International Update

IRS Enacts New International Intercompany Service Regulations, By Mary K. Thomas, CPA, JD

Amidst pressures to remain competitive in a global economy, businesses in Texas have established companies outside the United States. For such companies, during regular business dealings, the activities performed by one member of the group often benefit the other member.

Such services are the focus of the Internal Revenue Service’s recently-released Temporary Service Regulations, 1.482-9T, and revisions in Notice 2007-5. The Temp Regs apply to tax years beginning after Dec. 31, 2006, though Notice 2007-5 extends the application of the Cost Service Method to tax years beginning after Dec. 31, 2007. For the 2007 tax year, companies that use the Cost Service Method can elect to apply the old rules, or may choose to follow the new Temp Regs. Issues addressed in the Temp Regs include:

Shareholder or Stewardship Activities

The Temp Regs provide more detail regarding activities that constitute shareholder or stewardship-type activities. These activities are designed to protect the controlled entity’s capital investment or to ensure compliance with applicable legal, regulatory or reporting requirements and may not be charged to the recipient company. Development of policies regarding fair employment practices for all entities is an example of a shareholder or stewardship activity.

 Allocations for Shared Service Arrangements

A business may have centralized services that benefit the entities abroad in which it has controlling interests. For example, various human resources functions, such as retirement benefits administration, could be centralized. In such cases, the cost of providing those services is allocated to the other entities, based on the benefit they receive. For example, the allocation for retirement benefits administration could be based on the number of affected individuals employed by each related international entity.

 Cost Service Method

Under the prior service regulations, services could be charged out at cost – rather than at an arm’s length (fair market value) markup - if they were deemed non-integral to company operations. Under the new Temp Regs, in determining whether costs may be charged out at cost, businesses will now have to determine whether those services, such as payroll processing, are offered on the open market for more or less than the equivalent of a 7 percent arm’s length markup over cost.

If the open market benchmark for that service’s value is equal to or beneath that 7 percent threshold, the service can be charged out at cost. If the benchmark is above that threshold, a profit element must be included in that charge.

Transfer Pricing

Businesses and international companies they control often share proprietary IT design, consulting expertise and other services. Technology, emerging markets, relaxed trade barriers and other factors continue to make such service transactions more common and more complex. In response, the Temp Regs offer a number of transfer pricing methods, including:

• Comparable Uncontrolled Services Price
• Gross Services Margin
• Cost of Services Plus
• Comparable Profits
• Profit Split
• Unspecified Methods

Determining which method is applicable requires examining the nature of each service and the relationship between the entities involved in the transaction.

 Intangibles and Services

The transfer pricing regulations have always recognized the value of certain intangible items, such as a trademark. The Temp Regs, however, also include examples of other intangible items, including patents and technical data amassed during research and development efforts. The growing importance of intellectual property and international marketing activities make determining the price of such intangibles more crucial.

 Preparing for Transfer Pricing Documentation Under Temp Regs

While businesses have the option to wait a year before adhering to the Temp Regs, they still face a considerable task. Preparation requires examining current practices, including whether relationships meet the long-established arm’s length standard. They need to determine if some services, such as those related to compliance efforts, are properly classified as shareholder or stewardship activities.

Shared services prices must be based on appropriate allocation formulas, while fair market prices for services under the Cost Service Method must be benchmarked to determine whether they can be charged out at cost or whether they must include a profit element. Various transactions must be examined to determine the appropriate transfer pricing method, and businesses must define and examine the value of the company’s intangibles.

The IRS typically focuses scrutiny and audit efforts on returns that entail newly enacted regulations. That provides additional impetus for Texas businesses to thoroughly examine the relationships they have with controlled international entities and the related service transactions.

 The Potential Long-Term Impact of 1.482-9T

Companies can elect to wait another year before complying with Cost Services Method under the Temp Regs, so it will be at least that long before any assessments can be made regarding the long-term impact of the Temp Regs.

Maintaining relationships abroad, however, will rise in importance to Texas companies whose products and services compete in a global economy. Such a marketplace is quite dynamic and requires considerable responsiveness. The passage of 1.482-9T provides indication that the tax regulations associated with such relationships are likewise dynamic and require responsiveness and continual attention.

###

 Mary K. Thomas, CPA, JD, is the Director of International Tax Services for Weaver and Tidwell LLP, one of the largest certified public accounting firms in the nation with offices in Houston, Dallas and Fort Worth.