Transfer Pricing: Controlled Services Transactions

By Chris Barrett, CPA, and Hassan Sahardid, CPA, Columbus, OH

Tax Accounting

When tax professionals think of Sec. 482, cross-border transfer pricing studies usually come to mind. However, Sec. 482 can also apply to domestic companies that file returns in multiple states and domestic taxpayers that do not file a U.S. consolidated income tax return. In domestic or non-cross-border situations, the two areas in which clients most often run into Sec. 482 are interest allocations and controlled services transactions. The focus of this item is on controlled services transactions under Regs. Sec. 1.482-9.

A Brief History of Sec. 482 and Related Treasury Regs.

The first direct predecessor to Sec. 482 was enacted in 1921, just eight years after the first income tax act. The first explanatory regulations for the provision (promulgated in 1935 under the Revenue Act of 1934) articulated a general arm’s-length standard. These regulations remained relatively unchanged until 1968, when regulations were issued that added standards for specific transaction types. (In 1962, the Sec. 482 regulations had been added as part of the 1954 Code, replicating the existing regulations.) In 1994, the IRS issued final regulations that introduce the “best method” rule for selecting a pricing methodology to be applied to a controlled transaction.

The primary purpose of Sec. 482 is to ensure that taxpayers properly reflect income attributable to controlled transactions and to prevent the avoidance of taxes for such transactions. Sec. 482 places a controlled taxpayer on tax parity with an uncontrolled taxpayer by determining the “true” taxable income of the controlled taxpayer. In determining that taxable income, the standard to be applied for Sec. 482 is a taxpayer dealing at arm’s length with an uncontrolled taxpayer. A controlled transaction will meet the arm’s-length standard if the results of a transaction are consistent with the results that would have been met if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.

Controlled Services Transactions Regs.

The IRS issued final controlled services regulations on July 31, 2009. These regulations replaced the 2003 proposed services regulations, which had been revised and reissued as temporary regulations in 2006. The 2009 final services regulations are consistent with the 2006 temporary regulations with only clarifying changes. As did the 2006 temporary services regulations, the 2009 final services regulations authorize the IRS to issue a revenue procedure listing types of services that may be charged at their total cost (i.e., without a markup) and substituted a business judgment test for the previously required studies and analysis.

Taxpayers can apply the 2009 final services regulations retroactively to prior tax years by making an election on a timely filed return (including extensions) for the first tax year beginning after July 31, 2009. If the taxpayer adopted a shared services agreement prior to the issuance of the final regulations in 2009, the taxpayer would need to amend it to comply with the final regulations.

In general, the arm’s-length amount charged in a controlled services transaction must be determined under one of six transfer pricing methods provided for in Regs. Sec. 1.482-9(a). Among the six methods is the services cost method (SCM), which in certain circumstances allows taxpayers to price controlled services transactions at cost without a markup.

The SCM enables taxpayers to charge intercompany services at cost under two approaches:

  • Specified covered services; and
  • Certain low-margin covered services.

Specified covered services include common back office and administrative activities such as payroll, human resources, legal, etc. but do not encompass entire functional service areas. A revised revenue procedure (Rev. Proc. 2007-13) issued on December 20, 2006, expanded the initial list of covered services contained in the revenue procedure, which was issued simultaneously with the 2006 temporary services regulations. The IRS identified 101 covered services in Rev. Proc. 2007-13 and rejected proposals to expand this list with the issuance of the final services regulations.

For certain low-margin covered services, if the median of comparables as produced in a search is a net cost plus markup of 7% or less, taxpayers are also able to charge the services at cost.

The conditions required to apply the SCM as outlined in Regs. Sec. 1.482-9(b) are as follows:

  • The covered services will not contribute significantly to fundamental risks or key competitive advantages of any of the companies within a group.
  • The covered services cannot include activities critical to operations, such as manufacturing, production, extraction, construction, distribution, research and development, engineering, or financial transactions, including guarantees and insurance or reinsurance transactions.
  • The shared services cost must be strictly related to low-margin services or covered services, which include common support services such as tax services, legal services, and general administrative services. As noted above, in Rev. Proc. 2007-13 the IRS published a list of covered services transactions that may qualify as arm’s length without a markup.
  • Books and records must be maintained and must include: (1) a statement evidencing that the controlled group’s intention is to apply the SCM to evaluate whether allocated costs qualify as arm’s length; (2) a list of the companies that are party to the agreement; and (3) a description of the basis for allocating shared services costs.

Under the SCM, intercompany services costs should be allocated to reflect the reasonably anticipated benefit of each member for each cost. As a result, the allocation method will differ based upon the character of each cost. For example, a good measure of benefit to allocate salary-related costs would be employee headcount by company. Regs. Sec. 1.482-9(b)(8), Examples (16)–(19), illustrate how different types of costs should be allocated to the controlled members.

Conclusion

Sec. 482 has a broad reach to taxpayers and may apply to both domestic and multinational companies. Typically, domestic companies encounter Sec. 482 in a multistate context or when there are controlled taxpayers that do not file as part of a consolidated group. The authors typically encounter Sec. 482 for domestic companies relating to interest allocations and shared services. Although six methods are described to determine arm’s-length pricing of shared services costs, the SCM is generally preferred because it does not require any markup and therefore should be administratively easier to comply with.

Editor: Frank J. O’Connell Jr., CPA, Esq.

EditorNotes

Frank J. O’Connell Jr. is a partner in Crowe Horwath LLP in Oak Brook, IL.

For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or frank.oconnell@crowehorwath.com.

Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.

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