[Federal Register Volume 74, Number 148 (Tuesday, August 4, 2009)]
[Rules and Regulations]
[Pages 38830-38876]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E9-18326]
[[Page 38829]]
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Part IV
Department of the Treasury
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Internal Revenue Service
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26 CFR Parts 1 and 31, and 602
Treatment of Services Under Section 482; Allocation of Income and
Deductions From Intangible Property; Stewardship Expense; Final Rule
Federal Register / Vol. 74, No. 148 / Tuesday, August 4, 2009 / Rules
and Regulations
[[Page 38830]]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 31, and 602
[TD 9456]
RIN 1545-BI78, 1545-BI79, 1545-BI80
Treatment of Services Under Section 482; Allocation of Income and
Deductions From Intangible Property; Stewardship Expense
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations and removal of temporary regulations.
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SUMMARY: This document contains final regulations that provide guidance
regarding the treatment of controlled services transactions under
section 482 and the allocation of income from intangible property, in
particular with respect to contributions by a controlled party to the
value of intangible property owned by another controlled party. This
document also contains final regulations that modify the regulations
under section 861 concerning stewardship expenses to be consistent with
the changes made to the regulations under section 482. These final
regulations potentially affect controlled taxpayers within the meaning
of section 482. They provide updated guidance necessary to reflect
economic and legal developments since the issuance of the current
guidance.
DATES: Effective Date: These regulations are effective on July 31,
2009.
Applicability Dates: These regulations apply to taxable years
beginning after July 31, 2009.
FOR FURTHER INFORMATION CONTACT: Carol B. Tan or Gregory A. Spring,
(202) 435-5265 for matters relating to section 482, or Richard L.
Chewning (202) 622-3850 for matters relating to stewardship expenses
(not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained in these final regulations
has been reviewed and approved by the Office of Management and Budget
in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C.
3507(d)) under control number 1545-2149. The collection of information
in these final regulations is in Sec. 1.482-9. This information is
required to enable the IRS to verify that a taxpayer is reporting the
correct amount of taxable income. An agency may not conduct or sponsor,
and a person is not required to respond to, a collection of information
unless it displays a valid control number.
Books and records relating to a collection of information must be
retained as long as their contents might become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.
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 organizations, trades or businesses owned
or controlled by the same interests in order to prevent evasion of
taxes or clearly to reflect income of a controlled taxpayer.
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, 61 FR 21955, and 68 FR 51171) on July 8, 1994,
December 20, 1995, May 13, 1996, and August 26, 2003. While
comprehensive in other respects, these regulations did not modify
substantively the rules dealing with controlled services transactions.
On September 10, 2003, proposed regulations relating to the treatment
of controlled services transactions and the allocation of income from
intangible property, in particular with respect to contributions by a
controlled party to the value of intangible property owned by another
controlled party (the 2003 proposed regulations), were published in the
Federal Register (68 FR 53448, REG-146893-02 and REG-115037-00).
On August 4, 2006, temporary regulations relating to the treatment
of controlled services transactions, the allocation of income from
intangible property, and stewardship expenses (the 2006 temporary
regulations) were published in the Federal Register (71 FR 44466, TD
9278, REG-146893-02, REG-115037-00, and REG-138603-03). A notice of
proposed rulemaking cross-referencing the temporary regulations was
published in the Federal Register on the same day (71 FR 44247, REG-
146893-02, REG-115037-00, and REG-138603-03). Written comments
responding to the notice of proposed rulemaking were received, and a
public hearing was held on October 27, 2006.
The 2006 temporary regulations are generally effective with respect
to taxable years beginning after December 31, 2006, and Notice 2007-5,
2007-1 C.B. 269, published on January 16, 2007, partially modified the
effective date of the 2006 temporary regulations as it pertained to the
identification of controlled services transactions eligible to be
priced at cost. Accordingly, the 2006 temporary regulations related to
the new services cost method in Sec. 1.482-9T(b) (described in Section
A.1 in this preamble) apply to taxable years after December 31, 2007,
with the exception of the business judgment rule described in Sec.
1.482-9T(b)(2), which had the same effective date (taxable years after
December 31, 2006) as the other provisions of the temporary
regulations.
By issuing the 2006 temporary regulations in temporary and proposed
form, the Treasury Department and the IRS provided taxpayers an
opportunity to submit additional comments prior to the time these
regulations became effective. See Sec. 601.601(d)(2)(ii)(b). After
consideration of all the comments, the proposed regulations under
section 482 are adopted as revised by this Treasury decision, and the
corresponding temporary regulations are removed.
Explanation of Revisions and Summary of Comments
Introduction
The Treasury Department and the IRS received a number of comments
on the 2006 temporary regulations from taxpayers, their
representatives, as well as industry and professional groups.
Commentators generally approved of the 2006 temporary regulations and
found the changes from the 2003 proposed regulations to be useful.
Specifically, commentators approved of the replacement of the
simplified cost-based method with the services cost method (SCM) and
the inclusion of the shared services arrangement provision in the SCM
rules. Commentators also generally approved of changes made to the
profit split method. However, commentators did express concerns with
some aspects of the 2006 temporary regulations.
While these final regulations reflect some modifications in
response to comments received on the 2006 temporary regulations, both
the format and the substance of the final regulations are generally
consistent with the 2006 temporary regulations. The changes adopted are
intended to make certain clarifications and improvements without
fundamentally altering the policies reflected in the 2006 temporary
regulations.
[[Page 38831]]
Explanation of Provisions
A. Controlled Services
1. Services Cost Method--Treas. Reg. Sec. 1.482-9(b)
a. Applicability of the Services Cost Method
Most comments focused on the SCM. Several commentators requested
confirmation that application of the SCM is a matter within the control
of the taxpayer, provided that the underlying services otherwise
qualify for the SCM. Some commentators stated that the 2006 temporary
regulations could be interpreted as requiring a taxpayer to apply the
SCM if all the conditions for that method were satisfied.
Notice 2007-5 confirmed that taxpayers control whether the SCM
applies. The final regulations make this clear. Section 1.482-9(b)(1)
provides that, if a taxpayer applies the SCM in accordance with the
rules of Sec. 1.482-9(b), which requires that a statement evidencing
the taxpayer's intent to apply the SCM be contained in the taxpayer's
books and records, then the SCM will be considered the best method for
purposes of Sec. 1.482-1(c).
b. Specified Covered Services
Several commentators contended that the proposed list of specified
covered services in Announcement 2006-50, 2006-2 C.B. 321, is too
narrow. One commentator listed tax planning and public relations
activities as examples of activities not on the list that illustrated
the narrowness of the list. Some commentators suggested that the list
should refer to departments, cost centers, or accounting
classifications, rather than to specific activities or groups of
activities. One commentator suggested that all activities in particular
departments should be identified as eligible for the SCM. Commentators
also stated that a comprehensive analysis would be required and that it
would be too burdensome to track employee time for activities that are
specified covered services vs. non-specified covered services. See
Sec. 601.601(d)(2)(ii)(b). The Treasury Department and the IRS also
received suggestions to broaden the general administrative provision
and add additional specific activities to the list of specified covered
services, including warehousing and distribution, quality control and
quality assurance relating to manufacturing and construction, and
environmental remediation.
The SCM is intended to provide a practical and administrable means
of identifying low-margin services that may be evaluated by reference
to total services cost without a markup. The list of services eligible
to be priced at cost in the specified covered services portion of the
SCM was added specifically in response to requests from commentators
that the former simplified cost-based method be eliminated and replaced
with just such a list of eligible services. In response to public
comments, the Treasury Department and the IRS published Rev. Proc.
2007-13, 2007-1 C.B. 295, which added several categories as well as
activities within existing categories. In particular, public relations
and tax planning services were added to the list, and the individual
categories of specified covered services were expanded to include
``other similar activities.''
After careful consideration, the Treasury Department and the IRS
believe that Rev. Proc. 2007-13 strikes the appropriate balance between
broadening the list to include services similar to the specific
services described and expanding the categories of services. The
Treasury Department and the IRS do not believe that other additional
services suggested by commentators were appropriate, but will continue
to consider other recommendations for additional services to be added
to the list in the future.
One commentator expressed concern that a review of services to
determine if they qualify as specified covered services may require a
more extensive analysis than under previous regulations, including
interviews of individual employees or of small groups of employees.
Although the covered services list is not applied on a departmental
basis, a reasonable aggregation of similar services may be appropriate
for performing the specified covered services analysis in some cases.
To determine if the services cost method should apply to a particular
service (or group of services) performed by a group of employees, the
aggregation principle of Treas. Reg. Sec. 1.482-1(f)(2)(i)(A) should
be followed as appropriate. In certain cases, aggregation may assure a
more accurate result, especially if it recognizes synergies that an
individual employee analysis might ignore. An aggregation of employee
services may, thus, efficiently evaluate the work of employees engaged
in a common function, as well as recognize the added value that their
collaborative effort might produce. Conversely, analysis on an
aggregate basis does not permit characterization of an individual
service as a specified covered service if it, in fact, is not a
specified covered service.
c. Low Margin Covered Services
Commentators provided comments on low margin covered services
described in Sec. 1.482-9T(b)(4)(ii) of the 2006 temporary
regulations. One commentator believed that the 7 percent limit is too
high for the SCM. In the commentator's view, the limit should be lower
because the 7 percent figure will cover activities that are risky. Most
of the commentators, however, believed that the 7 percent limit is an
appropriate measure. The Treasury Department and the IRS continue to
believe that the 7 percent limit is appropriate in light of its
purpose. That is, it minimizes the compliance burden on taxpayers and
the IRS for relatively low-margin services.
Several commentators requested more guidance on low margin covered
services. One commentator suggested that the Treasury Department and
the IRS develop an analysis to determine if certain services have a
markup of 7 percent or less and publish the results. For example, the
IRS could develop a set of comparables for various groups of low margin
services, such as human resources, accounting and finance, information
services, and training. Some commentators requested guidance on when
and how often a transfer pricing study is needed to support a
determination that services are low margin covered services. In this
regard, some commentators requested that the regulations specify a
period of years (such as three years) for which a transfer pricing
study may be valid for purposes of determining if a service is a low
margin covered service. In support of this request, one commentator
stated that the regulations could provide, for example, that the
reliance period could apply to taxpayers whose facts and circumstances
have not changed materially from the time the service was most recently
established as a covered service.
The Treasury Department and IRS did not adopt this proposal.
Because there may be significant differences among services across
different businesses, a standardized, IRS-developed comparables set
would not be feasible and would conflict with the fact intensive nature
of an appropriately robust transfer pricing analysis. For similar
reasons, the Treasury Department and the IRS did not adopt the proposal
to specify the frequency or timing of transfer pricing analyses to
support taxpayer positions. To do so would be inconsistent with a
proper comparability analysis, including consideration of the time at
which
[[Page 38832]]
transactions were undertaken, as well as other relevant economic
circumstances.
One other commentator requested that the midpoint should be used in
measuring a comparable markup on total services costs for purposes of
low margin covered services. While it may be true that, in some cases,
the midpoint could be used depending on the statistical method used,
the interquartile range ordinarily provides an acceptable measure of an
arm's length range. See Sec. 1.482-1(e)(2)(iii)(B). Therefore, the
Treasury Department and the IRS believe that the interquartile range of
the comparable median markup is an appropriate measure.
d. Excluded Activities
One commentator requested that engineering be removed from the list
of services that are ineligible for the SCM in Sec. 1.482-9T(b)(3) of
the 2006 temporary regulations. This comment was not adopted, since, in
the view of the Treasury Department and the IRS, intragroup engineering
services generally should be subject to a robust transfer pricing
analysis.
e. Business Judgment Rule
Several commentators expressed concern over how the business
judgment rule would be administered. Some commentators requested that
statements in the preamble about the business judgment rule in the 2006
temporary regulations be incorporated in final regulations. Other
commentators suggested that the business judgment rule should be
applied by reference to one or more trades or business of the
controlled group rather than of the renderer, recipient, or both. These
commentators claimed that the business judgment rule may yield
incorrect results in some cases, for example, where a headquarters
services company or other legal entity is established solely to provide
centralized support services. The activities performed by such an
entity would potentially be ineligible for the SCM under the business
judgment rule because they would constitute the entity's core
capability.
The Treasury Department and the IRS agree that the business
judgment rule should be determined on a controlled group basis and
expressed this view in Notice 2007-5. The final regulations clarify
that the business judgment rule is determined by reference to a trade
or business of the controlled group.
Section 3.04 of Notice 2007-5 clarified that the business judgment
rule ``is satisfied by a reasonable exercise of the taxpayer's business
judgment, not a reasonable exercise of the IRS's judgment in examining
the taxpayer.'' The Treasury Department and the IRS reiterate that the
final regulations incorporate a high threshold for application of the
business judgment rule to exclude services otherwise eligible for the
SCM. Section 1.482-9(b)(5) provides that the rule is based on a
taxpayer's reasonable conclusion in its business judgment that the rule
is satisfied. It has come to the attention of the Treasury Department
and the IRS that the clarification in the notice of the business
judgment rule has been misconstrued as creating a non-rebuttable
presumption that a taxpayer's determination under the business judgment
rule is always correct. This construction of the clarification was not
intended and is not supported by the plain language of the business
judgment rule. The business judgment rule requires a reasonable
conclusion by the taxpayer. Thus, the taxpayer's business judgment is
only the starting point of the analysis, and the taxpayer must make a
reasonable conclusion in that regard. Whether the taxpayer's conclusion
is reasonable may be subject to examination by the IRS in the course of
an audit.
One commentator suggested that the regulations adopt a ``principal
activity'' test similar to the test described in the Organisation for
Economic Cooperation and Development Transfer Pricing Guidelines for
Multinational Enterprises and Tax Administrations (OECD Guidelines) in
place of the business judgment rule. The Treasury Department and the
IRS decline to adopt this suggestion. Another commentator pointed out
that the examples illustrating the business judgment rule more
accurately describe a high value service or intangible property, rather
than a covered service. The Treasury Department and the IRS agree that
some of the examples in the temporary regulations could be read as
describing transfers of intangible property rather than provisions of
services involving the intangible property. Some examples have been
edited to improve clarity, including to ensure that they cannot be read
as describing transfers of intangible property.
Commentators also raised questions concerning how to evidence the
necessary business judgment; for example, whether an executive's
representation must be preferred to the tax director's. The business
judgment rule is applied on a case-by-case basis and takes into account
the taxpayer's facts and circumstances.
One other commentator requested that the business judgment rule
take into account whether a particular activity, such as that of a
corporate tax department, contributes to the operating profit (as
defined in Sec. 1.482-5(d)(3)) of one or more controlled parties.
Notice 2007-5 provided several clarifications to the business judgment
rule, including a clarification that the business judgment rule should
take into account whether a particular activity contributes to the
operating profit of one or more controlled parties. After further
consideration, the Treasury Department and the IRS decided not to add
an operating profit consideration to the business judgment rule because
the operating profit concept is broader than the intended rule and
because it would implicitly require taxpayers to do the type of
economic analysis (and create the attendant administrative burden for
taxpayers) that the business judgment rule is intended to eliminate.
The Treasury Department and the IRS continue to believe, however,
that the conclusion in Notice 2007-5 is correct--that activities such
as back office tax services should not fail the business judgment rule
because they may affect net income by reducing domestic or foreign
income taxes. Depending on the facts and circumstances, tax services
may or may not satisfy the business judgment rule.
f. Reorganization of the SCM
Section 1.482-9T(b) of the 2006 temporary regulations contains
several requirements, all of which have to be satisfied in order for
the SCM to be applicable. In other words, the requirements under Sec.
1.482-9T(b) are conjunctive; failure to satisfy one of the requirements
renders a service ineligible for SCM treatment regardless of whether
any of the other requirements is satisfied. The Treasury Department and
the IRS are aware that the rules under Sec. 1.482-9T(b) have been
misinterpreted as disjunctive such that satisfaction of only one of the
requirements renders a service eligible for the SCM. This view is
unsupported by the plain language of Sec. 1.482-9T(b). To improve
clarity, the requirements for the SCM are reorganized in the final
regulations. Section Sec. 1.482-9(b)(2) lists the conditions necessary
for a service to be eligible for the SCM and provides a cross-reference
to the paragraph in Sec. 1.482-9(b) that corresponds to each
condition. In summary, to be eligible for the SCM, a service must be a
covered service, the service cannot be an excluded activity, the
service cannot be precluded from constituting a covered service by
reason of the business judgment rule, and adequate books and records
must be maintained with respect to the service. The
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reorganization does not substantively change the SCM rules.
Modifications have also been made to the list of excluded
activities to harmonize it with Rev. Proc. 2007-13. In particular,
instead of referring to ``excluded transactions,'' the regulations now
refer to ``excluded activities.''
g. Shared Services Arrangements
In general, commentators supported the shared services arrangement
(SSA) provision in the 2006 temporary regulations as a useful mechanism
for allocation of costs from shared or centralized services.
Commentators called into question, however, the restriction of SSAs to
covered services priced under the SCM. In response, Notice 2007-5
provided that a SSA may be used for controlled services transactions
outside of the SCM context. Specifically, Notice 2007-5 states: ``This
Notice confirms that taxpayers may also make allocations of arm's
length charges for services ineligible for the SCM that yield a benefit
to multiple members of a controlled group. In such a case, however, the
flexible rules under the SCM for establishing the joint benefits and
selecting the allocation key are inapplicable. Instead, the more robust
analysis under the general transfer pricing rules applies for purposes
of determining the appropriate arm's length charges, benefits,
allocation keys, etc.'' The Treasury Department and the IRS considered
providing additional SSA rules to services priced under methods other
than the SCM, but concluded that such rules would be unnecessary. In
any event, as stated in Notice 2007-5, the flexible SSA rules for
establishing the joint benefits and selecting the allocation key are
inapplicable in the non-SCM context.
Other commentators requested that a SSA should be respected even if
a party that reasonably anticipates a benefit makes a payment
equivalent to its share under an SSA to the service provider pursuant
to a different arrangement. For example, assume that a controlled
service provider performs services to ten taxpayers that are members of
its controlled group. Assume further that nine of the service
recipients agree in a single written contract to allocate the arm's
length charge based on a reasonable allocation basis, but the tenth
service recipient pays for its share of the services pursuant to a
separate agreement. These comments were not adopted because whether an
agreement constitutes a SSA requires a case-by-case determination based
on the facts and circumstances.
Some commentators observed that the SSA rules require the
allocation of costs on the basis that ``most reliably reflects'' the
participants' respective shares of reasonably anticipated benefits, but
some of the examples use the phrase ``precisely known.'' This led the
commentators to question whether the SSA rules create an unattainable
standard or, at least, a higher standard than the reasonable standard
for allocation of costs described in Treas. Reg. Sec. 1.482-9T(k) and
to suggest a change to the examples. The examples do not create a
standard based on precisely known shares of reasonably anticipated
benefits. Rather, the examples use hypothetical, precisely known
reasonably anticipated benefits as a measuring stick to provide an
easily understood comparative analysis of potential allocation keys for
illustrative purposes. The suggested changes are not adopted.
2. Comparable Uncontrolled Services Price Method--Treas. Reg. Sec.
1.482-9(c)
The comparable uncontrolled services price (CUSP) method evaluates
whether the consideration in a controlled services transaction is arm's
length by comparison to the price charged in a comparable uncontrolled
services transaction. This method is closely analogous to the
comparable uncontrolled price (CUP) method in Sec. 1.482-3(b).
One commentator objected to the statement in the second sentence of
Sec. 1.482-9T(c)(1) of the 2006 temporary regulations that, to be
evaluated under the CUSP method, a controlled service ordinarily must
be ``identical to or have a high degree of similarity'' to the
uncontrolled comparable transactions. The commentator claimed that such
language creates a higher standard for determining the best method than
in the rest of the section 482 regulations. For example, both Sec.
1.482-1(c)(1) and Sec. 1.482-9T(c)(2)(i) refer to the ``most reliable
measure of an arm's length result'' standard. The sentence in question
was intended merely as a guide to when the CUSP method is applicable.
It was not intended to change the standard under the best method rule.
To avoid further confusion, the sentence is removed, but without
effecting a substantive change.
The CUSP method in these final regulations is substantially similar
to the corresponding method in the 2006 temporary regulations.
3. Cost of Services Plus Method--Treas. Reg. Sec. 1.482-9(e)
The cost of services plus method is generally analogous to the cost
plus method for transfers of tangible property in existing Sec. 1.482-
3(d). 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. Section 1.482-9T(e)(3)(ii)(A) provides that,
if the appropriate gross services profit markup is derived from
comparable uncontrolled services transactions of other service
providers, then, in evaluating comparability, the controlled taxpayer
must consider the results under this method expressed as a markup on
total services costs of the controlled taxpayer because functional
differences may be reflected in differences in service costs other than
those included in comparable transactional costs.
One commentator objected to the required consideration of the
results of the cost of services plus method expressed as a markup on
total services costs of the controlled taxpayer when external
comparables are utilized. In the commentator's view, this rule requires
a confirming analysis under a comparable profits method (CPM) and,
therefore, places an undue burden on the taxpayer. The same commentator
also expressed the concern that the rule would create an even greater
burden by requiring two sets of external comparables for application of
the two methods.
These comments are not adopted for several reasons. First, the
restatement of the price does not require researching two sets of
external comparables under two different methods. The sole purpose of
the calculation is to determine whether it is necessary to perform
additional evaluation of functional comparability under the cost of
services plus method. That is, if the price indicates a markup on the
renderer's total services cost that is either low or negative when
restated, this may indicate differences in functions that have not been
accounted for under the traditional comparability factors under the
cost of services plus method. Thus, a low or negative markup merely
suggests the need for additional inquiry, which may lead to a
determination that the cost of services plus method is not the most
reliable measure of an arm's length result under the best method rule.
The cost of services plus method is adopted in the final
regulations without change.
4. Profit Split Method--Treas. Reg. Sec. Sec. 1.482-9(g) and 1.482-
6(c)(3)(i)(B)
The final regulations provide additional guidance concerning
application of the comparable profit
[[Page 38834]]
split and the residual profit split methods to controlled services
transactions in Sec. 1.482-9(g) and Sec. 1.482-6(c)(3)(i)(B).
Generally, the comparable profit split and the residual 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 Treasury Department and the IRS received several comments on
the profit split method. One commentator requested that Sec. 1.482-
8T(b), Example 12 of the 2006 temporary regulations explain why the
profit split method is preferable to using the financial results of a
set of publicly-traded companies engaged in selling merchandise and
related promotion and marketing activities. Example 12 is revised in
the final regulations to address this comment.
Another commentator argued that the profit split method should not
apply to a party that does not own valuable intangible property or does
not use any such property in the related party transaction being
evaluated. The commentator noted that other parts of the regulations,
such as the CPM, CUSP method, and costs of services plus method
reference valuable intangible property in the examples. The same
commentator asserted that the profit split method should be limited to
parties that bear substantial risk in their intercompany transactions.
The Treasury Department and the IRS believe that limiting application
of the profit split method to contributions of valuable intangible
property or the bearing of risks would be inappropriate. The changes in
the 2006 temporary regulations to routine and non-routine contributions
is an appropriate standard and conformed to the changes to Sec. 1.482-
6T(c)(3)(i)(B)(1), which defines a nonroutine contribution as ``a
contribution that is not accounted for as a routine contribution.'' In
other words, a nonroutine contribution is one for which the return
cannot be determined by reference to market benchmarks.
The 2006 temporary regulations provide that the residual profit
split method ordinarily is used where multiple controlled taxpayers
make significant nonroutine contributions. A commentator requested that
this provision be removed because it suggests that the method always
applies where there are no market benchmarks. The provision regarding
the residual profit split method that the commentator requested be
removed has been changed to conform to language in the cost sharing
regulations. Accordingly, Sec. 1.482-9(g)(1) provides that the
residual profit split method may not be used where only one controlled
taxpayer makes significant nonroutine contributions. The commentator
also claimed that the residual profit split method contains an
inconsistency because, although the method applies when there are no
market benchmarks, the method includes a market benchmark analysis for
comparability purposes. Compare Sec. Sec. 1.482-9(g)(1) and 1.482-
6(c)(3)(i)(B)(2). The Treasury Department and the IRS do not consider
that there is an inconsistency. The method contemplates the use of
market benchmarks, if available, to determine the profit split that
will be applied to the return to nonroutine contributions already
determined under the method. The same commentator requested that the
sentence in Sec. 1.482-6T(c)(2)(ii)(B) of the 2006 temporary
regulations relating to the comparable profit split method that states
that ``the comparable profit split method may not be used if the
combined operating profit (as a percentage of the combined assets) of
the uncontrolled comparables varies significantly from that earned by
the controlled taxpayers'' should be deleted. These comments are not
adopted, since the stated condition is fundamental to comparability
under the method.
5. Contingent Payments--Treas. Reg. Sec. 1.482-9(i)
The 2006 temporary regulations provide detailed guidance concerning
contingent-payment contractual terms. The rules built on the principle
that, in structuring controlled transactions, taxpayers are free to
choose from among a wide range of risk allocations. The provision
acknowledged that contingent-payment terms--terms requiring
compensation to be paid only if specified results are obtained--may be
particularly relevant in the context of controlled services
transactions.
Commentators raised several concerns about the substance and scope
of this provision. One commentator said that the regulations do not
address whether a taxpayer may, in the absence of a written agreement,
present facts to demonstrate that a contingent payment arrangement best
reflects the economic substance of the underlying transactions. The
Treasury Department and the IRS do not agree that an arrangement may be
treated as a contingent payment arrangement under Sec. 1.482-9(i)(2)
if the arrangement does not satisfy the requirements of the contingent
payment arrangement provision, including the written contract
requirement. However, where the Commissioner exercises its authority
pursuant to Sec. 1.482-1(d)(3)(ii)(B) to impute contractual terms, the
taxpayer may present additional facts to indicate if an alternative
agreement best reflects the economic substance of the underlying
transaction, consistent with the parties' course of conduct in a
particular case. See Sec. 1.482-1(d)(3)(ii)(C), Examples 4 and 6.
The same commentator also pointed out that the requirement to
evaluate whether a specified contingency bears a direct relationship to
the controlled services transaction based on all of the facts and
circumstances should be combined with the specified contingency
requirement. The Treasury Department and the IRS agree that the
language in Sec. 1.482-9(i)(2) should be clarified. Accordingly, the
regulations remove the last sentence in Sec. 1.482-9T(i)(2)(i)(C) of
the 2006 temporary regulations relating to a specified contingency and
combine it with the requirement under Sec. 1.482-9T(i)(2)(i)(B). Thus,
Sec. 1.482-9(i)(2)(i)(B) now requires that the contract state that
payment for a controlled services transaction is contingent (in whole
or in part) upon the happening of a future benefit (within the meaning
of Sec. 1.482-9(l)(3)) for the recipient directly related to the
activity or group of activities. For this purpose, whether the future
benefit is directly related to the activity or group of activities is
evaluated based on all the facts and circumstances.
6. Total Services Costs--Treas. Reg. Sec. 1.482-9(j)
In the 2006 temporary regulations, total services costs include all
costs directly identified with provision of the controlled services, as
well as all other costs reasonably allocable to such services under
Sec. 1.482-9(k). ``Costs'' must reflect all resources expended, used,
or made available to render the service. Generally accepted accounting
principles (GAAP) or Federal income tax accounting rules may provide an
appropriate starting point, but neither would necessarily be conclusive
in evaluating whether an item must be included in total services costs.
Another commentator requested that value added costs (that is,
labor costs and depreciation) should be distinguished from total
services costs. The commentator stated that a markup on value added
costs may be more reliable than a markup on total costs in certain
instances and that this could be a useful measure for any of the
transfer pricing methods, including the cost of services plus method.
The regulations already provide flexibility in the context of the cost
of services plus method,
[[Page 38835]]
which is determined by reference to comparable transactional costs, the
comparable profits method, and unspecified methods. Consequently, the
comment is not adopted. The definition of total services costs in these
regulations is, thus, similar to the provisions in the 2006 temporary
regulations.
Section 1.482-9T(j) of the 2006 temporary regulations explicitly
states that total services costs include stock-based compensation, and
Examples 3 through 6 of Sec. 1.482-9T(f)(3) illustrate when stock-
based compensation constitutes a material difference requiring
adjustments for comparability and reliability purposes. Commentators
requested further guidance regarding the valuation, comparability, and
reliability considerations for stock-based compensation. Other
commentators objected to the explicit statement that stock-based
compensation can be a total services cost. These final regulations do
not provide further guidance regarding stock-based compensation. The
Treasury Department and the IRS continue to consider technical issues
involving stock-based compensation in the services and other contexts
and intend to address those issues in a subsequent guidance project.
7. Controlled Services Transactions and Shareholder Activities--Treas.
Reg. Sec. 1.482-9(l)
Section 1.482-9(l) sets forth a threshold test for determining
whether an activity constitutes a controlled services transaction
subject to the general framework of Sec. 1.482-9. Section 1.482-
9(l)(3) provides rules for determining whether an activity provides a
benefit. Paragraphs (l)(3)(ii) through (v) provide guidelines that
indicate the presence or absence of a benefit. Section 1.482-
9T(l)(3)(iv) of the 2006 temporary regulations provides that an
activity is a shareholder activity if the sole effect of that activity
is either to protect the renderer's capital investment in the recipient
or in other members of the controlled group, or to facilitate
compliance by the renderer with reporting, legal, or regulatory
requirements applicable specifically to the renderer, or both.
The Treasury Department and the IRS received comments on
shareholder activities. Some commentators asserted that the ``sole
effect'' language is too restrictive and that the language should be
replaced by a ``primary effect'' standard. Other commentators argued
that the language appropriately encompasses shareholder activities.
Another commentator requested a change to the regulations such that a
shareholder activity should be considered to have a sole effect only if
the benefits provided to the other controlled group members are either
(i) indirect or remote or (ii) duplicative.
The Treasury Department and the IRS believe that the ``sole
effect'' language is appropriate. The ``primary effect'' language in
the 2003 proposed regulations could inappropriately include activities
that are not true shareholder activities and may even consist of
substantial activities that are non-shareholder activities. An activity
that is described in Sec. 1.482-9(l)(3)(ii) through (iv) does not
produce a benefit, but the mere fact that an activity is not described
in Sec. 1.482-9(l)(3)(ii) through (iv) does not mean that the activity
necessarily provides a benefit. An activity not described in Sec.
1.482-9(l)(3)(ii) through (iv) provides a benefit only if it satisfies
the incremental value standard of Sec. 1.482-9(l)(3)(i). Furthermore,
for that purpose, it may be more reliable, depending on the facts and
circumstances, to measure incremental value on a functional aggregate
activity, rather than a component activity-by-activity basis.
8. Third Party Costs--Treas. Reg. Sec. 1.482-9(l)(4)
Under Sec. 1.482-9T(l)(4) of the 2006 temporary regulations, a
controlled services transaction may be analyzed as a single transaction
or as two separate transactions depending on which approach provides
the most reliable measure of the arm's length result under the best
method rule in existing Sec. 1.482-1(c). Two examples are provided
illustrating different alternatives when a controlled services
transaction included expenses related to a third-party contract (third
party costs) with a controlled taxpayer. In both examples, third party
costs that could be reliably disaggregated could be charged at cost.
Commentators requested that all third party costs be treated as ``pass
through'' items that are not subject to a markup applicable to costs
incurred by the renderer in its capacity as service provider.
The Treasury Department and the IRS continue to maintain the view
that whether to consider ``pass through'' items as disaggregated from,
or aggregated with, other functions and costs, depends on which
analysis most reliably reflects an arm's length result. Therefore, the
rules of Sec. 1.482-9(l)(4) are adopted without change.
9. Coordination With Other Transfer Pricing Rules--Treas. Reg. Sec.
1.482-9(m) and Guarantees
Section 1.482-9(m) provides coordination rules applicable to a
controlled services transaction that is combined with, or includes
elements of, a non-services transaction. These coordination rules rely
on the best method rule in existing Sec. 1.482-1(c)(1) to determine
which method or methods would provide the most reliable measure of an
arm's length result for a particular controlled transaction.
a. Services Subject to a Qualified Cost Sharing Arrangement--Treas.
Reg. Sec. 1.482-9(m)(3)
Section 1.482-9T(m)(3) of the 2006 temporary regulations states
that services provided by a controlled participant under a qualified
cost sharing arrangement are subject to existing Sec. 1.482-7. As part
of the temporary cost sharing regulations (TD 9441, 2009-7 I.R.B. 460,
74 FR 340) published on January 5, 2009, the Treasury Department and
the IRS replaced the coordination rules with new Sec. 1.482-9T(m)(3).
Section 1.482-9(m)(3) is reserved pending finalization of the cost
sharing regulations.
b. Global Dealing Operations
The Treasury Department and the IRS are working on new global
dealing regulations. The intent of the Treasury Department and the IRS
is that, when final global dealing regulations are issued, those
regulations will govern the evaluation of the activities performed by a
global dealing operation. Pending the issuance of new global dealing
regulations, taxpayers may rely on the proposed global dealing
regulations to govern financial transactions entered into in connection
with a global dealing operation as defined in proposed Sec. 1.482-8.
Thus, the cross-reference under proposed Sec. 1.482-9(m)(6) (71 FR
44247), which provides that a controlled services transaction does not
include a financial transaction entered into in connection with a
global dealing operation as defined in proposed Sec. 1.482-8, remains
in proposed form. Section 1.482-9(m)(6) in these final regulations is
reserved pending issuance of global dealing regulations.
c. Guarantees, Including Financial Guarantees
Financial transactions, including guarantees, are explicitly
excluded from eligibility for the SCM by Sec. 1.482-9(b)(4)(viii).
However, no inference is intended that financial transactions
(including guarantees) would otherwise be considered the provision of
services
[[Page 38836]]
for transfer pricing purposes. The Treasury Department and the IRS
intend to issue future guidance regarding financial guarantees.
B. Income Attributable to Intangible Property--Treas. Reg. Sec. 1.482-
4(f)(3) and (4)
Paragraphs (3) and (4) of Sec. 1.482-4(f) provide rules for
determining the owner of intangible property for purposes of section
482 and also provide rules for determining the arm's length
compensation in situations where a controlled party other than the
owner makes contributions to the value of intangible property. Section
1.482-4(f)(3)(i)(A) provides that the legal owner of intangible
property pursuant to the intellectual property law of the relevant
jurisdiction, or the holder of rights constituting intangible property
pursuant to contractual terms (such as the terms of a license) or other
legal provision, will be considered the sole owner of intangible
property for purposes of this section unless such ownership is
inconsistent with the economic substance of the underlying
transactions. Some commentators believe that the rules should specify
that a holder of bare legal title to intangible property should not be
presumed to be the owner when other parties have all of the other
benefits and burdens of ownership. After considering the public
comments, the Treasury Department and the IRS continue to believe that
the legal ownership standard as set forth in Sec. 1.482-4(f)(3)(i)(A)
is the appropriate framework for determining ownership of intangible
property under section 482.
The provisions of Sec. 1.482-4(f)(3) and (4) are adopted without
change.
C. Economic Substance
A number of commentators expressed similar and sometimes
interrelated concerns regarding economic substance considerations,
imputation of contractual terms, the realistic alternatives principle,
and the rules for income attributable to intangible property. The
common thread running through these comments is a concern that the IRS
will inappropriately treat taxpayers as having engaged in transactions
different from those in which they actually engaged.
Section 1.482-4(f)(3)(i)(A) provides that, if no owner of
intangible property 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 that has control of
intangible property, based on all the facts and circumstances, will be
considered the sole owner of intangible property for purposes of this
section. One commentator believes that the control rule for determining
ownership of non-legally protected intangibles allows the IRS to
attribute ownership of intangible property in a manner that is
inconsistent with economic substance. Accordingly, the comment suggests
that such control determinations must be consistent with economic
substance in all cases. In the context of the control rule in Sec.
1.482-4(f)(3)(i)(A), this is already reflected in the language
``including terms imputed pursuant to Sec. 1.482-1(d)(3)(ii)(B).''
Section 1.482-9T(h) of the 2006 temporary regulations provides
that, consistent with the specified methods, an unspecified method
should take into account the general principle that uncontrolled
taxpayers compare the terms of a particular transaction to the
realistic alternatives to that transaction, including economically
similar transactions structured as other than services transactions,
and only enter into a transaction if none of the alternatives is
preferable to it. The realistic alternatives concept was imported from
Sec. 1.482-1(f)(2)(ii) to be consistent with the general aim to
coordinate the analyses under the various sections of the regulations
under section 482. This provision allows flexibility to consider non-
services alternatives to a services transaction, for example, a
transfer or license of intangible property, if such an approach
provides the most reliable measure of an arm's length result.
Commentators suggested that the realistic alternative principle be
clarified so that only transactions actually engaged in by the
controlled taxpayer can constitute realistic alternatives or that the
principle be removed altogether on the grounds that it inappropriately
treats taxpayers as engaging in transactions other than those they
chose. The Treasury Department and the IRS do not agree with the
assertion that consideration of realistic alternatives improperly
disregards a taxpayer's chosen arrangement and that the realistic
alternative principle is limited to internal comparables. It is a
longstanding principle under Sec. 1.482-1(f)(2)(ii)(A) and in the
valuation field, generally, that, although the Commissioner will
evaluate the results of a transaction as actually structured by the
taxpayer unless it lacks economic substance, the Commissioner may
consider alternatives available in determining the arm's length
valuation of the controlled transaction. The realistic alternatives
principle does not recast the transaction. Rather, it assumes that
taxpayers are rational and will not choose to price an arrangement in a
manner that makes them worse off economically than another available
alternative. Thus, if the price associated with a realistic alternative
appears preferable in comparison with the price associated with the
chosen arrangement, the logical implication is that the actual
arrangement has been priced incorrectly through a flawed application of
the best method rule. This is further reflected in the example in Sec.
1.482-9T(h), which illustrates when realistic alternatives may be
considered to evaluate the arm's length consideration, and explicitly
states that the best method rule of Sec. 1.482-1(c) governs the
analysis.
The unspecified method provisions in these final regulations are
adopted without change.
Section 1.482-9(i)(3) provides that, 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. When the 2003 proposed regulations were issued,
commentators expressed concerns with the rule for imputing contingent
payment terms to the extent that it permits the IRS to recast
arrangements if there is a disagreement about the pricing of a service.
The temporary regulations responded to this concern by providing a new
Example 5 in Sec. 1.482-1T(d)(3)(ii)(C) to illustrate that if a
taxpayer's pricing is outside of the arm's length range, that fact
alone would not support imputation of additional contractual terms
based on economic substance grounds. Commentators responded, however,
that the last sentence of Example 5 perpetuated the same problem of
allowing the IRS to recast arrangements if there were pricing disputes
between a taxpayer and the IRS.
The Treasury Department and the IRS agree that the last sentence of
Example 5 in Sec. 1.482-1T(d)(3)(ii)(C) did not clearly convey its
intended meaning, which is that a transfer pricing method and the price
derived from the application of that method do not inform the terms of
the transaction or the risks borne by the entities. Rather, the
selection and application of a transfer pricing method should be based
on a comparability analysis of the transaction, which must consider the
risks borne by each entity in the transaction. Thus, the last sentence
in Sec. 1.482-1T(d)(3)(ii)(C) Example 5,
[[Page 38837]]
paragraph (iv), was intended to explain that the IRS is not required to
accept the transfer pricing method and form of payment terms of a
transaction as represented by a taxpayer if they are inconsistent with
the conduct of the entities and the economic substance of the
transaction. Because this sentence caused confusion, it has been
removed. However, the Treasury Department and the IRS affirm that the
IRS may impute contingent-payment terms where the economic substance of
the transaction is consistent with the existence of such terms.
D. Stewardship Expenses--Sec. 1.861-8
The regulations under Sec. 1.861-8(e)(4) conform to, and are
consistent with, the language relating to controlled services
transactions as set forth in Sec. 1.482-9(l). The regulations under
Sec. 1.861-8(e)(4) are applicable for taxable years beginning after
December 31, 2006.
E. Effective/Applicability Date--Sec. 1.482-9(n)
These regulations are applicable for taxable years beginning after
July 31, 2009. Controlled taxpayers may elect to apply retroactively
all of the provisions of these regulations to any taxable year
beginning after September 10, 2003. Such election will be effective for
the year of the election and all subsequent taxable years.
Special Analyses
It has been determined that this Treasury decision is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It also has been
determined that section 553(b) of the Administrative Procedure Act (5
U.S.C. chapter 5) does not apply to this regulation. It is hereby
certified that the collections of information in this regulation will
not have a significant economic impact on a substantial number of small
entities. This certification is based on the fact that the collections
of information are related to elective provisions for determining
taxable income that simplify and reduce compliance burdens in
connection with controlled services transactions. When collection of
information is required, it is expected to take taxpayers approximately
2 hours to comply, and the administrative and economic costs will be
nominal in comparison with the resulting simplification and reduction
of compliance burdens. Thus, the economic impact of the collections of
information will not be significant. Similarly, while some small
entities may be subject to the collections of information if they elect
one of the provisions, the collections of information are not expected
to affect a substantial number of small entities. Accordingly, a
regulatory flexibility analysis under the Regulatory Flexibility Act (5
U.S.C. chapter 6) is not required. Pursuant to section 7805(f) of the
Internal Revenue Code, the notice of proposed rulemaking preceding
these regulations was submitted to the Small Business Administration
for comment on its impact on small business.
Drafting Information
The principal authors of these regulations are Carol B. Tan and
Gregory A. Spring, Office of Associate Chief Counsel (International)
for matters relating to section 482, and Richard L. Chewning, Office of
Associate Chief Counsel (International) for matters relating to
stewardship expenses.
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
and Unemployment compensation.
26 CFR Part 602
Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
0
Accordingly, 26 CFR parts 1, 31, and 602 are amended as follows:
PART 1--INCOME TAXES
0
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. * * *
0
Par. 2. Section 1.482-0 is amended as follows:
0
1. The introductory text is revised.
0
2. The entries for Sec. 1.482-1(a)(1), (d)(3)(ii)(C), (d)(3)(v),
(f)(2)(ii)(A), (f)(2)(iii)(B), (g)(4)(iii), (i) and (j) are revised.
0
3. The entries for Sec. 1.482-2(b), (e) and (f) are revised.
0
4. The entries for Sec. 1.482-4(f)(3), (f)(4), (g), and (h) are
revised.
0
5. The entry for Sec. 1.482-4(f)(7) is removed.
0
6. The entries for Sec. 1.482-6(c)(2)(ii)(B)(1), (c)(2)(ii)(D),
(c)(3)(i)(A), (c)(3)(i)(B), (c)(3)(ii)(D), and (d) are revised
0
7. The entry for Sec. 1.482-8(c) is added.
0
8. The entries for Sec. 1.482-9 are revised.
The addition and revisions read as follows:
Sec. 1.482-0 Outline of regulations under section 482.
This section contains major captions for Sec. Sec. 1.482-1 through
1.482-9.
Sec. 1.482-1 Allocation of income and deductions among taxpayers.
(a) * * *
(1) Purpose and scope.
* * * * *
(d) * * *
(3) * * *
(ii) * * *
(C) Examples.
* * * * *
(v) Property or services.
* * * * *
(f) * * *
(2) * * *
(ii) * * *
(A) In general.
* * * * *
(iii) * * *
(A) * * *
(B) Circumstances warranting consideration of multiple year data.
* * * * *
(g) * * *
(4) * * *
(iii) Examples.
* * * * *
(i) Definitions.
(j) Effective/applicability date.
Sec. 1.482-2 Determination of taxable income in specific situations.
* * * * *
(b) Rendering of services.
* * * * *
(e) [Reserved]. For further guidance, see Sec. 1.482-0T, the entry
for Sec. 1.482-2T(e).
(f) Effective/applicability date.
* * * * *
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) [Reserved]. For further guidance, see Sec. 1.482-0T, the entry
for Sec. 1.482-4T(f)(3)(i)(B).
(ii) Examples.
(4) Contribution to the value of intangible property owned by
another.
(i) In general.
[[Page 38838]]
(ii) Examples.
* * * * *
(g) [Reserved]. For further guidance, see Sec. 1.482-0T, the entry
for Sec. 1.482-4T(g).
(h) Effective/applicability date.
* * * * *
Sec. 1.482-6 Profit split method.
* * * * *
(c) * * *
(2) * * *
(ii) * * *
(B) * * *.
(1) In general.
* * * * *
(D) Other factors affecting reliability.
* * * * *
(3) * * *
(i) * * *
(A) Allocate income to routine contributions.
(B) Allocate residual profit.
(1) Nonroutine contributions generally.
(2) Nonroutine contributions of intangible property.
(ii) * * *
(D) Other factors affecting reliability.
* * * * *
(d) Effective/applicability date.
Sec. 1.482-8 Examples of the best method rule.
* * * * *
(c) Effective/applicability date.
Sec. 1.482-9 Methods to determine taxable income in connection with
a controlled services transaction.
(a) In general.
(b) Services cost method.
(1) In general.
(2) Eligibility for the services cost method.
(3) Covered services.
(i) Specified covered services.
(ii) Low margin covered services.
(4) Excluded activities.
(5) Not services that contribute significantly to fundamental risks
of business success or failure.
(6) Adequate books and records.
(7) Shared services arrangement.
(i) In general.
(ii) Requirements for shared services arrangement.
(A) Eligibility.
(B) Allocation.
(C) Documentation.
(iii) Definitions and special rules.
(A) Participant.
(B) Aggregation.
(C) Coordination with cost sharing arrangements.
(8) Examples.
(c) 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.
(d) Gross services margin method.
(1) In general.
(2) Determination of arm's length price.
(i) In general.
(ii) Relevant 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.
(e) Cost of services plus method.
(1) In general.
(2) Determination of arm's length price.
(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.
(f) 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.
(g) Profit split method.
(1) In general.
(2) Examples.
(h) Unspecified methods.
(i) Contingent-payment contractual terms for services.
(1) Contingent-payment contractual terms recognized in general.
(2) Contingent-payment arrangement.
(i) General requirements.
(A) Written contract.
(B) Specified contingency.
(C) Basis for payment.
(ii) Economic substance and conduct.
(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) Disaggregation of transactions.
(5) 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) [Reserved]. For further guidance, see Sec. 1.482-0T, the entry
for Sec. 1.482-9T(m)(3).
(4) Other types of transactions that include controlled services
transactions.
(5) Examples.
(n) Effective/applicability date.
(1) In general.
(2) Election to apply regulations to earlier taxable years.
0
Par. 3. Section 1.482-0T is amended as follows:
0
1. Revise the section heading and introductory text.
0
2. Revise the section headings for Sec. Sec. 1.482-1T, 1.482-4T and
1.482.9T and the entries for Sec. Sec. 1.482-1T, 1.482-2T, 1.482-4T
and 1.482.9T.
0
3. Remove the entries for Sec. 1.482-6T.
The revisions read as follows:
Sec. 1.482-0T Outline of regulations under section 482 (temporary).
This section contains major captions for Sec. Sec. 1.482-1T,
1.482-2T, 1.482-4T, 1.482-7T, 1.482-8T, and 1.482-9T.
[[Page 38839]]
Sec. 1.482-1T Allocation of income and deductions among taxpayers
(temporary).
(a) through (b)(2) [Reserved]. For further guidance, see Sec.
1.482-0, the entries for Sec. 1.482-1(a) through (b)(2).
(i) Methods.
(ii) [Reserved]. For further guidance, see Sec. 1.482-0, the entry
for Sec. 1.482-1(b)(2)(ii).
(iii) Coordination of methods applicable to certain intangible
development arrangements.
(c) through (i) [Reserved]. For further guidance, see Sec. 1.482-
0, the entries for Sec. 1.482-1(c) through (i).
(j) Effective/applicability date.
(k) Expiration date.
Sec. 1.482-2T Determination of taxable income in specific situations
(temporary).
(a) through (d) [Reserved]. For further guidance, see Sec. 1.482-
0, the entries for Sec. 1.482-2(a) through (d).
(e) Cost sharing arrangement.
(f) Effective/applicability date.
(1) In general.
(2) Election to apply regulation to earlier taxable years.
(3) Expiration date.
Sec. 1.482-4T Methods to determine taxable income in connection with
a transfer of intangible property (temporary).
(a) through (f)(3)(i)(A) [Reserved]. For further guidance, see
Sec. 1.482-0, the entries for Sec. 1.482-4(a) through (f)(3)(i)(A).
(B) Cost sharing arrangements.
(f)(3)(ii) through (f)(6) [Reserved]. For further guidance, see
Sec. 1.482-0, the entries for Sec. 1.482-4(f)(3)(ii) through (f)(6).
(g) Coordination with rules governing cost sharing arrangements.
(h) Effective/applicability date.
(i) Expiration date.
* * * * *
Sec. 1.482-9T Methods to determine taxable income in connection with
a controlled services transaction (temporary).
(a) through (m)(2) [Reserved]. For further guidance, see Sec.
1.482-0, the entries for Sec. 1.482-9(a) through (m)(2).
(3) Coordination with rules governing cost sharing arrangements.
(n) Effective/applicability dates.
(o) Expiration date.
0
Par. 4. Section 1.482-1 is amended by revising paragraphs (a)(1),
(d)(3)(ii)(C) Examples 3, 4, 5, and 6, (d)(3)(v), (f)(2)(ii)(A),
(f)(2)(iii)(B), (g)(4)(i), (g)(4)(iii) Example 1, (i), and (j)(6) to
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 January 5, 2009. 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.
* * * * *
(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 United States market by selling
YY wristwatches to its newly organized United States subsidiary,
USSub, for distribution in the United States market. USSub pays FP a
fixed price per wristwatch. USSub and FP undertake, without separate
compensation, marketing activities to establish the YY trademark in
the United States market. Unrelated foreign producers of trademarked
wristwatches and their authorized United States distributors
respectively undertake similar marketing activities in independent
arrangements involving distribution of trademarked wristwatches in
the United States 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 United States 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, authorized distributors of
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 United States market, as compared to
wristwatches marketed by the independent distributors. In year 7,
substantially all the premium return from the YY trademark in the
United States 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 the incremental marketing activities to develop or enhance
intangible property 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 agreement to exploit the YY trademark
in the United States 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, exclusive agreement to
exploit the YY trademark in the United States, 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 enters into a licensing agreement
that affords its newly organized United States subsidiary, USSub,
exclusive rights to certain manufacturing and marketing intangible
property (including the AA trademark) for purposes of manufacturing
and marketing athletic gear in the United States under the AA
trademark. The contractual terms of this
[[Page 38840]]
agreement obligate USSub to pay FP a royalty based on sales, and
also obligate both FP and USSub to undertake without separate
compensation specified types and levels of marketing activities.
Unrelated foreign businesses license independent United States
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 intangible property, 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 in paragraph
(ii) of this Example 4.
(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 with FP, that are also incremental as compared to those
observed in the comparables. 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 subsequent years. 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 the incremental marketing activities to develop or enhance
intangible property 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 by which 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 United States 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 United States 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. Non-arm's length compensation. (i) The facts are the
same as in paragraph (i) of Example 4. As in Example 4, assume that,
after adjustments are made to improve the reliability of the
comparison for any material differences relating to marketing
activities, manufacturing or marketing intangible property, 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
described in paragraph (ii) of this Example 5.
(ii) In years 1 through 4, USSub performs certain incremental
marketing activities with respect to the AA trademark athletic gear,
in addition to the activities required under the terms of the basic
license agreement, that are also incremental as compared with those
activities observed in the comparables. At the start of year 1, FP
enters into a separate services agreement with USSub, which states
that FP will compensate USSub quarterly, in an amount equal to
specified costs plus X%, for these incremental marketing functions.
Further, these written agreements reflect the intent of the parties
that USSub receive such compensation from FP throughout the term of
the agreement, without regard to the success or failure of the
promotional activities. During years 1 through 4, USSub performs
marketing activities pursuant to the separate services agreement and
in each year USSub receives the specified compensation from FP on a
cost of services plus basis.
(iii) In evaluating year 4, the Commissioner performs an
analysis of independent parties that perform promotional activities
comparable to those performed by USSub and that receive separately-
stated compensation on a current basis without contingency. The
Commissioner determines that the magnitude of the specified cost
plus X% is outside the arm's length range in each of years 1 through
4. Based on an evaluation of all the facts and circumstances, the
Commissioner makes an allocation to require payment of compensation
to USSub for the promotional activities performed in year 4, based
on the median of the interquartile range of the arm's length markups
charged by the uncontrolled comparables described in paragraph
(e)(3) of this section.
(iv) Given that based on facts and circumstances, the terms
agreed by the controlled parties were that FP would bear all risks
associated with the promotional activities performed by USSub to
promote the AA trademark product in the United States market, and
given that the parties' conduct during the years examined was
consistent with this allocation of risk, the fact that the cost of
services plus markup on USSub's services was outside the arm's
length range does not, without more, support imputation of
additional contractual terms based on alternative views of the
economic substance of the transaction, such as terms indicating that
USSub, rather than FP, bore the risk associated with these
activities.
Example 6. 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, Company X developed a compound 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, Company X makes
available to Company Y a large amount of technical data concerning
the new compound, which Company Y uses to register patent rights
with respect to the compound in several jurisdictions, making
Company Y the legal owner of such patents. Company Y then enters
into licensing agreements with group members that afford Company Y
100% of the premium return attributable to use of the intangible
property by its subsidiaries.
(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 an
uncontrolled taxpayer operating at arm's length would make available
the results of its research and development or perform services that
resulted in transfer of valuable know how to 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 and then providing technical data and know-how to Company
Y in year 4 is inconsistent with the registration and subsequent
exploitation 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
[[Page 38841]]
may impute a separate services agreement that affords Company X
contingent-payment compensation for its services in year 4 for the
benefit of Company Y, consisting of making available to Company Y
technical data, know-how, and other fruits of research and
development conducted in previous years. These services benefited
Company Y by giving rise to and contributing to the value of the
patent rights that were ultimately registered by Company Y. In the
alternative, the Commissioner may impute a transfer of patentable
intangible property 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 transactions, consistent with the
parties' course of conduct in the particular case.
* * * * *
(v) Property or services. Evaluating the degree of comparability
between controlled and uncontrolled transactions requires a comparison
of the property or services transferred in the transactions. This
comparison may include any intangible property that is embedded in
tangible property or services being transferred (embedded intangibles).
The comparability of the embedded intangibles will be analyzed using
the factors listed in Sec. 1.482-4(c)(2)(iii)(B)(1) (comparable
intangible property). The relevance of product comparability in
evaluating the relative reliability of the results will depend on the
method applied. For guidance concerning the specific comparability
considerations applicable to transfers of tangible and intangible
property and performance of services, see Sec. Sec. 1.482-3 through
1.482-6 and Sec. 1.482-9; see also Sec. Sec. 1.482-3(f), 1.482-
4(f)(4), and 1.482-9(m), dealing with the coordination of the
intangible and tangible property and performance of services rules.
* * * * *
(f) * * *
(2) * * *
(ii) Allocation based on taxpayer's actual transactions-(A) In
general. The Commissioner will evaluate the results of a transaction as
actually structured by the taxpayer unless its structure lacks economic
substance. However, the Commissioner may consider the alternatives
available to the taxpayer in determining whether the terms of the
controlled transaction would be acceptable to an uncontrolled taxpayer
faced with the same alternatives and operating under comparable
circumstances. In such cases the Commissioner may adjust the
consideration charged in the controlled transaction based on the cost
or profit of an alternative as adjusted to account for material
differences between the alternative and the controlled transaction, but
will not restructure the transaction as if the alternative had been
adopted by the taxpayer. See paragraph (d)(3) of this section (factors
for determining comparability; contractual terms and risk); Sec. Sec.
1.482-3(e), 1.482-4(d), and 1.482-9(h) (unspecified methods).
* * * * *
(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 are
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 property 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(f) (comparable profits 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(c) (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) * * *
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. During
the same taxable year P makes available to S the use of a machine to
be used in the construction of the factory, and the arm's length
rental value of the machine is $25,000. P bills S $125,000 for the
services, but does not charge S for the use of the machine. No
allocation will be made with respect to the undercharge for the
machine if P notifies the district director of the basis of the
claimed setoff within 30 days after the date of the letter from the
district director transmitting the examination report notifying P of
the proposed adjustment, establishes that the excess amount charged
for services was equal to an arm's length charge for the use of the
machine and that the taxable income and income tax liabilities of P
are not distorted, and documents the correlative allocations
resulting from the proposed setoff.
* * * * *
(i) Definitions. The definitions set forth in paragraphs (i)(1)
through (i)(10) of this section apply to this section and Sec. Sec.
1.482-2 through 1.482-9.
* * * * *
(j) * * *
(6)(i) The provisions of paragraphs (a)(1), (d)(3)(ii)(C) Example
3, Example 4, Example 5, and Example 6, (d)(3)(v), (f)(2)(ii)(A),
(f)(2)(iii)(B), (g)(4)(i), (g)(4)(iii), and (i) of this section are
generally applicable for taxable years beginning after July 31, 2009.
(ii) A person may elect to apply the provisions of paragraphs
(a)(1), (b)(2)(i), (d)(3)(ii)(C) Example 3, Example 4, Example 5, and
Example 6, (d)(3)(v), (f)(2)(ii)(A), (f)(2)(iii)(B), (g)(4)(i),
(g)(4)(iii), and (i) of this section to earlier taxable years in
accordance with the rules set forth in Sec. 1.482-9(n)(2).
0
Par. 5. Section 1.482-1T is amended by revising paragraphs (a), (b)(1),
the first sentence in paragraph (b)(2)(i), (b)(2)(ii), the second
sentence in paragraph (b)(2)(iii), (c), (d), (e), (f), (g), (h), (i),
and (j) to read as follows:
Sec. 1.482-1T Allocation of income and deductions among taxpayers
(temporary).
(a) through (b)(1) [Reserved]. For further guidance, see Sec.
1.482-1(a) through (b)(1).
(b)(2) * * * (i) * * * Sections 1.482-2 through 1.482-6, 1.482-7T
and 1.482-
[[Page 38842]]
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. * * *
(ii) [Reserved]. For further guidance, see Sec. 1.482-1(b)(2)(ii).
(iii) * * * Sections 1.482-4 and 1.482-9, as appropriate, provide
the specific methods to be used to determine arm's length results of
arrangements, including partnerships, for sharing the costs and risks
of developing intangible property, other that a cost sharing
arrangement covered by Sec. 1.482-7T. * * *
(c) through (j)(5) [Reserved]. For further guidance, see Sec.
1.482-1(c) through (j)(5).
(j)(6)(i) The provisions of paragraphs (b)(2)(i) and (b)(2)(iii) of
this section are generally applicable on January 5, 2009.
(ii) [Reserved]. For further guidance, see Sec. 1.482-1(j)(6)(ii).
(iii) The applicability of paragraphs (b)(2)(i) and (b)(2)(iii) of
this section expires on or before December 30, 2011.
0
Par. 6. Section 1.482-2 is amended by revising paragraph (b), (e), and
adding paragraph (f) 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.
* * * * *
(e) [Reserved]. For further guidance, see Sec. 1.482-2T(e).
(f) Effective/applicability date--(1) In general. The provision of
paragraph (b) of this section is generally applicable for taxable years
beginning after July 31, 2009.
(2) Election to apply regulation to earlier taxable years. A person
may elect to apply the provisions of paragraph (b) of this section to
earlier taxable years in accordance with the rules set forth in Sec.
1.482-9(n)(2).
0
Par. 7. Section 1.482-2T is amended as follows:
0
1. Revise paragraphs (a), (b), (c), (d), and (f)(2).
0
2. Remove the first sentence in both paragraphs (f)(1) and (f)(3).
The revisions read as follows:
Sec. 1.482-2T Determination of taxable income in specific situations
(temporary).
(a) through (d) [Reserved]. For further guidance, see Sec. 1.482-
2(a) through (d).
* * * * *
(f) * * *
(2) [Reserved]. For further guidance, see Sec. 1.482-2(f)(2).
* * * * *
0
Par. 8. Section 1.482-4 is amended as follows:
0
1. Revise paragraphs (f)(3) and (f)(4).
0
2. Add paragraphs (g) and (h).
The revisions and addition 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 intangible property pursuant to the
intellectual property law of the relevant jurisdiction, or the holder
of rights constituting an intangible property 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 property 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 property 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 property, based on all the facts and circumstances,
will be considered the sole owner of the intangible property for
purposes of this section.
(B) [Reserved]. For further guidance, see Sec. 1.482-
4T(f)(3)(i)(B).
(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 its 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 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 intangible property 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 intangible property owned by another controlled taxpayer will
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 property, 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 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 intangible property 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 an exclusive, five-
year, renewable agreement with its newly organized U.S. subsidiary,
USSub. The contractual terms of the agreement grant USSub the
exclusive right to re-sell YY trademark 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 exclusive right to
re-sell YY trademarked merchandise in the United States, 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
[[Page 38843]]
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. Sec.
1.482-1, 1.482-3, and this section through Sec. 1.482-6. The
comparability analysis would include consideration of all relevant
factors, including the nature of the intangible property embedded in
the wristwatches and the nature of the marketing activities required
under the agreement. 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. Sec. 1.482-3(f) and
1.482-9(m)(4).
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 intangible property 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 intangible property 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 paid for use
of the AA trademark, rather than provided for in a separate services
agreement. For illustrations of application of the best method rule,
see Sec. 1.482-8 Examples 10, 11, and 12.
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 executed in year 1. The parties do not execute a separate
agreement with respect to these 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 property (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, above and beyond the activities specified in the
license agreement executed in year 1. 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 intangible property 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 paid for use of the AA trademark. For illustrations of
application of the best method rule, see Sec. 1.482-8 Examples 10,
11, and 12.
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, not specified in the year 1 license, 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. 1.482-7T. 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 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. Sec. 1.482-1 through 1.482-3, this section, and Sec. Sec.
1.482-5 and 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
intangible property 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 paid for use of the AA trademark. For
illustrations of application of the best method rule, see Sec.
1.482-8, Example 10, Example 11, and Example 12.
* * * * *
(g) [Reserved]. For further guidance, see Sec. 1.482-4T(g).
(h) Effective/applicability date--(1) In general. The provisions of
paragraphs (f)(3)(i)(A), (f)(3)(ii), and (f)(4) of this section are
generally applicable for taxable years beginning after July 31, 2009.
(2) Election to apply regulation to earlier taxable years. A person
may elect to apply the provisions of paragraphs (f)(3)(i)(A),
(f)(3)(ii), and (f)(4) of this section to earlier taxable years in
accordance with the rules set forth in Sec. 1.482-9(n)(2).
0
Par. 9. Section 1.482-4T is amended as follows:
0
1. Revise paragraphs (a), (b), (c), (d), (e), (f)(1), (f)(2),
(f)(3)(i)(A), (f)(3)(ii), (f)(4), (f)(5), (f)(6), and (h)(3).
0
2. Redesignate paragraph (h)(1) as paragraph (h), revise the heading
and remove the first sentence in newly-designated paragraph (h).
0
3. Remove paragraph (h)(2).
0
4. Redesignate paragraph (h)(3) as paragraph (i).
The revisions read as follows:
[[Page 38844]]
Sec. 1.482-4T Methods to determine taxable income in connection with
a transfer of intangible property (temporary).
(a) through (f)(3)(i)(A) [Reserved]. For further guidance, see
Sec. 1.482-4(a) through (f)(3)(i)(A).
(B) * * *
(f)(3)(ii) through (f)(6) [Reserved]. For further guidance, see
Sec. 1.482-4(f)(3)(ii) through (f)(6)
(g) * * *
(h) Effective/applicability date. * * *
* * * * *
0
Par. 10. Section 1.482-6 is amended by revising paragraphs
(c)(2)(ii)(B)(1), (c)(2)(ii)(D), (c)(3)(i)(A), (c)(3)(i)(B),
(c)(3)(ii)(D), and adding paragraph (d) to read as follows:
Sec. 1.482-6 Profit split method.
* * * * *
(c) * * *
(2) * * *
(ii) * * *
(B) Comparability--(1) In general. The degree of comparability
between the controlled and uncontrolled taxpayers is determined by
applying the comparability provisions of Sec. 1.482-1(d). The
comparable profit split compares the division of operating profits
among the controlled taxpayers to the division of operating profits
among uncontrolled taxpayers engaged in similar activities under
similar circumstances. 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(f)(2)(iii) because this method is based on a comparison of the
operating profit of the controlled and uncontrolled taxpayers. In
addition, because the contractual terms of the relationship among the
participants in the relevant business activity will be a principal
determinant of the allocation of functions and risks among them,
comparability under this method also depends particularly on the degree
of similarity of the contractual terms of the controlled and
uncontrolled taxpayers. Finally, the comparable profit split may not be
used if the combined operating profit (as a percentage of the combined
assets) of the uncontrolled comparables varies significantly from that
earned by the controlled 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. As
indicated in Sec. 1.482-1(c)(2)(i), as the degree of comparability
between the controlled and uncontrolled transactions increases, the
relative weight accorded the analysis under this method will increase.
In addition, the reliability of the analysis under this method may be
enhanced by the fact that all parties to the controlled transaction are
evaluated under the comparable profit split. However, the reliability
of the results of an analysis based on information from all parties to
a transaction is affected by the reliability of the data and the
assumptions pertaining to each party to the controlled transaction.
Thus, if the data and assumptions are significantly more reliable with
respect to one of the parties than with respect to the others, a
different method, focusing solely on the results of that party, may
yield more reliable results.
* * * * *
(3) * * *
(i) * * *
(A) Allocate income to routine contributions. The first step
allocates operating income to each party to the controlled transactions
to provide a market return for its routine contributions to the
relevant business activity. Routine contributions are contributions of
the same or a similar kind to those made by uncontrolled taxpayers
involved in similar business activities for which it is possible to
identify market returns. Routine contributions ordinarily include
contributions of tangible property, services and intangible property
that are generally owned by uncontrolled taxpayers engaged in similar
activities. A functional analysis is required to identify these
contributions according to the functions performed, risks assumed, and
resources employed by each of the controlled taxpayers. 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 is not accounted for as a routine
contribution. 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 property. Finally, if the
intangible property 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.
* * * * *
(ii) * * *
(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. As indicated in Sec. 1.482-1(c)(2)(i), as the degree of
comparability between the controlled and uncontrolled transactions
increases, the relative weight accorded the analysis under this method
will increase. In addition, to the extent the allocation of profits in
the second step is not based on external market benchmarks, the
reliability of the analysis will be decreased in relation to an
analysis
[[Page 38845]]
under a method that relies on market benchmarks. Finally, the
reliability of the analysis under this method may be enhanced by the
fact that all parties to the controlled transaction are evaluated under
the residual profit split. However, the reliability of the results of
an analysis based on information from all parties to a transaction is
affected by the reliability of the data and the assumptions pertaining
to each party to the controlled transaction. Thus, if the data and
assumptions are significantly more reliable with respect to one of the
parties than with respect to the others, a different method, focusing
solely on the results of that party, may yield more reliable results.
* * * * *
(d) Effective/applicability date--(1) In general. The provisions of
paragraphs (c)(2)(ii)(B)(1) and (D), (c)(3)(i)(A) and (B), and
(c)(3)(ii)(D) of this section are generally applicable for taxable
years beginning after July 31, 2009.
(2) Election to apply regulation to earlier taxable years. A person
may elect to apply the provisions of paragraphs (c)(2)(ii)(B)(1) and
(D), (c)(3)(i)(A) and (B), and (c)(3)(ii)(D) of this section to earlier
taxable years in accordance with the rules set forth in Sec. 1.482-
9(n)(2).
Sec. 1.482-6T [Removed]
0
Par. 11. Section 1.482-6T is removed.
0
Par. 12. Section 1.482-8 is amended by revising paragraph (b) Examples
10, 11, 12, 13, 14, 15, 16, 17 and 18, and adding paragraph (c) to read
as follows:
Sec. 1.482-8 Examples of the best method rule.
* * * * *
(b) * * *
Example 10. Cost of services plus method preferred to other
methods. (i) FP designs and manufactures consumer electronic devices
that incorporate advanced technology. In year 1, FP introduces
Product X, an entertainment device targeted primarily at the youth
market. FP's wholly-owned, exclusive U.S. distributor, USSub, sells
Product X in the U.S. market. USSub hires an independent marketing
firm, Agency A, to promote Product X in the U.S. market. Agency A
has successfully promoted other electronic products on behalf of
other uncontrolled parties. USSub executes a one-year, renewable
contract with Agency A that requires it to develop the market for
Product X, within an annual budget set by USSub. In years 1 through
3, Agency A develops advertising, buys media, and sponsors events
featuring Product X. Agency A receives a markup of 25% on all
expenses of promoting Product X, with the exception of media buys,
which are reimbursed at cost. During year 3, sales of Product X
decrease sharply, as Product X is displaced by competitors'
products. At the end of year 3, sales of Product X are discontinued.
(ii) Prior to the start of year 4, FP develops a new
entertainment device, Product Y. Like Product X, Product Y is
intended for sale to the youth market, but it is marketed under a
new trademark distinct from that used for Product X. USSub decides
to perform all U.S. market promotion for Product Y. USSub hires key
Agency A staff members who handled the successful Product X
campaign. To promote Product Y, USSub intends to use methods similar
to those used successfully by Agency A to promote Product X (print
advertising, media, event sponsorship, etc.). FP and USSub enter
into a one-year, renewable agreement concerning promotion of Product
Y in the U.S. market. Under the agreement, FP compensates USSub for
promoting Product Y, based on a cost of services plus markup of A%.
Third-party media buys by USSub in connection with Product Y are
reimbursed at cost.
(iii) Assume that under the contractual arrangements between FP
and USSub, the arm's length consideration for Product Y and the
trademark or other intangible property may be determined reliably
under one or more transfer pricing methods. At issue in this example
is the separate evaluation of the arm's length compensation for the
year 4 promotional activities performed by USSub pursuant to its
contract with FP.
(iv) USSub's accounting records contain reliable data that
separately state the costs incurred to promote Product Y. A
functional analysis indicates that USSub's activities to promote
Product Y in year 4 are similar to activities performed by Agency A
during years 1 through 3 under the contract with FP. In other
respects, no material differences exist in the market conditions or
the promotional activities performed in year 4, as compared to those
in years 1 through 3.
(v) It is possible to identify uncontrolled distributors or
licensees of electronic products that perform, as one component of
their business activities, promotional activities similar to those
performed by USSub. However, it is unlikely that publicly available
accounting data from these companies would allow computation of the
comparable transactional costs or total services costs associated
with the marketing or promotional activities that these entities
perform, as one component of business activities. If that were
possible, the comparable profits method for services might provide a
reliable measure of an arm's length result. The functional analysis
of the marketing activities performed by USSub in year 4 indicates
that they are similar to the activities performed by Agency A in
years 1 through 3 for Product X. Because reliable information is
available concerning the markup on costs charged in a comparable
uncontrolled transaction, the most reliable measure of an arm's
length price is the cost of services plus method in Sec. 1.482-
9(e).
Example 11. CPM for services preferred to other methods. (i) FP
manufactures furniture and accessories for residential use. FP sells
its products to retailers in Europe under the trademark, ``Moda.''
FP holds all worldwide rights to the trademark, including in the
United States. USSub is FP's wholly-owned subsidiary in the U.S.
market and the exclusive U.S. distributor of FP's merchandise.
Historically, USSub dealt only with specialized designers in the
U.S. market and advertised in trade publications targeted to this
market. Although items sold in the U.S. and Europe are physically
identical, USSub's U.S. customers generally resell the merchandise
as non-branded merchandise.
(ii) FP retains an independent firm to evaluate the feasibility
of selling FP's trademarked merchandise in the general wholesale and
retail market in the United States. The study concludes that this
segment of the U.S. market, which is not exploited by USSub, may
generate substantial profits. Based on this study, FP enters into a
separate agreement with USSub, which provides that USSub will
develop this market in the United States for the benefit of FP.
USSub separately accounts for personnel expenses, overhead, and out-
of-pocket costs attributable to the initial stage of the marketing
campaign (Phase I). USSub receives as compensation its costs, plus a
markup of X%, for activities in Phase I. At the end of Phase I, FP
will evaluate the program. If success appears likely, USSub will
begin full-scale distribution of trademarked merchandise in the new
market segment, pursuant to agreements negotiated with FP at that
time.
(iii) Assume that under the contractual arrangements in effect
between FP and USSub, the arm's length consideration for the
merchandise and the trademark or other intangible property may be
determined reliably under one or more transfer pricing methods. At
issue in this example is the separate evaluation of the arm's length
compensation for the marketing activities conducted by USSub in
years 1 and following.
(iv) A functional analysis reveals that USSub's activities
consist primarily of modifying the promotional materials created by
FP, negotiating media buys, and arranging promotional events. FP
separately compensates USSub for all Phase I activities, and
detailed accounting information is available regarding the costs of
these activities. The Phase I activities of USSub are similar to
those of uncontrolled companies that perform, as their primary
business activity, a range of advertising and media relations
activities on a contract basis for uncontrolled parties.
(v) No information is available concerning the comparable
uncontrolled prices for services in transactions similar to those
engaged in by FP and USSub. Nor is any information available
concerning uncontrolled transactions that would allow application of
the cost of services plus method. It is possible to identify
uncontrolled distributors or licensees of home furnishings that
perform, as one component of their business activities, promotional
activities similar to those performed by USSub. However, it is
unlikely that publicly available accounting data from these
companies would allow computation of the comparable transactional
costs or total services costs associated with the marketing or
promotional activities that these entities performed, as one
component of their business activities. On the other hand, it is
possible to identify uncontrolled advertising and media relations
companies, the principal
[[Page 38846]]
business activities of which are similar to the Phase I activities
of USSub. Under these circumstances, the most reliable measure of an
arm's length price is the comparable profits method of Sec. 1.482-
9(f). The uncontrolled advertising comparables' treatment of
material items, such as classification of items as cost of goods
sold or selling, general, and administrative expenses, may differ
from that of USSub. Such inconsistencies in accounting treatment
between the uncontrolled comparables and the tested party, or among
the comparables, are less important when using the ratio of
operating profit to total services costs under the comparable
profits method for services in Sec. 1.482-9(f). Under this method,
the operating profit of USSub from the Phase I activities is
compared to the operating profit of uncontrolled parties that
perform general advertising and media relations as their primary
business activity.
Example 12. Residual profit split preferred to other methods.
(i) USP is a manufacturer of athletic apparel sold under the AA
trademark, to which FP owns the worldwide rights. USP sells AA
trademark apparel in countries throughout the world, but prior to
year 1, USP did not sell its merchandise in Country X. In year 1,
USP acquires an uncontrolled Country X company which becomes its
wholly-owned subsidiary, XSub. USP enters into an exclusive
distribution arrangement with XSub in Country X. Before being
acquired by USP in year 1, XSub distributed athletic apparel
purchased from uncontrolled suppliers and resold that merchandise to
retailers. After being acquired by USP in year 1, XSub continues to
distribute merchandise from uncontrolled suppliers and also begins
to distribute AA trademark apparel. Under a separate agreement with
USP, XSub uses its best efforts to promote the AA trademark in
Country X, with the goal of maximizing sales volume and revenues
from AA merchandise.
(ii) Prior to year 1, USP executed long-term endorsement
contracts with several prominent professional athletes. These
contracts give USP the right to use the names and likenesses of the
athletes in any country in which AA merchandise is sold during the
term of the contract. These contracts remain in effect for five
years, starting in year 1. Before being acquired by USP, XSub
renewed a long-term agreement with SportMart, an uncontrolled
company that owns a nationwide chain of sporting goods retailers in
Country X. XSub has been SportMart's primary supplier from the time
that SportMart began operations. Under the agreement, SportMart will
provide AA merchandise preferred shelf-space and will feature AA
merchandise at no charge in its print ads and seasonal promotions.
In consideration for these commitments, USP and XSub grant SportMart
advance access to new products and the right to use the professional
athletes under contract with USP in SportMart advertisements
featuring AA merchandise (subject to approval of content by USP).
(iii) Assume that it is possible to segregate all transactions
by XSub that involve distribution of merchandise acquired from
uncontrolled distributors (non-controlled transactions). In
addition, assume that, apart from the activities undertaken by USP
and XSub to promote AA apparel in Country X, the arm's length
compensation for other functions performed by USP and XSub in the
Country X market in years 1 and following can be reliably
determined. At issue in this Example 12 is the application of the
residual profit split analysis to determine the appropriate division
between USP and XSub of the balance of the operating profits from
the Country X market, that is the portion attributable to nonroutine
contributions to the marketing and promotional activities.
(iv) A functional analysis of the marketing and promotional
activities conducted in the Country X market, as described in this
example, indicates that both USP and XSub made nonroutine
contributions to the business activity. USP contributed the long-
term endorsement contracts with professional athletes. XSub
contributed its long-term contractual rights with SportMart, which
were made more valuable by its successful, long-term relationship
with SportMart.
(v) Based on the facts and circumstances, including the fact
that both USP and XSub made valuable nonroutine contributions to the
marketing and promotional activities and an analysis of the
availability (or lack thereof) of comparable and reliable market
benchmarks, the Commissioner determines that the most reliable
measure of an arm's length result is the residual profit split
method in Sec. 1.482-9(g). The residual profit split analysis would
take into account both routine and nonroutine contributions by USP
and XSub, in order to determine an appropriate allocation of the
combined operating profits in the Country X market from the sale of
AA merchandise and from related promotional and marketing
activities.
Examples 13 through 18. [Reserved]. For further guidance, see Sec.
1.482-8T(b) Examples 13 through 18.
(c) Effective/applicability date--(1) In general. The provisions of
paragraph (b) Examples 10, 11, and 12 of this section are generally
applicable for taxable years beginning after July 31, 2009.
(2) Election to apply regulation to earlier taxable years. A person
may elect to apply the provisions of paragraph (b) Examples 10, 11, and
12 of this section to earlier taxable years in accordance with the
rules set forth in Sec. 1.482-9(n)(2).
0
Par. 13. Section 1.482-8T is amended as follows:
0
1. Revise paragraph (b) Examples 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11 and
12.
0
2. Redesignate paragraph (c)(1) as paragraph (c), revise the heading
and remove the first sentence in newly-designated paragraph (c).
0
3. Remove paragraph (c)(2).
0
4. Redesignate paragraph (c)(3) as paragraph (d) and remove the first
sentence.
The revisions read as follows:
Sec. 1.482-8T Examples of the best method rule (temporary).
* * * * *
(b) Examples 1 through 12. [Reserved]. For further guidance, see
Sec. 1.482-8(b) Examples 1 through 12.
* * * * *
(c) Effective/applicability date. * * *
* * * * *
0
Par. 14. Section 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 services cost method, described in paragraph (b) of this
section;
(2) The comparable uncontrolled services price method, described in
paragraph (c) of this section;
(3) The gross services margin method, described in paragraph (d) of
this section;
(4) The cost of services plus method, described in paragraph (e) of
this section;
(5) The comparable profits method, described in Sec. 1.482-5 and
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) Services cost method--(1) In general. The services cost method
evaluates whether the amount charged for certain services is arm's
length by reference to the total services costs (as defined in
paragraph (j) of this section) with no markup. If a taxpayer applies
the services cost method in accordance with the rules of this paragraph
(b), then it will be considered the best method for purposes of Sec.
1.482-1(c), and the Commissioner's allocations will be limited to
adjusting the amount charged for such services to the properly
determined amount of such total services costs.
(2) Eligibility for the services cost method. To apply the services
cost method to a service in accordance with the rules of this paragraph
(b), all of the following requirements must be satisfied with respect
to the service--
[[Page 38847]]
(i) The service is a covered service as defined in paragraph (b)(3)
of this section;
(ii) The service is not an excluded activity as defined in
paragraph (b)(4) of this section;
(iii) The service is not precluded from constituting a covered
service by the business judgment rule described in paragraph (b)(5) of
this section; and
(iv) Adequate books and records are maintained as described in
paragraph (b)(6) of this section.
(3) Covered services. For purposes of this paragraph (b), covered
services consist of a controlled service transaction or a group of
controlled service transactions (see Sec. 1.482-1(f)(2)(i)
(aggregation of transactions)) that meet the definition of specified
covered services or low margin covered services.
(i) Specified covered services. Specified covered services are
controlled services transactions that the Commissioner specifies by
revenue procedure. Services will be included in such revenue procedure
based upon the Commissioner's determination that the specified covered
services are support services common among taxpayers across industry
sectors and generally do not involve a significant median comparable
markup on total services costs. For the definition of the median
comparable markup on total services costs, see paragraph (b)(3)(ii) of
this section. The Commissioner may add to, subtract from, or otherwise
revise the specified covered services described in the revenue
procedure by subsequent revenue procedure, which amendments will
ordinarily be prospective only in effect.
(ii) Low margin covered services. Low margin covered services are
controlled services transactions for which the median comparable markup
on total services costs is less than or equal to seven percent. For
purposes of this paragraph (b), the median comparable markup on total
services costs means the excess of the arm's length price of the
controlled services transaction determined under the general section
482 regulations without regard to this paragraph (b), using the
interquartile range described in Sec. 1.482-1(e)(2)(iii)(C) and as
necessary adjusting to the median of such interquartile range, over
total services costs, expressed as a percentage of total services
costs.
(4) Excluded activity. The following types of activities are
excluded activities:
(i) Manufacturing.
(ii) Production.
(iii) Extraction, exploration, or processing of natural resources.
(iv) Construction.
(v) Reselling, distribution, acting as a sales or purchasing agent,
or acting under a commission or other similar arrangement.
(vi) Research, development, or experimentation.
(vii) Engineering or scientific.
(viii) Financial transactions, including guarantees.
(ix) Insurance or reinsurance.
(5) Not services that contribute significantly to fundamental risks
of business success or failure. A service cannot constitute a covered
service unless the taxpayer reasonably concludes in its business
judgment that the service does not contribute significantly to key
competitive advantages, core capabilities, or fundamental risks of
success or failure in one or more trades or businesses of the
controlled group, as defined in Sec. 1.482-1(i)(6). In evaluating the
reasonableness of the conclusion required by this paragraph (b)(5),
consideration will be given to all the facts and circumstances.
(6) Adequate books and records. Permanent books of account and
records are maintained for as long as the costs with respect to the
covered services are incurred by the renderer. Such books and records
must include a statement evidencing the taxpayer's intention to apply
the services cost method to evaluate the arm's length charge for such
services. Such books and records must be adequate to permit
verification by the Commissioner of the total services costs incurred
by the renderer, including a description of the services in question,
identification of the renderer and the recipient of such services, and
sufficient documentation to allow verification of the methods used to
allocate and apportion such costs to the services in question in
accordance with paragraph (k) of this section.
(7) Shared services arrangement--(i) In general. If the services
cost method is used to evaluate the amount charged for covered
services, and such services are the subject of a shared services
arrangement, then the arm's length charge to each participant for such
services will be the portion of the total costs of the services
otherwise determined under the services cost method of this paragraph
(b) that is properly allocated to such participant pursuant to the
arrangement.
(ii) Requirements for shared services arrangement. A shared
services arrangement must meet the requirements described in this
paragraph (b)(7).
(A) Eligibility. To be eligible for treatment under this paragraph
(b)(7), a shared services arrangement must--
(1) Include two or more participants;
(2) Include as participants all controlled taxpayers that
reasonably anticipate a benefit (as defined under paragraph (l)(3)(i)
of this section) from one or more covered services specified in the
shared services arrangement; and
(3) Be structured such that each covered service (or each
reasonable aggregation of services within the meaning of paragraph
(b)(7)(iii)(B) of this section) confers a benefit on at least one
participant in the shared services arrangement.
(B) Allocation. The costs for covered services must be allocated
among the participants based on their respective shares of the
reasonably anticipated benefits from those services, without regard to
whether the anticipated benefits are in fact realized. Reasonably
anticipated benefits are benefits as defined in paragraph (l)(3)(i) of
this section. The allocation of costs must provide the most reliable
measure of the participants' respective shares of the reasonably
anticipated benefits under the principles of the best method rule. See
Sec. 1.482-1(c). The allocation must be applied on a consistent basis
for all participants and services. The allocation to each participant
in each taxable year must reasonably reflect that participant's
respective share of reasonably anticipated benefits for such taxable
year. If the taxpayer reasonably concluded that the shared services
arrangement (including any aggregation pursuant to paragraph
(b)(7)(iii)(B) of this section) allocated costs for covered services on
a basis that most reliably reflects the participants' respective shares
of the reasonably anticipated benefits attributable to such services,
as provided for in this paragraph (b)(7), then the Commissioner may not
adjust such allocation basis.
(C) Documentation. The taxpayer must maintain sufficient
documentation to establish that the requirements of this paragraph
(b)(7) are satisfied, and include--
(1) A statement evidencing the taxpayer's intention to apply the
services cost method to evaluate the arm's length charge for covered
services pursuant to a shared services arrangement;
(2) A list of the participants and the renderer or renderers of
covered services under the shared services arrangement;
(3) A description of the basis of allocation to all participants,
consistent with the participants' respective shares of reasonably
anticipated benefits; and
[[Page 38848]]
(4) A description of any aggregation of covered services for
purposes of the shared services arrangement, and an indication whether
this aggregation (if any) differs from the aggregation used to evaluate
the median comparable markup for any low margin covered services
described in paragraph (b)(3)(ii) of this section.
(iii) Definitions and special rules--(A) Participant. A participant
is a controlled taxpayer that reasonably anticipates benefits from
covered services subject to a shared services arrangement that
substantially complies with the requirements described in this
paragraph (b)(7).
(B) Aggregation. Two or more covered services may be aggregated in
a reasonable manner taking into account all the facts and
circumstances, including whether the relative magnitude of reasonably
anticipated benefits of the participants sharing the costs of such
aggregated services may be reasonably reflected by the allocation basis
employed pursuant to paragraph (b)(7)(ii)(B) of this section. The
aggregation of services under a shared services arrangement may differ
from the aggregation used to evaluate the median comparable markup for
any low margin covered services described in paragraph (b)(3)(ii) of
this section, provided that such alternative aggregation can be
implemented on a reasonable basis, including appropriately identifying
and isolating relevant costs, as necessary.
(C) Coordination with cost sharing arrangements. To the extent that
an allocation is made to a participant in a shared services arrangement
that is also a participant in a cost sharing arrangement subject to
Sec. 1.482-7T, such amount with respect to covered services is first
allocated pursuant to the shared services arrangement under this
paragraph (b)(7). Costs allocated pursuant to a shared services
arrangement may (if applicable) be further allocated between the
intangible property development activity under Sec. 1.482-7T and other
activities of the participant.
(8) Examples. The application of this section is illustrated by the
following examples. No inference is intended whether the presence or
absence of one or more facts is determinative of the conclusion in any
example. For purposes of Examples 1 through 14, assume that Company P
and its subsidiaries, Company Q and Company R, are corporations and
members of the same group of controlled entities (PQR Controlled
Group). For purposes of Example 15, assume that Company P and its
subsidiary, Company S, are corporations and members of the same group
of controlled entities (PS Controlled Group). For purposes of Examples
16 through 24, assume that Company P and its subsidiaries, Company X,
Company Y, and Company Z, are corporations and members of the same
group of controlled entities (PXYZ Group) and that Company P and its
subsidiaries satisfy all of the requirements for a shared services
arrangement specified in paragraphs (b)(7)(ii) and (iii) of this
section.
Example 1. Data entry services. (i) Company P, Company Q, and
Company R own and operate hospitals. Each owns an electronic
database of medical information gathered by doctors and nurses
during interviews and treatment of its patients. All three databases
are maintained and updated by Company P's administrative support
employees who perform data entry activities by entering medical
information from the paper records of Company P, Company Q, and
Company R into their respective databases.
(ii) Assume that these services relating to data entry are
specified covered services within the meaning of paragraph (b)(3)(i)
of this section. Under the facts and circumstances of the business
of the PQR Controlled Group, the taxpayer could reasonably conclude
that these services do not contribute significantly to the
controlled group's key competitive advantages, core capabilities, or
fundamental risks of success or failure in the group's business. If
these services meet the other requirements of this paragraph (b),
Company P will be eligible to charge these services to Company Q and
Company R in accordance with the services cost method.
Example 2. Data entry services. (i) Company P, Company Q, and
Company R specialize in data entry, data processing, and data
conversion. Company Q and Company R's data entry activities involve
converting medical information data contained in paper records to a
digital format. Company P specializes in data entry activities. This
specialization reflects, in part, proprietary quality control
systems and specially trained data entry experts used to ensure the
highest degree of accuracy of data entry services. Company P is
engaged by Company Q and Company R to perform these data entry
activities for them. Company Q and Company R then charge their
customers for the data entry activities performed by Company P.
(ii) Assume that these services performed by Company P relating
to data entry are specified covered services within the meaning of
paragraph (b)(3)(i) of this section. Under the facts and
circumstances, the taxpayer is unable to reasonably conclude that
these services do not contribute significantly to the controlled
group's key competitive advantages, core capabilities, or
fundamental risks of success or failure in the group's business.
Company P is not eligible to charge these services to Company Q and
Company R in accordance with the services cost method.
Example 3. Recruiting services. (i) Company P, Company Q, and
Company R are manufacturing companies that sell their products to
unrelated retail establishments. Company P's human resources
department recruits mid-level managers and engineers for itself as
well as for Company Q and Company R by attending job fairs and other
recruitment events. For recruiting higher-level managers and
engineers, each of these companies uses recruiters from unrelated
executive search firms.
(ii) Assume that these services relating to recruiting are
specified covered services within the meaning of paragraph (b)(3)(i)
of this section. Under the facts and circumstances of the business
of the PQR Controlled Group, the taxpayer could reasonably conclude
that these services do not contribute significantly to the
controlled group's key competitive advantages, core capabilities, or
fundamental risks of success or failure in the group's business. If
these services meet the other requirements of this paragraph (b),
Company P will be eligible to charge these services to Company Q and
Company R in accordance with the services cost method.
Example 4. Recruiting services. (i) Company Q and Company R are
executive recruiting service companies that are hired by other
companies to recruit professionals. Company P is a recruiting agency
that is engaged by Company Q and Company R to perform recruiting
activities on their behalf in certain geographic areas.
(ii) Assume that the services performed by Company P are
specified covered services within the meaning of paragraph (b)(3)(i)
of this section. Under the facts and circumstances, the taxpayer is
unable to reasonably conclude that these services do not contribute
significantly to the controlled group's key competitive advantages,
core capabilities, or fundamental risks of success or failure in the
group's business. Company P is not eligible to charge these services
to Company Q and Company R in accordance with the services cost
method.
Example 5. Credit analysis services. (i) Company P is a
manufacturer and distributor of clothing for retail stores. Company
Q and Company R are distributors of clothing for retail stores. As
part of its operations, personnel in Company P perform credit
analysis on its customers. Most of the customers have a history of
purchases from Company P, and the credit analysis involves a review
of the recent payment history of the customer's account. For new
customers, the personnel in Company P perform a basic credit check
of the customer using reports from a credit reporting agency. On
behalf of Company Q and Company R, Company P performs credit
analysis on customers who order clothing from Company Q and Company
R using the same method as Company P uses for itself.
(ii) Assume that these services relating to credit analysis are
specified covered services within the meaning of paragraph (b)(3)(i)
of this section. Under the facts and circumstances of the business
of the PQR Controlled Group, the taxpayer could reasonably conclude
that these services do not contribute significantly to the
controlled group's key competitive advantages, core capabilities, or
fundamental risks of success
[[Page 38849]]
or failure in the group's business. If these services meet the other
requirements of this paragraph (b), Company P will be eligible to
charge these services to Company Q and Company R in accordance with
the services cost method.
Example 6. Credit analysis services. (i) Company P, Company Q,
and Company R lease furniture to retail customers who present a
significant credit risk and are generally unable to lease furniture
from other providers. As part of its leasing operations, personnel
in Company P perform credit analysis on each of the potential
lessees. The personnel have developed special expertise in
determining whether a particular customer who presents a significant
credit risk (as indicated by credit reporting agencies) will be
likely to make the requisite lease payments on a timely basis. Also,
as part of its operations, Company P performs similar credit
analysis services for Company Q and Company R, which charge
correspondingly high monthly lease payments.
(ii) Assume that these services relating to credit analysis are
specified covered services within the meaning of paragraph (b)(3)(i)
of this section. Under the facts and circumstances, the taxpayer is
unable to reasonably conclude that these services do not contribute
significantly to the controlled group's key competitive advantages,
core capabilities, or fundamental risks of success or failure in the
group's business. Company P is not eligible to charge these services
to Company Q and Company R in accordance with the services cost
method.
Example 7. Credit analysis services. (i) Company P is a large
full-service bank, which provides products and services to corporate
and consumer markets, including unsecured loans, secured loans,
lines of credit, letters of credit, conversion of foreign currency,
consumer loans, trust services, and sales of certificates of
deposit. Company Q makes routine consumer loans to individuals, such
as auto loans and home equity loans. Company R makes only business
loans to small businesses.
(ii) Company P performs credit analysis and prepares credit
reports for itself, as well as for Company Q and Company R. Company
P, Company Q and Company R regularly employ these credit reports in
the ordinary course of business in making decisions regarding
extensions of credit to potential customers (including whether to
lend, rate of interest, and loan terms).
(iii) Assume that these services relating to credit analysis are
specified covered services within the meaning of paragraph (b)(3)(i)
of this section. Under the facts and circumstances, the credit
analysis services constitute part of a ``financial transaction''
described in paragraph (b)(4)(viii) of this section. Company P is
not eligible to charge these services to Company Q and Company R in
accordance with the services cost method.
Example 8. Data verification services. (i) Company P, Company Q
and Company R are manufacturers of industrial supplies. Company P's
accounting department performs periodic reviews of the accounts
payable information of Company P, Company Q and Company R, and
identifies any inaccuracies in the records, such as double-payments
and double-charges.
(ii) Assume that these services relating to verification of data
are specified covered services within the meaning of paragraph
(b)(3)(i) of this section. Under the facts and circumstances of the
business of the PQR Controlled Group, the taxpayer could reasonably
conclude that these services do not contribute significantly to the
controlled group's key competitive advantages, core capabilities, or
fundamental risks of success or failure in the group's business. If
these services meet the other requirements of this paragraph (b),
Company P will be eligible to charge these services to Company Q and
Company R in accordance with the services cost method.
Example 9. Data verification services. (i) Company P gathers and
inputs information regarding accounts payable and accounts
receivable from unrelated parties and utilizes its own computer
system to analyze that information for purposes of identifying
errors in payment and receipts (data mining). Company P is
compensated for these services based on a fee that reflects a
percentage of amounts collected by customers as a result of the data
mining services. These activities constitute a significant portion
of Company P's business. Company P performs similar activities for
Company Q and Company R by analyzing their accounts payable and
accounts receivable records.
(ii) Assume that these services relating to data mining are
specified covered services within the meaning of paragraph (b)(3)(i)
of this section. Under the facts and circumstances, the taxpayer is
unable to reasonably conclude that these services do not contribute
significantly to the controlled group's key competitive advantages,
core capabilities, or fundamental risks of success or failure in the
group's business. Company P is not eligible to charge these services
to Company Q and Company R in accordance with the services cost
method.
Example 10. Legal services. (i) Company P is a domestic
corporation with two wholly-owned foreign subsidiaries, Company Q
and Company R. Company P and its subsidiaries manufacture and
distribute equipment used by industrial customers. Company P
maintains an in-house legal department consisting of attorneys
experienced in a wide range of business and commercial matters.
Company Q and Company R maintain small legal departments, consisting
of attorneys experienced in matters that most frequently arise in
the normal course of business of Company Q and Company R in their
respective jurisdictions.
(ii) Company P seeks to maintain in-house legal staff with the
ability to address the majority of legal matters that arise in the
United States with respect to the operations of Company P, as well
as any U.S. reporting or compliance obligations of Company Q or
Company R. These include the preparation and review of corporate
contracts relating to, for example, product sales, equipment
purchases and leases, business liability insurance, real estate,
employee salaries and benefits. Company P relies on outside
attorneys for major business transactions and highly technical
matters such as patent licenses. The in-house legal staffs of
Company Q and Company R are much more limited. It is necessary for
Company P to retain several local law firms to handle litigation and
business disputes arising from the activities of Company Q and
Company R. Although Company Q and Company R pay the fees of these
law firms, the hiring authority and general oversight of the firms'
representation is in the legal department of Company P.
(iii) In determining what portion of the legal expenses of
Company P may be allocated to Company Q and Company R, Company P
first excludes any expenses relating to legal services that
constitute shareholder activities and other items that are not
properly analyzed as controlled services. Assume that the remaining
services relating to general legal functions performed by in-house
legal counsel are specified covered services within the meaning of
paragraph (b)(3)(i) of this section. Under the facts and
circumstances of the business of the PQR Controlled Group, the
taxpayer could reasonably conclude that these latter services do not
contribute significantly to the controlled group's key competitive
advantages, core capabilities, or fundamental risks of success or
failure in the group's business. If these services meet the other
requirements of this paragraph (b), Company P will be eligible to
charge these services to Company Q and Company R in accordance with
the services cost method.
Example 11. Legal services. (i) Company P is a domestic holding
company whose operating companies, Company Q and Company R, generate
electric power for consumers by operating nuclear plants. Assume
that, although Company P owns 100% of the stock of Companies Q and
R, the companies do not elect to file a consolidated Federal income
tax return with Company P.
(ii) Company P maintains an in-house legal department that
includes attorneys who are experts in the areas of Federal utilities
regulation, Federal labor and environmental law, and securities law.
Companies Q and R maintain their own, smaller in-house legal staffs
comprising experienced attorneys in the areas of state and local
utilities regulation, state labor and employment law, and general
commercial law. The legal department of Company P performs general
oversight of the legal affairs of the company and determines whether
a particular matter would be more efficiently handled by the Company
P legal department, by the legal staffs in the operating companies,
or in rare cases, by retained outside counsel. In general, Company P
has succeeded in minimizing duplication and overlap of functions
between the legal staffs of the various companies or by retained
outside counsel.
(iii) The domestic nuclear power plant operations of Companies Q
and R are subject to extensive regulation by the U.S. Nuclear
Regulatory Commission (NRC). Operators are required to obtain pre-
construction approval, operating licenses, and, at the end of the
operational life of the nuclear reactor, nuclear decommissioning
certificates. Company P files consolidated financial statements on
behalf of itself, as well as Companies Q and R, with the United
States
[[Page 38850]]
Securities and Exchange Commission (SEC). In these SEC filings,
Company P discloses that failure to obtain any of these licenses
(and the related periodic renewals) or agreeing to licenses on terms
less favorable than those granted to competitors would have a
material adverse impact on the operations of Company Q or Company R.
Company Q and Company R do not have in-house legal staff with
experience in the NRC area. Company P maintains a group of in-house
attorneys with specialized expertise in the NRC area that
exclusively represents Company Q and Company R before the NRC.
Although Company P occasionally hires an outside law firm or
industry expert to assist on particular NRC matters, the majority of
the work is performed by the specialized legal staff of Company P.
(iv) Certain of the legal services performed by Company P
constitute duplicative or shareholder activities that do not confer
a benefit on the other companies and therefore do not need to be
allocated to the other companies, while certain other legal services
are eligible to be charged to Company Q and Company R in accordance
with the services cost method.
(v) Assume that the specialized legal services relating to
nuclear licenses performed by in-house legal counsel of Company P
are specified covered services within the meaning of paragraph
(b)(3)(i) of this section. Under the facts and circumstances, the
taxpayer is unable to reasonably conclude that these services do not
contribute significantly to the controlled group's key competitive
advantages, core capabilities, or fundamental risks of success or
failure in the group's business. Company P is not eligible to charge
these services to Company Q and Company R in accordance with the
services cost method.
Example 12. Group of services. (i) Company P, Company Q, and
Company R are manufacturing companies that sell their products to
unrelated retail establishments. Company P has an enterprise
resource planning (ERP) system that maintains data relating to
accounts payable and accounts receivable information for all three
companies. Company P's personnel perform the daily operations on
this ERP system such as inputting data relating to accounts payable
and accounts receivable into the system and extracting data relating
to accounts receivable and accounts payable in the form of reports
or electronic media and providing those data to all three companies.
Periodically, Company P's computer specialists also modify the ERP
system to adapt to changing business functions in all three
companies. Company P's computer specialists make these changes by
either modifying the underlying software program or by purchasing
additional software or hardware from unrelated third party vendors.
(ii) Assume that the services relating to accounts payable and
accounts receivable are specified covered services within the
meaning of paragraph (b)(3)(i) of this section. Under the facts and
circumstances of the business of the PQR Controlled Group, the
taxpayer could reasonably conclude that these services do not
contribute significantly to the controlled group's key competitive
advantages, core capabilities, or fundamental risks of success or
failure in the group's business. If these services meet the other
requirements of this paragraph (b), Company P will be eligible to
charge these services to Company Q and Company R in accordance with
the services cost method.
(iii) Assume that the services performed by Company P's computer
specialists that relate to modifying the ERP system are specifically
excluded from the services described in a revenue procedure
referenced in paragraph (b)(3) of this section as developing
hardware or software solutions (such as systems integration, Web
site design, writing computer programs, modifying general
applications software, or recommending the purchase of commercially
available hardware or software). If these services do not constitute
low margin covered services within the meaning of paragraph
(b)(3)(ii) of this section, then Company P is not eligible to charge
these services to Company Q and Company R in accordance with the
services cost method.
Example 13. Group of services. (i) Company P manufactures and
sells widgets under an exclusive contract to Customer 1. Company Q
and Company R sell widgets under exclusive contracts to Customer 2
and Customer 3, respectively. At least one year in advance, each of
these customers can accurately forecast its need for widgets. Using
these forecasts, each customer over the course of the year places
orders for widgets with the appropriate company, Company P, Company
Q, or Company R. A customer's actual need for widgets seldom
deviates from that customer's forecasted need.
(ii) It is most efficient for the PQR Controlled Group companies
to manufacture and store an inventory of widgets in advance of
delivery. Although all three companies sell widgets, only Company P
maintains a centralized warehouse for widgets. Pursuant to a
contract, Company P provides storage of these widgets to Company Q
and Company R at an arm's length price.
(iii) Company P's personnel also obtain orders from all three
companies' customers to draw up purchase orders for widgets as well
as make payment to suppliers for widget replacement parts. In
addition, Company P's personnel use data entry to input information
regarding orders and sales of widgets and replacement parts for all
three companies into a centralized computer system. Company P's
personnel also maintain the centralized computer system and extract
data for all three companies when necessary.
(iv) Assume that these services relating to tracking purchases
and sales of inventory are specified covered services within the
meaning of paragraph (b)(3)(i) of this section. Under the facts and
circumstances of the business of the PQR Controlled Group, the
taxpayer could reasonably conclude that these services do not
contribute significantly to the controlled group's key competitive
advantages, core capabilities, or fundamental risks of success or
failure in the group's business. If these services meet the other
requirements of this paragraph (b), Company P will be eligible to
charge these services to Company Q and Company R in accordance with
the services cost method.
Example 14. Group of services. (i) Company P, Company Q, and
Company R assemble and sell gadgets to unrelated customers. Each of
these companies purchases the components necessary for assembly of
the gadgets from unrelated suppliers. As a service to its
subsidiaries, Company P's personnel obtain orders for components
from all three companies, prepare purchase orders, and make payment
to unrelated suppliers for the components. In addition, Company P's
personnel use data entry to input information regarding orders and
sales of gadgets for all three companies into a centralized
computer. Company P's personnel also maintain the centralized
computer system and extract data for all three companies on an as-
needed basis. The services provided by Company P personnel, in
conjunction with the centralized computer system, constitute a
state-of-the-art inventory management system that allows Company P
to order components necessary for assembly of the gadgets on a
``just-in-time'' basis.
(ii) Unrelated suppliers deliver the components directly to
Company P, Company Q and Company R. Each company stores the
components in its own facilities for use in filling specific
customer orders. The companies do not maintain any inventory that is
not identified in specific customer orders. Because of the
efficiencies associated with services provided by personnel of
Company P, all three companies are able to significantly reduce
their inventory-related costs. Company P's Chief Executive Officer
makes a statement in one of its press conferences with industry
analysts that its inventory management system is critical to the
company's success.
(iii) Assume that these services relating to tracking purchases
and sales of inventory are specified covered services within the
meaning of paragraph (b)(3)(i) of this section. Under the facts and
circumstances, the taxpayer is unable to reasonably conclude that
these services do not contribute significantly to the controlled
group's key competitive advantages, core capabilities, or
fundamental risks of success or failure in the group's business.
Company P is not eligible to charge these services to Company Q and
Company R in accordance with the services cost method.
Example 15. Low margin covered services. Company P renders
certain accounting services to Company S. Company P uses the
services cost method for the accounting services, and determines the
amount charged as its total cost of rendering the services, with no
markup. Based on an application of the section 482 regulations
without regard to this paragraph (b), the interquartile range of
arm's length markups on total services costs for these accounting
services is between 3% and 9%, and the median is 6%. Because the
median comparable markup on total services costs is 6%, which is
less than 7%, the accounting services constitute low margin covered
services within the meaning of paragraph (b)(3)(ii) of this section.
Example 16. Shared services arrangement and reliable measure of
reasonably anticipated benefit (allocation key). (i) Company P
operates a centralized data processing facility that performs
automated
[[Page 38851]]
invoice processing and order generation for all of its subsidiaries,
Companies X, Y, Z, pursuant to a shared services arrangement.
(ii) In evaluating the shares of reasonably anticipated benefits
from the centralized data processing services, the total value of
the merchandise on the invoices and orders may not provide the most
reliable measure of reasonably anticipated benefits shares, because
value of merchandise sold does not bear a relationship to the
anticipated benefits from the underlying covered services.
(iii) The total volume of orders and invoices processed may
provide a more reliable basis for evaluating the shares of
reasonably anticipated benefits from the data processing services.
Alternatively, depending on the facts and circumstances, total
central processing unit time attributable to the transactions of
each subsidiary may provide a more reliable basis on which to
evaluate the shares of reasonably anticipated benefits.
Example 17. Shared services arrangement and reliable measure of
reasonably anticipated benefit (allocation key). (i) Company P
operates a centralized center that performs human resources
functions, such as administration of pension, retirement, and health
insurance plans that are made available to employees of its
subsidiaries, Companies X, Y, Z, pursuant to a shared services
arrangement.
(ii) In evaluating the shares of reasonably anticipated benefits
from these centralized services, the total revenues of each
subsidiary may not provide the most reliable measure of reasonably
anticipated benefit shares, because total revenues do not bear a
relationship to the shares of reasonably anticipated benefits from
the underlying services.
(iii) Employee headcount or total compensation paid to employees
may provide a more reliable basis for evaluating the shares of
reasonably anticipated benefits from the covered services.
Example 18. Shared services arrangement and reliable measure of
reasonably anticipated benefit (allocation key). (i) Company P
performs human resource services (service A) on behalf of the PXYZ
Group that qualify for the services cost method. Under that method,
Company P determines the amount charged for these services pursuant
to a shared services arrangement based on an application of
paragraph (b)(7) of this section. Service A constitutes a specified
covered service described in a revenue procedure pursuant to
paragraph (b)(3)(i) of this section. The total services costs for
service A otherwise determined under the services cost method is
300.
(ii) Companies X, Y and Z reasonably anticipate benefits from
service A. Company P does not reasonably anticipate benefits from
service A. Assume that if relative reasonably anticipated benefits
were precisely known, the appropriate allocation of charges pursuant
to paragraph (k) of this section to Company X, Y and Z for service A
is as follows:
Service A
[Total cost 300]
------------------------------------------------------------------------
Company
------------------------------------------------------------------------
X....................................................... 150
Y....................................................... 75
Z....................................................... 75
------------------------------------------------------------------------
(iii) The total number of employees (employee headcount) in
each company is as follows:
Company X--600 employees.
Company Y--250 employees.
Company Z--250 employees.
(iv) Company P allocates the 300 total services costs of service
A based on employee headcount as follows:
Service A
[Total cost 300]
------------------------------------------------------------------------
Company
Allocation key -------------------------------
Headcount Amount
------------------------------------------------------------------------
X....................................... 600 164
Y....................................... 250 68
Z....................................... 250 68
------------------------------------------------------------------------
(v) Based on these facts, Company P may reasonably conclude that
the employee headcount allocation basis most reliably reflects the
participants' respective shares of the reasonably anticipated benefits
attributable to service A.
Example 19. Shared services arrangement and reliable measure of
reasonably anticipated benefit (allocation key). (i) Company P
performs accounts payable services (service B) on behalf of the PXYZ
Group and determines the amount charged for the services under such
method pursuant to a shared services arrangement based on an
application of paragraph (b)(7) of this section. Service B is a
specified covered service described in a revenue procedure pursuant
to paragraph (b)(3)(i) of this section. The total services costs for
service B otherwise determined under the services cost method is
500.
(ii) Companies X, Y and Z reasonably anticipate benefits from
service B. Company P does not reasonably anticipate benefits from
service B. Assume that if relative reasonably anticipated benefits were
precisely known, the appropriate allocation of charges pursuant to
paragraph (k) of this section to Companies X, Y and Z for service B is
as follows:
Service B
[Total cost 500]
------------------------------------------------------------------------
Company
------------------------------------------------------------------------
X....................................................... 125
Y....................................................... 205
Z....................................................... 170
------------------------------------------------------------------------
(iii) The total number of employees (employee headcount) in each
company is as follows:
Company X--600.
Company Y--200.
Company Z--200.
(iv) The total number of transactions (transaction volume) with
uncontrolled customers by each company is as follows:
Company X--2,000.
Company Y--4,000.
Company Z--3,500.
(v) If Company P allocated the 500 total services costs of service
B based on employee headcount, the resulting allocation would be as
follows:
Service B
[Total cost 500]
------------------------------------------------------------------------
Company
Allocation key -------------------------------
Headcount Amount
------------------------------------------------------------------------
X....................................... 600 300
Y....................................... 200 100
Z....................................... 200 100
------------------------------------------------------------------------
(vi) In contrast, if Company P used volume of transactions with
uncontrolled customers as the allocation basis under the shared
services arrangement, the allocation would be as follows:
Service B
[Total cost 500]
------------------------------------------------------------------------
Company
-------------------------------
Allocation key Transaction
Volume Amount
------------------------------------------------------------------------
X....................................... 2,000 105
Y....................................... 4,000 211
Z....................................... 3,500 184
------------------------------------------------------------------------
(vii) Based on these facts, Company P may reasonably conclude that
the transaction volume, but not the employee headcount, allocation
basis most reliably reflects the participants' respective shares of the
reasonably anticipated benefits attributable to service B.
Example 20. Shared services arrangement and aggregation. (i)
Company P performs human resource services (service A) and accounts
payable services (service B) on behalf of the PXYZ Group that
qualify for the services cost method. Company P determines the
amount charged for these services under such method pursuant to a
shared services arrangement based on an application of paragraph
(b)(7) of this section. Service A and service B are specified
covered services described in a revenue procedure pursuant to
paragraph (b)(3)(i) of this section. The total services costs
otherwise determined under the services cost method for service A is
300 and for service B is 500; total services costs
[[Page 38852]]
for services A and B are 800. Company P determines that aggregation
of services A and B for purposes of the arrangement is appropriate.
(ii) Companies X, Y and Z reasonably anticipate benefits from
services A and B. Company P does not reasonably anticipate benefits
from services A and B. Assume that if relative reasonably anticipated
benefits were precisely known, the appropriate allocation of total
charges pursuant to paragraph (k) of this section to Companies X, Y and
Z for services A and B is as follows:
Services A and B
[Total cost 800]
------------------------------------------------------------------------
Company
------------------------------------------------------------------------
X....................................................... 350
Y....................................................... 100
Z....................................................... 350
------------------------------------------------------------------------
(iii) The total volume of transactions with uncontrolled customers
in each company is as follows:
Company X--2,000.
Company Y--4,000.
Company Z--4,000.
(iv) The total number of employees in each company is as follows:
Company X--600.
Company Y--200.
Company Z--200.
(v) If Company P allocated the 800 total services costs of services
A and B based on transaction volume or employee headcount, the
resulting allocation would be as follows:
Aggregated Services AB
[Total cost 800]
----------------------------------------------------------------------------------------------------------------
Allocation key Allocation key
---------------------------------------------------------------
Company Transaction
volume Amount Headcount Amount
----------------------------------------------------------------------------------------------------------------
X............................................... 2,000 160 600 480
Y............................................... 4,000 320 200 160
Z............................................... 4,000 320 200 160
----------------------------------------------------------------------------------------------------------------
(vi) In contrast, if aggregated services AB were allocated by
reference to the total U.S. dollar value of sales to uncontrolled
parties (trade sales) by each company, the following results would
obtain:
Aggregated Services AB
[Total costs 800]
------------------------------------------------------------------------
Allocation key
-------------------------------
Company Trade sales
(millions) Amount
------------------------------------------------------------------------
X....................................... $400 314
Y....................................... 120 94
Z....................................... 500 392
------------------------------------------------------------------------
(vii) Based on these facts, Company P may reasonably conclude that
the trade sales, but not the transaction volume or the employee
headcount, allocation basis most reliably reflects the participants'
respective shares of the reasonably anticipated benefits attributable
to services AB.
Example 21. Shared services arrangement and aggregation. (i)
Company P performs services A through P on behalf of the PXYZ Group
that qualify for the services cost method. Company P determines the
amount charged for these services under such method pursuant to a
shared services arrangement based on an application of paragraph
(b)(7) of this section. All of these services A through P constitute
either specified covered services or low margin covered services
described in paragraph (b)(3) of this section. The total services
costs for services A through P otherwise determined under the
services cost method is 500. Company P determines that aggregation
of services A through P for purposes of the arrangement is
appropriate.
(ii) Companies X and Y reasonably anticipate benefits from
services A through P and Company Z reasonably anticipates benefits
from services A through M but not from services N through P (Company
Z performs services similar to services N through P on its own
behalf). Company P does not reasonably anticipate benefits from
services A through P. Assume that if relative reasonably anticipated
benefits were precisely known, the appropriate allocation of total
charges pursuant to paragraph (k) of this section to Company X, Y,
and Z for services A through P is as follows:
----------------------------------------------------------------------------------------------------------------
Services A-M (cost Services N-P (cost Services A-P
Company 490) 10) (total cost 500)
----------------------------------------------------------------------------------------------------------------
X................................................... 90 5 95
Y................................................... 240 5 245
Z................................................... 160 .................. 160
----------------------------------------------------------------------------------------------------------------
(iii) The total volume of transactions with uncontrolled
customers in each company is as follows:
Company X--2,000.
Company Y--4,500.
Company Z--3,500.
(iv) Company P allocates the 500 total services costs of
services A through P based on transaction volume as follows:
Aggregated Services A-Z
[Total costs 500]
------------------------------------------------------------------------
Allocation key
-------------------------------
Company Transaction
volume Amount
------------------------------------------------------------------------
X....................................... 2,000 100
Y....................................... 4,500 225
Z....................................... 3,500 175
------------------------------------------------------------------------
(v) Based on these facts, Company P may reasonably conclude
that the transaction volume allocation basis most reliably reflects
the participants' respective shares of the reasonably anticipated
benefits attributable to services A through P.
Example 22. Renderer reasonably anticipates benefits. (i)
Company P renders services on behalf of the PXYZ Group that qualify
for the services cost method. Company P determines the amount
charged for these services under such method. Company P's share of
reasonably anticipated benefits from services A, B, C, and D is 20%
of the total reasonably anticipated benefits of all participants.
Company P's total services cost for services A, B, C, and D charged
within the Group is 100.
[[Page 38853]]
(ii) Based on an application of paragraph (b)(7) of this
section, Company P charges 80 which is allocated among Companies X,
Y, and Z. No charge is made to Company P under the shared services
arrangement for activities that it performs on its own behalf.
Example 23. Coordination with cost sharing arrangement. (i)
Company P performs human resource services (service A) on behalf of
the PXYZ Group that qualify for the services cost method. Company P
determines the amount charged for these services under such method
pursuant to a shared services arrangement based on an application of
paragraph (b)(7) of this section. Service A constitutes a specified
covered service described in a revenue procedure pursuant to
paragraph (b)(3)(i) of this section. The total services costs for
service A otherwise determined under the services cost method is
300.
(ii) Company X, Y, Z, and P reasonably anticipate benefits from
service A. Using a basis of allocation that is consistent with the
controlled participants' respective shares of the reasonably
anticipated benefits from the shared services, the total charge of
300 is allocated as follows:
X--100.
Y--50.
Z--25.
P--125.
(ii) In addition to performing services, P undertakes 500 of R&D
and incurs manufacturing and other costs of 1,000.
(iii) Companies P and X enter into a cost sharing arrangement in
accordance with Sec. 1.482-7T. Under the arrangement, Company P
will undertake all intangible property development activities. All
of Company P's research and development (R&D) activity is devoted to
the intangible property development activity under the cost sharing
arrangement. Company P will manufacture, market, and otherwise
exploit the product in its defined territory. Companies P and X will
share intangible property development costs in accordance with their
reasonably anticipated benefits from the intangible property, and
Company X will make payments to Company P as required under Sec.
1.482-7T. Company X will manufacture, market, and otherwise exploit
the product in the rest of the world.
(iv) A portion of the charge under the shared services
arrangement is in turn allocable to the intangible property
development activity undertaken by Company P. The most reliable
estimate of the proportion allocable to the intangible property
development activity is determined to be 500 (Company P's R&D
expenses) divided by 1,500 (Company P's total non-covered services
costs), or one-third. Accordingly, one-third of Company P's charge
of 125, or 42, is allocated to the intangible property development
activity. Companies P and X must share the intangible property
development costs of the cost shared intangible property (including
the charge of 42 that is allocated under the shared services
arrangement) in proportion to their respective shares of reasonably
anticipated benefits under the cost sharing arrangement. That is,
the reasonably anticipated benefit shares under the cost sharing
arrangement are determined separately from reasonably anticipated
benefit shares under the shared services arrangement.
Example 24. Coordination with cost sharing arrangement. (i) The
facts and analysis are the same as in Example 25, except that
Company X also performs intangible property development activities
related to the cost sharing arrangement. Using a basis of allocation
that is consistent with the controlled participants' respective
shares of the reasonably anticipated benefits from the shared
services, the 300 of service costs is allocated as follows:
X--100.
Y--50.
Z--25.
P--125.
(ii) In addition to performing services, Company P undertakes
500 of R&D and incurs manufacturing and other costs of 1,000.
Company X undertakes 400 of R&D and incurs manufacturing and other
costs of 600.
(iii) Companies P and X enter into a cost sharing arrangement in
accordance with Sec. 1.482-7T. Under the arrangement, both
Companies P and X will undertake intangible property development
activities. All of the research and development activity conducted
by Companies P and X is devoted to the intangible property
development activity under the cost sharing arrangement. Both
Companies P and X will manufacture, market, and otherwise exploit
the product in their respective territories and will share
intangible property development costs in accordance with their
reasonably anticipated benefits from the intangible property, and
both will make payments as required under Sec. 1.482-7T.
(iv) A portion of the charge under the shared services
arrangement is in turn allocable to the intangible property
development activities undertaken by Companies P and X. The most
reliable estimate of the portion allocable to Company P's intangible
property development activity is determined to be 500 (Company P's
R&D expenses) divided by 1,500 (P's total non-covered services
costs), or one-third. Accordingly, one-third of Company P's
allocated services cost method charge of 125, or 42, is allocated to
its intangible property development activity.
(v) In addition, it is necessary to determine the portion of the
charge under the shared services arrangement to Company X that
should be further allocated to Company X's intangible property
development activities under the cost sharing arrangement. The most
reliable estimate of the portion allocable to Company X's intangible
property development activity is 400 (Company X's R&D expenses)
divided by 1,000 (Company X's costs), or 40%. Accordingly, 40% of
the 100 that was allocated to Company X, or 40, is allocated in turn
to Company X's intangible property development activities. Company X
makes a payment to Company P of 100 under the shared services
arrangement and includes 40 of services cost method charges in the
pool of intangible property development costs.
(vi) The parties' respective contributions to intangible
property development costs under the cost sharing arrangement are as
follows:
P: 500 + (0.333 * 125) = 542
X: 400 + (0.40 * 100) = 440
(c) 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.
(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 (c)(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 intangible property (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
[[Page 38854]]
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 (for example, 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) Intangible property (if any) used in rendering the services;
(4) Geographic market in which the services are rendered or
received;
(5) Risks borne (for example, 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 (c) 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 (c)(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 (c)(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 (c)(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 intangible property. (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 (c)(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-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
(c)(2)(ii)(A) of this section.
Example 6. Adjustments for differences. (i) The facts are the
same as in Example 5,
[[Page 38855]]
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
(c)(2)(ii)(A) 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--
(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
(c)(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.
(d) 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 an 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 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 relevant uncontrolled transaction is
arm's length by determining the appropriate gross profit of the
controlled taxpayer.
(ii) Relevant uncontrolled transaction. The relevant 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
relevant 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 (d)(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 relevant
uncontrolled transaction, including an
[[Page 38856]]
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, intangible property (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 relevant uncontrolled
transaction to the related transactions involved in the uncontrolled
comparables. However, substantial differences in the nature of the
relevant uncontrolled transaction and the relevant transactions
involved in the uncontrolled comparables, such as differences in the
type of property transferred or service provided in the relevant
uncontrolled transaction, may indicate significant differences in the
services or functions performed by the controlled and uncontrolled
taxpayers with respect to their respective relevant transactions. Thus,
it ordinarily would be expected that the services or functions
performed in the controlled and uncontrolled transactions would be with
respect to relevant transactions involving the transfer of property
within the same product categories or the provision of services of the
same general type (for example, information-technology systems design).
Furthermore, significant differences in the intangible property (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 (for example, 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) Intangible property (if any) used in performing the services or
function;
(3) Geographic market in which the services or function are
performed or in which the relevant 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 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 (d) 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 relevant 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 relevant 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 relevant 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
[[Page 38857]]
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 relevant 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 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 relevant 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 relevant 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 relevant 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 relevant 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 in providing such agent services is 3%
of total fees charged in Company B's relevant 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 engages 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.
(e) 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
[[Page 38858]]
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 may include as well 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 are
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, intangible property
(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 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. If the appropriate gross services profit markup is derived
from comparable uncontrolled services transactions of other service
providers, in evaluating comparability the controlled taxpayer must
consider the results under this method expressed as a markup on total
services costs of the controlled taxpayer, because differences in
functions performed may be reflected in differences in service costs
other than those included in comparable transactional costs.
(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 (for example, 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 intangible property, 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
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 (for example, 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 (e)(3)(iii)(B), the
term comparable transactional costs includes the cost of acquiring
tangible
[[Page 38859]]
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 (e) 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 as well as certain other
related costs necessary to complete the project. This fee includes
the cost of hardware and software purchased from uncontrolled
vendors and incorporated in the final network or system, plus a
reasonable allocation of certain specified overhead costs incurred
by Company A in providing these services. Reliable accounting
records maintained by Company A indicate that Company A earned a
gross services profit markup of 10% on its time, materials and
specified overhead 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 (e)(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, together
with 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 an
unrelated Company C, instead of Company A, renders similar services
to uncontrolled parties and publicly available information indicates
that Company C earned a gross services profit markup of 10% on its
time, materials and certain specified overhead in providing those
services. As in Example 1, Company A still provides services for its
Country X subsidiary, Company B. In accordance with the requirements
in paragraph (e)(3)(ii) of this section, the taxpayer performs
additional analysis and restates the results of Company A's
controlled services transaction with its Country X subsidiary,
Company B, in the form of a markup on Company A's 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 functional differences likely
exist between the controlled services transaction performed by
Company A and uncontrolled services transactions performed by
Company C, and that these differences may not be reflected in the
comparable transactional costs. Upon further scrutiny, the presence
of such functional 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 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 this table:
------------------------------------------------------------------------
Category Rate
------------------------------------------------------------------------
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,
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 300% 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.
(f) 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 relating to the comparable
profits method apply to controlled services transactions, except as
modified in this paragraph (f).
(2) Determination of arm's length result--(i) Tested party. This
paragraph (f) 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
[[Page 38860]]
services, the rules under this paragraph (f) 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 (f) 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 intangible property 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 year 1 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 B incurs in performing the consulting
services and do not make use of valuable intangible property 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 report only 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 1 through 3, Company B shows the
following results for the services performed for Company A:
----------------------------------------------------------------------------------------------------------------
Year 1 Year 2 Year 3 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 1 through 3 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 1 through 3 would
lead to the following comparable operating profit (COP) for the
services rendered by Company B:
------------------------------------------------------------------------
OP/Total
service Company B
Uncontrolled service provider costs COP
(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
------------------------------------------------------------------------
[[Page 38861]]
(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 year 3 is compared to the comparable operating
profits derived from the comparables' results for year 3. The ratio
of operating profit to total services costs in year 3 is calculated
for each of the comparables and applied to Company B's year 3 total
services costs to derive the following results:
------------------------------------------------------------------------
OP/Total
service
Uncontrolled service provider costs (for Company B
year 3) COP
(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 year 3 is $151,775. Therefore, Company B's
income for year 3 is increased by $151,775, the difference between
Company B's reported operating profit for year 3 of zero and the
median of the comparable operating profits for year 3.
Example 3. Material difference in accounting for stock-based
compensation. (i) Taxpayer, a U.S. corporation the stock of which is
publicly traded, performs controlled services for its wholly-owned
subsidiaries. The arm's length price of these controlled services is
evaluated under the comparable profits method for services in
paragraph (f) of this section by reference to the net cost plus
profit level indicator (PLI). Taxpayer is the tested party under
paragraph (f)(2)(i) of this section. The Commissioner identifies the
most narrowly identifiable business activity of the tested party for
which data are available that incorporate the controlled transaction
(the relevant business activity). The Commissioner also identifies
four uncontrolled domestic service providers, Companies A, B, C, and
D, each of which performs exclusively activities similar to the
relevant business activity of Taxpayer that is subject to analysis
under paragraph (f) of this section. The stock of Companies A, B, C,
and D is publicly traded on a U.S. stock exchange. Assume that
Taxpayer makes an election to apply these regulations to earlier
taxable years.
(ii) Stock options are granted to the employees of Taxpayer that
engage in the relevant business activity. Assume that, as determined
under a method in accordance with U.S. generally accepted accounting
principles, the fair value of such stock options attributable to the
employees' performance of the relevant business activity is 500 for
the taxable year in question. In evaluating the controlled services,
Taxpayer includes salaries, fringe benefits, and related
compensation of these employees in ``total services costs,'' as
defined in paragraph (j) of this section. Taxpayer does not include
any amount attributable to stock options in total services costs,
nor does it deduct that amount in determining ''reported operating
profit'' within the meaning of Sec. 1.482-5(d)(5), for the year
under examination.
(iii) Stock options are granted to the employees of Companies A,
B, C, and D. Under a fair value method in accordance with U.S.
generally accepted accounting principles, the comparables include in
total compensation the value of the stock options attributable to
the employees' performance of the relevant business activity for the
annual financial reporting period, and treat this amount as an
expense in determining operating profit for financial accounting
purposes. The treatment of employee stock options is summarized in
the following table:
----------------------------------------------------------------------------------------------------------------
Salaries and
other non- Stock options Stock options
option fair value expensed
compensation
----------------------------------------------------------------------------------------------------------------
Taxpayer........................................................ 1,000 500 0
Company A....................................................... 7,000 2,000 2,000
Company B....................................................... 4,300 250 250
Company C....................................................... 12,000 4,500 4,500
Company D....................................................... 15,000 2,000 2,000
----------------------------------------------------------------------------------------------------------------
(iv) A material difference in accounting for stock-based
compensation (within the meaning of Sec. 1.482-7T(d)(3)(i)) exists.
Analysis indicates that this difference would materially affect the
measure of an arm's length result under this paragraph (f). In
making an adjustment to improve comparability under Sec. Sec.
1.482-1(d)(2) and 1.482-5(c)(2)(iv), the Commissioner includes in
total services costs of the tested party the total compensation
costs of 1,500 (including stock option fair value). In addition, the
Commissioner calculates the net cost plus PLI by reference to the
financial-accounting data of Companies A, B, C, and D, which take
into account compensatory stock options.
Example 4. Material difference in utilization of stock-based
compensation.
(i) The facts are the same as in paragraph (i) of Example 3.
(ii) No stock options are granted to the employees of Taxpayer
that engage in the relevant business activity. Thus, no deduction
for stock options is made in determining ``reported operating
profit'' (within the meaning of Sec. 1.482-5(d)(5)) for the taxable
year under examination.
(iii) Stock options are granted to the employees of Companies A,
B, C, and D, but none of these companies expense stock options for
financial accounting purposes. Under a method in accordance with
U.S. generally accepted accounting principles, however, Companies A,
B, C, and D disclose the fair value of the stock options for
financial accounting purposes. The utilization and treatment of
employee stock options is summarized in the following table:
----------------------------------------------------------------------------------------------------------------
Salaries and
other non- Stock options Stock options
option fair value expensed
compensation
----------------------------------------------------------------------------------------------------------------
Taxpayer........................................................ 1,000 0 N/A
Company A....................................................... 7,000 2,000 0
Company B....................................................... 4,300 250 0
Company C....................................................... 12,000 4,500 0
Company D....................................................... 15,000 2,000 0
----------------------------------------------------------------------------------------------------------------
[[Page 38862]]
(iv) A material difference in the utilization of stock-based
compensation (within the meaning of Sec. 1.482-7T(d)(3)(i)) exists.
Analysis indicates that these differences would materially affect
the measure of an arm's length result under this paragraph (f). In
evaluating the comparable operating profits of the tested party, the
Commissioner uses Taxpayer's total services costs, which include
total compensation costs of 1,000. In considering whether an
adjustment is necessary to improve comparability under Sec. Sec.
1.482-1(d)(2) and 1.482-5(c)(2)(iv), the Commissioner recognizes
that the total compensation provided to employees of Taxpayer is
comparable to the total compensation provided to employees of
Companies A, B, C, and D. Because Companies A, B, C, and D do not
expense stock-based compensation for financial accounting purposes,
their reported operating profits must be adjusted in order to
improve comparability with the tested party. The Commissioner
increases each comparable's total services costs, and also reduces
its reported operating profit, by the fair value of the stock-based
compensation incurred by the comparable company.
(v) The adjustments to the data of Companies A, B, C, and D
described in paragraph (iv) of this Example 4 are summarized in the
following table:
----------------------------------------------------------------------------------------------------------------
Salaries and
other non- Stock options Total services Operating Net cost plus
option fair value costs (A) profit (B) PLI (B/A)
compensation (Percent)
----------------------------------------------------------------------------------------------------------------
Per financial statements:
Company A................... 7,000 2,000 25,000 6,000 24.00
Company B................... 4,300 250 12,500 2,500 20.00
Company C................... 12,000 4,500 36,000 11,000 30.56
Company D................... 15,000 2,000 27,000 7,000 25.93
As adjusted:
Company A................... 7,000 2,000 27,000 4,000 14.81
Company B................... 4,300 250 12,750 2,250 17.65
Company C................... 12,000 4,500 40,500 6,500 16.05
Company D................... 15,000 2,000 29,000 5,000 17.24
----------------------------------------------------------------------------------------------------------------
Example 5. Non-material difference in utilization of stock-based
compensation.
(i) The facts are the same as in paragraph (i) of Example 3.
(ii) Stock options are granted to the employees of Taxpayer that
engage in the relevant business activity. Assume that, as determined
under a method in accordance with U.S. generally accepted accounting
principles, the fair value of such stock options attributable to the
employees' performance of the relevant business activity is 50 for
the taxable year. Taxpayer includes salaries, fringe benefits, and
all other compensation of these employees (including the stock
option fair value) in ``total services costs,'' as defined in
paragraph (j) of this section, and deducts these amounts in
determining ``reported operating profit'' within the meaning of
Sec. 1.482-5(d)(5), for the taxable year under examination.
(iii) Stock options are granted to the employees of Companies A,
B, C, and D, but none of these companies expense stock options for
financial accounting purposes. Under a method in accordance with
U.S. generally accepted accounting principles, however, Companies A,
B, C, and D disclose the fair value of the stock options for
financial accounting purposes. The utilization and treatment of
employee stock options is summarized in the following table:
----------------------------------------------------------------------------------------------------------------
Salaries and
other non- Stock options Stock options
option fair value expensed
compensation
----------------------------------------------------------------------------------------------------------------
Taxpayer........................................................ 1,000 50 50
Company A....................................................... 7,000 100 0
Company B....................................................... 4,300 40 0
Company C....................................................... 12,000 130 0
Company D....................................................... 15,000 75 0
----------------------------------------------------------------------------------------------------------------
(iv) Analysis of the data reported by Companies A, B, C, and D
indicates that an adjustment for differences in utilization of
stock-based compensation would not have a material effect on the
determination of an arm's length result.
----------------------------------------------------------------------------------------------------------------
Salaries and
other non- Stock options Total services Operating Net cost plus
option fair value costs (A) profit (B) PLI (B/A)
compensation (percent)
----------------------------------------------------------------------------------------------------------------
Per financial statements:
Company A................... 7,000 100 25,000 6,000 24.00
Company B................... 4,300 40 12,500 2,500 20.00
Company C................... 12,000 130 36,000 11,000 30.56
Company D................... 15,000 75 27,000 7,000 25.93
As adjusted:
Company A................... 7,000 100 25,100 5,900 23.51
Company B................... 4,300 40 12,540 2,460 19.62
Company C................... 12,000 130 36,130 10,870 30.09
Company D................... 15,000 75 27,075 6,925 25.58
----------------------------------------------------------------------------------------------------------------
(v) Under the circumstances, the difference in utilization of
stock-based compensation would not materially affect the
determination of the arm's length result under this paragraph (f).
Accordingly, in calculating the net cost plus PLI, no comparability
[[Page 38863]]
adjustment is made to the data of Companies A, B, C, or D pursuant
to Sec. Sec. 1.482-1(d)(2) and 1.482-5(c)(2)(iv).
Example 6. Material difference in comparables' accounting for
stock-based compensation. (i) The facts are the same as in paragraph
(i) of Example 3.
(ii) Stock options are granted to the employees of Taxpayer that
engage in the relevant business activity. Assume that, as determined
under a method in accordance with U.S. generally accepted accounting
principles, the fair value of such stock options attributable to
employees' performance of the relevant business activity is 500 for
the taxable year. Taxpayer includes salaries, fringe benefits, and
all other compensation of these employees (including the stock
option fair value) in ``total services costs,'' as defined in
paragraph (j) of this section, and deducts these amounts in
determining ``reported operating profit'' (within the meaning of
Sec. 1.482-5(d)(5)) for the taxable year under examination.
(iii) Stock options are granted to the employees of Companies A,
B, C, and D. Companies A and B expense the stock options for
financial accounting purposes in accordance with U.S. generally
accepted accounting principles. Companies C and D do not expense the
stock options for financial accounting purposes. Under a method in
accordance with U.S. generally accepted accounting principles,
however, Companies C and D disclose the fair value of these options
in their financial statements. The utilization and accounting
treatment of options are depicted in the following table:
----------------------------------------------------------------------------------------------------------------
Salary and
other non- Stock options Stock options
option fair value expensed
compensation
----------------------------------------------------------------------------------------------------------------
Taxpayer........................................................ 1,000 500 500
Company A....................................................... 7,000 2,000 2,000
Company B....................................................... 4,300 250 250
Company C....................................................... 12,000 4,500 0
Company D....................................................... 15,000 2,000 0
----------------------------------------------------------------------------------------------------------------
(iv) A material difference in accounting for stock-based
compensation (within the meaning of Sec. 1.482-7T(d)(3)(i)) exists.
Analysis indicates that this difference would materially affect the
measure of the arm's length result under paragraph (f) of this
section. In evaluating the comparable operating profits of the
tested party, the Commissioner includes in total services costs
Taxpayer's total compensation costs of 1,500 (including stock option
fair value of 500). In considering whether an adjustment is
necessary to improve comparability under Sec. Sec. 1.482-1(d)(2)
and 1.482-5(c)(2)(iv), the Commissioner recognizes that the total
employee compensation (including stock options provided by Taxpayer
and Companies A, B, C, and D) provides a reliable basis for
comparison. Because Companies A and B expense stock-based
compensation for financial accounting purposes, whereas Companies C
and D do not, an adjustment to the comparables' operating profit is
necessary. In computing the net cost plus PLI, the Commissioner uses
the financial-accounting data of Companies A and B, as reported. The
Commissioner increases the total services costs of Companies C and D
by amounts equal to the fair value of their respective stock
options, and reduces the operating profits of Companies C and D
accordingly.
(v) The adjustments described in paragraph (iv) of this Example
6 are depicted in the following table. For purposes of illustration,
the unadjusted data of Companies A and B are also included.
----------------------------------------------------------------------------------------------------------------
Salaries and
other non- Stock options Total services Operating Net cost plus
option fair value costs (A) profit (B) PLI (B/A)
compensation (percent)
----------------------------------------------------------------------------------------------------------------
Per financial statements:
Company A................... 7,000 2,000 27,000 4,000 14.80
Company B................... 4,300 250 12,750 2,250 17.65
As adjusted:
Company C................... 12,000 4,500 40,500 6,500 16.05
Company D................... 15,000 2,000 29,000 5,000 17.24
----------------------------------------------------------------------------------------------------------------
(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. For application of the profit split method (both the
comparable profit split and the residual profit split), see Sec.
1.482-6. The residual profit split method may not be used where only
one controlled taxpayer makes significant nonroutine contributions.
(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 take 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
[[Page 38864]]
B possess valuable intangible property 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, there are no market comparables for the transactions
between Company A and Company B 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 Country 1
corporation, provides specialized services pertaining to the
processing and storage of Level 1 hazardous waste (for purposes of
this example, the most dangerous type of waste). Under long-term
contracts with private companies and governmental entities in
Country 1, Company A performs multiple services, including
transportation of Level 1 waste, development of handling and storage
protocols, recordkeeping, and supervision of waste-storage
facilities owned and maintained by the contracting parties. Company
A's research and development unit has also developed new and unique
processes for transport and storage of Level 1 waste that minimize
environmental and occupational effects. In addition to this novel
technology, Company A has substantial know-how and a long-term
record of safe operations in Country 1.
(ii) Company A's subsidiary, Company B, has been in operation
continuously for a number of years in Country 2. Company B has
successfully completed several projects in Country 2 involving Level
2 and Level 3 waste, including projects with government-owned
entities. Company B has a license in Country 2 to handle Level 2
waste (Level 3 does not require a license). Company B has
established a reputation for completing these projects in a
responsible manner. Company B has cultivated contacts with
procurement officers, regulatory and licensing officials, and other
government personnel in Country 2.
(iii) Country 2 government publishes invitations to bid on a
project to handle the country's burgeoning volume of Level 1 waste,
all of which is generated in government-owned facilities. Bidding is
limited to companies that are domiciled in Country 2 and that
possess a license from the government to handle Level 1 or Level 2
waste. In an effort to submit a winning bid to secure the contract,
Company B points to its Level 2 license and its record of successful
completion of projects, and also demonstrates to these officials
that it has access to substantial technical expertise pertaining to
processing of Level 1 waste.
(iv) Company A enters into a long-term technical services
agreement with Company B. Under this agreement, Company A agrees to
supply to Company B project managers and other technical staff who
have detailed knowledge of Company A's proprietary Level 1
remediation techniques. Company A commits to perform under any long-
term contracts entered into by Company B. Company B agrees to
compensate Company A based on a markup on Company A's marginal costs
(pro rata compensation and current expenses of Company A personnel).
In the bid on the Country 2 contract for Level 1 waste remediation,
Company B proposes to use a multi-disciplinary team of specialists
from Company A and Company B. Project managers from Company A will
direct the team, which will also include employees of Company B and
will make use of physical assets and facilities owned by Company B.
Only Company A and Company B personnel will perform services under
the contract. Country 2 grants Company B a license to handle Level 1
waste.
(v) Country 2 grants Company B a five-year, exclusive contract
to provide processing services for all Level 1 hazardous waste
generated in County 2. Under the contract, Company B is to be paid a
fixed price per ton of Level 1 waste that it processes each year.
Company B undertakes that all services provided will meet
international standards applicable to processing of Level 1 waste.
Company B begins performance under the contract.
(vi) Analysis of the facts and circumstances indicates that both
Company A and Company B make nonroutine contributions to the Level 1
waste processing activity in Country 2. In addition, it is
determined that reliable comparables are not available for the
services that Company A provides under the long-term contract, in
part because those services incorporate specialized knowledge and
process intangible property developed by Company A. It is also
determined that reliable comparables are not available for the Level
2 license in Country 2, the successful track record, the government
contacts with Country 2 officials, and other intangible property
that Company B provided. In view of these facts, the Commissioner
determines that the residual profit split method for services in
paragraph (g) of this section provides the most reliable means of
evaluating the arm's length results for the transaction. In
evaluating the appropriate returns to Company A and Company B for
their respective contributions, the Commissioner takes into account
that the controlled parties incur different risks, because the
contract between the controlled parties provides that Company A will
be compensated on the basis of marginal costs incurred, plus a
markup, whereas the contract between Company B and the government of
Country 2 provides that Company B will be compensated on a fixed-
price basis per ton of Level 1 waste processed.
(vii) In the first stage of the residual profit split, an arm's
length return is determined for routine activities performed by
Company B in Country 2, such as transportation, recordkeeping, and
administration. In addition, an arm's length return is determined
for routine activities performed by Company A (administrative, human
resources, etc.) in connection with providing personnel to Company
B. After the arm's length return for these functions is determined,
residual profits may be present. In the second stage of the residual
profit split, any residual profit is allocated by reference to the
relative value of the nonroutine contributions made by each
taxpayer. Company A's nonroutine contributions include its
commitment to perform under the contract and the specialized
technical knowledge made available through the project managers
under the services agreement with Company B. Company B's nonroutine
contributions include its licenses to handle Level 1 and Level 2
waste in Country 2, its knowledge of and contacts with procurement,
regulatory and licensing officials in the government of Country 2,
and its record in Country 2 of successfully handling non-Level 1
waste.
(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, including
economically similar transactions structured as other than services
transactions, 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 (for example, outsourcing a particular
service function, rather than performing the
[[Page 38865]]
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.
Example. (i) Company T, a U.S. corporation, develops computer
software programs including a real estate investment program that
performs financial analysis of commercial real properties. Companies
U, V, and W are owned by Company T. The primary business activity of
Companies U, V, and W is commercial real estate development. For
business reasons, Company T does not sell the computer program to
its customers (on a compact disk or via download from Company T's
server through the Internet). Instead, Company T maintains the
software program on its own server and allows customers to access
the program through the Internet by using a password. The
transactions between Company T and Companies U, V, and W are
structured as controlled services transactions whereby Companies U,
V, and W obtain access via the Internet to Company T's software
program for financial analysis. Each year, Company T provides a
revised version of the computer program including the most recent
data on the commercial real estate market, rendering the old version
obsolete.
(ii) In evaluating whether the consideration paid by Companies
U, V, and W to Company T was arm's length, the Commissioner may
consider, subject to the best method rule of Sec. 1.482-1(c),
Company T's alternative of selling the computer program to Companies
U, V, and W on a compact disk or via download through the Internet.
The Commissioner determines that the controlled services
transactions between Company T and Companies U, V, and W are
comparable to the transfer of a similar software program on a
compact disk or via download through the Internet between
uncontrolled parties. Subject to adjustments being made for material
differences between the controlled services transactions and the
comparable uncontrolled transactions, the uncontrolled transfers of
tangible property may be used to evaluate the arm's length results
for the controlled services transactions between Company T and
Companies U, V, and W.
(i) Contingent-payment contractual terms for services--(1)
Contingent-payment contractual terms recognized in general. In the case
of a contingent-payment arrangement, the arm's length result for the
controlled services transaction generally 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. 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 generally 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.
(2) Contingent-payment arrangement. For purposes of this paragraph
(i), an arrangement will be treated as a contingent-payment arrangement
if it meets all of the requirements in paragraph (i)(2)(i) of this
section and is consistent with the economic substance and conduct
requirement in paragraph (i)(2)(ii) of this section.
(i) General requirements--(A) Written contract. The arrangement is
set forth in a written contract entered into prior to, or
contemporaneous with, the start of the activity or group of activities
constituting the controlled services transaction.
(B) Specified contingency. The contract states that payment for a
controlled services transaction is contingent (in whole or in part)
upon the happening of a future benefit (within the meaning of Sec.
1.482-9(l)(3)) for the recipient directly related to the activity or
group of activities. For purposes of the preceding sentence, whether
the future benefit is directly related to the activity or group of
activities is evaluated based on all the facts and circumstances.
(C) 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.
(ii) Economic substance and conduct. The arrangement, including the
contingency and the basis for payment, is consistent with the economic
substance of the controlled transaction and the conduct of the
controlled parties. See Sec. 1.482-1(d)(3)(ii)(B).
(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 regulations under
section 482. 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 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 through 9. In
evaluating whether the contingent-payment terms will be recognized,
the Commissioner considers
[[Page 38866]]
whether the conditions of paragraph (i)(2) of this section are met
and whether the arrangement, including the specified contingency and
basis of payment, is 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. Based on all these facts, the Commissioner
determines that the contingent-payment arrangement is 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 this section and other
applicable rules under section 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 whether the compensation of
x% of gross sales that is paid to Company X during the first four
years of commercial sales of derivative products is arm's length,
the Commissioner may consider the royalties (or other consideration)
charged for intangible property 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 Example 1, except
that no commercial sales ever materialize with regard to the
patented compound so that, consistent with the agreement, Company Y
makes no payments to Company X in years 6 through 9.
(ii) Based on all the facts and circumstances, the Commissioner
determines that the contingent-payment arrangement is consistent
with economic substance, and the result (no payments in years 6
through 9) is consistent with an arm's length result.
Example 3. (i) The facts are the same as in 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 through 9. In
evaluating whether the contingent-payment terms will be recognized,
the Commissioner considers whether the requirements of paragraph
(i)(2) of this section were met at the time the written agreement
was entered into and whether the arrangement, including the
specified contingency and basis for payment, is 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. Based on all the facts and circumstances, the
Commissioner determines that the contingent-payment arrangement is
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, 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 this section 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 intangible property 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 in cash or in kind (including stock-based compensation) that,
based on analysis of the facts and circumstances, are directly
identified with, or reasonably allocated in accordance with the
principles of paragraph (k)(2) of this section to, the services. In
general, costs for this purpose should comprise provision 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
may provide a useful starting point but will not necessarily be
conclusive regarding inclusion of costs in total services costs. 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
performed for the benefit of the
[[Page 38867]]
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 (for example, 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
intangible property if the renderer engages in an activity that
[[Page 38868]]
is reasonably anticipated to result in an increase in the value of that
intangible property. Paragraphs (l)(3)(ii) through (v) of this section
provide guidelines that indicate the presence or absence of a benefit
for the activities in the controlled services transaction.
(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 generally 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 sole effect of that activity is either to
protect the renderer's capital investment in the recipient or in other
members of the controlled group, or to facilitate compliance by the
renderer with reporting, legal, or regulatory requirements applicable
specifically to the renderer, or both. 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) Disaggregation of transactions. A controlled services
transaction may be analyzed as two separate transactions for purposes
of determining the arm's length consideration, if that analysis is the
most reliable means of determining the arm's length consideration for
the controlled services transaction. See the best method rule under
Sec. 1.482-1(c).
(5) 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 a 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.
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. The intellectual property legal staff
specializes in technology licensing, patents, copyrights, and
negotiating and drafting intellectual property agreements. 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. Company Y does not have in-house counsel of
its own to review intellectual property 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. Company X's intellectual property legal staff
possess valuable knowledge of Company Y's patents and technological
achievements. They are capable of identifying particular scientific
attributes protected under patent that strengthen Company Y's
negotiating position, and of discovering flaws in the patents
offered by the unrelated party. To reduce risk associated with the
transaction, Company X's intellectual property legal staff reviews
the transaction documents before Company Y executes the contracts.
Company X's intellectual property legal staff also separately
evaluates the patents and copyrights with respect to the licensing
arrangements 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 risk
associated with the transaction in a way that confers an additional
benefit on Company Y.
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, Company Y and each
of the other subsidiaries maintain their own separate accounting
departments that record individual transactions and prepare
financial statements in accordance with their local accounting
practices. Company Y, and
[[Page 38869]]
the other subsidiaries, forward the results of their financial
performance to Company X, which analyzes and compiles these data
into periodic reports in accordance with U.S. laws and regulations.
Because Company X's preparation and filing of the reports relate
solely to its role as an investor of capital or shareholder in
Company Y or to its compliance with reporting, legal, or regulatory
requirements, or both, 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's accounting department maintains a
general ledger recording individual transactions, but does not
prepare any financial statements (such as profit and loss statements
and balance sheets). Instead, Company Y forwards the general ledger
data to Company X, and Company X analyzes and compiles financial
statements for Company Y, as well as for Company X's overall
operations, for purposes of complying with U.S. reporting
requirements. 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 are 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 does not relate solely
to its role as an investor of capital or shareholder in Company Y,
or to its compliance with reporting, legal, or regulatory
requirements, or both, these activities do not constitute
shareholder activities.
Example 9. Shareholder activities. Members of Company X's
internal audit staff 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 sole effect of the reviews by
Company X's audit staff is to protect Company X's investment in
Company Y, or to facilitate Company X's compliance with U.S. anti-
bribery laws, or both, 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's retention of the firms facilitates
Company Y's ability to pay dividends and other amounts and has the
sole effect of protecting Company X's investment in Company Y, these
activities constitute shareholder activities and 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 primarily to enhance
Company Y's profitability and the efficiency of its operations, and
not solely to protect Company X's investment in Company Y or to
facilitate Company X's compliance with Country B's corporate laws,
or to both, these activities do not constitute shareholder
activities.
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, this activity does not relate solely to
Company X's role as an investor of capital or a shareholder of
Company Y, and therefore does not constitute a shareholder 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 solely 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.
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 intangible property 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
materially 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.
Example 18. Passive association/benefit. The facts are the same
as in Example 15, except that Company X sent a letter to the
financial institution in Country B, which represented that Company X
had a certain percentage ownership in Company Y and that Company X
would maintain that same percentage ownership interest in Company Y
until the contract was completed. This letter allowed Company Y to
obtain the contract on more favorable terms than otherwise would
have been possible. Since this letter from Company X to the
financial institution simply affirmed Company Y's status as a member
of the controlled group and represented that this status would be
maintained until the contract was completed,
[[Page 38870]]
Company Y is not considered to obtain a benefit from Company X's
furnishing of the letter.
Example 19. Passive association/benefit. (i) S is a company that
supplies plastic containers to companies in various industries. S
establishes the prices for its containers through a price list that
offers customers discounts based solely on the volume of containers
purchased.
(ii) Company X is the parent corporation of a large controlled
group in the information technology sector. Company Y is a wholly-
owned subsidiary of Company X located in Country B. Company X and
Company Y both purchase plastic containers from unrelated supplier
S. In year 1, Company X purchases 1 million units and Company Y
purchases 100,000 units. S, basing its prices on purchases by the
entire group, completes the order for 1.1 million units at a price
of $0.95 per unit, and separately bills and ships the orders to each
company. Companies X and Y undertake no bargaining with supplier S
with respect to the price charged, and purchase no other products
from supplier S.
(iii) R1 and its wholly-owned subsidiary R2 are a controlled
group of taxpayers (unrelated to Company X or Company Y) each of
which carries out functions comparable to those of Companies X and Y
and undertakes purchases of plastic containers from supplier S,
identical to those purchased from S by Company X and Company Y,
respectively. S, basing its prices on purchases by the entire group,
charges R1 and R2 $0.95 per unit for the 1.1 million units ordered.
R1 and R2 undertake no bargaining with supplier S with respect to
the price charged, and purchase no other products from supplier S.
(iv) U is an uncontrolled taxpayer that carries out comparable
functions and undertakes purchases of plastic containers from
supplier S identical to Company Y. U is not a member of a controlled
group, undertakes no bargaining with supplier S with respect to the
price charged, and purchases no other products from supplier S. U
purchases 100,000 plastic containers from S at the price of $1.00
per unit.
(v) Company X charges Company Y a fee of $5,000, or $0.05 per
unit of plastic containers purchased by Company Y, reflecting the
fact that Company Y receives the volume discount from supplier S.
(vi) In evaluating the fee charged by Company X to Company Y,
the Commissioner considers whether the transactions between R1, R2,
and S or the transactions between U and S provide a more reliable
measure of the transactions between Company X, Company Y and S. The
Commissioner determines that Company Y's status as a member of a
controlled group should be taken into account for purposes of
evaluating comparability of the transactions, and concludes that the
transactions between R1, R2, and S are more reliably comparable to
the transactions between Company X, Company Y, and S. The comparable
charge for the purchase was $0.95 per unit. Therefore, obtaining the
plastic containers at a favorable rate (and the resulting $5,000
savings) is entirely 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. Consequently,
Company Y is not considered to obtain a benefit from Company X or
any other member of the controlled group.
Example 20. Disaggregation of transactions. (i) X, a domestic
corporation, is a pharmaceutical company that develops and
manufactures ethical pharmaceutical products. Y, a Country B
corporation, is a distribution and marketing company that also
performs clinical trials for X in Country B. Because Y does not
possess the capability to conduct the trials, it contracts with a
third party to undertake the trials at a cost of $100. Y also incurs
$25 in expenses related to the third-party contract (for example, in
hiring and working with the third party).
(ii) Based on a detailed functional analysis, the Commissioner
determines that Y performed functions beyond merely facilitating the
clinical trials for X, such as audit controls of the third party
performing those trials. In determining the arm's length price, the
Commissioner may consider a number of alternatives. For example, for
purposes of determining the arm's length price, the Commissioner may
determine that the intercompany service is most reliably analyzed on
a disaggregated basis as two separate transactions: in this case,
the contract between Y and the third party could constitute an
internal CUSP with a price of $100. Y would be further entitled to
an arm's length remuneration for its facilitating services. If the
most reliable method is one that provides a markup on Y's costs,
then ``total services cost'' in this context would be $25.
Alternatively, the Commissioner may determine that the intercompany
service is most reliably analyzed as a single transaction, based on
comparable uncontrolled transactions involving the facilitation of
similar clinical trial services performed by third parties. If the
most reliable method is one that provides a markup on all of Y's
costs, and the base of the markup determined by the comparable
companies includes the third-party clinical trial costs, then such a
markup would be applied to Y's total services cost of $125.
Example 21. Disaggregation of transactions. (i) X performs a
number of administrative functions for its subsidiaries, including
Y, a distributor of widgets in Country B. These services include
those relating to working capital (inventory and accounts
receivable/payable) management. To facilitate provision of these
services, X purchases an ERP system specifically dedicated to
optimizing working capital management. The system, which entails
significant third-party costs and which includes substantial
intellectual property relating to its software, costs $1,000.
(ii) Based on a detailed functional analysis, the Commissioner
determines that in providing administrative services for Y, X
performed functions beyond merely operating the ERP system itself,
since X was effectively using the ERP as an input to the
administrative services it was providing to Y. In determining arm's
length price for the services, the Commissioner may consider a
number of alternatives. For example, if the most reliable
uncontrolled data is derived from companies that use similar ERP
systems purchased from third parties to perform similar
administrative functions for uncontrolled parties, the Commissioner
may determine that a CPM is the best method for measuring the
functions performed by X, and, in addition, that a markup on total
services costs, based on the markup from the comparable companies,
is the most reliable PLI. In this case, total services cost, and the
basis for the markup, would include appropriate reflection of the
ERP costs of $1,000. Alternatively, X's functions may be most
reliably measured based on comparable uncontrolled companies that
perform similar administrative functions using their customers' own
ERP systems. Under these circumstances, the total services cost
would equal X's costs of providing the administrative services
excluding the ERP cost of $1,000.
(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 certain cases include an element that constitutes the transfer
of intangible property or may result in a transfer, in whole or in
part, of intangible property. Notwithstanding paragraph (m)(1) of this
section, 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 must be corroborated or
determined by an analysis under Sec. 1.482-4.
[[Page 38871]]
(3) [Reserved]. For further guidance, see Sec. 1.482-9T(m)(3).
(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) Examples. The principles of this paragraph (m) are illustrated
by the following examples:
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 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 perform research and development activities relating to
integrated circuits. In addition, Company Y manufactures integrated
circuits. In years 1 through 3, Company X engages in substantial
research and development activities, gains significant know-how
regarding the development of a particular high-temperature resistant
integrated circuit, and memorializes that research in a written
report. In years 1 through 3, Company X generates overall net
operating losses as a result of the expenditures associated with
this research and development effort. At the beginning of year 4,
Company X enters into a technical assistance agreement with Company
Y. As part of this agreement, the researchers from Company X
responsible for this project meet with the researchers from Company
Y and provide them with a copy of the written report. Three months
later, the researchers from Company Y apply for a patent for a high-
temperature resistant integrated circuit based in large part upon
the know-how obtained from the researchers from Company X.
(ii) The controlled services transaction between Company X and
Company Y includes an element that constitutes the transfer of
intangible property (such as, 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.
(6) Global dealing operations. [Reserved].
(n) Effective/applicability date--(1) In general. This section is
generally applicable for taxable years beginning after July 31, 2009.
In addition, a person may elect to apply the provisions of this section
to earlier taxable years. See paragraph (n)(2) of this section.
(2) Election to apply regulations to earlier taxable years--(i)
Scope of election. A taxpayer may elect to apply Sec. 1.482-1(a)(1),
(b)(2)(i), (d)(3)(ii)(C) Examples 3 through 6, (d)(3)(v),
(f)(2)(ii)(A), (f)(2)(iii)(B), (g)(4)(i), (g)(4)(iii) Example 1, (i),
(j)(6)(i) and (j)(6)(ii), Sec. 1.482-2(b), (f)(1) and (2), Sec.
1.482-4(f)(3)(i)(A), (f)(3)(ii) Examples 1 and 2, (f)(4), (h)(1) and
(2), Sec. 1.482-6(c)(2)(ii)(B)(1), (c)(2)(ii)(D), (c)(3)(i)(A),
(c)(3)(i)(B), (c)(3)(ii)(D), and (d), Sec. 1.482-8(b) Examples 10
through 12, (c)(1) and (c)(2), Sec. 1.482-9(a) through (m)(2), and
(m)(4) through (n)(2), Sec. 1.861-8(a)(5)(ii), (b)(3), (e)(4),
(f)(4)(i), (g) Examples 17, 18, and 30, Sec. 1.6038A-3(a)(3) Example 4
and (i), Sec. 1.6662-6(d)(2)(ii)(B), (d)(2)(iii)(B)(4),
(d)(2)(iii)(B)(6), and (g), and Sec. 31.3121(s)-1(c)(2)(iii) and (d)
of this chapter to any taxable year
[[Page 38872]]
beginning after September 10, 2003. Such election requires that all of
the provisions of such sections be applied to such taxable year and all
subsequent taxable years (earlier taxable years) of the taxpayer making
the election.
(ii) Effect of election. An election to apply the regulations to
earlier taxable years has no effect on the limitations on assessment
and collection or on the limitations on credit or refund (see Chapter
66 of the Internal Revenue Code).
(iii) Time and manner of making election. An election to apply the
regulations to earlier taxable years must be made by attaching a
statement to the taxpayer's timely filed U.S. tax return (including
extensions) for its first taxable year beginning after July 31, 2009.
(iv) Revocation of election. An election to apply the regulations
to earlier taxable years may not be revoked without the consent of the
Commissioner.
0
Par. 15. Section 1.482-9T is amended by revising paragraphs (a), (b),
(c), (d), (e), (f), (g), (h), (i), (j), (k), (l), (m)(1), (m)(2),
(m)(4), (m)(5), and (n), and adding paragraph (o) to read as follows:
Sec. 1.482-9T Methods to determine taxable income in connection with
a controlled services transaction (temporary).
(a) through (m)(2) [Reserved]. For further guidance, see Sec.
1.482-9(a) through (m)(2).
(3) * * *
(4) and (m)(5) [Reserved]. For further guidance, see Sec. 1.482-
9(m)(4) and (m)(5).
(n) Effective/applicability date. Paragraph (m)(3) of this section
is generally applicable on January 5, 2009.
(o) Expiration date. The applicability of paragraph (m)(3) of this
section expires on December 30, 2011.
0
Par. 16. Section 1.861-8 is amended by revising paragraphs (a)(5)(ii),
(b)(3), (e)(4), (f)(4), (g) Examples 17, 18 and 30, and (h) to read as
follows:
Sec. 1.861-8 Computation of taxable income from sources within the
United States and from other sources and activities.
* * * * *
(a) * * *
(5) * * *
(ii) Paragraph (e)(4), the last sentence of paragraph (f)(4)(i),
and paragraph (g), Examples 17, 18, and 30 of this section are
generally applicable for taxable years beginning after July 31, 2009.
In addition, a person may elect to apply the provisions of paragraph
(e)(4) of this section to earlier years. Such election shall be made in
accordance with the rules set forth in Sec. 1.482-9(n)(2).
* * * * *
(b) * * *
(3) Supportive functions. Deductions which are supportive in nature
(such as overhead, general and administrative, and supervisory
expenses) may relate to other deductions which can more readily be
allocated to gross income. In such instance, such supportive deductions
may be allocated and apportioned along with the deductions to which
they relate. On the other hand, it would be equally acceptable to
attribute supportive deductions on some reasonable basis directly to
activities or property which generate, have generated or could
reasonably be expected to generate gross income. This would ordinarily
be accomplished by allocating the supportive expenses to all gross
income or to another broad class of gross income and apportioning the
expenses in accordance with paragraph (c)(1) of this section. For this
purpose, reasonable departmental overhead rates may be utilized. For
examples of the application of the principles of this paragraph (b)(3)
to expenses other than expenses attributable to stewardship activities,
see Examples 19 through 21 of paragraph (g) of this section. See
paragraph (e)(4)(ii) of this section for the allocation and
apportionment of deductions attributable to stewardship expenses.
However, supportive deductions that are described in Sec. 1.861-
14T(e)(3) shall be allocated and apportioned in accordance with the
rules of Sec. 1.861-14T and shall not be allocated and apportioned by
reference only to the gross income of a single member of an affiliated
group of corporations as defined in Sec. 1.861-14T(d).
* * * * *
(e) * * *
(4) Stewardship and controlled services--(i) Expenses attributable
to controlled services. If a corporation performs a controlled services
transaction (as defined in Sec. 1.482-9(l)(3)), which includes any
activity by one member of a group of controlled taxpayers that results
in a benefit to a related corporation, and the rendering corporation
charges the related corporation for such services, section 482 and
these regulations provide for an allocation where the charge is not
consistent with an arm's length result as determined. The deductions
for expenses of the corporation attributable to the controlled services
transaction are considered definitely related to the amounts so charged
and are to be allocated to such amounts.
(ii) Stewardship expenses attributable to dividends received.
Stewardship expenses, which result from ``overseeing'' functions
undertaken for a corporation's own benefit as an investor in a related
corporation, shall be considered definitely related and allocable to
dividends received, or to be received, from the related corporation.
For purposes of this section, stewardship expenses of a corporation are
those expenses resulting from ``duplicative activities'' (as defined in
Sec. 1.482-9(l)(3)(iii)) or ``shareholder activities'' (as defined in
Sec. 1.482-9(l)(3)(iv)) of the corporation with respect to the related
corporation. Thus, for example, stewardship expenses include expenses
of an activity the sole effect of which is either to protect the
corporation's capital investment in the related corporation or to
facilitate compliance by the corporation with reporting, legal, or
regulatory requirements applicable specifically to the corporation, or
both. If a corporation has a foreign or international department which
exercises overseeing functions with respect to related foreign
corporations and, in addition, the department performs other functions
that generate other foreign-source income (such as fees for services
rendered outside of the United States for the benefit of foreign
related corporations, foreign-source royalties, and gross income of
foreign branches), some part of the deductions with respect to that
department are considered definitely related to the other foreign-
source income. In some instances, the operations of a foreign or
international department will also generate United States source income
(such as fees for services performed in the United States). Permissible
methods of apportionment with respect to stewardship expenses include
comparisons of time spent by employees weighted to take into account
differences in compensation, or comparisons of each related
corporation's gross receipts, gross income, or unit sales volume,
assuming that stewardship activities are not substantially
disproportionate to such factors. See paragraph (f)(5) of this section
for the type of verification that may be required in this respect. See
Sec. 1.482-9(l)(5) for examples that illustrate the principles of
Sec. 1.482-9(l)(3). See Example 17 and Example 18 of paragraph (g) of
this section for the allocation and apportionment of stewardship
expenses. See paragraph (b)(3) of this section for the allocation and
apportionment of deductions attributable to supportive functions other
than stewardship expenses, such as expenses in the nature of day-to-day
management, and paragraph (e)(5) of
[[Page 38873]]
this section generally for the allocation and apportionment of
deductions attributable to legal and accounting fees and expenses.
* * * * *
(f) * * *
(4) Adjustments made under other provisions of the Code--(i) In
general. If an adjustment which affects the taxpayer is made under
section 482 or any other provision of the Code, it may be necessary to
recompute the allocations and apportionments required by this section
in order to reflect changes resulting from the adjustment. The
recomputation made by the Commissioner shall be made using the same
method of allocation and apportionment as was originally used by the
taxpayer, provided such method as originally used conformed with
paragraph (a)(2) of this section and, in light of the adjustment, such
method does not result in a material distortion. In addition to
adjustments which would be made aside from this section, adjustments to
the taxpayer's income and deductions which would not otherwise be made
may be required before applying this section in order to prevent a
distortion in determining taxable income from a particular source of
activity. For example, if an item included as a part of the cost of
goods sold has been improperly attributed to specific sales, and, as a
result, gross income under one of the operative sections referred to in
paragraph (f)(1) of this section is improperly determined, it may be
necessary for the Commissioner to make an adjustment to the cost of
goods sold, consistent with the principles of this section, before
applying this section. Similarly, if a domestic corporation transfers
the stock in its foreign subsidiaries to a domestic subsidiary and the
parent corporation continues to incur expenses in connection with
protecting its capital investment in the foreign subsidiaries (see
paragraph (e)(4) of this section), it may be necessary for the
Commissioner to make an allocation under section 482 with respect to
such expenses before making allocations and apportionments required by
this section, even though the section 482 allocation might not
otherwise be made.
* * * * *
(g) * * *
Example 17. Stewardship expenses (consolidation). (i) (A) Facts.
X, a domestic corporation, wholly owns M, N, and O, also domestic
corporations. X, M, N, and O file a consolidated income tax return.
All the income of X and O is from sources within the United States,
all of M's income is general category income from sources within
South America, and all of N's income is general category income from
sources within Africa. X receives no dividends from M, N, or O.
During the taxable year, the consolidated group of corporations
earned consolidated gross income of $550,000 and incurred total
deductions of $370,000 as follows:
------------------------------------------------------------------------
Gross
income Deductions
------------------------------------------------------------------------
Corporations:
X......................................... $100,000 $50,000
M......................................... 250,000 100,000
N......................................... 150,000 200,000
O......................................... 50,000 20,000
-------------------------
Total................................. 550,000 370,000
------------------------------------------------------------------------
(B) Of the $50,000 of deductions incurred by X, $15,000 relates
to X's ownership of M; $10,000 relates to X's ownership of N; $5,000
relates to X's ownership of O; and the sole effect of the entire
$30,000 of deductions is to protect X's capital investment in M, N,
and O. X properly categorizes the $30,000 of deductions as
stewardship expenses. The remainder of X's deductions ($20,000)
relates to production of United States source income from its plant
in the United States.
(ii) (A) Allocation. X's deductions of $50,000 are definitely
related and thus allocable to the types of gross income to which
they give rise, namely $25,000 wholly to general category income
from sources outside the United States ($15,000 for stewardship of M
and $10,000 for stewardship of N) and the remainder ($25,000) wholly
to gross income from sources within the United States. Expenses
incurred by M and N are entirely related and thus wholly allocable
to general category income earned from sources without the United
States, and expenses incurred by O are entirely related and thus
wholly allocable to income earned within the United States. Hence,
no apportionment of expenses of X, M, N, or O is necessary. For
purposes of applying the foreign tax credit limitation; the
statutory grouping is general category gross income from sources
without the United States and the residual grouping is gross income
from sources within the United States. As a result of the allocation
of deductions, the X consolidated group has taxable income from
sources without the United States in the amount of $75,000, computed
as follows:
------------------------------------------------------------------------
------------------------------------------------------------------------
Foreign source general category gross income ($250,000 from $400,000
M + $150,000 from N).......................................
Less: Deductions allocable to foreign source general (325,000)
category gross income ($25,000 from X, $100,000 from M, and
$200,000 from N)...........................................
-----------
Total foreign-source taxable income..................... 75,000
------------------------------------------------------------------------
(B) Thus, in the combined computation of the general category
limitation, the numerator of the limiting fraction (taxable income
from sources outside the United States) is $75,000.
Example 18. Stewardship and supportive expenses. (i) (A) Facts.
X, a domestic corporation, manufactures and sells pharmaceuticals in
the United States. X's domestic subsidiary S, and X's foreign
subsidiaries T, U, and V perform similar functions in the United
States and foreign countries T, U, and V, respectively. Each
corporation derives substantial net income during the taxable year
that is general category income described in section 904(d)(1). X's
gross income for the taxable year consists of:
Domestic sales income..................................... $32,000,000
Dividends from S (before dividends received deduction).... 3,000,000
Dividends from T.......................................... 2,000,000
Dividends from U.......................................... 1,000,000
Dividends from V.......................................... 0
Royalties from T and U.................................... 1,000,000
Fees from U for services performed by X................... 1,000,000
-------------
Total gross income.................................... 40,000,000
(B) In addition, X incurs expenses of its supervision department
of $1,500,000.
(C) X's supervision department (the Department) is responsible
for the supervision of its four subsidiaries and for rendering
certain services to the subsidiaries, and this Department provides
all the supportive functions necessary for X's foreign activities.
The Department performs three principal types of activities. The
first type consists of services for the direct benefit of U for
which a fee is paid by U to X. The cost of the services for U is
$900,000 (which results in a total charge to U of $1,000,000). The
second type consists of activities described in Sec. 1.482-
9(l)(3)(iii) that are in the nature of shareholder oversight that
duplicate functions performed by the subsidiaries' own employees and
that do not provide an additional benefit to the subsidiaries. For
example, a team of auditors from X's accounting department
periodically audits the subsidiaries' books and prepares internal
reports for use by X's management. Similarly, X's treasurer
periodically reviews for the board of directors of X the
subsidiaries' financial policies. These activities do not provide an
additional benefit to the related corporations. The cost of the
duplicative services and related supportive expenses is $540,000.
The third type of activity consists of providing services which are
ancillary to the license agreements which X maintains with
subsidiaries T and U. The cost of the ancillary services is $60,000.
(ii) Allocation. The Department's outlay of $900,000 for
services rendered for the benefit of U is allocated to the
$1,000,000 in fees paid by U. The remaining $600,000 in the
Department's deductions are definitely related to the types of gross
income to which they give rise, namely dividends from subsidiaries
S, T, U, and V and royalties from T and U. However, $60,000 of the
$600,000 in deductions are found to be attributable to the ancillary
services and are definitely related (and therefore allocable) solely
to royalties received from T and U, while the remaining $540,000 in
deductions are
[[Page 38874]]
definitely related (and therefore allocable) to dividends received
from all the subsidiaries.
(iii) (A) Apportionment. For purposes of applying the foreign
tax credit limitation, the statutory grouping is general category
gross income from sources outside the United States and the residual
grouping is gross income from sources within the United States. X's
deduction of $540,000 for the Department's expenses and related
supportive expenses which are allocable to dividends received from
the subsidiaries must be apportioned between the statutory and
residual groupings before the foreign tax credit limitation may be
applied. In determining an appropriate method for apportioning the
$540,000, a basis other than X's gross income must be used since the
dividend payment policies of the subsidiaries bear no relationship
either to the activities of the Department or to the amount of
income earned by each subsidiary. This is evidenced by the fact that
V paid no dividends during the year, whereas S, T, and U paid
dividends of $1 million or more each. In the absence of facts that
would indicate a material distortion resulting from the use of such
method, the stewardship expenses ($540,000) may be apportioned on
the basis of the gross receipts of each subsidiary.
(B) The gross receipts of the subsidiaries were as follows:
S......................................................... $4,000,000
T......................................................... 3,000,000
U......................................................... 500,000
V......................................................... 1,500,000
-------------
Total................................................. 9,000,000
(C) Thus, the expenses of the Department are apportioned for
purposes of the foreign tax credit limitation as follows:
Apportionment of stewardship expenses to the statutory $300,000
grouping of gross income: $540,000 x [($3,000,000 +
$500,000 + $1,500,000)/$9,000,000].......................
Apportionment of supervisory expenses to the residual 240,000
grouping of gross income: $540,000 x [$4,000,000/
9,000,000]...............................................
-------------
Total: Apportioned stewardship expense................ 540,000
* * * * *
Example 30. Income taxes. (i)(A) Facts. As in Example 17 of this
paragraph (g), X is a domestic corporation that wholly owns M, N,
and O, also domestic corporations. X, M, N, and O file a
consolidated income tax return. All the income of X and O is from
sources within the United States, all of M's income is general
category income from sources within South America, and all of N's
income is general category income from sources within Africa. X
receives no dividends from M, N, or O. During the taxable year, the
consolidated group of corporations earned consolidated gross income
of $550,000 and incurred total deductions of $370,000. X has gross
income of $100,000 and deductions of $50,000, without regard to its
deduction for state income tax. Of the $50,000 of deductions
incurred by X, $15,000 relates to X's ownership of M; $10,000
relates to X's ownership of N; $5,000 relates to X's ownership of O;
and the entire $30,000 constitutes stewardship expenses. The
remainder of X's $20,000 of deductions (which is assumed not to
include state income tax) relates to production of U.S. source
income from its plant in the United States. M has gross income of
$250,000 and deductions of $100,000, which yield foreign-source
general category taxable income of $150,000. N has gross income of
$150,000 and deductions of $200,000, which yield a foreign-source
general category loss of $50,000. O has gross income of $50,000 and
deductions of $20,000, which yield U.S. source taxable income of
$30,000.
(B) Unlike Example 17 of this paragraph (g), however, X also has
a deduction of $1,800 for state A income taxes. X's state A taxable
income is computed by first making adjustments to the Federal
taxable income of X to derive apportionable taxable income for state
A tax purposes. An analysis of state A law indicates that state A
law also includes in its definition of the taxable business income
of X which is apportionable to X's state A activities, the taxable
income of M, N, and O, which is related to X's business. As in
Example 25 of this paragraph (g), the amount of apportionable
taxable income attributable to business activities conducted in
state A is determined by multiplying apportionable taxable income by
a fraction (the ``state apportionment fraction'') that compares the
relative amounts of payroll, property, and sales within state A with
worldwide payroll, property, and sales. Assuming that X's
apportionable taxable income equals $180,000, $100,000 of which is
from sources without the United States, and $80,000 is from sources
within the United States, and that the state apportionment fraction
is equal to 10 percent, X has state A taxable income of $18,000. The
state A income tax of $1,800 is then derived by applying the state A
income tax rate of 10 percent to the $18,000 of state A taxable
income.
(ii) Allocation and apportionment. Assume that under Example 29
of this paragraph (g), it is determined that X's deduction for state
A income tax is definitely related to a class of gross income
consisting of income from sources both within and without the United
States, and that the state A tax is apportioned $1,000 to sources
without the United States, and $800 to sources within the United
States. Under Example 17 of this paragraph (g), without regard to
the deduction for X's state A income tax, X has a separate loss of
($25,000) from sources without the United States. After taking into
account the deduction for state A income tax, X's separate loss from
sources without the United States is increased by the $1,000 state A
tax apportioned to sources without the United States, and equals a
loss of ($26,000), for purposes of computing the numerator of the
consolidated general category foreign tax credit limitation.
0
Par. 17. Section 1.861-8T is amended by revising paragraphs (a)(3),
(a)(4), (a)(5), (b), (e)(3), (e)(4), (e)(5), (e)(6), (e)(7), (e)(8),
(e)(9), (e)(10), (e)(11), (f)(1)(i), (f)(1)(iii), (f)(2), (f)(3),
(f)(4), (f)(5), (g) Examples 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12,
13,14, 15, 16, 17, 18, 19, 20, 21, 22, 22, 23, and 30, and (h) to read
as follows:
Sec. 1.861-8T Computation of taxable income from sources within the
United States and from other sources and activities (temporary).
* * * * *
(a)(3) through (b) [Reserved]. For further guidance, see Sec.
1.861-8(a)(3) through (b).
* * * * *
(e) * * *
(3) through (f)(1)(i) [Reserved]. For further guidance, see Sec.
1.861-8(e)(3) through (f)(1)(i).
* * * * *
(f)(1)(iii) through (g) Examples 1 through 23 [Reserved]. For
further guidance, see Sec. 1.861-8(f)(1)(iii) through (g) Examples 1
through 23.
* * * * *
Example 30. [Reserved]. For further guidance, see Sec. 1.861-8(g)
Example 30.
(h) Effective/applicability date. (1) Paragraphs (f)(1)(vi)(E),
(f)(1)(vi)(F), and (f)(1)(vi)(G) of this section apply to taxable years
ending after April 9, 2008.
(2) Paragraph (e)(4), the last sentence of paragraph (f)(4)(i), and
paragraph (g), Examples 17, 18, and 30 of this section apply to taxable
years beginning after July 31, 2009.
(3) Also, see paragraph (e)(12)(iv) of this section and 1.861-
14(e)(6) for rules concerning the allocation and apportionment of
deductions for charitable contributions.
0
Par. 18. Section 1.861-9T(k) is amended by adding new first and second
sentences to read as follows:
Sec. 1.861-9T Allocation and apportionment of interest expense
(temporary).
* * * * *
(k) * * * In general, the rules of this section apply for taxable
years beginning after December 31, 1986. Paragraphs (b)(2) (concerning
the treatment of certain foreign currency) and (d)(2) (concerning the
treatment of interest incurred by nonresident aliens) of this section
are applicable for taxable years commencing after December 31, 1988. *
* *
[[Page 38875]]
0
Par. 19. Section 1.861-10T is amended by revising the section heading
and adding new paragraph (f) to read as follows:
Sec. 1.861-10T Special allocations of interest expense (temporary).
* * * * *
(f) Effective/applicability date. (1) In general, the rules of this
section apply for taxable years beginning after December 31, 1986.
(2) Paragraphs (b)(3)(ii) (providing an operating costs test for
purposes of the nonrecourse indebtedness exception) and (b)(6)
(concerning excess collaterization of nonrecourse borrowings) of this
section are applicable for taxable years commencing after December 31,
1988.
(3) Paragraph (e) (concerning the treatment of related controlled
foreign corporation indebtedness) of this section is applicable for
taxable years commencing after December 31, 1987. For rules for taxable
years beginning before January 1, 1987, and for later years to the
extent permitted by Sec. 1.861-13T, see Sec. 1.861-8 (revised as of
April 1, 1986).
0
Par. 20. Section 1.861-11T is amended by revising the section heading
and adding new paragraph (h) to read as follows:
Sec. 1.861-11T Special rules for allocating and apportioning interest
expense of an affiliated group of corporations (temporary).
* * * * *
(h) Effective/applicability date. The rules of this section apply
for taxable years beginning after December 31, 1986.
0
Par. 21. Section 1.861-12T is amended by revising the section heading
and adding new paragraph (k) to read as follows:
Sec. 1.861-12T Characterization rules and adjustments for certain
assets (temporary).
* * * * *
(k) Effective/applicability date. The rules of this section apply
for taxable years beginning after December 31, 1986.
0
Par. 22. Section 1.861-14T is amended by adding new paragraph (k) to
read as follows:
Sec. 1.861-14T Special rules for allocating and apportioning certain
expenses (other than interest expense) of an affiliated group of
corporations (temporary).
* * * * *
(k) Effective/applicability date. The rules of this section apply
for taxable years beginning after December 31, 1986.
Sec. 1.6038A-1 [Amended]
0
Par. 23. Section 1.6038A-1 is amended by removing paragraph (n)(3) and
redesignating paragraphs (n)(4), (n)(5), (n)(6) and (n)(7) as
paragraphs (n)(3), (n)(4), (n)(5) and (n)(6), respectively.
0
Par. 24. Section 1.6038A-3 is amended by revising paragraphs (a)(3)
Example 4, and (i) 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, it is determined
that the cost of services plus method, as described in Sec. 1.482-
9(e), 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(e)(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.
* * * * *
(i) Effective/applicability date--(1) In general. This section is
generally applicable on December 10, 1990. However, records described
in this section in existence on or after March 20, 1990, must be
maintained, without regard to when the taxable year to which the
records relate began. Paragraph (a)(3) Example 4 of this section is
generally applicable for taxable years beginning after July 31, 2009.
(2) Election to apply regulation to earlier taxable years. A person
may elect to apply the provisions of paragraph (a)(3) Example 4 of this
section to earlier taxable years in accordance with the rules set forth
in Sec. 1.482-9(n)(2).
Sec. 1.6038A-3T [Removed]
0
Par. 25. Section 1.6038A-3T is removed.
0
Par. 26. Section 1.6662-6 is amended by revising paragraphs
(d)(2)(ii)(B), (d)(2)(iii)(B)(4), (d)(2)(iii)(B)(6), and (g) to 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) Services cost method. A taxpayer's selection of the services
cost method for certain services, described in Sec. 1.482-9(b), 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 allocated and apportioned
costs in accordance with Sec. 1.482-9(k), and reasonably concluded
that the controlled services transaction satisfies the requirements
described in Sec. 1.482-9(b)(2). 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 services cost 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) Effective/applicability date--(1) In general. This section is
generally applicable on February 9, 1996. However, taxpayers may elect
to apply this section to all open taxable years beginning after
December 31, 1993.
(2) Special rules. The provisions of paragraphs (d)(2)(ii)(B),
(d)(2)(iii)(B)(4) and (d)(2)(iii)(B)(6) of this section are applicable
for taxable years beginning after July 31, 2009. However, taxpayers may
elect to apply the provisions of paragraphs (d)(2)(ii)(B),
(d)(2)(iii)(B)(4) and (d)(2)(iii)(B)(6) of this section to
[[Page 38876]]
earlier taxable years in accordance with the rules set forth in Sec.
1.482-9(n)(2).
Sec. 1.6662-6T [Removed]
0
Par. 27. Section 1.6662-6T is removed.
PART 31--EMPLOYMENT TAXES AND COLLECTION OF INCOME TAX AT THE
SOURCE
0
Par. 28. The authority citation for part 31 continues to read in part
as follows:
Authority: 26 U.S.C. 7805 * * *
0
Par. 29. Section 31.3121(s)-1 is amended by revising paragraphs
(c)(2)(iii) and (d) to read as follows:
Sec. 31.3121(s)-1 Concurrent employment by related corporations with
common paymaster.
* * * * *
(c) * * *
(2) * * *
(iii) Group-wide allocation rules. Under the group-wide method of
allocation, the Commissioner may allocate the taxes imposed by sections
3102 and 3111 in an appropriate manner to a related corporation that
remunerates an employee through a common paymaster if the common
paymaster fails to remit the taxes to the Internal Revenue Service.
Allocation in an appropriate manner varies according to the
circumstances. It may be based on sales, property, corporate payroll,
or any other basis that reflects the distribution of the services
performed by the employee, or a combination of the foregoing bases. 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 July 31, 2009.
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 July 31, 2009.
(d) Effective/applicability date--(1) In general. This section is
applicable with respect to wages paid after December 31, 1978. The
fourth sentence of paragraph (c)(2)(iii) of this section is applicable
with respect to wages paid after December 31, 1978, and on or before
July 31, 2009. The fifth sentence of paragraph (c)(2)(iii) of this
section is applicable with respect to wages paid after July 31, 2009.
(2) Election to apply regulation to earlier taxable years. A person
may elect to apply the fifth sentence of paragraph (c)(2)(iii) of this
section to earlier taxable years in accordance with the rules set forth
in Sec. 1.482-9(n)(2) of this chapter.
Sec. 31.3121(s)-1T [Removed]
0
Par. 30. Section 31.3121(s)-1T is removed.
PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
0
Par. 31. The authority citation for part 602 continues to read as
follows:
Authority: 26 U.S.C. 7805.
0
Par. 32. In Sec. 602.101, paragraph (b) is amended by adding an entry
for ``Sec. 1.482-9(b)'' to the table to read follows:
Sec. 602.101 OMB Control numbers.
* * * * *
(b) * * *
------------------------------------------------------------------------
Current OMB
CFR part or section where identified and described control
number
------------------------------------------------------------------------
* * * * *
1.482-9(b)................................................. 1545-2149
* * * * *
------------------------------------------------------------------------
Approved: July 25, 2009.
Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
Michael Mundaca,
Acting Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. E9-18326 Filed 7-31-09; 8:45 am]
BILLING CODE 4830-01-P