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The Internal Revenue Service (IRS) Large Business and International division (LB&I) released an International Practice Unit (IPU) entitled ”High Value Services: Technical and Marketing Fees - Inbound” on September 15, 2017, analysing certain service transactions within a controlled group, noting that some services may not qualify for treatment under the Services Cost Method and therefore may require an arm’s length mark-up be applied to the costs incurred in the provision of such services.
It is important to note that IPUs are intended as a general discussion of a concept, process, or transaction and not official pronouncements of law or directives. Nevertheless, IPUs provide useful guidance on what the IRS is prioritizing and how IRS examiners may approach certain topics in an audit situation. An awareness of the topics, issues, technical foundations, and conceptual approaches outlined in IPUs can assist U.S. taxpayers in structuring their intercompany transactions with foreign related parties as well preparing for potential IRS examination of their Federal income tax returns.
The Internal Revenue Code (IRC) 482 transfer pricing services regulations promulgated in Treas. Reg. 1.482-9 outline the methods available for determining the arm’s length nature of controlled services transactions. The IPU referenced herein focuses specifically on the application of services cost method (SCM) in certain controlled service transactions. The SCM deems an arm’s length price to be the reimbursement of the costs incurred in providing the covered services with no markup applied. ”Covered services” include specified covered services, which are outlined in Rev. Proc. 2007-13, and low margin services. Low margin services are defined as controlled services transactions for which the median comparable markup on total services cost is 7 percent or less.
The SCM cannot be applied to services that the U.S. taxpayer reasonably concludes contribute to key competitive advantages, core capabilities, or fundamental risks of success or failure in one or more trades or businesses of the renderer, the recipient, or both. Treas. Reg. § 1.482-9(b)(2). Excluded transactions under the SCM include manufacturing; production; extraction, exploration or processing of natural resources; construction; reselling, distribution, acting as a sales or purchasing agent, or acting under a commission or similar arrangement; research, development or experimentation; engineering or scientific; financial transactions, including guarantees; and insurance or reinsurance.
U.S. taxpayers must maintain adequate books and records of controlled services transactions to qualify for the SCM. Without supporting documentation, the IRS may determine that the U.S. taxpayer cannot use the SCM to determine the arm’s length nature of its controlled services transactions.
Because IT services encompass a wide range of technology-related services, the IRS notes that certain types of IT services are eligible for application of the SCM while other types of IT services are not. IT services eligible for analysis under the SCM include support services common among taxpayers across industry sectors. Examples of eligible services are listed as activities including supporting companywide computer systems, maintaining and repairing IT systems, and providing technical assistance and training to users of computer systems. These activities generally do not involve a significant median comparable mark-up on total services cost.
Once a method is selected, the U.S. taxpayer should maintain proper supporting documentation to defend the method selected for determining the arm’s length nature of the controlled services.
Once a method is selected, the U.S. taxpayer should have documentation in place to defend the selection of the best method to determine the arm’s length nature of these services
U.S. taxpayers must be aware of the fact need to be aware that based on the specific facts and circumstances intercompany services rendered to their foreign related parties may not qualify for treatment under the SCM if these transactions do not meet the specifications set forth in the transfer pricing services regulations under Section 482 of the Internal Revenue Code. Because the prices charged in controlled services transactions may be viewed as manipulative by the IRS, it is important that proper internal and external documentation supporting the arm’s length nature of controlled service transactions be in place. If the prices charged for controlled services rendered to a U.S. taxpayer’s foreign related parties are not considered to be arm’s length in nature, the IRS could upon examination propose and sustain an adjustment to the U.S. taxpayer’s taxable income that potentially will result in additional tax due as well as the imposition of any applicable penalties.
Brad Pittman
Partner
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