(3)(i), the determination of whether a benefit 
is indirect or remote focuses on the recipient.
    Under proposed Sec.  1.482-9(l)(3)(iii), an activity that is 
duplicative of an activity performed by another controlled taxpayer 
generally will not be considered to provide a benefit unless it yields 
an identifiable, additional benefit to one or more members of the 
controlled group.
    iii. Shareholder Activities--Sec.  1.482-9(l)(3)(iv). Substantial 
controversy has arisen under the existing regulations concerning 
whether activities performed by an owner-member in a controlled group 
may be classified as shareholder or stewardship activities that benefit 
the owner-member that renders such services and not other controlled 
parties. Stewardship or shareholder activities are activities performed 
by reason of or on account of the renderer's status as a shareholder or 
as an investor of capital. The existing regulations do not provide 
specific guidance with respect to these issues.
    Proposed Sec.  1.482-9(l)(3)(iv) provides that an activity whose 
primary benefit is to protect the renderer's capital investment in one 
or more members of the controlled group, or an activity relating 
primarily to compliance by the renderer with reporting, legal, or 
regulatory requirements applicable specifically to the renderer, will 
not be considered to provide a benefit to another member of the 
controlled group. The proposed regulations further provide that 
activities in the nature of day-to-day management generally do not 
relate to the protection of the renderer's capital investment, and that 
activities performed in connection with a corporate reorganization 
(including payments to unrelated service providers) may be considered 
to provide a benefit to one or more controlled taxpayers.
    In the view of the Treasury Department and the IRS, the relatively 
narrow definition of shareholder activities in the proposed regulations 
reflects the arm's length standard and is consistent with particular 
international standards in this area. The Treasury Department and the 
IRS recognize that there are a wide range of activities and factual 
scenarios within a multinational group to which this guidance will 
apply. For example, if an activity is performed in order to comply with 
legal requirements applicable to shareholders, or in order to preserve 
or safeguard the controlled taxpayer's equity investment in a 
subsidiary, such an activity should be properly viewed as a shareholder 
activity. It may be appropriate to conclude that other activities also 
provide no benefit to other members of the controlled group, but such 
conclusion would be based on a detailed analysis of the facts and 
circumstances.
    iv. Passive Association--Sec.  1.482-9(l)(3)(v). Proposed Sec.  
1.482-9(l)(3)(v) provides that a member of a controlled group that 
obtains a benefit solely on account of its status as a member of the 
group (for example, by obtaining favorable commercial terms from an 
uncontrolled party by reason of its membership in the controlled group) 
is generally not considered to receive a benefit. A controlled 
taxpayer's status as a member of a controlled group may, however, be 
considered in evaluating comparability between controlled and 
uncontrolled transactions.
    d. Examples--Sec.  1.482-9(l)(4). Proposed Sec.  1.482-9(l)(4) 
provides a significant number of examples to illustrate the rules of 
Sec.  1.482-9(l). Like all examples in the proposed regulations, these 
examples are limited to an application of the substantive rules of the 
proposed regulations to the specific facts contained therein.
13. Coordination With Other Transfer Pricing Rules--Sec.  1.482-9(m)
    Proposed Sec.  1.482-9(m) provides rules to coordinate the rules 
applicable to services with rules applicable to other categories of 
transactions under section 482. Generally, the section 482 regulations 
set forth specific transfer pricing methods for evaluating the results 
of controlled transactions under the arm's length standard. Certain 
methods apply only to specific types of transactions, while other 
methods apply more generally. Selection of a method for a particular 
type of transaction is subject to the best method rule of existing 
Sec.  1.482-1(c)(1), which states that the method selected should 
provide the most reliable measure of an arm's length result. The 
proposed regulations include coordination provisions that provide 
guidance on selection of an appropriate transfer pricing method when a 
controlled services transaction is combined with or has elements of 
another type of transaction. The proposed regulations provide examples 
that illustrate the application of these rules.
    a. Services Transactions That Include Other Types of Transactions--
Sec.  1.482-9(m)(1). A transaction structured as a services transaction 
may also include elements comprising a different type of transaction. 
In the case of such an integrated transaction, proposed Sec.  1.482-
9(m)(1) provides that whether the integrated transaction may be 
evaluated by use of the transfer pricing methods in proposed Sec.  
1.482-9 or whether one or more elements of the transaction should be 
evaluated separately under the methods in other section 482 regulations 
depends on which approach will provide the most reliable measure of an 
arm's length result. In cases where the non-services element of an 
integrated transaction may be adequately accounted for in evaluating 
the comparability of the controlled transaction to the uncontrolled 
comparables, the integrated transaction may be adequately evaluated 
under a single method provided under Sec.  1.482-9.
    b. Services Transactions That Effect a Transfer of Intangible 
Property--Sec.  1.482-9(m)(2). A transaction structured as a services 
transaction may result in a transfer of intangible property, may have 
an effect similar to the transfer of intangible property, or may 
include an element that constitutes the transfer of intangible 
property. In such cases, proposed Sec.  1.482-9(m)(2) provides that if 
the element that relates to the transfer of intangible property is 
material to the evaluation of the transaction, the arm's length result 
with respect to such element must be either determined under or 
corroborated by reference to a method under existing Sec.  1.482-4. The 
Treasury Department and the IRS believe that it is critical that 
economically similar transactions, in particular transactions that 
effect the transfer of intangible property, be evaluated consistently 
under the transfer pricing regulations.
    c. Services Subject to a Qualified Cost Sharing Arrangement--Sec.  
1.482-9(m)(3). Proposed Sec.  1.482-9(m)(3) provides that services 
provided by a controlled participant under a qualified cost sharing 
arrangement are subject to existing Sec.  1.482-7. The Treasury 
Department and the IRS are reviewing the current regulatory guidance 
related to qualified cost sharing arrangements, and intend to issue 
proposed regulations in the near term.
    d. Other Types of Transaction That Include a Services Transaction--
Sec.  1.482-9(m)(4). A transaction structured as a transaction other 
than a services transaction may also include elements comprising a 
services transaction. In the case of such an integrated transaction, 
proposed Sec.  1.482-9(m)(4) provides rules to determine the manner in 
which such integrated transactions should be evaluated that are similar 
to the rules in proposed Sec.  1.482-9(m)(1) provided for

[[Page 53458]]

integrated transactions structured as services transactions.
    e. Global Dealing Operations--Sec.  1.482-9(m)(5). Under proposed 
Sec.  1.482-9(m)(5), guidance concerning the treatment of global 
dealing operations is reserved, pending the issuance of transfer 
pricing guidance specifically applicable to global dealing operations.

C. Income Attributable to Intangibles--Sec.  1.482-4(f)(3) and (4)

    The proposed regulations would replace the provisions of Sec.  
1.482-4(f)(3), relating to the allocation of income from intangibles, 
with proposed Sec.  1.482-4(f)(3) and (4).
1. Ownership of Intangible Property--Sec.  1.482-4(f)(3)
    Proposed Sec.  1.482-4(f)(3)(i)(A) provides guidance for 
determining the owner of an intangible. In general, the owner is the 
taxpayer identified as the owner of an intangible under the 
intellectual property laws of the relevant jurisdiction, or the 
taxpayer that holds rights constituting an intangible in accordance 
with contractual terms or other legal provision. For example, in the 
case of a typical license of an intangible between controlled parties, 
the proposed regulations treat the licensee as the owner of contractual 
rights pursuant to the license, and the licensor as the owner of the 
intangible subject to the license. The identification of a single owner 
for each discrete intangible replaces the provision in the existing 
regulations that under certain circumstances could be read to provide 
for multiple owners of an intangible. See existing Sec.  1.482-
4(f)(3)(i) and Sec.  1.482-4(f)(3)(iv), Example 4. The ownership of an 
intangible must in all cases accord with the economic substance of the 
underlying transaction. See Sec.  1.482-1(d)(3). In the case of 
intangible property for which no owner can be identified under 
intellectual property law, contractual terms, or other legal provision, 
the owner will be the controlled taxpayer that has control of the 
intangible, based on all the facts and circumstances.
    Proposed Sec.  1.482-4(f)(3)(i)(B) generally excludes from the 
rules of proposed Sec.  1.482-4(f)(3)(i)(A) intangibles subject to the 
cost sharing provisions of Sec.  1.482-7. The Treasury Department and 
the IRS are reviewing the current regulatory guidance related to 
qualified cost sharing arrangements, and intend to issue proposed 
regulations in the near term.
    Proposed Sec.  1.482-4(f)(3) does not include the rules in the 
existing regulations for allocations with respect to assistance 
provided to the owner of intangible property. These rules, in modified 
form, are provided in proposed Sec.  1.482-4(f)(4).
2. Contributions To Develop or Enhance an Intangible--Sec.  1.482-
4(f)(4)
    Proposed Sec.  1.482-4(f)(4)(i) provides that the arm's length 
consideration for a contribution by one controlled taxpayer to develop 
or enhance an intangible owned by another controlled taxpayer must be 
determined under the applicable rules of section 482.
    The section 482 regulations generally give effect to the 
contractual terms specified for controlled transactions. Consistent 
with this principle, proposed Sec.  1.482-4(f)(4)(i) also provides 
rules for situations where controlled taxpayers ``embed'' compensation 
for a contribution in the contractual terms of a transaction involving 
an intangible. For instance, under a typical intangible license between 
controlled parties the licensee may render marketing services that are 
anticipated to enhance the intangible owned by the licensor. The 
licensor may compensate such services through a separately stated fee, 
or such compensation may be embedded within the royalty paid by the 
licensee (i.e., through reduction of the royalty). In addition, the 
licensee may undertake marketing activities that are anticipated to 
enhance the value of its rights to exploit its license. Such activities 
do not require compensation by the licensor.
    Proposed Sec.  1.482-4(f)(4)(i) provides that ordinarily no 
separate allocation is appropriate where compensation for a 
contribution is embedded within the terms of a related controlled 
transaction. The contribution, however, must be taken into account in 
evaluating the comparability of the controlled transaction to any 
uncontrolled comparables and in determining the arm's length 
consideration for the controlled transaction that includes the embedded 
contribution. This rule is intended to reach a result that is implicit 
under the existing regulations.
    In some cases, this rule may operate in conjunction with Sec.  
1.482-3(f), which deals with transfers of tangible property that 
contains an embedded intangible. For example, in a typical distribution 
arrangement for the resale of trademarked goods, the distributor may 
perform marketing services that are not separately compensated. In such 
a case, ordinarily no separate allocation would be appropriate with 
respect to either the embedded trademark or the embedded marketing 
services. These embedded elements, however, must be taken into account 
in evaluating the comparability of the controlled transfer to any 
uncontrolled comparables and in determining the arm's length 
consideration for the intercompany sale of the trademarked goods. See 
proposed Sec.  1.482-4(f)(4)(ii), Example 2.
    The Treasury Department and the IRS intend that this rule 
pertaining to contributions to develop or enhance an intangible will 
provide a clearer framework for analysis than existing Sec.  1.482-
4(f)(3), particularly where controlled taxpayers document the relevant 
transactions in advance and act in accordance with the documentation. 
In this regard, the proposed regulations are intended to encourage 
controlled taxpayers to document such transactions contemporaneously 
and consistently over time.
    Examples in proposed Sec.  1.482-4(f)(4)(ii) illustrate the 
application of proposed Sec.  1.482-4(f)(4) to a range of transactions 
involving contributions to develop or enhance an intangible.

D. Contractual Terms Imputed From Economic Substance--Sec.  1.482-
1(d)(3)(ii)(C), Examples 3, 4, and 5

    The proposed regulations recognize that controlled taxpayers have 
considerable flexibility to specify the contractual terms regarding 
contributions to develop or enhance an intangible. The Commissioner 
generally will give effect to these contractual terms for Federal 
income tax purposes, provided that they are consistent with the 
economic substance of the parties' conduct. On the other hand, if the 
controlled taxpayer fails to specify contractual terms for a 
transaction, or if the stated terms do not accord with the economic 
substance of the underlying activities, the Commissioner may impute 
contractual terms that are consistent with the economic substance of 
the underlying transactions. See Sec.  1.482-1(d)(3).
    Proposed Example 3, Example 4, and Example 5 in Sec.  1.482-
1(d)(3)(ii)(C) illustrate scenarios in which the Commissioner may 
impute contractual terms based on the principles in proposed Sec.  
1.482-4(f)(3) and (f)(4) and proposed Sec.  1.482-9. These new examples 
illustrate the imputation of contractual terms in cases where 
controlled taxpayers fail to specify contractual terms or where the 
contractual terms specified do not accord with economic substance.

E. Conforming Changes to Other Provisions

    In view of the proposed changes described above, conforming changes 
to Sec. Sec.  1.482-0 through -2, 1.6038A-3, 1.6662-6(g), and 
31.3121(s)-1 are

[[Page 53459]]

necessary. Proposed amendments to these provisions are set forth in 
this document. In addition, the Treasury Department and the IRS are 
considering the extent to which changes to Sec.  1.861-8(e)(4), which 
provides guidance regarding expenses attributable to dividends received 
and which refers to the existing services regulations, may be 
appropriate to improve the coordination of that regulation with the 
transfer pricing regulations.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and because 
these regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f), this notice of proposed rulemaking 
will be submitted to the Chief Counsel for Advocacy of the Small 
Business Administration for comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any electronic or written comments (a 
signed original and eight (8) copies) that are submitted timely to the 
IRS. The Treasury Department and the IRS specifically request comments 
on the clarity of the proposed regulations and how they may be made 
easier to understand. All comments will be available for public 
inspection and copying.
    A public hearing has been scheduled for January 14, 2004, at 10 
a.m., in the auditorium, Internal Revenue Building, 1111 Constitution 
Avenue, NW, Washington, DC. Due to building security procedures, 
visitors must enter at the Constitution Avenue entrance. In addition, 
all visitors must present photo identification to enter the building. 
Because of access restrictions, visitors will not be admitted beyond 
the immediate entrance more than 30 minutes before the hearing starts. 
For information about having your name placed on the building access 
list to attend the hearing, see the FOR FURTHER INFORMATION CONTACT 
section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit electronic or 
written comments and an outline of the topics to be discussed and the 
time to be devoted to each topic (signed original and eight (8) copies) 
by December 23, 2003. A period of 10 minutes will be allotted to each 
person for making comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal authors of these proposed regulations are J. Peter 
Luedtke and Helen Hong-George of the Office of Chief Counsel 
(International). However, other personnel from the Treasury Department 
and the IRS participated in their development.

List of Subjects

26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 31

    Employment taxes, Income taxes, Penalties, Pensions, Railroad 
retirement, Reporting and recordkeeping requirements, Social security, 
Unemployment compensation.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR parts 1 and 31 are proposed to be amended as 
follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 is amended by adding 
an entry in numerical order to read in part as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.482-9 also issued under 26 U.S.C. 482. * * *

    Par. 2. Section 1.482-0 is amended by:
    1. Revising the section heading.
    2. Removing the entries for Sec.  1.482-2(b) and adding a new entry 
in its place.
    3. Revising the entries for Sec.  1.482-4(f)(3), (f)(4) and (f)(5) 
and adding new entries for Sec.  1.482-4(f)(6).
    4. Adding new entries for Sec. Sec.  1.482-6(c)(3)(i)(B)(1) and (2) 
and 1.482-9.
    The additions and revisions read as follows:


Sec.  1.482-0  Outline of regulations under section 482.

* * * * *

Sec.  1.482-2 Determination of taxable income in specific 
situations.

* * * * *
    (b) Rendering of services.
* * * * *

Sec.  1.482-4 Methods to determine taxable income in connection 
with a transfer of intangible property.

* * * * *
    (f) * * *
    (3) Ownership of intangible property.
    (i) Identification of owner.
    (A) In general.
    (B) Cost sharing arrangements.
    (ii) Examples.
    (4) Contribution to the value of an intangible owned by another.
    (i) In general.
    (ii) Examples.
    (5) Consideration not artificially limited.
    (6) Lump-sum payments.
    (i) In general.
    (ii) Exceptions.
    (iii) Example.

Sec.  1.482-6 Profit split method.

* * * * *
    (c) * * *
    (3) * * *
    (i) In general. * * *
    (B) Allocate residual profit.
    (1) Nonroutine contributions generally.
    (2) Nonroutine contributions of intangible property.

Sec.  1.482-9 Methods to determine taxable income in connection 
with a controlled services transaction.

    (a) In general.
    (b) Comparable uncontrolled services price method.
    (1) In general.
    (2) Comparability and reliability considerations.
    (i) In general.
    (ii) Comparability.
    (A) In general.
    (B) Adjustments for differences between controlled and 
uncontrolled transactions.
    (iii) Data and assumptions.
    (3) Arm's length range.
    (4) Examples.
    (5) Indirect evidence of the price of a comparable uncontrolled 
services transaction.
    (i) In general.
    (ii) Example.
    (c) Gross services margin method.
    (1) In general.
    (2) Determination of arm's length price.
    (i) In general.
    (ii) Related uncontrolled transaction.
    (iii) Applicable uncontrolled price.
    (iv) Appropriate gross services profit.
    (v) Arm's length range.
    (3) Comparability and reliability considerations.
    (i) In general.
    (ii) Comparability.
    (A) Functional comparability.
    (B) Other comparability factors.
    (C) Adjustments for differences between controlled and 
uncontrolled transactions.
    (D) Buy-sell distributor.
    (iii) Data and assumptions.
    (A) In general.
    (B) Consistency in accounting.
    (4) Examples.
    (d) Cost of services plus method.
    (1) In general.
    (2) Determination of arm's length price.

[[Page 53460]]

    (i) In general.
    (ii) Appropriate gross services profit.
    (iii) Comparable transactional costs.
    (iv) Arm's length range.
    (3) Comparability and reliability considerations.
    (i) In general.
    (ii) Comparability.
    (A) Functional comparability.
    (B) Other comparability factors.
    (C) Adjustments for differences between the controlled and 
uncontrolled transactions.
    (iii) Data and assumptions.
    (A) In general.
    (B) Consistency in accounting.
    (4) Examples.
    (e) Comparable profits method.
    (1) In general.
    (2) Determination of arm's length result.
    (i) Tested party.
    (ii) Profit level indicators.
    (iii) Comparability and reliability considerations--Data and 
assumptions--Consistency in accounting.
    (3) Examples.
    (f) Simplified cost-based method for certain services.
    (1) Evaluation of arm's length charge.
    (i) In general.
    (ii) Coordination with best method rule.
    (2) Limitation on allocations by Commissioner.
    (i) In general.
    (ii) Applicable number of percentage points.
    (iii) Method inapplicable to high-margin transactions.
    (iv) Measurement of limitations on allocations.
    (v) Scope of limitation on allocations by the Commissioner.
    (A) Loss transactions and transactions priced in excess of arm's 
length.
    (B) Allocation and apportionment of costs.
    (3) Conditions on application of simplified cost-based method.
    (i) Adequate books and records.
    (ii) Written contract.
    (A) In general.
    (B) De minimis exception.
    (4) Transactions not eligible for simplified cost-based method.
    (i) Services similar to services provided by renderer or 
recipient to uncontrolled parties.
    (ii) Services rendered to a recipient that receives services 
from controlled taxpayers in significant amounts.
    (iii) Services involving the use of intangible property.
    (iv) Non-services transactions included in integrated 
transactions.
    (v) Certain transactions.
    (5) Examples.
    (g) Profit split method.
    (1) In general.
    (2) Examples.
    (h) Unspecified methods.
    (i) Contingent-payment contractual terms for services.
    (1) Economic substance of contingent payment contractual terms 
recognized.
    (2) Contingent-payment arrangement.
    (i) Written contract.
    (ii) Specified contingency.
    (iii) Basis for payment.
    (3) Commissioner's authority to impute contingent-payment terms.
    (4) Evaluation of arm's length charge.
    (5) Examples.
    (j) Total services costs.
    (k) Allocation of costs.
    (1) In general.
    (2) Appropriate method of allocation and apportionment.
    (i) Reasonable method standard.
    (ii) Use of general practices.
    (3) Examples.
    (l) Controlled services transaction.
    (1) In general.
    (2) Activity.
    (3) Benefit.
    (i) In general.
    (ii) Indirect or remote benefit.
    (iii) Duplicative activities.
    (iv) Shareholder activities.
    (v) Passive association.
    (4) Examples.
    (m) Coordination with transfer pricing rules for other 
transactions.
    (1) Services transactions that include other types of 
transactions.
    (2) Services transactions that effect a transfer of intangible 
property.
    (3) Services subject to a qualified cost sharing arrangement.
    (4) Other types of transactions that include controlled services 
transactions.
    (5) Global dealing operations.
    (6) Examples.
    (n) Effective date.

    Par. 3. Section 1.482-1 is amended by:
    1. Revising paragraphs (a)(1), (b)(2)(i), (d)(3)(ii)(C) Example 3, 
(f)(2)(iii)(B), (g)(4)(i), the first two sentences in paragraph 
(g)(4)(iii) Example 1, and paragraph (i) introductory text.
    2. Adding paragraph (d)(3)(ii)(C), Example 4 and Example 5.
    3. Adding a sentence at the end of paragraph (d)(3)(v).
    The additions and revisions read as follows:


Sec.  1.482-1  Allocation of income and deductions among taxpayers.

    (a) In general--(1) Purpose and scope. The purpose of section 482 
is to ensure that taxpayers clearly reflect income attributable to 
controlled transactions, and to prevent the avoidance of taxes with 
respect to such transactions. Section 482 places a controlled taxpayer 
on a tax parity with an uncontrolled taxpayer by determining the true 
taxable income of the controlled taxpayer. This section sets forth 
general principles and guidelines to be followed under section 482. 
Section 1.482-2 provides rules for the determination of the true 
taxable income of controlled taxpayers in specific situations, 
including controlled transactions involving loans or advances or the 
use of tangible property. Sections 1.482-3 through 1.482-6 provide 
rules for the determination of the true taxable income of controlled 
taxpayers in cases involving the transfer of property. Section 1.482-7T 
sets forth the cost sharing provisions applicable to taxable years 
beginning on or after October 6, 1994, and before January 1, 1996. 
Section 1.482-7 sets forth the cost sharing provisions applicable to 
taxable years beginning on or after January 1, 1996. Section 1.482-8 
provides examples illustrating the application of the best method rule. 
Finally, Sec.  1.482-9 provides rules for the determination of the true 
taxable income of controlled taxpayers in cases involving the 
performance of services.
* * * * *
    (b) * * *
    (2) Arm's length methods--(i) Methods. Sections 1.482-2 through 
1.482-6 and Sec.  1.482-9 provide specific methods to be used to 
evaluate whether transactions between or among members of the 
controlled group satisfy the arm's length standard and if they do not 
to determine the arm's length result. Section 1.482-7 provides the 
specific method to be used to evaluate whether a qualified cost sharing 
arrangement produces results consistent with an arm's length result.
* * * * *
    (d) * * *
    (3) * * *
    (ii) * * *
    (C) * * *
    Example 3. Contractual terms imputed from economic substance. 
(i) FP, a foreign producer of wristwatches, is the registered holder 
of the YY trademark in the United States and in other countries 
worldwide. In Year 1, FP enters the U.S. market by selling YY 
wristwatches to its newly organized U.S. subsidiary, USSub, for 
distribution in the U.S. market. USSub pays FP a fixed price per 
wristwatch, and USSub and FP undertake without separate compensation 
marketing activities to establish the YY trademark in the U.S. 
market. Unrelated foreign producers of trademarked wristwatches and 
U.S. distributors respectively undertake similar marketing 
activities in independent arrangements involving distribution of 
trademarked wristwatches in the U.S. market. In Years 1 through 6, 
USSub markets and sells YY wristwatches in the United States. 
Further, in Years 1 through 6, USSub undertakes incremental 
marketing activities in addition to the activities similar to those 
observed in the independent distribution transactions in the U.S. 
market. FP does not directly or indirectly compensate USSub for 
performing these incremental activities during Years 1 through 6. 
Assume that, aside from these incremental activities, and after any 
adjustments are made to improve the reliability of the comparison, 
the price paid per wristwatch by the independent distributors for 
wristwatches would provide the most reliable measure of the arm's 
length price paid per YY wristwatch by USSub.
    (ii) By Year 7, the wristwatches with the YY trademark generate 
a premium return in the U.S. market, as compared to wristwatches 
marketed by the independent distributors. In

[[Page 53461]]

Year 7, substantially all the premium return from the YY trademark 
in the U.S. market is attributed to FP, for example through an 
increase in the price paid per watch by USSub, or by some other 
means.
    (iii) In determining whether an allocation of income is 
appropriate in Year 7, the Commissioner may consider the economic 
substance of the arrangements between USSub and FP, and the parties' 
course of conduct throughout their relationship. Based on this 
analysis, the Commissioner determines that it is unlikely that, ex 
ante, an uncontrolled taxpayer operating at arm's length would 
engage in marketing activities to develop or enhance an intangible 
owned by another party unless it received contemporaneous 
compensation or otherwise had a reasonable anticipation of receiving 
a future benefit from those activities. In this case, USSub's 
undertaking the incremental marketing activities in Years 1 through 
6 is a course of conduct that is inconsistent with the parties' 
attribution to FP in Year 7 of substantially all the premium return 
from the enhanced YY trademark in the United States market. 
Therefore, the Commissioner may impute one or more agreements 
between USSub and FP, consistent with the economic substance of 
their course of conduct, which would afford USSub an appropriate 
portion of the premium return from the YY trademark wristwatches. 
For example, the Commissioner may impute a separate services 
agreement that affords USSub contingent-payment compensation for its 
incremental marketing activities in Years 1 through 6, which 
benefited FP by contributing to the value of the trademark owned by 
FP. In the alternative, the Commissioner may impute a long-term 
exclusive U.S. distribution agreement to exploit the YY trademark 
that allows USSub to benefit from the incremental marketing 
activities it performed. As another alternative, the Commissioner 
may require FP to compensate USSub for terminating USSub's imputed 
long-term distribution agreement, an agreement that USSub made more 
valuable at its own expense and risk. The taxpayer may present 
additional facts that could indicate which of these or other 
alternative agreements best reflects the economic substance of the 
underlying transactions, consistent with the parties' course of 
conduct in the particular case.
    Example 4. Contractual terms imputed from economic substance. 
(i) FP, a foreign producer of athletic gear, is the registered 
holder of the AA trademark in the United States and in other 
countries worldwide. In Year 1, FP licenses to its newly organized 
U.S. subsidiary, USSub, exclusive rights to certain manufacturing 
and marketing intangibles (including the AA trademark) for purposes 
of manufacturing and marketing athletic gear in the United States 
under the AA trademark. The contractual terms obligate USSub to pay 
FP a royalty based on sales, and obligate both FP and USSub to 
undertake without separate compensation specified types and levels 
of marketing activities. Unrelated foreign businesses license 
independent U.S. businesses to manufacture and market athletic gear 
in the United States, using trademarks owned by the unrelated 
foreign businesses. The contractual terms of these uncontrolled 
transactions require the licensees to pay royalties based on sales 
of the merchandise, and obligate the licensors and licensees to 
undertake without separate compensation specified types and levels 
of marketing activities. In Years 1 through 6, USSub manufactures 
and sells athletic gear under the AA trademark in the United States. 
Assume that, after adjustments are made to improve the reliability 
of the comparison for any material differences relating to marketing 
activities, manufacturing or marketing intangibles, and other 
comparability factors, the royalties paid by independent licensees 
would provide the most reliable measure of the arm's length royalty 
owed by USSub to FP, apart from the additional facts.
    (ii) In Years 1 through 6, USSub performs incremental marketing 
activities with respect to the AA trademark athletic gear, in 
addition to the activities required under the terms of the license 
agreement. FP does not directly or indirectly compensate USSub for 
performing these incremental activities during Years 1 through 6. By 
Year 7, AA trademark athletic gear generates a premium return in the 
United States, as compared to similar athletic gear marketed by 
independent licensees. In Year 7, USSub and FP enter into a separate 
services agreement under which FP agrees to compensate USSub on a 
cost basis for the incremental marketing activities that USSub 
performed during Years 1 through 6, and to compensate USSub on a 
cost basis for any incremental marketing activities it may perform 
in Year 7 and thereafter. In addition, the parties revise the 
license agreement executed in Year 1, and increase the royalty to a 
level that attributes to FP substantially all the premium return 
from sales of the AA trademark athletic gear in the United States.
    (iii) In determining whether an allocation of income is 
appropriate in Year 7, the Commissioner may consider the economic 
substance of the arrangements between USSub and FP and the parties' 
course of conduct throughout their relationship. Based on this 
analysis, the Commissioner determines that it is unlikely that, ex 
ante, an uncontrolled taxpayer operating at arm's length would 
engage in incremental marketing activities to develop or enhance an 
intangible owned by another party unless it received contemporaneous 
compensation or otherwise had a reasonable anticipation of a future 
benefit. In this case, USSub's undertaking the incremental marketing 
activities in Years 1 through 6 is a course of conduct that is 
inconsistent with the parties' adoption in Year 7 of contractual 
terms whereby FP compensates USSub on a cost basis for the 
incremental marketing activities that it performed. Therefore, the 
Commissioner may impute one or more agreements between USSub and FP, 
consistent with the economic substance of their course of conduct, 
which would afford USSub an appropriate portion of the premium 
return from the AA trademark athletic gear. For example, the 
Commissioner may impute a separate services agreement that affords 
USSub contingent-payment compensation for the incremental activities 
it performed during Years 1 through 6, which benefited FP by 
contributing to the value of the trademark owned by FP. In the 
alternative, the Commissioner may impute a long-term exclusive U.S. 
license agreement that allows USSub to benefit from the incremental 
activities. As another alternative, the Commissioner may require FP 
to compensate USSub for terminating USSub's imputed long-term U.S. 
license agreement, a license that USSub made more valuable at its 
own expense and risk. The taxpayer may present additional facts that 
could indicate which of these or other alternative agreements best 
reflects the economic substance of the underlying transactions, 
consistent with the parties' course of conduct in this particular 
case.

    Example 5. Contractual terms imputed from economic substance. 
(i) Company X is a member of a controlled group that has been in 
operation in the pharmaceutical sector for many years. In Years 1 
through 4, Company X undertakes research and development activities. 
As a result of those activities, a compound is developed that may be 
more effective than existing medications in the treatment of certain 
conditions.
    (ii) Company Y is acquired in Year 4 by the controlled group 
that includes Company X. Once Company Y is acquired, patent rights 
with respect to the compound in several jurisdictions are registered 
by Company Y, making Company Y the legal owner of such patents.
    (iii) In determining whether an allocation is appropriate in 
Year 4, the Commissioner may consider the economic substance of the 
arrangements between Company X and Company Y, and the parties' 
course of conduct throughout their relationship. Based on this 
analysis, the Commissioner determines that it is unlikely that, ex 
ante, an uncontrolled taxpayer operating at arm's length would 
engage in research and development activities to develop a 
patentable compound to be registered by another party unless it 
received contemporaneous compensation or otherwise had a reasonable 
anticipation of receiving a future benefit from those activities. In 
this case, Company X's undertaking the research and development 
activities is inconsistent with the registration of the patent by 
Company Y. Therefore, the Commissioner may impute one or more 
agreements between Company X and Company Y consistent with the 
economic substance of their course of conduct, which would afford 
Company X an appropriate portion of the premium return from the 
patent rights. For example, the Commissioner may impute a separate 
services agreement that affords Company X contingent-payment 
compensation for its research and development activities in Years 1 
through 4, which benefited Company Y by creating and further 
contributing to the value of the patent rights ultimately registered 
by Company Y. In the alternative, the Commissioner may impute a 
transfer of patentable intangible rights from Company X to Company Y 
immediately preceding the registration of patent rights by Company 
Y. The taxpayer may present additional facts that could indicate 
which of these or other alternative agreements best reflects the 
economic substance of the underlying

[[Page 53462]]

transactions, consistent with the parties' course of conduct in the 
particular case.

* * * * *
    (v) * * * See Sec.  1.482-9(m).
* * * * *
    (f) * * *
    (2) * * *
    (iii) * * *
    (B) Circumstances warranting consideration of multiple year data. 
The extent to which it is appropriate to consider multiple year data 
depends on the method being applied and the issue being addressed. 
Circumstances that may warrant consideration of data from multiple 
years include the extent to which complete and accurate data is 
available for the taxable year under review, the effect of business 
cycles in the controlled taxpayer's industry, or the effects of life 
cycles of the product or intangible being examined. Data from one or 
more years before or after the taxable year under review must 
ordinarily be considered for purposes of applying the provisions of 
paragraph (d)(3)(iii) of this section (Risk), paragraph (d)(4)(i) of 
this section (Market share strategy), Sec.  1.482-4(f)(2) (Periodic 
adjustments), Sec.  1.482-5 (Comparable profits method), Sec.  1.482-
9(e) (Comparable profits method for services), Sec.  1.482-9(f) 
(Simplified cost-based method for services), and Sec.  1.482-9(i) 
(Contingent-payment contractual terms for services). On the other hand, 
multiple year data ordinarily will not be considered for purposes of 
applying the comparable uncontrolled price method of Sec.  1.482-3(b) 
or the comparable uncontrolled services price method of Sec.  1.482-
9(b) (except to the extent that risk or market share strategy issues 
are present).
* * * * *
    (g) * * *
    (4) Setoffs--(i) In general. If an allocation is made under section 
482 with respect to a transaction between controlled taxpayers, the 
Commissioner will take into account the effect of any other non-arm's 
length transaction between the same controlled taxpayers in the same 
taxable year which will result in a setoff against the original section 
482 allocation. Such setoff, however, will be taken into account only 
if the requirements of paragraph (g)(4)(ii) of this section are 
satisfied. If the effect of the setoff is to change the 
characterization or source of the income or deductions, or otherwise 
distort taxable income, in such a manner as to affect the U.S. tax 
liability of any member, adjustments will be made to reflect the 
correct amount of each category of income or deductions. For purposes 
of this setoff provision, the term arm's length refers to the amount 
defined in paragraph (b) of this section (Arm's length standard), 
without regard to the rules in Sec.  1.482-2(a) that treat certain 
interest rates as arm's length rates of interest.
* * * * *
    (iii) Examples. * * *

    Example 1. P, a U.S. corporation, renders construction services 
to S, its foreign subsidiary in Country Y, in connection with the 
construction of S's factory. An arm's length charge for such 
services determined under Sec.  1.482-9 would be $100,000. * * *

* * * * *
    (i) Definitions. The definitions set forth in paragraphs (i)(1) 
through (i)(10) of this section apply to this Sec. Sec.  1.482-1 
through 1.482-9.
* * * * *
    Par. 4. Section 1.482-2(b) is revised to read as follows:


Sec.  1.482-2  Determination of taxable income in specific situations.

* * * * *
    (b) Rendering of services. For rules governing allocations under 
section 482 to reflect an arm's length charge for controlled 
transactions involving the rendering of services, see Sec.  1.482-9.
* * * * *
    Par. 5. Section 1.482-4 is amended by:
    1. Redesignating paragraphs (f)(4) and (f)(5) as paragraphs (f)(5) 
and (f)(6), respectively.
    2. Revising paragraph (f)(3) and adding new paragraph (f)(4). The 
revisions and additions read as follows.


Sec.  1.482-4  Methods to determine taxable income in connection with a 
transfer of intangible property.

* * * * *
    (f) * * *
    (3) Ownership of intangible property--(i) Identification of owner--
(A) In general. The legal owner of an intangible pursuant to the 
intellectual property law of the relevant jurisdiction, or the holder 
of rights constituting an intangible pursuant to contractual terms 
(such as the terms of a license) or other legal provision, will be 
considered the sole owner of the respective intangible for purposes of 
this section unless such ownership is inconsistent with the economic 
substance of the underlying transactions. See Sec.  1.482-
1(d)(3)(ii)(B) (Identifying contractual terms). If no owner of the 
respective intangible is identified under the intellectual property law 
of the relevant jurisdiction, or pursuant to contractual terms 
(including terms imputed pursuant to Sec.  1.482-1(d)(3)(ii)(B)) or 
other legal provision, then the controlled taxpayer who has control of 
the intangible, based on all the facts and circumstances, will be 
considered the sole owner of the intangible for purposes of this 
section.
    (B) Cost sharing arrangements. The rule in paragraph (f)(3)(i)(A) 
of this section shall apply to interests in covered intangibles, as 
defined in Sec.  1.482-7(b)(4)(iv), only as provided in Sec.  1.482-7 
(Sharing of costs).
    (ii) Examples. The principles of this paragraph (f)(3) are 
illustrated by the following examples:

    Example 1. FP, a foreign corporation, is the registered holder 
of the AA trademark in the United States. FP licenses to a U.S. 
subsidiary, USSub, the exclusive rights to manufacture and market 
products in the United States under the AA trademark. FP is the 
owner of the trademark pursuant to intellectual property law. USSub 
is the owner of the license pursuant to the contractual terms of the 
license, but is not the owner of the trademark. See paragraphs 
(b)(3) and (4) of this section (defining an intangible as, among 
other things, a trademark or a license).
    Example 2. The facts are the same as in Example 1. As a result 
of its sales and marketing activities, USSub develops a list of 
several hundred creditworthy customers that regularly purchase AA 
trademarked products. Neither the terms of the contract between FP 
and USSub nor the relevant intellectual property law specify which 
party owns the customer list. Because USSub has knowledge of the 
contents of the list, and has practical control over its use and 
dissemination, USSub is considered the sole owner of the customer 
list for purposes of this paragraph (f)(3).

    (4) Contribution to the value of an intangible owned by another--
(i) In general. The arm's length consideration for a contribution by 
one controlled taxpayer that develops or enhances the value, or may be 
reasonably anticipated to develop or enhance the value, of an 
intangible owned by another controlled taxpayer shall be determined in 
accordance with the applicable rules under section 482. If the 
consideration for such a contribution is embedded within the 
contractual terms for a controlled transaction that involves such 
intangible, then ordinarily no separate allocation will be made with 
respect to such contribution. In such cases, pursuant to Sec.  1.482-
1(d)(3), the contribution must be accounted for in evaluating the 
comparability of the controlled transaction to uncontrolled 
comparables, and accordingly in determining the arm's length 
consideration in the controlled transaction.
    (ii) Examples. The principles of this paragraph (f)(4) are 
illustrated by the following examples:

    Example 1. A, a member of a controlled group, allows B, another 
member of the

[[Page 53463]]

controlled group, to use tangible property, such as laboratory 
equipment, in connection with B's development of an intangible that 
B owns. By furnishing tangible property, A makes a contribution to 
the development of an intangible owned by another controlled 
taxpayer, B. Pursuant to paragraph (f)(4)(i) of this section, the 
arm's length charge for A's furnishing of tangible property will be 
determined under the rules for use of tangible property in Sec.  
1.482-2(c).
    Example 2. (i) Facts. FP, a foreign producer of wristwatches, is 
the registered holder of the YY trademark in the United States and 
in other countries worldwide. FP enters into a five-year, renewable 
distribution agreement with its newly organized U.S. subsidiary, 
USSub. The contractual terms of the agreement grant USSub the right 
to sell trademark YY wristwatches in the United States, obligate 
USSub to pay a fixed price per wristwatch throughout the entire term 
of the contract, and obligate both FP and USSub to undertake without 
separate compensation specified types and levels of marketing 
activities.
    (ii) The consideration for FP's and USSub's marketing 
activities, as well as the consideration for the license to sell YY 
trademarked merchandise, are embedded in the transfer price paid for 
the wristwatches. Accordingly, pursuant to paragraph (f)(4)(i) of 
this section, ordinarily no separate allocation would be appropriate 
with respect to these embedded contributions.
    (iii) Whether an allocation is warranted with respect to the 
transfer price for the wristwatches is determined under Sec.  1.482-
1 and Sec. Sec.  1.482-3 through 1.482-6. The comparability analysis 
would include consideration of all relevant factors, including the 
nature of the intangible embedded in the wristwatches and the nature 
of the marketing activities required under the contract. This 
analysis would also take into account that the compensation for the 
activities performed by USSub and FP, as well as the consideration 
for USSub's use of the YY trademark, is embedded in the transfer 
price for the wristwatches, rather than provided for in separate 
agreements. See Sec.  1.482-3(f) and 1.482-9(m)(4). If it is not 
possible to identify uncontrolled transactions that incorporate a 
similar range of interrelated elements and there are nonroutine 
contributions by each of FP and USSub, then the most reliable 
measure of the arm's length price for the wristwatches may be the 
residual profit split method. The analysis would take into account 
routine and nonroutine contributions by USSub and FP in order to 
determine an appropriate allocation of the combined operating 
profits from the sale of the wristwatches and related activities.
    Example 3. (i) Facts. FP, a foreign producer of athletic gear, 
is the registered holder of the AA trademark in the United States 
and in other countries. In Year 1, FP licenses to a newly organized 
U.S. subsidiary, USSub, the exclusive rights to use certain 
manufacturing and marketing intangibles to manufacture and market 
athletic gear in the United States under the AA trademark. The 
license agreement obligates USSub to pay a royalty based on sales of 
trademarked merchandise. The license agreement also obligates FP and 
USSub to perform without separate compensation specified types and 
levels of marketing activities. In Year 1, USSub manufactures and 
sells athletic gear under the AA trademark in the United States.
    (ii) The consideration for FP's and USSub's respective marketing 
activities is embedded in the contractual terms of the license for 
the AA trademark. Accordingly, pursuant to paragraph (f)(4)(i) of 
this section, ordinarily no separate allocation would be appropriate 
with respect to the embedded contributions in Year 1. See Sec.  
1.482-9(m)(4).
    (iii) Whether an allocation is warranted with respect to the 
royalty under the license agreement would be analyzed under Sec.  
1.482-1 and this section through Sec.  1.482-6. The comparability 
analysis would include consideration of all relevant factors, such 
as the term and geographical exclusivity of the license, the nature 
of the intangibles subject to the license, and the nature of the 
marketing activities required to be undertaken pursuant to the 
license. Pursuant to paragraph (f)(4)(i) of this section, the 
analysis would also take into account the fact that the compensation 
for the marketing services is embedded in the royalty for the AA 
trademark, rather than provided for in a separate services 
agreement. If it is not possible to identify uncontrolled 
transactions that incorporate a similar range of interrelated 
elements and there are nonroutine contributions by each of FP and 
USSub, then the most reliable measure of the arm's length royalty 
for the AA trademark may be the residual profit split method. The 
analysis would take into account routine and nonroutine 
contributions by USSub and FP in order to determine an appropriate 
allocation of the combined operating profits from the sale of the AA 
trademarked merchandise and related activities.
    Example 4. (i) Facts. The Year 1 facts are the same as in 
Example 3, with the following exceptions. In Year 2, USSub 
undertakes certain incremental marketing activities, in addition to 
those required by the contractual terms of the license for the AA 
trademark. The parties do not execute a separate agreement with 
respect to the incremental marketing activities performed by USSub. 
The license agreement executed in Year 1 is of sufficient duration 
that it is reasonable to anticipate that USSub will obtain the 
benefit of its incremental activities, in the form of increased 
sales or revenues of trademarked products in the U.S. market.
    (ii) To the extent that it was reasonable to anticipate that 
USSub's incremental marketing activities would increase the value 
only of USSub's intangible (that is, USSub's license to use the AA 
trademark for a specified term), and not the value of the AA 
trademark owned by FP, USSub's incremental activities do not 
constitute a contribution for which an allocation is warranted under 
paragraph (f)(4)(i) of this section.
    Example 5. (i) Facts. The Year 1 facts are the same as in 
Example 3. In Year 2, FP and USSub enter into a separate services 
agreement that obligates USSub to perform certain incremental 
marketing activities to promote AA trademark athletic gear in the 
United States, beyond the activities specified in license agreement. 
In Year 2, USSub begins to perform these incremental activities, 
pursuant to the separate services agreement with FP.
    (ii) Whether an allocation is warranted with respect to USSub's 
incremental marketing activities covered by the separate services 
agreement would be evaluated under Sec. Sec.  1.482-1 and 1.482-9, 
including a comparison of the compensation provided for the services 
with the results obtained under a method pursuant to Sec.  1.482-9, 
selected and applied in accordance with the best method rule of 
Sec.  1.482-1(c).
    (iii) Whether an allocation is warranted with respect to the 
royalty under the license agreement is determined under Sec.  1.482-
1 and this section through Sec.  1.482-6. The comparability analysis 
would include consideration of all relevant factors, such as the 
term and geographical exclusivity of the license, the nature of the 
intangibles subject to the license, and the nature of the marketing 
activities required to be undertaken pursuant to the license. The 
comparability analysis would take into account that the compensation 
for the incremental activities by USSub is provided for in the 
separate services agreement, rather than embedded in the royalty for 
the AA trademark. If it is not possible to identify uncontrolled 
transactions that incorporate a similar range of interrelated 
elements and there are nonroutine contributions by each of FP and 
USSub, then the most reliable measure of the arm's length royalty 
for the AA trademark may be the residual profit split method. The 
analysis would take into account routine and nonroutine 
contributions by USSub and FP in order to determine an appropriate 
allocation of the combined operating profits from the sale of the AA 
trademarked merchandise and related activities.
    Example 6. (i) Facts. The Year 1 facts are the same as in 
Example 3. In Year 2, FP and USSub enter into a separate services 
agreement that obligates FP to perform incremental marketing 
activities by advertising AA trademarked athletic gear in selected 
international sporting events, such as the Olympics and the soccer 
World Cup. FP's corporate advertising department develops and 
coordinates these special promotions. The separate services 
agreement obligates USSub to pay an amount to FP for the benefit to 
USSub that may reasonably be anticipated as the result of FP's 
incremental activities. The separate services agreement is not a 
qualified cost sharing arrangement under Sec.  1.482-7. FP begins to 
perform the incremental activities in Year 2 pursuant to the 
separate services agreement.
    (ii) Whether an allocation is warranted with respect to the 
incremental marketing activities performed by FP under the separate 
services agreement would be evaluated under Sec.  1.482-9. Under the 
circumstances, it is reasonable to anticipate that FP's activities 
would increase the value of USSub's license as well as the value of 
FP's trademark. Accordingly, the incremental activities by FP may 
constitute in part a controlled services transaction for which USSub 
must compensate FP. The analysis of whether an

[[Page 53464]]

allocation is warranted would include a comparison of the 
compensation provided for the services with the results obtained 
under a method pursuant to Sec.  1.482-9, selected and applied in 
accordance with the best method rule of Sec.  1.482-1(c).
    (iii) Whether an allocation is appropriate with respect to the 
royalty under the license agreement would be evaluated under Sec.  
1.482-1 and this section through Sec.  1.482-6. The comparability 
analysis would include consideration of all relevant factors, such 
as the term and geographical exclusivity of USSub's license, the 
nature of the intangibles subject to the license, and the marketing 
activities required to be undertaken by both FP and USSub pursuant 
to the license. This comparability analysis would take into account 
that the compensation for the incremental activities performed by FP 
was provided for in the separate services agreement, rather than 
embedded in the royalty for the AA trademark. If it is not possible 
to identify uncontrolled transactions that incorporate a similar 
range of interrelated elements and there are nonroutine 
contributions by each of FP and USSub, then the most reliable 
measure of the arm's length royalty for the AA trademark may be the 
residual profit split method. The analysis would take into account 
routine and nonroutine contributions by USSub and FP in order to 
determine an appropriate allocation of the combined operating 
profits from the sale of the AA trademarked merchandise and related 
activities.

* * * * *
    Par. 6. Section 1.482-6 is amended by:
    1. Revising the third sentence in paragraph (c)(2)(ii)(B)(1), the 
first sentence in paragraph (c)(2)(ii)(D), the last sentence in 
paragraph (c)(3)(i)(A) and the first sentence in paragraph 
(c)(3)(ii)(D).
    2. Revising paragraph (c)(3)(i)(B).
    The revisions read as follows:


Sec.  1.482-6  Profit split method.

* * * * *
    (c) * * *
    (2) * * *
    (ii) * * *
    (B) * * * (1) * * * Although all of the factors described in Sec.  
1.482-1(d)(3) must be considered, comparability under this method is 
particularly dependent on the considerations described under the 
comparable profits method in Sec.  1.482-5(c)(2) or Sec.  1.482-
9(e)(2)(iii), because this method is based on a comparison of the 
operating profit of the controlled and uncontrolled taxpayers. * * *
* * * * *
    (D) Other factors affecting reliability. Like the methods described 
in Sec. Sec.  1.482-3, 1.482-4, 1.482-5 and 1.482-9, the comparable 
profit split relies exclusively on external market benchmarks. * * *
* * * * *
    (3) * * * (i) * * *
    (A) * * * Market returns for the routine contributions should be 
determined by reference to the returns achieved by uncontrolled 
taxpayers engaged in similar activities, consistent with the methods 
described in Sec. Sec.  1.482-3, 1.482-4, 1.482-5 and 1.482-9.
    (B) Allocate residual profit--(1) Nonroutine contributions 
generally. The allocation of income to the controlled taxpayer's 
routine contributions will not reflect profits attributable to each 
controlled taxpayer's contributions to the relevant business activity 
that are not routine (nonroutine contributions). A nonroutine 
contribution is a contribution that cannot be fully accounted for by 
reference to market returns, or that is so interrelated with other 
transactions that it cannot be reliably evaluated on a separate basis. 
Thus, in cases where such nonroutine contributions are present there 
normally will be an unallocated residual profit after the allocation of 
income described in paragraph (c)(3)(i)(A) of this section. Under this 
second step, the residual profit generally should be divided among the 
controlled taxpayers based upon the relative value of their nonroutine 
contributions to the relevant business activity. The relative value of 
the nonroutine contributions of each taxpayer should be measured in a 
manner that most reliably reflects each nonroutine contribution made to 
the controlled transaction and each controlled taxpayer's role in the 
nonroutine contributions. If the nonroutine contribution by one of the 
controlled taxpayers is also used in other business activities (such as 
transactions with other controlled taxpayers), an appropriate 
allocation of the value of the nonroutine contribution must be made 
among all the business activities in which it is used.
    (2) Nonroutine contributions of intangible property. In many cases, 
nonroutine contributions of a taxpayer to the relevant business 
activity may be contributions of intangible property. For purposes of 
paragraph (c)(3)(i)(B)(1) of this section, the relative value of 
nonroutine intangible property contributed by taxpayers may be measured 
by external market benchmarks that reflect the fair market value of 
such intangible property. Alternatively, the relative value of 
nonroutine intangible property contributions may be estimated by the 
capitalized cost of developing the intangible property and all related 
improvements and updates, less an appropriate amount of amortization 
based on the useful life of each intangible. Finally, if the intangible 
development expenditures of the parties are relatively constant over 
time and the useful life of the intangible property contributed by all 
parties is approximately the same, the amount of actual expenditures in 
recent years may be used to estimate the relative value of nonroutine 
intangible property contributions.
    (D) Other factors affecting reliability. Like the methods described 
in Sec. Sec.  1.482-3, 1.482-4, 1.482-5 and 1.482-9, the first step of 
the residual profit split relies exclusively on external market 
benchmarks. * * *
* * * * *
    Par. 7. A new Sec.  1.482-9 is added to read as follows:


Sec.  1.482-9  Methods to determine taxable income in connection with a 
controlled services transaction.

    (a) In general. The arm's length amount charged in a controlled 
services transaction must be determined under one of the methods 
provided for in this section. Each method must be applied in accordance 
with the provisions of Sec.  1.482-1, including the best method rule of 
Sec.  1.482-1(c), the comparability analysis of Sec.  1.482-1(d), and 
the arm's length range of Sec.  1.482-1(e), except as those provisions 
are modified in this section. The methods are--
    (1) The comparable uncontrolled services price method, described in 
paragraph (b) of this section;
    (2) The gross services margin method, described in paragraph (c) of 
this section;
    (3) The cost of services plus method, described in paragraph (d) of 
this section;
    (4) The comparable profits method, described in Sec.  1.482-5 and 
in paragraph (e) of this section;
    (5) The simplified cost-based method for certain services, 
described in paragraph (f) of this section;
    (6) The profit split method, described in Sec.  1.482-6 and in 
paragraph (g) of this section; and
    (7) Unspecified methods, described in paragraph (h) of this 
section.
    (b) Comparable uncontrolled services price method--(1) In general. 
The comparable uncontrolled services price method evaluates whether the 
amount charged in a controlled services transaction is arm's length by 
reference to the amount charged in a comparable uncontrolled services 
transaction. The comparable uncontrolled services price method is 
ordinarily used where the controlled services either are identical to 
or have a high degree of similarity to the services in the uncontrolled 
transaction.

[[Page 53465]]

    (2) Comparability and reliability considerations--(i) In general. 
Whether results derived from application of this method are the most 
reliable measure of the arm's length result must be determined using 
the factors described under the best method rule in Sec.  1.482-1(c). 
The application of these factors under the comparable uncontrolled 
services price method is discussed in paragraphs (b)(2)(ii) and (iii) 
of this section.
    (ii) Comparability--(A) In general. The degree of comparability 
between controlled and uncontrolled transactions is determined by 
applying the provisions of Sec.  1.482-1(d). Although all of the 
factors described in Sec.  1.482-1(d)(3) must be considered, similarity 
of the services rendered, and of the intangibles (if any) used in 
performing the services, generally will have the greatest effects on 
comparability under this method. In addition, because even minor 
differences in contractual terms or economic conditions could 
materially affect the amount charged in an uncontrolled transaction, 
comparability under this method depends on close similarity with 
respect to these factors, or adjustments to account for any 
differences. The results derived from applying the comparable 
uncontrolled services price method generally will be the most direct 
and reliable measure of an arm's length price for the controlled 
transaction if an uncontrolled transaction has no differences from the 
controlled transaction that would affect the price, or if there are 
only minor differences that have a definite and reasonably 
ascertainable effect on price and for which appropriate adjustments are 
made. If such adjustments cannot be made, or if there are more than 
minor differences between the controlled and uncontrolled transactions, 
the comparable uncontrolled services price method may be used, but the 
reliability of the results as a measure of the arm's length price will 
be reduced. Further, if there are material differences for which 
reliable adjustments cannot be made, this method ordinarily will not 
provide a reliable measure of an arm's length result.
    (B) Adjustments for differences between controlled and uncontrolled 
transactions. If there are differences between the controlled and 
uncontrolled transactions that would affect price, adjustments should 
be made to the price of the uncontrolled transaction according to the 
comparability provisions of Sec.  1.482-1(d)(2). Specific examples of 
factors that may be particularly relevant to application of this method 
include--
    (1) Quality of the services rendered;
    (2) Contractual terms (e.g., scope and terms of warranties or 
guarantees regarding the services, volume, credit and payment terms, 
allocation of risks, including any contingent-payment terms and whether 
costs were incurred without a provision for current reimbursement);
    (3) Intangibles (if any) used in rendering the services;
    (4) Geographic market in which the services are rendered or 
received;
    (5) Risks borne (e.g., costs incurred to render the services, 
without provision for current reimbursement);
    (6) Duration or quantitative measure of services rendered;
    (7) Collateral transactions or ongoing business relationships 
between the renderer and the recipient, including arrangement for the 
provision of tangible property in connection with the services; and
    (8) Alternatives realistically available to the renderer and the 
recipient.
    (iii) Data and assumptions. The reliability of the results derived 
from the comparable uncontrolled services price method is affected by 
the completeness and accuracy of the data used and the reliability of 
the assumptions made to apply the method. See Sec.  1.482-1(c) (Best 
method rule).
    (3) Arm's length range. See Sec.  1.482-1(e)(2) for the 
determination of an arm's length range.
    (4) Examples. The principles of this paragraph (b) are illustrated 
by the following examples:

    Example 1. Internal comparable uncontrolled services price. 
Company A, a United States corporation, performs shipping, 
stevedoring, and related services for controlled and uncontrolled 
parties on a short-term or as-needed basis. Company A charges 
uncontrolled parties in Country X a uniform fee of $60 per container 
to place loaded cargo containers in Country X on oceangoing vessels 
for marine transportation. Company A also performs identical 
services in Country X for its wholly owned subsidiary, Company B, 
and there are no substantial differences between the controlled and 
uncontrolled transactions. In evaluating the appropriate measure of 
the arm's length price for the container-loading services performed 
for Company B, because Company A renders substantially identical 
services in Country X to both controlled and uncontrolled parties, 
it is determined that the comparable uncontrolled services price 
constitutes the best method for determining the arm's length price 
for the controlled services transaction. Based on the reliable data 
provided by Company A concerning the price charged for services in 
comparable uncontrolled transactions, a loading charge of $60 per 
cargo container will be considered the most reliable measure of the 
arm's length price for the services rendered to Company B. See 
paragraph (b)(2)(ii)(A) of this section.
    Example 2. External comparable uncontrolled services price. (i) 
The facts are the same as in Example 1, except that Company A 
performs services for Company B, but not for uncontrolled parties. 
Based on information obtained from unrelated parties (which is 
determined to be reliable under the comparability standards set 
forth in paragraph (b)(2) of this section), it is determined that 
uncontrolled parties in Country X perform services comparable to 
those rendered by Company A to Company B, and that such parties 
charge $60 per cargo container.
    (ii) In evaluating the appropriate measure of an arm's length 
price for the loading services that Company A renders to Company B, 
the $60 per cargo container charge is considered evidence of a 
comparable uncontrolled services price. See paragraph (b)(2)(ii)(A) 
of this section.
    Example 3. External comparable uncontrolled services price. The 
facts are the same as in Example 2, except that uncontrolled parties 
in Country X render similar loading and stevedoring services, but 
only under contracts that have a minimum term of one year. If the 
difference in the duration of the services has a material effect on 
prices, adjustments to account for these differences must be made to 
the results of the uncontrolled transactions according to the 
provisions of Sec.  1.482-1(d)(2), and such adjusted results may be 
used as a measure of the arm's length result.
    Example 4. Use of valuable intangibles. (i) Company A, a United 
States corporation in the biotechnology sector, renders research and 
development services exclusively to its affiliates. Company B is 
Company A's wholly owned subsidiary in Country X. Company A renders 
research and development services to Company B.
    (ii) In performing its research and development services 
function, Company A uses proprietary software that it developed 
internally. Company A uses the software to evaluate certain 
genetically engineered compounds developed by Company B. Company A 
owns the copyright on this software and does not license it to 
uncontrolled parties.
    (iii) No uncontrolled parties can be identified that perform 
services identical or with a high degree of similarity to those 
performed by Company A. Because there are material differences for 
which reliable adjustments cannot be made, the comparable 
uncontrolled services price method is unlikely to provide a reliable 
measure of the arm's length price. See paragraph (b)(2)(ii)(A) of 
this section.
    Example 5. Internal comparable. (i) Company A, a United States 
corporation, and its subsidiaries render computer consulting 
services relating to systems integration and networking to business 
clients in various countries. Company A and its subsidiaries render 
only consulting services, and do not manufacture computer hardware 
or software nor distribute such products. The controlled group is 
organized according to industry specialization, with key industry 
specialists working for Company A. These personnel typically form 
the core consulting group that teams with consultants from the 
local-

[[Page 53466]]

country subsidiaries to serve clients in the subsidiaries' 
respective countries.
    (ii) Company A and its subsidiaries sometimes undertake 
engagements directly for clients, and sometimes work as 
subcontractors to unrelated parties on more extensive supply-chain 
consulting engagements for clients. In undertaking the latter 
engagements with third party consultants, Company A typically prices 
its services based on consulting hours worked multiplied by a rate 
determined for each category of employee. The company also charges, 
at no markup, for out-of-pocket expenses such as travel, lodging, 
and data acquisition charges. The Company has established the 
following schedule of hourly rates:

Category/Rate

Project managers--$400 per hour
Technical staff--$300 per hour

    (iii) Thus, for example, a project involving 100 hours of the 
time of project managers and 400 hours of technical staff time would 
result in the following project fees (without regard to any out-of-
pocket expenses): ([100 hrs. x $400/hr.] + [400 hrs. x $300/hr.]) = 
$40,000 + $120,000 = $160,000.
    (iv) Company B, a Country X subsidiary of Company A, contracts 
to perform consulting services for a Country X client in the banking 
industry. In undertaking this engagement, Company B uses its own 
consultants and also uses Company A project managers and technical 
staff that specialize in the banking industry for 75 hours and 380 
hours, respectively. In determining an arm's length charge, the 
price that Company A charges for consulting services as a 
subcontractor in comparable uncontrolled transactions will be 
considered evidence of a comparable uncontrolled services price. 
Thus, in this case, a payment of $144,000, (or [75 hrs. x $400/hr.] 
+ [380 hrs. x $300/hr.] = $30,000 + $114,000) may be used as a 
measure of the arm's length price for the work performed by Company 
A project mangers and technical staff. In addition, if the 
comparable uncontrolled services price method is used, then, 
consistent with the practices employed by the comparables with 
respect to similar types of expenses, Company B must reimburse 
Company A for appropriate out-of-pocket expenses. See paragraph 
(b)(2)(ii)(A) of this section.
    Example 6. Adjustments for differences. (i) The facts are the 
same as in Example 5, except that the engagement is undertaken with 
the client on a fixed fee basis. That is, prior to undertaking the 
engagement Company B and Company A estimate the resources required 
to undertake the engagement, and, based on hourly fee rates, charge 
the client a single fee for completion of the project. Company A's 
portion of the engagement results in fees of $144,000.
    (ii) The engagement, once undertaken, requires 20% more hours by 
each of Companies A and B than originally estimated. Nevertheless, 
the unrelated client pays the fixed fee that was agreed upon at the 
start of the engagement. Company B pays Company A $144,000, in 
accordance with the fixed fee arrangement.
    (iii) Company A often enters into similar fixed fee engagements 
with clients. In addition, Company A's records for similar 
engagements show that when it experiences cost overruns, it does not 
collect additional fees from the client for the difference between 
projected and actual hours. Accordingly, in evaluating whether the 
fees paid by Company B to Company A are arm's length, it is 
determined that no adjustments to the intercompany service charge 
are warranted. See Sec.  1.482-1(d)(3)(ii) and paragraph 
(b)(2)(ii)(A) of this section.
    Example 7. Adjustments for differences. The facts are the same 
as in Example 6, except that Company A does not typically enter into 
fixed fee engagements with clients, and in addition Company A 
typically receives payments equal to its full fee (i.e., the 
appropriate hourly fee rate multiplied by the number of hours to 
complete the engagement) for all consulting work that it performs, 
regardless of whether actual hours exceed pre-engagement estimates. 
When Company A's realistic alternatives to entering into the 
engagement with Company B are taken into account, it is determined 
that the intercompany charge paid by Company B to Company A should 
be adjusted to the amount of its full fee. See Sec.  1.482-
1(d)(3)(ii) and paragraph (b)(2)(ii)(B)(8) of this section.

    (5) Indirect evidence of the price of a comparable uncontrolled 
services transaction--(i) In general. The price of a comparable 
uncontrolled services transaction may be derived based on indirect 
measures of the price charged in comparable uncontrolled services 
transactions, but only if the following requirements are met--
    (A) The data are widely and routinely used in the ordinary course 
of business in the particular industry or market segment for purposes 
of determining prices actually charged in comparable uncontrolled 
services transactions;
    (B) The data are used to set prices in the controlled services 
transaction in the same way they are used to set prices in uncontrolled 
services transactions of the controlled taxpayer, or in the same way 
they are used by uncontrolled taxpayers to set prices in uncontrolled 
services transactions; and
    (C) The amount charged in the controlled services transaction may 
be reliably adjusted to reflect differences in quality of the services, 
contractual terms, market conditions, risks borne (including 
contingent-payment terms), duration or quantitative measure of services 
rendered, and other factors that may affect the price to which 
uncontrolled taxpayers would agree.
    (ii) Example. The following example illustrates this paragraph 
(b)(5):

    Example. Indirect evidence of comparable uncontrolled services 
price. (i) Company A is a United States insurance company. Company 
A's wholly owned Country X subsidiary, Company B, performs 
specialized risk analysis for Company A as well as for uncontrolled 
parties. In determining the price actually charged to uncontrolled 
entities for performing such risk analysis, Company B uses a 
proprietary, multi-factor computer program, which relies on the 
gross value of the policies in the customer's portfolio, the 
relative composition of those policies, their location, and the 
estimated number of personnel hours necessary to complete the 
project. Uncontrolled companies that perform comparable risk 
analysis in the same industry or market-segment use similar 
proprietary computer programs to price transactions with 
uncontrolled customers (the competitors' programs may incorporate 
different inputs, or may assign different weights or values to 
individual inputs, in arriving at the price).
    (ii) During the taxable year subject to audit, Company B 
performed risk analysis for uncontrolled parties as well as for 
Company A. Because prices charged to uncontrolled customers 
reflected the composition of each customer's portfolio together with 
other factors, the prices charged in Company B's uncontrolled 
transactions do not provide a reliable basis for determining the 
comparable uncontrolled services price for the similar services 
rendered to Company A. However, in evaluating an arm's length price 
for the studies performed by Company B for Company A, Company B's 
proprietary computer program may be considered as indirect evidence 
of the comparable uncontrolled services price that would be charged 
to perform the services for Company A. The reliability of the 
results obtained by application of this internal computer program as 
a measure of an arm's length price for the services will be 
increased to the extent that Company A used the internal computer 
program to generate actual transaction prices for risk-analysis 
studies performed for uncontrolled parties during the same taxable 
year under audit; Company A used data that are widely and routinely 
used in the ordinary course of business in the insurance industry to 
determine the price charged; and Company A reliably adjusted the 
price charged in the controlled services transaction to reflect 
differences that may affect the price to which uncontrolled 
taxpayers would agree.

    (c) Gross services margin method--(1) In general. The gross 
services margin method evaluates whether the amount charged in a 
controlled services transaction is arm's length by reference to the 
gross profit margin realized in comparable uncontrolled transactions. 
This method ordinarily is used in cases where a controlled taxpayer 
performs services or functions in connection with a related 
uncontrolled transaction between a member of the controlled group and 
an uncontrolled taxpayer. 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

[[Page 53467]]

provide services to an uncontrolled taxpayer (intermediary function) 
and another member of the controlled group actually performs a portion 
of the services provided.
    (2) Determination of arm's length price--(i) In general. The gross 
services margin method evaluates whether the price charged or amount 
retained by a controlled taxpayer in the controlled services 
transaction in connection with the related uncontrolled transaction is 
arm's length by determining the appropriate gross profit of the 
controlled taxpayer.
    (ii) Related uncontrolled transaction. The related uncontrolled 
transaction is a transaction between a member of the controlled group 
and an uncontrolled taxpayer as to which the controlled taxpayer 
performs agent services or an intermediary function.
    (iii) Applicable uncontrolled price. The applicable uncontrolled 
price is the price paid or received by the uncontrolled taxpayer in the 
related uncontrolled transaction.
    (iv) Appropriate gross services profit. The appropriate gross 
services profit is computed by multiplying the applicable uncontrolled 
price by the gross services profit margin in comparable uncontrolled 
transactions. The determination of the appropriate gross services 
profit will take into account any functions performed by other members 
of the controlled group, as well as any other relevant factors 
described in Sec.  1.482-1(d)(3). The comparable gross services profit 
margin may be determined by reference to the commission in an 
uncontrolled transaction, where that commission is stated as a 
percentage of the price charged in the uncontrolled transaction.
    (v) Arm's length range. See Sec.  1.482-1(e)(2) for determination 
of the arm's length range.
    (3) Comparability and reliability considerations--(i) In general. 
Whether results derived from application of this method are the most 
reliable measure of the arm's length result must be determined using 
the factors described under the best method rule in Sec.  1.482-1(c). 
The application of these factors under the gross services margin method 
is discussed in paragraphs (c)(3)(ii) and (iii) of this section.
    (ii) Comparability--(A) Functional comparability. The degree of 
comparability between an uncontrolled transaction and a controlled 
transaction is determined by applying the comparability provisions of 
Sec.  1.482-1(d). A gross services profit provides compensation for 
services or functions that bear a relationship to the related 
uncontrolled transaction, including an operating profit in return for 
the investment of capital and the assumption of risks by the controlled 
taxpayer performing the services or functions under review. Therefore, 
although all of the factors described in Sec.  1.482-1(d)(3) must be 
considered, comparability under this method is particularly dependent 
on similarity of services or functions performed, risks borne, 
intangibles (if any) used in providing the services or functions, and 
contractual terms, or adjustments to account for the effects of any 
such differences. If possible, the appropriate gross services profit 
margin should be derived from comparable uncontrolled transactions by 
the controlled taxpayer under review, because similar characteristics 
are more likely found among different transactions by the same 
controlled taxpayer than among transactions by other parties. In the 
absence of comparable uncontrolled transactions involving the same 
controlled taxpayer, an appropriate gross services profit margin may be 
derived from transactions of uncontrolled taxpayers involving 
comparable services or functions with respect to similarly related 
transactions.
    (B) Other comparability factors. Comparability under this method is 
not dependent on close similarity of the related uncontrolled 
transaction to the related transactions involved in the uncontrolled 
comparables. However, substantial differences in the nature of the 
related uncontrolled transaction and the related transactions involved 
in the uncontrolled comparables, such as differences in the type of 
property transferred or service provided in the related uncontrolled 
transaction, may indicate significant differences in the services or 
functions performed by the controlled and uncontrolled taxpayers with 
respect to their respective related transactions. Thus, it ordinarily 
would be expected that the services or functions performed in the 
controlled and uncontrolled transactions would be with respect to 
related transactions involving the transfer of property within the same 
product categories or the provision of services of the same general 
type (e.g., information-technology systems design). Furthermore, 
significant differences in the intangibles (if any) used by the 
controlled taxpayer in the controlled services transaction as distinct 
from the uncontrolled comparables may also affect the reliability of 
the comparison. Finally, the reliability of profit measures based on 
gross services profit may be adversely affected by factors that have 
less effect on prices. For example, gross services profit may be 
affected by a variety of other factors, including cost structures or 
efficiency (for example, differences in the level of experience of the 
employees performing the service in the controlled and uncontrolled 
transactions). Accordingly, if material differences in these factors 
are identified based on objective evidence, the reliability of the 
analysis may be affected.
    (C) Adjustments for differences between controlled and uncontrolled 
transactions. If there are material differences between the controlled 
and uncontrolled transactions that would affect the gross services 
profit margin, adjustments should be made to the gross services profit 
margin, according to the comparability provisions of Sec.  1.482-
1(d)(2). For this purpose, consideration of the total services costs 
associated with functions performed and risks assumed may be necessary, 
because differences in functions performed are often reflected in these 
costs. If there are differences in functions performed, however, the 
effect on gross services profit of such differences is not necessarily 
equal to the differences in the amount of related costs. Specific 
examples of factors that may be particularly relevant to this method 
include--
    (1) Contractual terms (e.g., scope and terms of warranties or 
guarantees regarding the services or function, volume, credit and 
payment terms, and allocation of risks, including any contingent-
payment terms);
    (2) Intangibles (if any) used in performing the services or 
function;
    (3) Geographic market in which the services or function are 
performed or in which the related uncontrolled transaction takes place; 
and
    (4) Risks borne, including, if applicable, inventory-type risk.
    (D) Buy-sell distributor. If a controlled taxpayer that performs an 
agent service or intermediary function is comparable to a distributor 
that takes title to goods and resells them, the gross profit margin 
earned by such distributor on uncontrolled sales, stated as a 
percentage of the price for the goods, may be used as the comparable 
gross services profit margin.
    (iii) Data and assumptions--(A) In general. The reliability of the 
results derived from the gross services margin method is affected by 
the completeness and accuracy of the data used and the reliability of 
the assumptions made to apply this method. See Sec.  1.482-1(c) (Best 
method rule).
    (B) Consistency in accounting. The degree of consistency in 
accounting practices between the controlled

[[Page 53468]]

transaction and the uncontrolled comparables that materially affect the 
gross services profit margin affects the reliability of the results 
under this method.
    (4) Examples. The principles of this paragraph (c) are illustrated 
by the following examples:

    Example 1. Agent services. Company A and Company B are members 
of a controlled group. Company A is a foreign manufacturer of 
industrial equipment. Company B is a U.S. company that acts as a 
commission agent for Company A by arranging for Company A to make 
direct sales of the equipment it manufactures to unrelated 
purchasers in the U.S. market. Company B does not take title to the 
equipment, but instead receives from Company A commissions that are 
determined as a specified percentage of the sales price for the 
equipment that is charged by Company A to the unrelated purchaser. 
Company B also arranges for direct sales of similar equipment by 
unrelated foreign manufacturers to unrelated purchasers in the U.S. 
market. Company B charges these unrelated foreign manufacturers a 
commission fee of 5% of the sales price charged by the unrelated 
foreign manufacturers to the unrelated U.S. purchasers for the 
equipment. Information regarding the comparable agent services 
provided by Company B to unrelated foreign manufacturers is 
sufficiently complete to conclude that it is likely that all 
material differences between the controlled and uncontrolled 
transactions have been identified and adjustments for such 
differences have been made. If the comparable gross services profit 
margin is 5% of the price charged in the related transactions 
involved in the uncontrolled comparables, then the appropriate gross 
services profit that Company B may earn and the arm's length price 
that it may charge Company A for its agent services is equal to 5% 
of the applicable uncontrolled price charged by Company A in sales 
of equipment in the related uncontrolled transactions.
    Example 2. Agent services. The facts are the same as in Example 
1, except that Company B does not act as a commission agent for 
unrelated parties and it is not possible to obtain reliable 
information concerning commission rates charged by uncontrolled 
commission agents that engage in comparable transactions with 
respect to related sales of property. It is possible, however, to 
obtain reliable information regarding the gross profit margins 
earned by unrelated parties that briefly take title to and then 
resell similar property in uncontrolled transactions, in which they 
purchase the property from foreign manufacturers and resell the 
property to purchasers in the U.S. market. Analysis of the facts and 
circumstances indicates that, aside from certain minor differences 
for which adjustments can be made, the uncontrolled parties that 
resell property perform similar functions and assume similar risks 
as Company B performs and assumes when it acts as a commission agent 
for Company A's sales of property. Under these circumstances, the 
gross profit margin earned by the unrelated distributors on the 
purchase and resale of property may be used, subject to any 
adjustments for any material differences between the controlled and 
uncontrolled transactions, as a comparable gross services profit 
margin. The appropriate gross services profit that Company B may 
earn and the arm's length price that it may charge Company A for its 
agent services is therefore equal to this comparable gross services 
margin, multiplied by the applicable uncontrolled price charged by 
Company A in its sales of equipment in the related uncontrolled 
transactions.
    Example 3. Agent services. (i) Company A and Company B are 
members of a controlled group. Company A is a U.S. corporation that 
renders computer consulting services, including systems integration 
and networking, to business clients.
    (ii) In undertaking engagements with clients, Company A in some 
cases pays a commission of 3% of its total fees to unrelated parties 
that assist Company A in obtaining consulting engagements. 
Typically, such fees are paid to non-computer consulting firms that 
provide strategic management services for their clients. When 
Company A obtains a consulting engagement with a client of a non-
computer consulting firm, Company A does not subcontract with the 
other consulting firm, nor does the other consulting firm play any 
role in Company A's consulting engagement.
    (iii) Company B, a Country X subsidiary of Company A, assists 
Company A in obtaining an engagement to perform computer consulting 
services for a Company B banking industry client in Country X. 
Although Company B has an established relationship with its Country 
X client and was instrumental in arranging for Company A's 
engagement with the client, Company A's particular expertise was the 
primary consideration in the motivating the client to engage Company 
A. Based on the relative contributions of Companies A and B in 
obtaining and undertaking the engagement, Company B's role was 
primarily to facilitate the consulting engagement between Company A 
and the Country X client. Information regarding the commissions paid 
by Company A to unrelated parties for providing similar services to 
facilitate Company A's consulting engagements is sufficiently 
complete to conclude that it is likely that all material differences 
between these uncontrolled transactions and the controlled 
transaction between Company B and Company A have been identified and 
that appropriate adjustments have been made for any such 
differences. If the comparable gross services margin earned by 
unrelated parties in providing such agent services is 3% of total 
fees charged in the similarly related transactions involved in the 
uncontrolled comparables, then the appropriate gross services profit 
that Company B may earn and the arm's length price that it may 
charge Company A for its agent services is equal to this comparable 
gross services margin (3%), multiplied by the applicable 
uncontrolled price charged by Company A in its related uncontrolled 
consulting engagement with Company B's client.
    Example 4. Intermediary function. (i) The facts are the same as 
in Example 3, except that Company B contracts directly with its 
Country X client to provide computer consulting services and Company 
A performs the consulting services on behalf of Company B. Company A 
does not enter into a consulting engagement with Company B's Country 
X client. Instead, Company B charges its Country X client an 
uncontrolled price for the consulting services, and Company B pays a 
portion of the uncontrolled price to Company A for performing the 
consulting services on behalf of Company B.
    (ii) Analysis of the relative contributions of Companies A and B 
in obtaining and undertaking the consulting contract indicates that 
Company B functioned primarily as an intermediary-contracting party, 
and the gross services margin method is the most reliable method for 
determining the amount that Company B may retain as compensation for 
its intermediary function with respect to Company A's consulting 
services. In this case, therefore, because Company B entered into 
the related uncontrolled transaction to provide services, Company B 
receives the applicable uncontrolled price that is paid by the 
Country X client for the consulting services. Company A technically 
performs services for Company B when it performs, on behalf of 
Company B, the consulting services Company B contracted to provide 
to the Country X client. The arm's length amount that Company A may 
charge Company B for performing the consulting services on Company 
B's behalf is equal to the applicable uncontrolled price received by 
Company B in the related uncontrolled transaction, less Company B's 
appropriate gross services profit, which is the amount that Company 
B may retain as compensation for performing the intermediary 
function.
    (iii) Reliable data concerning the commissions that Company A 
paid to uncontrolled parties for assisting it in obtaining 
engagements to provide consulting services similar to those it has 
provided on behalf of Company B provide useful information in 
applying the gross services margin method. However, consideration 
should be given to whether the third party commission data may need 
to be adjusted to account for any additional risk that Company B may 
have assumed as a result of its function as an intermediary-
contracting party, compared with the risk it would have assumed if 
it had provided agent services to assist Company A in entering into 
an engagement to provide its consulting service directly. In this 
case, the information regarding the commissions paid by Company A to 
unrelated parties for providing agent services to facilitate its 
performance of consulting services for unrelated parties is 
sufficiently complete to conclude that all material differences 
between these uncontrolled transactions and the controlled 
performance of an intermediary function, including possible 
differences in the amount of risk assumed in connection with 
performing that function, have been identified and that appropriate 
adjustments have been made. If the comparable gross services margin 
earned by unrelated parties

[[Page 53469]]

in providing such agent services is 3% of total fees charged in 
Company B's related uncontrolled transactions, then the appropriate 
gross services profit that Company B may retain as compensation for 
performing an intermediary function (and the amount, therefore, that 
is deducted from the applicable uncontrolled price to arrive at the 
arm's length price that Company A may charge Company B for 
performing consulting services on Company B's behalf) is equal to 
this comparable gross services margin (3%), multiplied by the 
applicable uncontrolled price charged by Company B in its contract 
to provide services to the uncontrolled party.
    Example 5. External comparable. (i) The facts are the same as in 
Example 4, except that neither Company A nor Company B engage in 
transactions with third parties that facilitate similar consulting 
engagements.
    (ii) Analysis of the relative contributions of Companies A and B 
in obtaining and undertaking the contract indicates that Company B's 
role was primarily to facilitate the consulting arrangement between 
Company A and the Country X client. Although no reliable internal 
data are available regarding comparable transactions with 
uncontrolled entities, reliable data exist regarding commission 
rates for similar facilitating services between uncontrolled 
parties. These data indicate that a 3% commission (3% of total 
engagement fee) is charged in such transactions. Information 
regarding the uncontrolled comparables is sufficiently complete to 
conclude that it is likely that all material differences between the 
controlled and uncontrolled transactions have been identified and 
adjusted for. If the appropriate gross services profit margin is 3% 
of total fees, then an arm's length result of the controlled 
services transaction is for Company B to retain an amount equal to 
3% of total fees paid to it.

    (d) Cost of services plus method--(1) In general. The cost of 
services plus method evaluates whether the amount charged in a 
controlled services transaction is arm's length by reference to the 
gross services profit markup realized in comparable uncontrolled 
transactions. The cost of services plus method is ordinarily used in 
cases where the controlled service renderer provides the same or 
similar services to both controlled and uncontrolled parties. This 
method is ordinarily not used in cases where the controlled services 
transaction involves a contingent-payment arrangement, as described in 
paragraph (i)(2) of this section.
    (2) Determination of arm's length price--(i) In general. The cost 
of services plus method measures an arm's length price by adding the 
appropriate gross services profit to the controlled taxpayer's 
comparable transactional costs.
    (ii) Appropriate gross services profit. The appropriate gross 
services profit is computed by multiplying the controlled taxpayer's 
comparable transactional costs by the gross services profit markup, 
expressed as a percentage of the comparable transactional costs earned 
in comparable uncontrolled transactions.
    (iii) Comparable transactional costs. Comparable transactional 
costs consist of the costs of providing the services under review that 
are taken into account as the basis for determining the gross services 
profit markup in comparable uncontrolled transactions. Depending on the 
facts and circumstances, such costs typically include all compensation 
attributable to employees directly involved in the performance of such 
services, materials and supplies consumed or made available in 
rendering such services, and other costs of rendering the services. 
Comparable transactional costs must be determined on a basis that will 
facilitate comparison with the comparable uncontrolled transactions. 
For that reason, comparable transactional costs may not necessarily 
equal total services costs, as defined in paragraph (j) of this 
section, and in appropriate cases may be a subset of total services 
costs. Generally accepted accounting principles or Federal income tax 
accounting rules (where Federal income tax data for comparable 
transactions or business activities is available) may provide useful 
guidance, but will not conclusively establish the appropriate 
comparable transactional costs for purposes of this method.
    (iv) Arm's length range. See Sec.  1.482-1(e)(2) for determination 
of an arm's length range.
    (3) Comparability and reliability considerations--(i) In general. 
Whether results derived from the application of this method are the 
most reliable measure of the arm's length result must be determined 
using the factors described under the best method rule in Sec.  1.482-
1(c).
    (ii) Comparability--(A) Functional comparability. The degree of 
comparability between controlled and uncontrolled transactions is 
determined by applying the comparability provisions of Sec.  1.482-
1(d). A service renderer's gross services profit provides compensation 
for performing services related to the controlled services transaction 
under review, including an operating profit for the service renderer's 
investment of capital and assumptions of risks. Therefore, although all 
of the factors described in Sec.  1.482-1(d)(3) must be considered, 
comparability under this method is particularly dependent on similarity 
of services or functions performed, risks borne, intangibles (if any) 
used in providing the services or functions, and contractual terms, or 
adjustments to account for the effects of any such differences. For 
purposes of evaluating functional comparability, it may be necessary to 
consider the results under this method expressed as a markup on total 
services costs of the controlled taxpayer and comparable uncontrolled 
parties, because differences in functions performed may be reflected in 
differences in service costs other than those included in comparable 
transactional costs. If possible, the appropriate gross services profit 
markup should be derived from comparable uncontrolled transactions of 
the same taxpayer participating in the controlled services transaction, 
because similar characteristics are more likely to be found among 
services provided by the same service provider than among services 
provided by other service providers. In the absence of such services 
transactions, an appropriate gross services profit markup may be 
derived from comparable uncontrolled services transactions of other 
service providers.
    (B) Other comparability factors. Comparability under this method is 
less dependent on close similarity between the services provided than 
under the comparable uncontrolled services price method. Substantial 
differences in the services may, however, indicate significant 
functional differences between the controlled and uncontrolled 
taxpayers. Thus, it ordinarily would be expected that the controlled 
and uncontrolled transactions would involve services of the same 
general type (e.g., information-technology systems design). 
Furthermore, if a significant amount of the controlled taxpayer's 
comparable transactional costs consists of service costs incurred in a 
tax accounting period other than the tax accounting period under 
review, the reliability of the analysis would be reduced. In addition, 
significant differences in the value of the services rendered, due for 
example to the use of valuable intangibles, may also affect the 
reliability of the comparison. Finally, the reliability of profit 
measures based on gross services profit may be adversely affected by 
factors that have less effect on prices. For example, gross services 
profit may be affected by a variety of other factors, including cost 
structures or efficiency-related factors (for example, differences in 
the level of experience of the employees performing the service in the 
controlled and uncontrolled transactions). Accordingly, if material 
differences in these factors are identified based on objective

[[Page 53470]]

evidence, the reliability of the analysis may be affected.
    (C) Adjustments for differences between the controlled and 
uncontrolled transactions. If there are material differences between 
the controlled and uncontrolled transactions that would affect the 
gross services profit markup, adjustments should be made to the gross 
services profit markup earned in the comparable uncontrolled 
transaction according to the provisions of Sec.  1.482-1(d)(2). For 
this purpose, consideration of the comparable transactional costs 
associated with the functions performed and risks assumed may be 
necessary, because differences in the functions performed are often 
reflected in these costs. If there are differences in functions 
performed, however, the effect on gross services profit of such 
differences is not necessarily equal to the differences in the amount 
of related comparable transactional costs. Specific examples of the 
factors that may be particularly relevant to this method include--
    (1) The complexity of the services;
    (2) The duration or quantitative measure of services;
    (3) Contractual terms (e.g., scope and terms of warranties or 
guarantees provided, volume, credit and payment terms, allocation of 
risks, including any contingent-payment terms);
    (4) Economic circumstances; and
    (5) Risks borne.
    (iii) Data and assumptions--(A) In general. The reliability of the 
results derived from the cost of services plus method is affected by 
the completeness and accuracy of the data used and the reliability of 
the assumptions made to apply this method. See Sec.  1.482-1(c) (Best 
method rule).
    (B) Consistency in accounting. The degree of consistency in 
accounting practices between the controlled transaction and the 
uncontrolled comparables that materially affect the gross services 
profit markup affects the reliability of the results under this method. 
Thus, for example, if differences in cost accounting practices would 
materially affect the gross services profit markup, the ability to make 
reliable adjustments for such differences would affect the reliability 
of the results obtained under this method. Further, reliability under 
this method depends on the extent to which the controlled and 
uncontrolled transactions reflect consistent reporting of comparable 
transactional costs. For purposes of this paragraph (d)(3)(iii)(B), the 
term comparable transactional costs includes the cost of acquiring 
tangible property that is transferred (or used) with the services, to 
the extent that the arm's length price of the tangible property is not 
separately evaluated as a controlled transaction under another 
provision.
    (4) Examples. The principles of this paragraph (d) are illustrated 
by the following examples:

    Example 1. Internal comparable. (i) Company A designs and 
assembles information-technology networks and systems. When Company 
A renders services for uncontrolled parties, it receives 
compensation based on time and materials spent on the project. This 
fee includes the cost of hardware and software purchased from 
uncontrolled vendors and incorporated in the final network or 
system. Reliable accounting records maintained by Company A indicate 
that Company A earned a gross services profit markup of 10% on its 
time and materials in providing design services during the year 
under examination on information technology projects for 
uncontrolled entities.
    (ii) Company A designed an information-technology network for 
its Country X subsidiary, Company B. The services rendered to 
Company B are similar in scope and complexity to services that 
Company A rendered to uncontrolled parties during the year under 
examination. Using Company A's accounting records (which are 
determined to be reliable under paragraph (d)(3) of this section), 
it is possible to identify the comparable transactional costs 
involved in the controlled services transaction with reference to 
the costs incurred by Company A in rendering similar design services 
to uncontrolled parties. Company A's records indicate that it does 
not incur any additional types of costs in rendering similar 
services to uncontrolled customers. The data available are 
sufficiently complete to conclude that it is likely that all 
material differences between the controlled and uncontrolled 
transactions have been identified and adjusted for. Based on the 
gross services profit markup data derived from Company A's 
uncontrolled transactions involving similar design services, an 
arm's length result for the controlled services transaction is equal 
to the price that will allow Company A to earn a 10% gross services 
profit markup on its comparable transactional costs.
    Example 2. Inability to adjust for differences in comparable 
transactional costs. The facts are the same as in Example 1, except 
that Company A's staff that rendered the services to Company B 
consisted primarily of engineers in training status or on temporary 
rotation from other Company A subsidiaries. In addition, the Company 
B network incorporated innovative features, including specially 
designed software suited to Company B's requirements. The use of 
less-experienced personnel and staff on temporary rotation, and the 
special features of the Company B network significantly increased 
the time and costs associated with the project, as compared to time 
and costs associated with similar projects completed for 
uncontrolled customers. These factors constitute material 
differences between the controlled and the uncontrolled transactions 
that affect the determination of Company A's comparable 
transactional costs associated with the controlled services 
transaction, as well as the gross services profit markup. Moreover, 
it is not possible to perform reliable adjustments for these 
differences, on the basis of the available accounting data. Under 
these circumstances, the reliability of the cost of services plus 
method as a measure of an arm's length price is substantially 
reduced.
    Example 3. Operating loss by reference to total services costs. 
The facts and analysis are the same as in Example 1, except that 
available information indicates that there may be material 
differences between the controlled and uncontrolled services 
transactions, and that these differences may not be reflected in the 
comparable transactional costs. Accordingly, the taxpayer performs 
additional analysis pursuant to paragraph (d)(3)(ii) of this 
section, and restates the results in Example 1 (in which the arm's 
length charge was determined by reference to 10% gross services 
profit markup on comparable transactional costs) in the form of a 
markup on total services costs. This analysis by reference to total 
services costs shows that Company A generated an operating loss on 
the controlled services transaction, which indicates that material 
differences likely exist between the total services costs in the 
controlled and uncontrolled transactions, other than the costs that 
are identified as comparable transactional costs. Upon further 
scrutiny, the presence of such material differences between the 
controlled and uncontrolled transactions may indicate that the cost 
of services plus method does not provide the most reliable measure 
of an arm's length result under the facts and circumstances.
    Example 4. Internal comparable. (i) Company A, a U.S. 
corporation, and its subsidiaries perform computer consulting 
services relating to systems integration and networking for business 
clients in various countries. Company A and its subsidiaries render 
only consulting services and do not manufacture or distribute 
computer hardware or software to clients. The controlled group is 
organized according to industry specialization, with key industry 
specialists working for Company A. These personnel typically form 
the core consulting group that teams with consultants from the 
local-country subsidiaries to serve clients in the subsidiaries' 
respective countries.
    (ii) On some occasions, Company A and its subsidiaries undertake 
engagements directly for clients. On other occasions, they work as 
subcontractors for uncontrolled parties on more extensive supply-
chain consulting engagements for clients. In undertaking the latter 
engagements with third-party consultants, Company A typically prices 
its services at four times the compensation costs of its 
consultants, defined as the consultants' base salary plus estimated 
fringe benefits, as defined in the table below:

Category/Rates

Project managers--$100 per hour
Technical staff--$75 per hour

    (iii) In uncontrolled transactions, Company A also charges the 
customer, at no markup, for out-of-pocket expenses such as travel,

[[Page 53471]]

lodging, and data acquisition charges. Thus, for example, a project 
involving 100 hours of time from project managers, and 400 hours of 
technical staff time would result in total compensation costs to 
Company A of (100 hrs. x $100/hr.) + (400 hrs. x $75/hr.) = $10,000 
+ $30,000 = $40,000. Applying the markup of 300%, the total fee 
charged would thus be (4 x $40,000), or $160,000, plus out-of-pocket 
expenses.
    (iv) Company B, a Country X subsidiary of Company A, contracts 
to render consulting services to a Country X client in the banking 
industry. In undertaking this engagement, Company B uses its own 
consultants and also uses the services of Company A project managers 
and technical staff that specialize in the banking industry for 75 
hours and 380 hours, respectively. The data available are 
sufficiently complete to conclude that it is likely that all 
material differences between the controlled and uncontrolled 
transactions have been identified and adjusted for. Based on 
reliable data concerning the compensation costs to Company A, an 
arm's length result for the controlled services transaction is equal 
to $144,000. This is calculated as follows: [4 x (75 hrs. x $100/
hr.)] + [4 x (380 hrs. x $75/hr.)] = $30,000 + $114,000 = $144,000, 
reflecting a 4x markup on the total compensation costs for Company A 
project managers and technical staff. In addition, consistent with 
Company A's pricing of uncontrolled transactions, Company B must 
reimburse Company A for appropriate out-of-pocket expenses incurred 
in performing the services.

    (e) Comparable profits method--(1) In general. The comparable 
profits method evaluates whether the amount charged in a controlled 
transaction is arm's length, based on objective measures of 
profitability (profit level indicators) derived from uncontrolled 
taxpayers that engage in similar business activities under similar 
circumstances. The rules in Sec.  1.482-5 for application of the 
comparable profits method apply to controlled services transactions, 
except as modified in this paragraph (e).
    (2) Determination of arm's length result--(i) Tested party. This 
paragraph (e) applies where the relevant business activity of the 
tested party as determined under Sec.  1.482-5(b)(2) is the rendering 
of services in a controlled services transaction. Where the tested 
party determined under Sec.  1.482-5(b)(2) is instead the recipient of 
the controlled services, the rules under this paragraph (e) are not 
applicable to determine the arm's length result.
    (ii) Profit level indicators. In addition to the profit level 
indicators provided in Sec.  1.482-5(b)(4), a profit level indicator 
that may provide a reliable basis for comparing operating profits of 
the tested party involved in a controlled services transaction and 
uncontrolled comparables is the ratio of operating profit to total 
services costs (as defined in paragraph (j) of this section).
    (iii) Comparability and reliability considerations--Data and 
assumptions--Consistency in accounting. Consistency in accounting 
practices between the relevant business activity of the tested party 
and the uncontrolled service providers is particularly important in 
determining the reliability of the results under this method, but less 
than in applying the cost of services plus method. Adjustments may be 
appropriate if materially different treatment is applied to particular 
cost items related to the relevant business activity of the tested 
party and the uncontrolled service providers. For example, adjustments 
may be appropriate where the tested party and the uncontrolled 
comparables use inconsistent approaches to classify similar expenses as 
``cost of goods sold'' and ``selling, general, and administrative 
expenses.'' Although distinguishing between these two categories may be 
difficult, the distinction is less important to the extent that the 
ratio of operating profit to total services costs is used as the 
appropriate profit level indicator. Determining whether adjustments are 
necessary under these or similar circumstances requires thorough 
analysis of the functions performed and consideration of the cost 
accounting practices of the tested party and the uncontrolled 
comparables. Other adjustments as provided in Sec.  1.482-5(c)(2)(iv) 
may also be necessary to increase the reliability of the results under 
this method.
    (3) Examples. The principles of this paragraph (e) are illustrated 
by the following examples:

    Example 1. Ratio of operating profit to total services costs as 
the appropriate profit level indicator. (i) A Country T parent firm, 
Company A, and its Country Y subsidiary, Company B, both engage in 
manufacturing as their principal business activity. Company A also 
performs certain advertising services for itself and its affiliates. 
In year 1, Company A renders advertising services to Company B.
    (ii) Based on the facts and circumstances, it is determined that 
the comparable profits method will provide the most reliable measure 
of an arm's length result. Company A is selected as the tested 
party. No data are available for comparable independent 
manufacturing firms that render advertising services to third 
parties. Financial data are available, however, for ten independent 
firms that render similar advertising services as their principal 
business activity in Country X. The ten firms are determined to be 
comparable under Sec.  1.482-5(c). Neither Company A nor the 
comparable companies use valuable intangibles in rendering the 
services.
    (iii) Based on the available financial data of the comparable 
companies, it cannot be determined whether these comparable 
companies report costs for financial accounting purposes in the same 
manner as the tested party. The publicly available financial data of 
the comparable companies segregate total services costs into cost of 
goods sold and sales, general and administrative costs, with no 
further segmentation of costs provided. Due to the limited 
information available regarding the cost accounting practices used 
by the comparable companies, the ratio of operating profits to total 
services costs is determined to be the most appropriate profit level 
indicator. This ratio includes total services costs to minimize the 
effect of any inconsistency in accounting practices between Company 
A and the comparable companies.
    Example 2. Application of the operating profit to total services 
costs profit level indicator. (i) Company A is a foreign subsidiary 
of Company B, a U.S. corporation. Company B is under examination for 
its 2005 taxable year. Company B renders management consulting 
services to Company A. Company B's consulting function includes 
analyzing Company A's operations, benchmarking Company A's financial 
performance against companies in the same industry, and to the 
extent necessary, developing a strategy to improve Company A's 
operational performance. The accounting records of Company B allow 
reliable identification of the total services costs of the 
consulting staff associated with the management consulting services 
rendered to Company A. Company A reimburses Company B for its costs 
associated with rendering the consulting services, with no markup.
    (ii) Based on all the facts and circumstances, it is determined 
that the comparable profits method will provide the most reliable 
measure of an arm's length result. Company B is selected as the 
tested party, and its rendering of management consulting services is 
identified as the relevant business activity. Data are available 
from ten domestic companies that operate in the industry segment 
involving management consulting and that perform activities 
comparable to the relevant business activity of Company B. These 
comparables include entities that primarily perform management 
consulting services for uncontrolled parties. The comparables incur 
similar risks as Company A incurs in performing the consulting 
services, and do not make use of valuable intangibles or special 
processes.
    (iii) Based on the available financial data of the comparables, 
it cannot be determined whether the comparables report their costs 
for financial accounting purposes in the same manner as Company B 
reports its costs in the relevant business activity. The available 
financial data for the comparables only report an aggregate figure 
for costs of goods sold and operating expenses, and do not segment 
the underlying services costs. Due to this limitation, the ratio of 
operating profits to total services costs is determined to be the 
most appropriate profit level indicator.
    (iv) For the taxable years 2003 through 2005, Company B shows 
the following results for the services performed for Company A:

[[Page 53472]]



----------------------------------------------------------------------------------------------------------------
                                                       2003            2004            2005           Average
----------------------------------------------------------------------------------------------------------------
Revenues........................................       1,200,000       1,100,000       1,300,000       1,200,000
Cost of Goods Sold..............................         100,000         100,000             N/A          66,667
Operating Expenses..............................       1,100,000       1,000,000       1,300,000       1,133,333
Operating Profit................................               0               0               0               0
----------------------------------------------------------------------------------------------------------------

    (v) After adjustments have been made to account for identified 
material differences between the relevant business activity of 
Company B and the comparables, the average ratio for the taxable 
years 2003 through 2005 of operating profit to total services costs 
is calculated for each of the uncontrolled service providers. 
Applying each ratio to Company B's average total services costs from 
the relevant business activity for the taxable years 2003 through 
2005 would lead to the following comparable operating profit (COP) 
for the services rendered by Company B:

------------------------------------------------------------------------
                                             OP/total
      Uncontrolled service provider        service costs  Company B  COP
                                           (In percent)
------------------------------------------------------------------------
Company 1...............................           15.75        $189,000
Company 2...............................           15.00         180,000
Company 3...............................           14.00         168,000
Company 4...............................           13.30         159,600
Company 5...............................           12.00         144,000
Company 6...............................           11.30         135,600
Company 7...............................           11.25         135,000
Company 8...............................           11.18         134,160
Company 9...............................           11.11         133,320
Company 10..............................           10.75         129,000
------------------------------------------------------------------------

    (vi) The available data are not sufficiently complete to 
conclude that it is likely that all material differences between the 
relevant business activity of Company B and the comparables have 
been identified. Therefore, an arm's length range can be established 
only pursuant to Sec.  1.482-1(e)(2)(iii)(B). The arm's length range 
is established by reference to the interquartile range of the 
results as calculated under Sec.  1.482-1(e)(2)(iii)(C), which 
consists of the results ranging from $168,000 to $134,160. Company 
B's reported average operating profit of zero ($0) falls outside 
this range. Therefore, an allocation may be appropriate.
    (vii) Because Company B reported income of zero, to determine 
the amount, if any, of the allocation, Company B's reported 
operating profit for 2005 is compared to the comparable operating 
profits derived from the comparables' results for 2005. The ratio of 
operating profit to total services costs in 2005 is calculated for 
each of the comparables and applied to Company B's 2005 total 
services costs to derive the following results:

------------------------------------------------------------------------
                                             OP/total
                                           service costs
      Uncontrolled service provider         (For 2005)    Company B  COP
                                           (In percent)
------------------------------------------------------------------------
Company 1...............................           15.00        $195,000
Company 2...............................           14.75         191,750
Company 3...............................           14.00         182,000
Company 4...............................           13.50         175,500
Company 5...............................           12.30         159,900
Company 6...............................           11.05         143,650
Company 7...............................           11.03         143,390
Company 8...............................           11.00         143,000
Company 9...............................           10.50         136,500
Company 10..............................           10.25         133,250
------------------------------------------------------------------------

    (viii) Based on these results, the median of the comparable 
operating profits for 2005 is $151,775. Therefore, Company B's 
income for 2005 is increased by $151,775, the difference between 
Company B's reported operating profit for 2005 of zero and the 
median of the comparable operating profits for 2005.

    (f) Simplified cost-based method for certain services--(1) 
Evaluation of arm's length charge--(i) In general. The simplified cost-
based method evaluates whether the amount charged in a controlled 
services transaction that meets the conditions of paragraph (f)(3) of 
this section and is not described in paragraph (f)(2)(iii) or (f)(4) of 
this section is arm's length by reference to the markup on total 
services costs by uncontrolled taxpayers that engage in similar 
business activities under similar circumstances. This measure of an 
arm's length price corresponds to the profit level indicator consisting 
of the ratio of operating profit to total services costs, described in 
paragraph (e)(2)(ii) of this section.
    (ii) Coordination with best method rule. If a controlled services 
transaction that meets the conditions of paragraph (f)(3) of this 
section and is not described in paragraphs (f)(2)(iii) or (f)(4) of 
this section is priced under or consistent with the simplified cost-
based method, then the simplified cost-based method will be considered 
the best method for purposes of Sec.  1.482-1(c).
    (2) Limitation on allocations by the Commissioner--(i) In general. 
Except as provided in paragraphs (f)(2)(iv) and (v) of this section, 
the Commissioner may make an allocation with respect to a controlled 
services transaction that meets the conditions of paragraph (f)(3) of 
this section, that is not described in paragraphs (f)(2)(iii) or (f)(4) 
of this section, and that is priced under or consistent with the 
simplified cost-based method, only if the arm's length

[[Page 53473]]

markup on total services costs exceeds the markup charged by the 
taxpayer on total services costs in the controlled transaction by at 
least the applicable number of percentage points described in paragraph 
(f)(2)(ii) of this section. For purposes of this paragraph (f), the 
arm's length markup on total services costs means the excess of the 
arm's length price of the controlled services transaction determined in 
accordance with the applicable rules under the section 482 regulations, 
without regard to this paragraph (f), over total services costs (as 
defined in paragraph (j) of this section), expressed as a percentage of 
total services costs.
    (ii) Applicable number of percentage points. The applicable number 
of percentage points is six if the amount charged by the taxpayer is 
equal to total services costs, and the applicable number of percentage 
points declines ratably to zero by one percentage point for every 
increase of two percentage points in the markup on total services costs 
charged in the controlled transaction.
    (iii) Method inapplicable to high-margin transactions. The 
simplified cost-based method may not be used if the arm's length markup 
on total services costs exceeds 10%.
    (iv) Measurement of limitation on allocations. The rules of 
paragraphs (f)(2)(i) and (ii) of this section are expressed in this 
paragraph in equations and a table. The minimum arm's length markup 
necessary for an allocation by the Commissioner (``Z'') is the sum of 
the markup charged by the taxpayer (``X'') and the applicable number of 
percentage points determined under paragraph (f)(2)(ii) of this section 
(``Y''). This minimum arm's length markup necessary for allocation by 
the Commissioner (``Z'') also equals the lesser of--
    (A) The sum of six percentage points and half of the markup charged 
by the taxpayer (``X''); and
    (B) Ten percentage points, where the markup charged by the taxpayer 
is not less than zero. Thus:

Z = X + Y = min((6% + 0.5 x X),10%) where X = 0.

    (C) The following table illustrates the results of these 
calculations in representative cases:

--------------------------------------------------------------------------------------------------------------------------------------------------------
 
--------------------------------------------------------------------------------------------------------------------------------------------------------
Markup charged by taxpayer (X).  0%           1%          2%          3%          4%          5%          6%          7%          8%          9%
Applicable number of percentage  6            5.5         5           4.5         4           3.5         3           2.5         2           n/a
 points (Y).
Arm's length markup necessary    6%           6.5%        7%          7.5%        8%          8.5%        9%          9.5%        10%         10%
 for allocation by the
 Commissioner (Z).
--------------------------------------------------------------------------------------------------------------------------------------------------------

    (v) Scope of limitation on allocations by the Commissioner--(A) 
Loss transactions and transactions priced in excess of arm's length. 
Nothing in this paragraph (f) shall limit the authority of the 
Commissioner to make an allocation where--
    (1) The amount charged by the taxpayer is less than the total 
services costs with respect to the services; or
    (2) The markup on total services costs charged by the taxpayer in 
the controlled transaction exceeds the arm's length markup on total 
services costs.
    (B) Allocation and apportionment of costs. Nothing in this 
paragraph (f) limits the authority of the Commissioner to determine the 
total services costs in the controlled services transaction where the 
taxpayer's method of allocating and apportioning total services costs 
to the controlled service is not consistent with the method used to 
allocate and apportion total services costs in determining the arm's 
length markup, or otherwise does not constitute a reasonable method of 
allocation and apportionment, based on all the facts and circumstances.
    (3) Conditions on application of simplified cost-based method. The 
arm's length amount charged in a controlled services transaction may be 
evaluated under the simplified cost-based method only if the following 
conditions are met.
    (i) Adequate books and records. Permanent books of account and 
records must be maintained throughout the time when costs with respect 
to the controlled services are incurred by the renderer. Such books and 
records must be adequate to permit verification by the Commissioner of 
the total services costs incurred by the renderer, including 
verification of the methods used to allocate and apportion such costs 
to the services in question.
    (ii) Written contract--(A) In general. A written contract must be 
in place throughout the time when costs with respect to the controlled 
services are incurred by the renderer and must provide the following--
    (1) That the controlled recipient of such services becomes 
unconditionally obligated at the time the renderer incurs costs to pay 
the renderer an amount equal to total costs plus, to the extent 
provided in such contract, any markup on total services costs; and
    (2) A general description of the classes of controlled services 
transactions subject to the contract.
    (B) De minimis exception. A written contract need not be in place 
if the conduct of the controlled taxpayers is consistent with the terms 
described in paragraph (f)(3)(ii)(A) of this section and, for the 
taxable year at issue, the controlled taxpayer rendering the services 
establishes to the satisfaction of the Commissioner that--
    (1) The aggregate gross income of the members controlled group 
consisting of taxpayers that are United States persons (as defined in 
Sec.  7701(a)(30)) is less than $200 million; or
    (2) The aggregate costs of such controlled group members evaluated 
under the simplified cost-based method are less than $10 million.
    (4) Transactions not eligible for simplified cost-based method--(i) 
Services similar to services provided by renderer or recipient to 
uncontrolled parties. The arm's length charge in a controlled services 
transaction may not be determined under the simplified cost-based 
method where the renderer, the recipient, or another controlled 
taxpayer in the same controlled group renders, or has rendered, similar 
services to one or more uncontrolled taxpayers (unless such services 
are rendered on a de minimis basis).
    (ii) Services rendered to a recipient that receives services from 
controlled taxpayers in significant amounts. The arm's length charge in 
a controlled services transaction may not be determined under the 
simplified cost-based method where the services are rendered to a 
recipient that receives services from controlled taxpayers in 
significant amounts. A recipient may be presumed to receive services in 
significant amounts unless the controlled taxpayer rendering the 
services establishes, to the satisfaction of the Commissioner, that the 
aggregate amount paid or accrued by the recipient of the controlled 
services to the renderer or renderers with respect to such services 
during a taxable year of the recipient is less than an amount equal to 
50% of the total costs of the recipient in that taxable year. For 
purposes of this paragraph (f)(4)(ii), the total costs of the recipient 
exclude any amounts paid or accrued for materials that are properly 
reflected in the recipient's cost of goods sold.
    (iii) Services involving the use of intangible property. The arm's 
length charge in a controlled services

[[Page 53474]]

transaction may not be determined under the simplified cost-based 
method where the renderer's valuable or unique intangible property, or 
the renderer's particular resources or capabilities (such as the 
knowledge of and ability to take advantage of particularly advantageous 
situations or circumstances), contribute significantly to the value of 
the services and the renderer's costs associated with the services do 
not include costs with respect to such use of its intangible property 
or resources that are significant.
    (iv) Non-services transactions included in integrated transactions. 
The arm's length charge in a controlled services transaction may not be 
determined under the simplified cost-based method to the extent a 
transaction other than a services transaction (such as a transfer of 
tangible property) accounts for a more than de minimis amount of value 
in a transaction structured as a controlled services transaction. In 
such cases, the arm's length charge for only the services element of 
the integrated transaction may be determined under the simplified cost-
based method.
    (v) Certain transactions. The arm's length charge may not be 
determined under the simplified cost-based method in any of the 
following categories of transactions:
    (A) Manufacturing;
    (B) Production;
    (C) Extraction;
    (D) Construction;
    (E) Reselling, distribution, acting as a sales or purchasing agent, 
or acting under a commission or other similar arrangement;
    (F) Research, development, or experimentation;
    (G) Engineering or scientific;
    (H) Financial transactions, including guarantees; and
    (I) Insurance or reinsurance.
    (5) Examples. The following examples illustrate the operation of 
this paragraph (f), including the limitations of paragraph (f)(2) of 
this section on allocations by the Commissioner. For purposes of 
illustrating the operation and scope of such limitations, the examples 
assume a determination of an arm's length markup on total services 
costs and, where appropriate, the interquartile range and median with 
respect to the arm's length markup on total costs. In each example, 
assume that S is a wholly owned subsidiary of P; that the conditions 
described in paragraph (f)(3) of this section are satisfied; and that 
the relevant controlled services are not described in paragraph (f)(4) 
of this section.

    Example 1. Company P renders accounting services to Company S. 
Company P uses the simplified cost-based method for the accounting 
services, and determines the amount charged as Company P's total 
cost of rendering the services, with no markup. Based on an 
application of the section 482 regulations without regard to this 
paragraph (f), the Commissioner determines that the interquartile 
range of arm's length markups on total services costs is between 3% 
and 6%, and the median is 4%. Because the arm's length markup on 
total services costs (4%) exceeds the markup on total services costs 
applied by the taxpayer (0%) by fewer than the applicable number of 
percentage points (6), the Commissioner may not make an allocation.
    Example 2. Company P performs logistics-coordination services 
for its subsidiaries, including Company S. Company P uses the 
simplified cost-based method for the logistics services, and 
determines the amount charged as Company P's total cost of rendering 
the services, plus a markup of 5%. Based on an application of the 
section 482 regulations without regard to this paragraph (f), the 
Commissioner determines that the interquartile range of arm's length 
markups on total services costs is between 6% and 13%, and the 
median is 9%. Because the arm's length markup on total services 
costs (9%) exceeds the markup on total services costs applied by the 
taxpayer (5%) by more than the applicable number of percentage 
points (3.5), the limitations imposed by this rule on the 
Commissioner's authority to make an allocation do not apply. With 
respect to the determination and application of the arm's length 
range, see Sec.  1.482-1(e).
    Example 3. Company P renders administrative services to its 
subsidiaries, including Company S. Company P uses the simplified 
cost-based method for the administrative services, as it has for the 
preceding two years, and determines for all three years the amount 
charged as Company P's total cost of rendering the services, plus a 
markup of 5%. Based on an application of the section 482 regulations 
without regard to this paragraph (f), the Commissioner identifies 
uncontrolled comparables in the same industry segment that perform 
similar functions and bear similar risks as Company P. These 
transactions meet the comparability criteria under the comparable 
profits method of paragraph (e) of this section and Sec.  1.482-5. 
An analysis of the information available on the comparable parties 
shows that the ratio of operating profit to total services costs is 
the most appropriate profit level indicator, and that this ratio is 
relatively stable where at least three years are included in the 
average. The information available is not sufficiently complete to 
conclude that it is likely that all material differences between 
Company P and the uncontrolled comparables have been identified. 
Consequently, the Commissioner determines an arm's length range 
based on the results of all the uncontrolled comparables that 
achieve a similar level of comparability and reliability, and the 
Commissioner adjusts that range by applying a valid statistical 
method to the results of all the uncontrolled comparables. The 
Commissioner determines an interquartile range of arm's length 
markups on total services costs, which is between 6% and 13%, with a 
median of 9%. Because the arm's length markup on total services 
costs (9%) exceeds the average three-year markup on total services 
costs applied by the taxpayer (5%) by more than the applicable 
number of percentage points (3.5), the limitations imposed by this 
rule on the Commissioner's authority to make an allocation do not 
apply. With respect to the determination and application of the 
arm's length range, see Sec.  1.482-1(e).
    Example 4. Company P renders administrative services to Company 
S. Company P uses the simplified cost-based method for the 
administrative services, and determines the amount charged as 
Company P's total cost of rendering the services, plus a markup of 
6%. Based on an application of the section 482 regulations without 
regard to this paragraph (f), the Commissioner determines that the 
interquartile range of arm's length markups on total services costs 
is between 3% and 5%, and the median is 4.5%. Because the arm's 
length markup on total services costs (4.5%) is less than the markup 
applied by the taxpayer (6%), the limitations imposed by this rule 
on the Commissioner's authority to make an allocation do not apply.
    Example 5. Company P provides administrative services to Company 
S. P uses the simplified cost-based method for the administrative 
services, and determines the amount charged as Company P's total 
cost of providing the services, minus a ``markdown'' of 1%. Because 
the markup on total services costs applied by the taxpayer in the 
controlled transaction (-1%) is less than zero, the limitations 
imposed by this rule on the Commissioner's authority to make an 
allocation do not apply.
    Example 6. Company P performs custodial and maintenance services 
for certain office properties owned by Company S. Company P uses the 
simplified cost-based method for the administrative services, and 
determines the amount charged as Company P's total cost of providing 
the services plus a markup of 8%. The Commissioner identifies 
uncontrolled comparables that perform a similar range of custodial 
and maintenance services for uncontrolled parties and charge those 
parties an annual fee based on the total square footage of the 
property. These transactions meet the comparability criteria under 
the comparable uncontrolled services price method of paragraph (b) 
of this section. Based on reliable accounting information, the 
Commissioner determines that it is possible to restate the price for 
the maintenance and custodial services charged to uncontrolled 
parties as representing a markup on total services costs of 4%. 
Because the markup on total services costs charged by the taxpayer 
on the controlled transactions exceeds the markup on total services 
costs determined by an application of the section 482 regulations 
without regard to this paragraph (f), the limitations imposed by 
this rule on the Commissioner's authority to make an allocation do 
not apply.
    Example 7. Company P performs logistics-coordination services 
for its subsidiaries, including Company S. Company P uses the

[[Page 53475]]

simplified cost-based method for the logistics services, and 
determines the amount charged as P's total cost of providing the 
services, plus a markup of 4%. Based on an application of the 
section 482 regulations without regard to this paragraph (f), the 
Commissioner determines that the interquartile range of arm's length 
markups on total services costs is between 3% and 11%, and the 
median is 8.5%. Given that the arm's length markup on total services 
costs (8.5%) exceeds the markup applied by the taxpayer (4%) by more 
than the applicable number of percentage points (4), the limitations 
imposed by this rule on the Commissioner's authority to make an 
allocation do not apply. With respect to the application of the 
arm's length range, see Sec.  1.482-1(e).
    Example 8. Company P provides administrative services to Company 
S. Company P uses the simplified cost-based method for the 
administrative services, and determines the amount charged as 
Company P's total cost of providing the services, plus a markup of 
4%. The taxpayer allocates and apportions to the administrative 
services total services costs of 300x, and reports a total price of 
312x. Based on an application of the section 482 regulations without 
regard to this paragraph (f), the Commissioner determines that the 
interquartile range of arm's length markups on total services costs 
is between 3% and 6%, and the median is 4%. Because the arm's length 
markup on total services costs (4%) is equivalent to the markup on 
total services costs applied by the taxpayer (4%), the simplified 
cost-based method would generally prevent an allocation by the 
Commissioner based on the amount of markup charged. On examination, 
the Commissioner determines that the taxpayer should have allocated 
and apportioned total services costs of 325x to the administrative 
services, rather than 300x. Because the taxpayer's method of 
allocation and apportionment was not reasonable under the facts and 
circumstances, the Commissioner may make an allocation to reflect 
application of the markup on total services costs claimed by the 
taxpayer to the correct base of costs.
    Example 9. Company P provides administrative services to Company 
S. Company P uses the simplified cost-based method for the 
administrative services, and determines the amount charged as 
Company P's total cost of providing the services, with a 4% markup. 
The taxpayer allocates and apportions to the administrative services 
total services costs of 300x. Based on an application of the section 
482 regulations without regard to this paragraph (f), the 
Commissioner determines that the interquartile range of arm's length 
markups on total services costs is between 3% and 6%, and the median 
is 4%. Because the arm's length markup on total services costs (4%) 
is equivalent to the markup on total services costs applied by the 
taxpayer (4%), the simplified cost-based method would generally 
prevent an allocation by the Commissioner based on the amount of 
markup charged. On examination, the Commissioner determines that the 
taxpayer should have allocated and apportioned total services costs 
of 280x to the administrative services, rather than 300x. Because 
the taxpayer's method of allocation and apportionment was not 
reasonable under the facts and circumstances, the Commissioner may 
make an allocation to reflect application of the markup on total 
services costs claimed by the taxpayer to the correct base of costs.
    Example 10. Company P performs supply-chain management services 
for its subsidiaries, including Company S. Company P uses the 
simplified cost-based method for these supply-chain services, and 
determines the amount charged as the total costs of providing the 
services plus a markup of 8%. Based on an application of the section 
482 regulations without regard to this paragraph (f), the 
Commissioner determines that the interquartile range of arm's length 
markups is between 7% and 25%, and the median is 18%. Because the 
arm's length markup on total services costs is more than 10%, the 
simplified cost-based method is not applicable.

    (g) Profit split method--(1) In general. The profit split method 
evaluates whether the allocation of the combined operating profit or 
loss attributable to one or more controlled transactions is arm's 
length by reference to the relative value of each controlled taxpayer's 
contribution to that combined operating profit or loss. The relative 
value of each controlled taxpayer's contribution is determined in a 
manner that reflects the functions performed, risks assumed and 
resources employed by such controlled taxpayer in the relevant business 
activity. The profit split method is ordinarily used in controlled 
services transactions involving high-value services or transactions 
that are highly integrated and that cannot be reliably evaluated on a 
separate basis. For application of the profit split method (both the 
comparable profit split and the residual profit split), see Sec.  
1.482-6.
    (2) Examples. The principles of this paragraph (g) are illustrated 
by the following examples:

    Example 1. Residual profit split. (i) Company A, a corporation 
resident in Country X, auctions spare parts by means of an 
interactive database. Company A maintains a database that lists all 
spare parts available for auction. Company A developed the software 
used to run the database. Company A's database is managed by Company 
A employees in a data center located in Country X, where storage and 
manipulation of data also takes place. Company A has a wholly owned 
subsidiary, Company B, located in Country Y. Company B performs 
marketing and advertising activities to promote Company A's 
interactive database. Company B solicits unrelated companies to 
auction spare parts on Company A's database, and solicits customers 
interested in purchasing spare parts online. Company B owns and 
maintains a computer server in Country Y, where it receives 
information on spare parts available for auction. Company B has also 
designed a specialized communications network that connects its data 
center to Company A's data center in Country X. The communications 
network allows Company B to enter data from uncontrolled companies 
on Company A's database located in Country X. Company B's 
communications network also allows uncontrolled companies to access 
Company A's interactive database and purchase spare parts. Company B 
bore the risks and cost of developing this specialized 
communications network. Company B enters into contracts with 
uncontrolled companies and provides the companies access to Company 
A's database through the Company B network.
    (ii) Analysis of the facts and circumstances indicates that both 
Company A and Company B possess valuable intangibles that they use 
to conduct the spare parts auction business. Company A bore the 
economic risks of developing and maintaining software and the 
interactive database. Company B bore the economic risks of 
developing the necessary technology to transmit information from its 
server to Company A's data-center, and to allow uncontrolled 
companies to access Company A's database. Company B helped to 
enhance the value of Company A's trademark and to establish a 
network of customers in Country Y. In addition, because the 
transactions between Company A and Company B are highly integrated, 
it is difficult to reliably evaluate them separately. Given the 
facts and circumstances, the Commissioner determines that a residual 
profit split method will provide the most reliable measure of an 
arm's length result.
    (iii) Under the residual profit split method, profits are first 
allocated based on the routine contributions of each taxpayer. 
Routine contributions include general sales, marketing or 
administrative functions performed by Company B for Company A for 
which it is possible to identify market returns. Any residual 
profits will be allocated based on the nonroutine contributions of 
each taxpayer. Since both Company A and Company B provided 
nonroutine contributions, the residual profits are allocated based 
on these contributions.
    Example 2. Residual profit split. (i) Company A, a U.S. 
corporation, is a large multinational corporation engaged in oil and 
mineral exploration, development and extraction/mining. In 
performing these functions, Company A uses teams of specialists who 
are drawn from its employees and employees of two of its wholly 
owned subsidiaries, Company B and Company C. Company B is a U.S. 
corporation engaged in the business of providing general 
construction contracting services. Company C is a mining/extraction 
subsidiary of Company A and is located in Country C.
    (ii) Through its long-term relationship with the Country C 
government, Company C obtains drilling rights on a tract of land for 
which it already owns mining rights. Because Company C lacks the 
expertise and personnel to perform oil exploration, Company C enters 
into an agreement with Companies A and B to provide certain services 
to facilitate exploration for oil on the tract. Specifically, 
Company A provides management services and Company B provides all 
necessary labor

[[Page 53476]]

and equipment for the exploration. All three controlled companies 
provide their own administrative support for their respective 
functions.
    (iii) Analysis of the facts and circumstances indicates that 
Companies A, B, and C all make nonroutine contributions. In 
addition, because the transactions between Companies A, B and C are 
highly integrated, it is difficult to reliably evaluate them on a 
separate basis. Given the facts and circumstances, the Commissioner 
determines that a residual profit split method will provide the most 
reliable measure of the arm's length results of the services 
performed by all three related taxpayers.
    (iv) Under the residual profit split method, profits are first 
allocated based on the routine contributions of the three controlled 
taxpayers. Routine contributions include any general, sales, 
marketing or administrative functions performed by either Companies 
A, B or C for which it is possible to identify market returns. Any 
residual profits will be allocated based on the nonroutine 
contributions made by each taxpayer. Since Company C provided 
nonroutine contributions in the form of drilling rights, residual 
profits are allocated to Company C based on this contribution.

    (h) Unspecified methods. Methods not specified in paragraphs (b) 
through (g) of this section may be used to evaluate whether the amount 
charged in a controlled services transaction is arm's length. Any 
method used under this paragraph (h) must be applied in accordance with 
the provisions of Sec.  1.482-1. Consistent with the specified methods, 
an unspecified method should take into account the general principle 
that uncontrolled taxpayers evaluate the terms of a transaction by 
considering the realistic alternatives to that transaction, and only 
enter into a particular transaction if none of the alternatives is 
preferable to it. For example, the comparable uncontrolled services 
price method compares a controlled services transaction to similar 
uncontrolled transactions to provide a direct estimate of the price to 
which the parties would have agreed had they resorted directly to a 
market alternative to the controlled services transaction. Therefore, 
in establishing whether a controlled services transaction achieved an 
arm's length result, an unspecified method should provide information 
on the prices or profits that the controlled taxpayer could have 
realized by choosing a realistic alternative to the controlled services 
transaction (e.g., outsourcing a particular service function, rather 
than performing the function itself). As with any method, an 
unspecified method will not be applied unless it provides the most 
reliable measure of an arm's length result under the principles of the 
best method rule. See Sec.  1.482-1(c). Therefore, in accordance with 
Sec.  1.482-1(d) (Comparability), to the extent that an unspecified 
method relies on internal data rather than uncontrolled comparables, 
its reliability will be reduced. Similarly, the reliability of a method 
will be affected by the reliability of the data and assumptions used to 
apply the method, including any projections used.
    (i) Contingent-payment contractual terms for services--(1) Economic 
substance of contingent payment contractual terms recognized. In the 
case of a contingent-payment arrangement, the arm's length result for 
the controlled services transaction ordinarily would not require 
payment by the recipient to the renderer in the tax accounting period 
in which the service is rendered if the specified contingency does not 
occur in that period, provided that it is reasonable to conclude that 
no such payment would be made by uncontrolled taxpayers engaged in 
similar transactions under similar circumstances. If the specified 
contingency occurs in a tax accounting period subsequent to the period 
in which the service is rendered, the arm's length result for the 
controlled services transaction ordinarily would require payment by the 
recipient to the renderer on a basis that reflects the recipient's 
benefit from the services rendered and the risks borne by the renderer 
in performing the activities in the absence of a provision that 
unconditionally obligates the recipient to pay for the activities 
performed in the tax accounting period in which the service is 
rendered, provided that it is reasonable to conclude that such payment 
would be made by uncontrolled taxpayers that engaged in similar 
transactions under similar circumstances.
    (2) Contingent-payment arrangement. For purposes of this paragraph 
(i), an arrangement shall be treated as a contingent-payment 
arrangement if--
    (i) Written contract. The arrangement is set forth in a written 
contract entered into prior to the start of the activity or group of 
activities constituting the controlled services transaction;
    (ii) Specified contingency. The contract states that payment is 
contingent (in whole or in part) upon the happening of a future benefit 
(within the meaning of paragraph (l)(3) of this section) for the 
recipient directly related to the controlled services transaction; and
    (iii) Basis for payment. The contract provides for payment on a 
basis that reflects the recipient's benefit from the services rendered 
and the risks borne by the renderer. Whether the specified contingency 
bears a direct relationship to the controlled services transaction, and 
whether the basis for payment reflects the recipient's benefit and the 
renderer's risk, are evaluated based on all the facts and 
circumstances. Pursuant to Sec.  1.482-1(d)(3)(ii)(B), one factor that 
is especially important is whether the contingency and the basis for 
payment are consistent with the economic substance of the controlled 
transaction and the conduct of the controlled parties.
    (3) Commissioner's authority to impute contingent-payment terms. 
Consistent with the authority in Sec.  1.482-1(d)(3)(ii)(B), the 
Commissioner may impute contingent-payment contractual terms in a 
controlled services transaction if the economic substance of the 
transaction is consistent with the existence of such terms.
    (4) Evaluation of arm's length charge. Whether the amount charged 
in a contingent-payment arrangement is arm's length will be evaluated 
in accordance with this section and other applicable rules under 
section 482. Payment under a contingent-payment contract must be 
reasonable and consistent with the economic substance of the controlled 
services transaction, based on all facts and circumstances, and must 
reflect the recipient's benefit from the services rendered and the 
risks borne by the renderer. In evaluating whether the amount charged 
in a contingent-payment arrangement for the manufacture, construction, 
or development of tangible or intangible property owned by the 
recipient is arm's length, the charge determined under the rules of 
Sec. Sec.  1.482-3 and 1.482-4 for the transfer of similar property may 
be considered. See Sec.  1.482-1(f)(2)(ii).
    (5) Examples. The principles of this paragraph (i) are illustrated 
by the following examples:

    Example 1. (i) Company X is a member of a controlled group that 
has operated in the pharmaceutical sector for many years. In Year 1, 
Company X enters into a written services agreement with Company Y, 
another member of the controlled group, whereby Company X will 
perform certain research and development activities for Company Y. 
The parties enter into the agreement before Company X undertakes any 
of the research and development activities covered by the agreement. 
At the time the agreement is entered into, the possibility that any 
new products will be developed is highly uncertain and the possible 
market or markets for any products that may be developed are not 
known and cannot be estimated with any reliability. Under the 
agreement, Company Y will own any patent or other rights that result 
from the activities of Company X under the agreement and Company Y 
will make

[[Page 53477]]

payments to Company X only if such activities result in commercial 
sales of one or more derivative products. In that event, Company Y 
will pay Company X, for a specified period, x% of Company Y's gross 
sales of each of such products. Payments are required with respect 
to each jurisdiction in which Company Y has sales of such a 
derivative product, beginning with the first year in which the sale 
of a product occurs in the jurisdiction and continuing for six 
additional years with respect to sales of that product in that 
jurisdiction.
    (ii) As a result of research and development activities 
performed by Company X for Company Y in Years 1 through 4, a 
compound is developed that may be more effective than existing 
medications in the treatment of certain conditions. Company Y 
registers the patent rights with respect to the compound in several 
jurisdictions in Year 4. In Year 6, Company Y begins commercial 
sales of the product in Jurisdiction A and, in that year, Company Y 
makes the payment to Company X that is required under the agreement. 
Sales of the product continue in Jurisdiction A in Years 7 through 9 
and Company Y makes the payments to Company X in Years 7 through 9 
that are required under the agreement.
    (iii) The years under examination are Years 6 though 9. In 
evaluating whether the contingent payment terms will be recognized, 
the Commissioner considers whether the conditions of Sec.  1.482-
9(i)(2) are met and whether the specified contingency and basis of 
payment are consistent with the economic substance of the controlled 
services transaction and with the conduct of the controlled parties. 
The Commissioner determines that the contingent-payment arrangement 
is reflected in the written agreement between Company X and Company 
Y; that commercial sales of products developed under the arrangement 
represent future benefits for Company Y directly related to the 
controlled services transaction; and that the basis for the payment 
provided for in the event such sales occur reflects the recipient's 
benefit and the renderer's risk. Consistent with Sec.  1.482-
1(d)(3)(ii)(B) and (iii)(B), the Commissioner determines that the 
parties' conduct over the term of the agreement has been consistent 
with their contractual allocation of risk; that Company X has the 
financial capacity to bear the risk that its research and 
development services may be unsuccessful and that it may not receive 
compensation for such services; and that Company X exercises 
managerial and operational control over the research and 
development, such that it is reasonable for Company X to assume the 
risk of those activities. The Commissioner also determines that the 
arrangement is consistent with terms that uncontrolled parties 
operating under similar conditions could reasonably be expected to 
adopt with respect to comparable research and development 
activities. Based on all these facts, the Commissioner determines 
that the terms of the contingent-payment arrangement are consistent 
with economic substance.
    (iv) In determining whether the amount charged under the 
contingent-payment arrangement in each of Years 6 through 9 is arm's 
length, the Commissioner evaluates under Sec.  1.482-9 and other 
applicable rules under Sec.  482 the compensation paid in each year 
for the research and development services. This analysis takes into 
account that under the contingent-payment terms Company X bears the 
risk that it might not receive payment for its services in the event 
that those services do not result in marketable products and the 
risk that the magnitude of its payment depends on the magnitude of 
product sales, if any. The Commissioner also considers the 
alternatives reasonably available to the parties in connection with 
the controlled services transaction. One such alternative, in view 
of Company X's willingness and ability to bear the risk and expenses 
of research and development activities, would be for Company X to 
undertake such activities on its own behalf and to license the 
rights to products successfully developed as a result of such 
activities. Accordingly, in evaluating the reasonableness of the 
compensation of x% of gross sales that is paid to Company X during 
the first four years of commercial sales of derivative products, the 
Commissioner may consider the royalties (or other consideration) 
charged for intangibles that are comparable to those incorporated in 
the derivative products and that resulted from Company X's research 
and development activities under the contingent-payment arrangement.
    Example 2. (i) The facts are the same as in paragraphs (i) and 
(ii) of Example 1, except that, in the event that Company X's 
activities result in commercial sales of one or more derivative 
products by Company Y, Company Y will pay Company X a fee equal to 
the research and development costs borne by Company X plus an amount 
equal to x% of such costs, with the payment to be made in the first 
year in which any such sales occur. The x% markup on costs is within 
the range, ascertainable in Year 1, of markups on costs of 
independent contract researchers that are compensated under terms 
that unconditionally obligate the recipient to pay for the 
activities performed in the tax accounting period in which the 
service is rendered. In Year 6, Company Y makes the single payment 
to Company X that is required under the arrangement.
    (ii) The years under examination are Years 6 though 9. In 
evaluating whether the contingent payment terms will be recognized, 
the Commissioner considers whether the requirements of Sec.  1.482-
9(i)(2) were met at the time the written agreement was entered into 
and whether the specified contingency and basis for payment are 
consistent with the economic substance of the controlled services 
transaction and with the conduct of the controlled parties. The 
Commissioner determines that the contingent-payment terms are 
reflected in the written agreement between Company X and Company Y 
and that commercial sales of products developed under the 
arrangement represent future benefits for Company Y directly related 
to the controlled services transaction. However, in this case, the 
Commissioner determines that the basis for payment provided for in 
the event such sales occur (costs of the services plus x%, 
representing the markup for contract research in the absence of any 
nonpayment risk) does not reflect the recipient's benefit and the 
renderer's risks in the controlled services transaction. The 
Commissioner also determines that the arrangement is not consistent 
with terms that uncontrolled parties operating under similar 
conditions could reasonably be expected to adopt with respect to 
comparable research and development activities. Based on all these 
facts, the Commissioner determines that the terms of the contingent-
payment arrangement are not consistent with economic substance.
    (iii) Accordingly, the Commissioner determines to exercise its 
authority to impute contingent-payment contractual terms that accord 
with economic substance, pursuant to paragraph (i)(3) of this 
section and Sec.  1.482-1(d)(3)(ii)(B). In this regard, the 
Commissioner takes into account that at the time the arrangement was 
entered into, the possibility that any new products would be 
developed was highly uncertain and the possible market or markets 
for any products that may be developed were not known and could not 
be estimated with any reliability. In such circumstances, it is 
reasonable to conclude that one possible basis of payment that 
uncontrolled parties could adopt in similar transactions under 
similar circumstances, in order to reflect the recipient's benefit 
and the renderer's risks, would be a charge equal to a percentage of 
commercial sales of one or more derivative products that result from 
the research and development activities. The Commissioner in this 
case may impute terms that require Company Y to pay Company X a 
percentage of sales of the products developed under the agreement in 
each of Years 6 through 9.
    (iv) In determining an appropriate arm's length charge under 
such imputed contractual terms, the Commissioner conducts an 
analysis under Sec.  1.482-9 and other applicable rules under 
section 482, and considers the alternatives reasonably available to 
the parties in connection with the controlled services transaction. 
One such alternative, in view of Company X's willingness and ability 
to bear the risks and expenses of research and development 
activities, would be for Company X to undertake such activities on 
its own behalf and to license the rights to products successfully 
developed as a result of such activities. Accordingly, for purposes 
of its determination, the Commissioner may consider the royalties 
(or other consideration) charged for intangibles that are comparable 
to those incorporated in the derivative products that resulted from 
Company X's research and development activities under the 
contingent-payment arrangement.

    (j) Total services costs. For purposes of this section, total 
services costs means all costs of rendering those services for which 
total services costs are being determined. Total services costs include 
all costs, based on analysis of the facts and circumstances, that can 
be directly identified with the act of rendering the services, and all 
other costs reasonably allocable to the services, under the principles 
of

[[Page 53478]]

paragraph (k)(2) of this section. In general, costs for this purpose 
should comprise full consideration for all resources expended, used, or 
made available to achieve the specific objective for which the service 
is rendered. Reference to generally accepted accounting principles or 
Federal income tax accounting rules (where Federal income tax data for 
comparable transactions or business activities are available) may 
provide a useful starting point but will not be conclusive. Total 
services costs do not include interest expense, foreign income taxes 
(as defined in Sec.  1.901-2(a)), or domestic income taxes.
    (k) Allocation of costs--(1) In general. In any case where the 
renderer's activity that results in a benefit (within the meaning of 
paragraph (l)(3) of this section) for one recipient in a controlled 
services transaction also generates a benefit for one or more other 
members of a controlled group (including the benefit, if any, to the 
renderer), and the amount charged under this section in the controlled 
services transaction is determined under a method that makes reference 
to costs, costs must be allocated among the portions of the activity 
for the benefit of the first mentioned recipient and such other members 
of the controlled group under this paragraph (k). The principles of 
this paragraph (k) must also be used whenever it is appropriate to 
allocate and apportion any class of costs (e.g., overhead costs) in 
order to determine the total services costs of rendering the services. 
In no event will an allocation of costs based on a generalized or non-
specific benefit be appropriate.
    (2) Appropriate method of allocation and apportionment--(i) 
Reasonable method standard. Any reasonable method may be used to 
allocate and apportion costs under this section. In establishing the 
appropriate method of allocation and apportionment, consideration 
should be given to all bases and factors, including, for example, total 
services costs, total costs for a relevant activity, assets, sales, 
compensation, space utilized, and time spent. The costs incurred by 
supporting departments may be apportioned to other departments on the 
basis of reasonable overall estimates, or such costs may be reflected 
in the other departments' costs by applying reasonable departmental 
overhead rates. Allocations and apportionments of costs must be made on 
the basis of the full cost, as opposed to the incremental cost.
    (ii) Use of general practices. The practices used by the taxpayer 
to apportion costs in connection with preparation of statements and 
analyses for the use of management, creditors, minority shareholders, 
joint venturers, clients, customers, potential investors, or other 
parties or agencies in interest will be considered as potential 
indicators of reliable allocation methods, but need not be accorded 
conclusive weight by the Commissioner. In determining the extent to 
which allocations are to be made to or from foreign members of a 
controlled group, practices employed by the domestic members in 
apportioning costs among themselves will also be considered if the 
relationships with the foreign members are comparable to the 
relationships among the domestic members of the controlled group. For 
example, if for purposes of reporting to public stockholders or to a 
governmental agency, a corporation apportions the costs attributable to 
its executive officers among the domestic members of a controlled group 
on a reasonable and consistent basis, and such officers exercise 
comparable control over foreign members of the controlled group, such 
domestic apportionment practice will be considered in determining the 
allocations to be made to the foreign members.
    (3) Examples. The principles of this paragraph (k) are illustrated 
by the following examples:

    Example 1. Company A pays an annual license fee of 500x to an 
uncontrolled taxpayer for unlimited use of a database within the 
corporate group. Under the terms of the license with the 
uncontrolled taxpayer, Company A is permitted to use the database 
for its own use and in rendering research services to its 
subsidiary, Company B. Company B obtains benefits from the database 
that are similar to those that it would obtain if it had 
independently licensed the database from the uncontrolled taxpayer. 
Evaluation of the arm's length charge (under a method in which costs 
are relevant) to Company B for the controlled services that 
incorporate use of the database must take into account the full 
amount of the license fee of 500x paid by Company A, as reasonably 
allocated and apportioned to the relevant benefits, although the 
incremental use of the database for the benefit of Company B did not 
result in an increase in the license fee paid by Company A.
    Example 2. (i) Company A is a consumer products company located 
in the United States. Companies B and C are wholly owned 
subsidiaries of Company A and are located in Countries B and C, 
respectively. Company A and its subsidiaries manufacture products 
for sale in their respective markets. Company A hires a consultant 
who has expertise regarding a manufacturing process used by Company 
A and its subsidiary, Company B. Company C, the Country C 
subsidiary, uses a different manufacturing process, and accordingly 
will not receive any benefit from the outside consultant hired by 
Company A. In allocating and apportioning the cost of hiring the 
outside consultant (100), Company A determines that sales constitute 
the most appropriate allocation key.
    (ii) Company A and its subsidiaries have the following sales:

------------------------------------------------------------------------
                Company                     A       B       C     Total
------------------------------------------------------------------------
Sales..................................    400     100     200      700
------------------------------------------------------------------------

    (iii) Because Company C does not obtain any benefit from the 
consultant, none of the costs are allocated to it. Rather, the costs 
of 100 are allocated and apportioned ratably to Company A and 
Company B as the entities that obtain a benefit from the campaign, 
based on the total sales of those entities (500). An appropriate 
allocation of the costs of the consultant is as follows:

------------------------------------------------------------------------
                 Company                       A          B       Total
------------------------------------------------------------------------
Allocation...............................    400/500    100/500  .......
Amount...................................         80         20      100
------------------------------------------------------------------------

    (l) Controlled services transaction--(1) In general. A controlled 
services transaction includes any activity (as defined in paragraph 
(l)(2) of this section) by one member of a group of controlled 
taxpayers (the renderer) that results in a benefit (as defined in 
paragraph (l)(3) of this section) to one or more other members of the 
controlled group (the recipient(s)).
    (2) Activity. An activity includes the performance of functions, 
assumptions of risks, or use by a renderer of tangible or intangible 
property or other resources, capabilities, or knowledge, such as 
knowledge of and ability to take advantage of particularly advantageous 
situations or circumstances. An activity also includes making available 
to the recipient any property or other resources of the renderer.
    (3) Benefit--(i) In general. An activity is considered to provide a 
benefit to the recipient if the activity directly results in a 
reasonably identifiable increment of economic or commercial value that 
enhances the recipient's commercial position, or that may reasonably be 
anticipated to do so. An activity is generally considered to confer a 
benefit if, taking into account the facts and circumstances, an 
uncontrolled taxpayer in circumstances comparable to those of the 
recipient would be willing to pay an uncontrolled party to perform the 
same or similar activity on either a fixed or contingent-payment basis, 
or if the recipient otherwise would have performed for itself the same 
activity or a similar activity. A benefit may result to the owner of an 
intangible if the renderer engages in an activity that is reasonably 
anticipated to result in an increase in the value of that intangible.

[[Page 53479]]

    (ii) Indirect or remote benefit. An activity is not considered to 
provide a benefit to the recipient if, at the time the activity is 
performed, the present or reasonably anticipated benefit from that 
activity is so indirect or remote that the recipient would not be 
willing to pay, on either a fixed or contingent-payment basis, an 
uncontrolled party to perform a similar activity, and would not be 
willing to perform such activity for itself for this purpose. The 
determination whether the benefit from an activity is indirect or 
remote is based on the nature of the activity and the situation of the 
recipient, taking into consideration all facts and circumstances.
    (iii) Duplicative activities. If an activity performed by a 
controlled taxpayer duplicates an activity that is performed, or that 
reasonably may be anticipated to be performed, by another controlled 
taxpayer on or for its own account, the activity is not considered to 
provide a benefit to the recipient, unless the duplicative activity 
itself provides an additional benefit to the recipient.
    (iv) Shareholder activities. An activity is not considered to 
provide a benefit if the primary effect of that activity is to protect 
the renderer's capital investment in the recipient or in other members 
of the controlled group, or if the activity relates primarily to 
compliance by the renderer with reporting, legal, or regulatory 
requirements applicable specifically to the renderer, where the 
renderer controls every other member in such group. Activities in the 
nature of day-to-day management generally do not relate to protection 
of the renderer's capital investment. Based on analysis of the facts 
and circumstances, activities in connection with a corporate 
reorganization may be considered to provide a benefit to one or more 
controlled taxpayers.
    (v) Passive association. A controlled taxpayer generally will not 
be considered to obtain a benefit where that benefit results from the 
controlled taxpayer's status as a member of a controlled group. A 
controlled taxpayer's status as a member of a controlled group may, 
however, be taken into account for purposes of evaluating comparability 
between controlled and uncontrolled transactions.
    (4) Examples. The principles of this paragraph (l) are illustrated 
by the following examples. In each example, assume that Company X is a 
U.S. corporation and Company Y is wholly owned subsidiary of Company X 
in Country B.

    Example 1. In general. In developing a worldwide advertising and 
promotional campaign for a consumer product, Company X pays for and 
obtains designation as an official sponsor of the Olympics. This 
designation allows Company X and all its subsidiaries, including 
Company Y, to identify themselves as sponsors and to use the Olympic 
logo in advertising and promotional campaigns. The Olympic 
sponsorship campaign generates benefits to Company X, Company Y, and 
other subsidiaries of Company X.
    Example 2. Indirect or remote benefit. Based on recommendations 
contained in a study performed by its internal staff, Company X 
implements certain changes in its management structure and the 
compensation of managers of divisions located in the United States. 
No changes were recommended or considered for Company Y in Country 
B. The internal study and the resultant changes in its management 
may increase the competitiveness and overall efficiency of Company 
X. Any benefits to Company Y as a result of the study are, however, 
indirect or remote. Consequently, Company Y is not considered to 
obtain a benefit from the study.
    Example 3. Indirect or remote benefit. Based on recommendations 
contained in a study performed by its internal staff, Company X 
decides to make changes to the management structure and management 
compensation of its subsidiaries, in order to increase their 
profitability. As a result of the recommendations in the study, 
Company X implements substantial changes in the management structure 
and management compensation scheme of Company Y. The study and the 
changes implemented as a result of the recommendations are 
anticipated to increase the profitability of Company X and its 
subsidiaries. The increased management efficiency of Company Y that 
results from these changes is considered to be a specific and 
identifiable benefit, rather than remote or speculative. 
Consequently, Company Y is considered to obtain a benefit from the 
study.
    Example 4. Duplicative activities. At its corporate headquarters 
in the United States, Company X performs certain treasury functions 
for Company X and for its subsidiaries, including Company Y. These 
treasury functions include raising capital, arranging medium and 
long-term financing for general corporate needs, including cash 
management. Under these circumstances, the treasury functions 
performed by Company X do not duplicate the functions performed by 
Company Y's staff. Accordingly, Company Y is considered to obtain a 
benefit from the functions performed by Company X.
    Example 5. Duplicative activities. The facts are the same as in 
Example 4, except that Company Y's functions include ensuring that 
the financing requirements of its own operations are met. Analysis 
of the facts and circumstances indicates that Company Y 
independently administers all financing and cash-management 
functions necessary to support its operations, and does not utilize 
financing obtained by Company X. Under the circumstances, the 
treasury functions performed by Company X are duplicative of similar 
functions performed by Company Y's staff, and the duplicative 
functions do not enhance Company Y's position. Accordingly, Company 
Y is not considered to obtain a benefit from the duplicative 
activities performed by Company X.
    Example 6. Duplicative activities. Company X's in-house legal 
staff has specialized expertise in several areas, including 
intellectual property law. Company Y is involved in negotiations 
with an unrelated party to enter into a complex joint venture that 
includes multiple licenses and cross-licenses of patents and 
copyrights. Company Y retains outside counsel that specializes in 
intellectual property law to review the transaction documents. 
Outside counsel advises that the terms for the proposed transaction 
are advantageous to Company Y and that the contracts are valid and 
fully enforceable. Before Company Y executes the contracts, the 
legal staff of Company X also reviews the transaction documents and 
concurs in the opinion provided by outside counsel. The activities 
performed by Company X substantially duplicate the legal services 
obtained by Company Y, but they also reduce the commercial risk 
associated with the transaction. Accordingly, Company Y is 
considered to obtain a benefit from Company X's duplicative review 
of the contracts.
    Example 7. Shareholder activities. Company X is a publicly held 
corporation. U.S. laws and regulations applicable to publicly held 
corporations such as Company X require the preparation and filing of 
periodic reports that show, among other things, profit and loss 
statements, balance sheets, and other material financial information 
concerning the company's operations. Company X analyzes and compiles 
data regarding operation of its subsidiaries, including Company Y. 
The periodic reports prepared and filed by Company X include 
information on the financial results of Company Y and other 
subsidiaries. Because Company X's preparation and filing of the 
reports relate primarily to its role as an investor of capital and a 
shareholder in Company Y, these activities constitute shareholder 
activities and therefore Company Y is not considered to obtain a 
benefit from the preparation and filing of the reports.
    Example 8. Shareholder activities. The facts are the same as in 
Example 7, except that Company Y is subject to reporting 
requirements in Country B similar to those applicable to Company X 
in the United States. Much of the data that Company X analyzes and 
compiles regarding Company Y's operations for purposes of complying 
with the U.S. reporting requirements is made available to Company Y 
for its use in preparing reports that must be filed in Country B. 
Company Y incorporates these data, after minor adjustments for 
differences in local accounting practices, into the reports that it 
files in Country B. Under these circumstances, because Company X's 
analysis and compilation of Company Y's financial data do not relate 
primarily to its role as an investor of capital or shareholder in 
Company Y, Company Y is considered to obtain a benefit from the 
analysis and compilation of Company Y's financial data.
    Example 9. Shareholder activities. Members of Company X's 
internal audit staff

[[Page 53480]]

visit Company Y on a semiannual basis in order to review the 
subsidiary's adherence to internal operating procedures issued by 
Company X and its compliance with U.S. anti-bribery laws, which 
apply to Company Y on account of its ownership by a U.S corporation. 
Because the reviews by Company X's audit staff relate primarily to 
Company X's investment in Company Y by ensuring that Company X and 
its subsidiaries are in compliance with Company X's internal 
operating procedures and Country A laws, the visits are shareholder 
activities and therefore Company Y is not considered to obtain a 
benefit from the visits.
    Example 10. Shareholder activities. Country B recently enacted 
legislation that changed the foreign currency exchange controls 
applicable to foreign shareholders of Country B corporations. 
Company X concludes that it may benefit from changing the capital 
structure of Company Y, thus taking advantage of the new foreign 
currency exchange control laws in Country B. Company X engages an 
investment banking firm and a law firm to review the Country B 
legislation and to propose possible changes to the capital structure 
of Company Y. Because Company X retains and pays the firms in order 
to facilitate Company Y's ability to pay dividends and other 
amounts, these expenses relate primarily to Company X's role as an 
investor of capital and therefore Company Y is not considered to 
obtain a benefit from the activities.
    Example 11. Shareholder activities. The facts are the same as in 
Example 10, except that Company Y bears the full cost of retaining 
the firms to evaluate the new foreign currency control laws in 
Country B and to make appropriate changes to its stock ownership by 
Company X. Company X is considered to obtain a benefit from the 
rendering by Company Y of these activities, which would be 
shareholder activities if conducted by Company X (see Example 10).
    Example 12. Shareholder activities. The facts are the same as in 
Example 10, except that the new laws relate solely to corporate 
governance in Country B, and Company X retains the law firm and 
investment banking firm in order to evaluate whether restructuring 
would increase Company Y's profitability, reduce the number of legal 
entities in Country B, and increase Company Y's ability to introduce 
new products more quickly in Country B. Because Company X retained 
the law firm and the investment banking firm solely to enhance 
Company Y's profitability and the efficiency of its operations, the 
activities do not relate primarily to Company X's role as a 
shareholder or investor of capital and therefore Company Y is 
considered to obtain.
    Example 13. Shareholder activities. Company X establishes 
detailed personnel policies for its subsidiaries, including Company 
Y. Company X also reviews and approves the performance appraisals of 
Company Y's executives, monitors levels of compensation paid to all 
Company Y personnel, and is involved in hiring and firing decisions 
regarding the senior executives of Company Y. Because this 
personnel-related activity by Company X involves day-to-day 
management of Company Y, it does not relate primarily to Company X's 
role as an investor of capital or a shareholder of Company Y, and 
therefore Company Y is considered to obtain a benefit from the 
activity.
    Example 14. Shareholder activities. Each year, Company X 
conducts a two-day retreat for its senior executives. The purpose of 
the retreat is to refine the long-term business strategy of Company 
X and its subsidiaries, including Company Y, and to produce a 
confidential strategy statement. The strategy statement identifies 
several potential growth initiatives for Company X and its 
subsidiaries and lists general means of increasing the profitability 
of the company as a whole. The strategy statement is made available 
without charge to Company Y and the other subsidiaries of Company X. 
Company Y independently evaluates whether to implement some, all, or 
none of the initiatives contained in the strategy statement. Because 
the preparation of the strategy statement does not relate primarily 
to Company X's role as an investor of capital or a shareholder of 
Company Y, the expense of preparing the document is not a 
shareholder expense. In determining whether Company Y obtained a 
benefit from the making available of access to the strategy 
statement, the test is whether, based on the facts and 
circumstances, Company Y would be willing to pay for a similar 
analysis and similar recommendations, or otherwise would have 
undertaken a similar analysis on its own if it were an uncontrolled 
taxpayer operating under similar conditions as Company Y.
    Example 15. Passive association/benefit. Company X is the parent 
corporation of a large controlled group that has been in operation 
in the information-technology sector for ten years. Company Y is a 
small corporation that was recently acquired by the Company X 
controlled group from local Country B owners. Several months after 
the acquisition of Company Y, Company Y obtained a contract to 
redesign and assemble the information-technology networks and 
systems of a large financial institution in Country B. The project 
was significantly larger and more complex than any other project 
undertaken to date by Company Y. Company Y did not use Company X's 
marketing intangibles to solicit the contract, and Company X had no 
involvement in the solicitation, negotiation, or anticipated 
execution of the contract. For purposes of this section, Company Y 
is not considered to obtain a benefit from Company X or any other 
member of the controlled group because the ability of Company Y to 
obtain the contract, or to obtain the contract on more favorable 
terms than would have been possible prior to its acquisition by the 
Company X controlled group, was due to Company Y's status as a 
member of the Company X controlled group and not to any specific 
activity by Company X or any other member of the controlled group.
    Example 16. Passive association/benefit. The facts are the same 
as in Example 15, except that Company X executes a performance 
guarantee with respect to the contract, agreeing to assist in the 
project if Company Y fails to meet certain mileposts. This 
performance guarantee allowed Company Y to obtain the contract on 
more favorable terms than otherwise would have been possible. 
Company Y is considered to obtain a benefit from Company X's 
execution of the performance guarantee.
    Example 17. Passive association/benefit. The facts are the same 
as in Example 15, except that Company X began the process of 
negotiating the contract with the financial institution in Country B 
before acquiring Company Y. Once Company Y was acquired by Company 
X, the contract with the financial institution was entered into by 
Company Y. Company Y is considered to obtain a benefit from Company 
X's negotiation of the contract.

    (m) Coordination with transfer pricing rules for other 
transactions--(1) Services transactions that include other types of 
transactions. A transaction structured as a controlled services 
transaction may include other elements for which a separate category or 
categories of methods are provided, such as a loan or advance, a 
rental, or a transfer of tangible or intangible property. See 
Sec. Sec.  1.482-1(b)(2) and 1.482-2(a), (c), and (d). Whether such an 
integrated transaction is evaluated as a controlled services 
transaction under this section or whether one or more elements should 
be evaluated separately under other sections of the section 482 
regulations depends on which approach will provide the most reliable 
measure of an arm's length result. Ordinarily, an integrated 
transaction of this type may be evaluated under this section and its 
separate elements need not be evaluated separately, provided that each 
component of the transaction may be adequately accounted for in 
evaluating the comparability of the controlled transaction to the 
uncontrolled comparables and, accordingly, in determining the arm's 
length result in the controlled transaction. See Sec.  1.482-1(d)(3).
    (2) Services transactions that effect a transfer of intangible 
property. A transaction structured as a controlled services transaction 
may in some cases result in a transfer, in whole or in part, of 
intangible property, or may have an effect similar to the transfer of 
intangible property, or may include an element that constitutes the 
transfer of intangible property. If such element relating to intangible 
property is material to the evaluation, the arm's length result for the 
element of the transaction that involves intangible property generally 
must be corroborated or determined by an analysis under Sec.  1.482-4.
    (3) Services subject to a qualified cost sharing arrangement. 
Services provided by a controlled participant under a

[[Page 53481]]

qualified cost sharing arrangement are subject to Sec.  1.482-7.
    (4) Other types of transactions that include controlled services 
transactions. A transaction structured other than as a controlled 
services transaction may include one or more elements for which 
separate pricing methods are provided in this section. Whether such an 
integrated transaction is evaluated under another section of the 
section 482 regulations or whether one or more elements should be 
evaluated separately under this section depends on which approach will 
provide the most reliable measure of an arm's length result. 
Ordinarily, a single method may be applied to such an integrated 
transaction, and the separate services component of the transaction 
need not be separately analyzed under this section, provided that the 
controlled services may be adequately accounted for in evaluating the 
comparability of the controlled transaction to the uncontrolled 
comparables and, accordingly, in determining the arm's length results 
in the controlled transaction. See Sec.  1.482-1(d)(3).
    (5) Global dealing operations. [Reserved].
    (6) Examples. The following examples illustrate paragraphs (m)(1) 
through (4) of this section:

    Example 1. (i) U.S. parent corporation Company X enters into an 
agreement to maintain equipment of Company Y, a foreign subsidiary. 
The maintenance of the equipment requires the use of spare parts. 
The cost of the spare parts necessary to maintain the equipment 
amounts to approximately 25 percent of the total costs of 
maintaining the equipment. Company Y pays a fee that includes a 
charge for labor and parts.
    (ii) Whether this integrated transaction is evaluated as a 
controlled services transaction or is evaluated as a controlled 
services transaction and the transfer of tangible property depends 
on which approach will provide the most reliable measure of an arm's 
length result. If it is not possible to find comparable uncontrolled 
services transactions that involve similar services and tangible 
property transfers as the controlled transaction between Company X 
and Company Y, it will be necessary to determine the arm's length 
charge for the controlled services, and then to evaluate separately 
the arm's length charge for the tangible property transfers under 
Sec.  1.482-1 and Sec. Sec.  1.482-3 through 1.482-6. Alternatively, 
it may be possible to apply the comparable profits method of Sec.  
1.482-5, to evaluate the arm's length profit of Company X or Company 
Y from the integrated controlled transaction. The comparable profits 
method may provide the most reliable measure of measure of an arm's 
length result if uncontrolled parties are identified that perform 
similar, combined functions of maintaining and providing spare parts 
for similar equipment.
    Example 2. (i) U.S. parent corporation Company X sells 
industrial equipment to its foreign subsidiary, Company Y. In 
connection with this sale, Company X renders to Company Y services 
that consist of demonstrating the use of the equipment and assisting 
in the effective start-up of the equipment. Company X structures the 
integrated transaction as a sale of tangible property and determines 
the transfer price under the comparable uncontrolled price method of 
Sec.  1.482-3(b).
    (ii) Whether this integrated transaction is evaluated as a 
transfer of tangible property or is evaluated as a controlled 
services transaction and a transfer of tangible property depends on 
which approach will provide the most reliable measure of an arm's 
length result. In this case, the controlled services may be similar 
to services rendered in the transactions used to determine the 
comparable uncontrolled price, or they may appropriately be 
considered a difference between the controlled transaction and 
comparable transactions with a definite and reasonably ascertainable 
effect on price for which appropriate adjustments can be made. See 
Sec.  1.482-1(d)(3)(ii)(A)(6). In either case, application of the 
comparable uncontrolled price method to evaluate the integrated 
transaction may provide a reliable measure of an arm's length 
result, and application of a separate transfer pricing method for 
the controlled services element of the transaction is not necessary.
    Example 3. (i) The facts are the same as in Example 2 except 
that, after assisting Company Y in start-up, Company X also renders 
ongoing services, including instruction and supervision regarding 
Company Y's ongoing use of the equipment. Company X structures the 
entire transaction, including the incremental ongoing services, as a 
sale of tangible property, and determines the transfer price under 
the comparable uncontrolled price method of Sec.  1.482-3(b).
    (ii) Whether this integrated transaction is evaluated as a 
transfer of tangible property or is evaluated as a controlled 
services transaction and a transfer of tangible property depends on 
which approach will provide the most reliable measure of an arm's 
length result. It may not be possible to identify comparable 
uncontrolled transactions in which a seller of merchandise renders 
services similar to the ongoing services rendered by Company X to 
Company Y. In such a case, the incremental services in connection 
with ongoing use of the equipment could not be taken into account as 
a comparability factor because they are not similar to the services 
rendered in connection with sales of similar tangible property. 
Accordingly, it may be necessary to evaluate separately the transfer 
price for such services under this section in order to produce the 
most reliable measure of an arm's length result. Alternatively, it 
may be possible to apply the comparable profits method of Sec.  
1.482-5 to evaluate the arm's length profit of Company X or Company 
Y from the integrated controlled transaction. The comparable profits 
method may provide the most reliable measure of an arm's length 
result if uncontrolled parties are identified that perform the 
combined functions of selling equipment and rendering ongoing after-
sale services associated with such equipment. In that case, it would 
not be necessary to separately evaluate the transfer price for the 
controlled services under this section.
    Example 4. (i) Company X, a U.S. corporation, and Company Y, a 
foreign corporation, are members of a controlled group. Both 
companies develop and manufacture adhesives. Company X also renders 
research and development services. As part of rendering these 
services, Company X provides technical manuals and documentation 
relating to Company X's manufacturing activities. In the process of 
performing research and development activities for Company Y, 
Company X developed know-how regarding a more cost-effective process 
to manufacture adhesives. Company X memorialized this know-how in 
technical manuals and other related technical documentation, and 
provided these documents to Company Y, without any restrictions on 
Company Y's use of the know-how or related materials.
    (ii) The controlled services transaction between Company X and 
Company Y includes an element that constitutes the transfer of 
intangible property (i.e., know-how). Because the element relating 
to the intangible property is material to the arm's length 
evaluation, the arm's length result for that element must be 
corroborated or determined by an analysis under Sec.  1.482-4.

    (n) Effective date. This section is generally applicable for 
taxable years beginning on or after the date of publication of this 
section as final regulations in the Federal Register.
    Par. 8. In Sec.  1.6038A-3(a)(3), Example 4, the text is revised to 
read as follows:


Sec.  1.6038A-3  Record maintenance.

    (a) * * *
    (3) * * *

    Example 4. S, a U.S. reporting corporation, provides computer 
consulting services for its foreign parent, X. Based on the 
application of section 482 and the regulations thereunder, it is 
determined that the cost of services plus method, as described in 
Sec.  1.482-9(d), will provide the most reliable measure of an arm's 
length result, based on the facts and circumstances of the 
controlled transaction between S and X. S is required to maintain 
records to permit verification upon audit of the comparable 
transactional costs (as described in Sec.  1.482-9(d)(2)(iii)) used 
to calculate the arm's length price. Based on the facts and 
circumstances, if it is determined that X's records are relevant to 
determine the correct U.S. tax treatment of the controlled 
transaction between S and X, the record maintenance requirements 
under section 6038A(a) and this section will be applicable to the 
records of X.
* * * * *
    Par. 9. Section 1.6662-6 is amended by:
    1. Redesignating paragraphs (d)(2)(ii)(A) through (d)(2)(ii)(G) as 
paragraphs (d)(2)(ii)(A)(1) through

[[Page 53482]]

(d)(2)(ii)(A)(7), respectively, and redesignating paragraph (d)(2)(ii) 
introductory text as paragraph (d)(2)(ii)(A).
    2. Adding a new paragraph (d)(2)(ii)(B).
    3. Revising paragraphs (d)(2)(iii)(B)(4) and (d)(2)(iii)(B)(6).
    4. Adding a third sentence to paragraph (g).
    The revisions and additions read as follows:


Sec.  1.6662-6  Transactions between persons described in section 482 
and net section 482 transfer price adjustments.

* * * * *
    (d) * * *
    (2) * * *
    (ii) * * *
    (B) Simplified cost-based method. A taxpayer's selection of the 
simplified cost-based method for certain services, described in Sec.  
1.482-9(f), and its application of that method to a controlled services 
transaction will be considered reasonable for purposes of the specified 
method requirement only if the taxpayer reasonably concluded that the 
controlled services transaction meets the conditions of Sec.  1.482-
9(f)(3) and is not described in paragraphs Sec.  1.482-9(f)(2)(iii) or 
(f)(4). Whether the taxpayer's conclusion was reasonable must be 
determined from all the facts and circumstances. The factors relevant 
to this determination include those described in paragraph 
(d)(2)(ii)(A) of this section, to the extent applicable.
    (iii) * * *
    (B) * * *
    (4) A description of the method selected and an explanation of why 
that method was selected, including an evaluation of whether the 
regulatory conditions and requirements for application of that method, 
if any, were met;
* * * * *
    (6) A description of the controlled transactions (including the 
terms of sale) and any internal data used to analyze those 
transactions. For example, if a profit split method is applied, the 
documentation must include a schedule providing the total income, 
costs, and assets (with adjustments for different accounting practices 
and currencies) for each controlled taxpayer participating in the 
relevant business activity and detailing the allocations of such items 
to that activity. Similarly, if a cost-based method (such as the cost 
plus method, the simplified cost-based method for certain services, or 
a comparable profits method with a cost-based profit level indicator) 
is applied, the documentation must include a description of the manner 
in which relevant costs are determined and are allocated and 
apportioned to the relevant controlled transaction.
* * * * *
    (g) * * * Paragraphs (d)(2)(ii)(B), (iii)(B)(4) and (iii)(B)(6) of 
this section are applicable for taxable years beginning after the date 
the final regulations are published in the Federal Register.

PART 31--EMPLOYMENT TAXES AND COLLECTION OF INCOME TAX AT THE 
SOURCE

    Par. 10. The authority citation for part 31 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 11. Section 31.3121(s)-1 is amended by:
    1. Revising the fourth sentence and adding a fifth sentence in 
paragraph (c)(2)(iii).
    2. Adding a second sentence to paragraph (d).
    The revision and additions read as follows:


Sec.  31.3121(s)-1  Concurrent employment by related corporations with 
common paymaster.

* * * * *
    (c) * * *
    (2) * * *
    (iii) Group-wide allocation rules. * * * To the extent practicable, 
the Commissioner may use the principles of Sec.  1.482-2(b) of this 
chapter in making the allocations with respect to wages paid after 
December 31, 1978, and on or before the date the final regulations are 
published in the Federal Register. To the extent practicable, the 
Commissioner may use the principles of Sec.  1.482-9 of this chapter in 
making the allocations with respect to wages paid after the date of the 
final regulations are published in the Federal Register.
    (d) Effective date. * * * The fifth sentence of paragraph 
(c)(2)(iii) of this section is applicable with respect to wages paid on 
or after the date of publication of that sentence as final regulations 
in the Federal Register.

Dale F. Hart,
Acting Deputy Commissioner for Services and Enforcement.
[FR Doc. 03-22550 Filed 9-5-03; 2:46 pm]
BILLING CODE 4830-01-P