The 2003 proposed regulations set forth a simplified cost based method (SCBM). The SCBM was intended to preserve the salutary aspects of the current §1.482-2(b) cost safe harbor that provide appropriately reduced administrative and compliance burdens for low margin services. At the same time, the existing rules would be brought more in line with the arm’s length standard, and various problematic features of those rules would be eliminated. The goal was to provide certainty concerning the pricing of low margin services, thus allowing the compliance efforts of both taxpayers and the IRS to concentrate on those services for which a robust transfer pricing analysis is particularly appropriate. The preamble to the 2003 proposed regulations also indicated that in certain cases, the allocation or sharing among group members of expenses or charges relating to corporate headquarters or other centralized service activities may be consistent with the proposed regulations, but no further guidance was provided on such service sharing arrangements.

A number of commentators argued that the SCBM was actually counterproductive to its stated goals. These commentators contended that to apply the SCBM, taxpayers would potentially need to expend substantial sums to prepare comparability studies, perhaps separately for each of the numerous categories of back office services. They contended that, although taxpayers have in-depth knowledge concerning their businesses and the relative value added by their back offices, the SCBM called for quantitative judgments that business people are not qualified to make by themselves, especially in the prevailing compliance environment. As a matter of proper accountability, taxpayers would be required as a practical matter to devote significant compliance resources to enlist outside consultants or otherwise to develop support for those judgments.

Commentators suggested a range of proposed alternatives to the SCBM regime. One such proposal was simply to return to the approach in the existing regulations under §1.482-2(b). The 1968 regulations are fairly rudimentary in nature, particularly, in today’s tax compliance environment. In addition, those regulations were open to substantial manipulation by taxpayers (both inbound and outbound). Moreover, there have been extensive and far-reaching developments in the services economy since the existing regulations were published in 1968, with real prospects that many intragroup services have values significantly in excess of their cost. As a result, in the course of considering comments on the 2003 proposed regulations, the Treasury Department and the IRS have concluded that it would not be appropriate simply to readopt the standard in the 1968 regulations. Additional proposals by commentators included development of a list of activities that would qualify to be priced at cost or detailed provisions regarding cost sharing arrangements for low value services performed on a centralized basis, and other options.

The Treasury Department and the IRS may have decided not to return to the 1968 regulations, but have nonetheless taken the full range of comments on the 2003 proposed regulations seriously. Therefore, in light of the extensive comments on these issues, the Treasury Department and the IRS have substantially redesigned the relevant provisions. The Treasury Department and the IRS recognize that the section 482 services regulations potentially affect a large volume of intragroup back office services that are common across many industries. It is in the interest of good tax administration to minimize the compliance burdens applicable to such services, especially to the extent that the arm’s length markups are low and the activities do not significantly contribute to business success or failure.

Accordingly, based on the comments, these temporary regulations eliminate the SCBM and replace it with the services cost method (SCM), as set forth in §1.482-9T(b). The SCM evaluates whether the price for covered services, as defined, is arm’s length by reference to the total services costs with no markup. Where the conditions on application of the method are met, the SCM will be considered the best method for purposes of §1.482-1(c).

Section 1.482-9T(b)(4) provides for two categories of covered services that are eligible for the SCM if the other conditions on application of the method are met. If the conditions are satisfied, covered services in each category may be charged at cost with no markup. The first category consists of specified covered services identified in a revenue procedure published by the IRS. This revenue procedure approach is consistent with taxpayer comments. Services will be identified in such revenue procedure based upon the determination of the Treasury Department and the IRS that they constitute support services of a type common across industry sectors and generally do not involve a significant arm’s length markup on total services costs. Because the government performs the analysis necessary to determine the eligibility of specified covered services, the compliance burden that was previously imposed by the SCBM is eliminated for a broad class of commonly provided services.

An initial proposed list of specified covered services is contained in an announcement being published contemporaneously with these temporary regulations. This announcement will be published in the Internal Revenue Bulletin. For copies of the Internal Revenue Bulletin, see §601.601(d)(2)(ii)(b). The Treasury Department and the IRS solicit public input on whether the list of services sufficiently covers the full range of back office services typical within multinational groups, on the descriptions provided for these covered services, and on other matters related to the announcement. It is contemplated that a final revenue procedure, reflecting appropriate comments, will be issued to coincide with the effective date of the temporary regulations for taxable years beginning after December 31, 2006. In the future, particular services may be added to, clarified in, or deleted from the list, depending on ongoing developments.

The second category of covered services is certain low margin covered services. Taxpayers objected to the requirement under the SCBM that all services qualify for that method based on a quantitative analysis, but based on comments the Treasury Department and the IRS believe that controlled taxpayers might nonetheless want the discretion to show that particular services—not otherwise covered by the revenue procedure—qualify for the SCM, using a modified quantitative approach. Low margin covered services consist of services for which the median comparable arm’s length markup on total services costs is less than or equal to seven percent. As under the SCBM, the median comparable arm’s length markup on total services costs means the excess of the arm’s length price of the controlled services transaction over total services costs, expressed as a percentage of total services costs. For this purpose, the arm’s length price is determined under the general transfer pricing rules without regard to the SCM, using the interquartile range (including any adjustment to the median in the case of results outside such range). Again, if the markup on costs for eligible services is seven percent or less, this category of services can be charged out at cost with no markup.

Under §1.482-9T(b)(2), specified covered services or low margin covered services otherwise eligible for the SCM will qualify for the method if the taxpayer reasonably concludes in its business judgment that the services do not contribute significantly to key competitive advantages, core capabilities, or fundamental chances of success or failure in one or more trades or businesses of the renderer, the recipient, or both. Unlike the quantitative judgment called for under the SCBM, this is a business judgment preeminently within the business person’s own expertise. Exact precision is not needed and it is expected that the taxpayer’s judgment will be accepted in most cases. This condition is intended to focus transfer pricing compliance resources of both taxpayers and the IRS principally on significant valuation issues. Thus, it is anticipated that in most cases the examination of relevant services will focus only on verification of total services costs and their appropriate allocation. These are issues even under the 1968 regulations. There will be little need in all but the most unusual cases to challenge the taxpayer’s reasonable business judgment in concluding that such typical back office services do not contribute significantly to fundamental risks of success or failure. The condition effectively is reserved to allow the IRS to reject any attempt to claim that a core competency of the taxpayer’s business qualifies as a mere back office service. For illustrations of the role performed by this condition, see the contrasting pairs of Example 1 and Example 2, Example 3 and Example 4, Example 5 and Example 6, Example 8 and Example 9, Example 10 and Example 11, and Example 12 and Example 13 in §1.482-9T(b)(6).

As indicated in this preamble, it is expected that in all but unusual cases, the taxpayer’s business judgment will be respected. In evaluating the reasonableness of the taxpayer’s conclusion, the Commissioner will consider all the relevant facts and circumstances. This provision avoids the need to exclude from the SCM certain back office services that as a general matter and across a range of industry sectors are low margin, but that in the context of a particular business nonetheless constitute high margin services. That is, it permits the Treasury Department and the IRS to include a greater range of service categories under the SCM, even though in specific circumstances an otherwise covered service of a particular taxpayer will be ineligible.

In addition, under §1.482-9T(b)(3)(i), a single procedural requirement applies under the SCM. The taxpayer must maintain documentation of covered services costs and their allocation. The documentation must include a statement evidencing the taxpayer’s intention to apply the SCM.

In §1.482-9T(b)(3)(ii), the SCM preserves the same list of categories of controlled transactions that are not eligible to be priced under the method as under the SCBM. The Treasury Department and the IRS continue to believe that these transactions tend to be high margin transactions, transactions for which total services costs constitute an inappropriate reference point, or other types of transactions that should be subject to a more robust arm’s length analysis under the general section 482 rules. Comments are requested in this regard in light of the other substantial changes made in the regulations.

Consistent with the purpose of providing for appropriately reduced compliance burdens for services subject to the SCM, the temporary regulations retain provisions in §1.6662-6T(d)(2) similar to those associated with the SCBM.

Section 1.482-9T(b)(5) of the temporary regulations provides explicit guidance on shared services arrangements (SSAs). In general, an SSA must include two or more participants; must include as participants all controlled taxpayers that benefit from one or more covered services subject to the SSA; and must be structured such that each covered service (or group of covered services) confers a benefit on at least one participant. A participant is a controlled taxpayer that reasonably anticipates benefits from covered services subject to the SSA and that substantially complies with the SSA requirements.

Under an SSA, the arm’s length charge to each participant is the portion of the total costs of the services otherwise determined under the SCM that is properly allocated to such participant under the arrangement. For purposes of an SSA, two or more covered services may be aggregated, provided that the aggregation is reasonable based on the facts and circumstances, including whether it reasonably reflects the relative magnitude of the benefits that the participants reasonably anticipate from the services in question. Such aggregation may, but need not, correspond to the aggregation used in applying other provisions of the SCM. If the taxpayer reasonably concludes that the SSA (including any aggregation for purposes of the SSA) results in an allocation of the costs of covered services that provides the most reliable measure of the participants’ respective shares of the reasonably anticipated benefits from those services, then the Commissioner may not adjust such allocation basis.

In addition, as a procedural matter, the taxpayer must maintain documentation concerning the SSA, including a statement that it intends to apply the SCM under the SSA and information on the participants, the allocation basis, and grouping of services for purposes of the SSA. Guidance is also provided on the coordination of cost allocations under an SSA and cost allocations under a qualified cost sharing arrangement.

The SCM is considerably streamlined as compared to the SCBM. Upon further consideration, and in light of public comments, many of the conditions, contractual requirements, quantitative screens, and other technicalities associated with the SCBM have been eliminated. The Treasury Department and the IRS believe this streamlined approach serves the interests of both the government and taxpayers by reducing complexity and administrative burden.

The 2003 proposed regulations set forth the comparable uncontrolled services price (CUSP) method. This method evaluated 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 was closely analogous to the comparable uncontrolled price (CUP) method in existing §1.482-3(b).

One commentator objected to the statement in §1.482-9(b)(1) of the 2003 proposed regulations that, to be evaluated under the CUSP method, a controlled service ordinarily needed to be “identical to or have a high degree of similarity” to the uncontrolled comparable transactions. The commentator viewed the comparability analysis in the examples in proposed §1.482-9(b)(4) as more consistent with the standard in existing §1.482-3(b)(2)(ii)(A). The Treasury Department and the IRS agree that the comparability standards under the CUSP method for services should run parallel to those under the CUP method for sales of tangible property. Indeed, the provisions are parallel. The commentator misconstrues the purpose of the quoted provision.

Although the provision contains general guidance on situations in which the method ordinarily applies, it is not intended to and does not alter the substantive comparability standards. Just like the CUP method, the standards under the CUSP method emphasize the relative similarity of the controlled services to the uncontrolled transaction and the presence or absence of nonroutine intangibles. Section 1.482-9T(c)(2)(ii) of the temporary regulations also provides, consistent with the best method rule, that the CUSP method generally provides the most direct and reliable measure of an arm’s length result if the uncontrolled transaction either has no differences from the controlled services transaction or has only minor differences that have a definite and reasonably ascertainable effect on price, and appropriate adjustments may be made for such differences. If such adjustments cannot be made, or if there are more than minor differences between the controlled and uncontrolled transactions, the comparable uncontrolled services price method may be used, but the reliability of the results as a measure of the arm’s length price will be reduced. Further, if there are material differences for which reliable adjustments cannot be made, this method ordinarily will not provide a reliable measure of an arm’s length result.

The CUSP provisions in these temporary regulations are substantially similar to the corresponding provisions in the 2003 proposed regulations.

The 2003 proposed regulations provided for a gross services margin method, which evaluated the amount charged in a controlled services transaction by reference to the gross services profit margin in uncontrolled transactions that involve similar services. The method was analogous to the resale price method for transfers of tangible property in existing §1.482-3(c).

Under the 2003 proposed regulations, this method would ordinarily be used where a controlled taxpayer performs activities in connection with a “related uncontrolled transaction” between a member of the controlled group and an uncontrolled taxpayer. For example, the method may be used where a controlled taxpayer renders services to another member of the controlled group in connection with a transaction between that other member and an uncontrolled party (agent services), or where a controlled taxpayer contracts to provide services to an uncontrolled taxpayer and another member of the controlled group actually performs the services (intermediary function).

The 2003 proposed regulations defined the terms “related uncontrolled transaction,” “applicable uncontrolled price,” and “appropriate gross services profit”. A “related uncontrolled transaction” is a transaction between a member of the controlled group and an uncontrolled taxpayer for which a controlled taxpayer performs either agent services or an intermediary function. The “applicable uncontrolled price” is the sales price paid by the uncontrolled party in the related uncontrolled transaction. The “appropriate gross services profit” is the product of the applicable uncontrolled price and the gross services profit margin in comparable uncontrolled services transactions. The gross services profit margin takes into account all functions performed by other members of the controlled group and any other relevant factors.

One commentator mistakenly interpreted the term “related uncontrolled transaction” to suggest that the comparable transaction under this method is one that takes place between controlled parties. While this was not intended, the Treasury Department and the IRS agree that the nomenclature is potentially confusing, and as a result, these regulations substitute the term “relevant uncontrolled transaction” in lieu of “related uncontrolled transaction” wherever that appeared. In other respects, the gross services margin provisions in these temporary regulations are substantially similar to the provisions in the 2003 proposed regulations.

The 2003 proposed regulations set forth the cost of services plus method. This method evaluated the amount charged in a controlled services transaction by reference to the gross services profit markup in comparable uncontrolled services transactions. The gross services profit is determined by reference to the markup as a percentage of comparable transactional costs in comparable uncontrolled transactions. This method would ordinarily apply where the renderer of controlled services provides the same or similar services to both controlled and uncontrolled parties. In general, those are the only circumstances in which a controlled taxpayer would likely have the detailed information concerning comparable transactional costs necessary to apply this method reliably.

The cost of services plus method in the 2003 proposed regulations was generally analogous to the cost plus method for transfers of tangible property in existing §1.482-3(d). The method implicitly recognized that financial accounting standards applicable to services have not developed to the same degree as the standards applicable to other categories of transactions, such as manufacturing or distribution of tangible property. For that reason, the method adopted the concept of “comparable transactional costs,” which the 2003 proposed regulations defined as all costs of providing the services taken into account in determining the gross services profit markup in comparable uncontrolled services transactions. In this context, comparable uncontrolled transactions could be either services transactions between the controlled taxpayer and uncontrolled parties (internal comparables), or services transactions between two uncontrolled parties (external comparables).

The 2003 proposed regulations also recognized that comparable transactional costs could be a subset of total services costs. Generally accepted accounting principles (GAAP) or Federal income tax accounting rules (if income tax data for comparable uncontrolled transactions are available) could provide an appropriate platform for analysis under this provision, but neither is necessarily conclusive.

Commentators objected that the concept of comparable transactional costs was imprecise, and they suggested that such costs should in any event include only the direct costs associated with providing a particular service, as determined under GAAP or Federal income tax accounting rules. As noted above, the financial accounting standards for services transactions are not as precise as the standards applicable to other types of transactions. The relative lack of uniformity in turn makes it impractical to derive a single definition of cost that would apply generally to controlled services transactions.

Comparable transactional costs may potentially include direct and indirect costs, if such costs are included in the internal or external uncontrolled transactions that form the basis for comparison. Section 1.482-9T(e)(4) Example 1 has been modified to clarify this concept.

Several commentators objected to §1.482-9(d)(3)(ii)(A) of the 2003 proposed regulations. In their view, this provision required the results obtained under the cost of services plus method to be confirmed by means of a separate analysis under the comparable profits method (CPM) for services. If a confirming analysis under the CPM for services were required in all cases, commentators reasoned, the cost of services plus method could not be viewed as a specified method in its own right.

The Treasury Department and the IRS agree and clarify that the intent of the rules is not to require confirmation of the results under the cost of services plus method. In response to public comments, §1.482-9T(e)(3)(ii)(A) of these temporary regulations incorporates several changes. First, restatement of the price under this method in the form of a markup on total costs of the controlled taxpayer is necessary only if the cost of services plus method utilizes external comparables. If internal comparables are used, this calculation need not be performed. Second, in situations where the price is restated, the sole purpose is to determine whether it is necessary to perform additional evaluation of functional comparability.

For example, if the price under the cost of services plus method, when restated, indicates a markup on the renderer’s total services costs that is either low or negative, this may indicate differences in functions that have not been accounted for under the traditional comparability factors. A low or negative markup suggests the need for additional inquiry, the outcome of which may suggest that the cost of services plus method is not the most reliable measure of an arm’s length result under the best method rule. Conforming changes have been made in §1.482-9T(e)(4) Example 3 of these temporary regulations.

The 2003 proposed regulations provided for a Comparable Profits Method (CPM) for services, which was similar to the CPM in existing §1.482-5. In general, the CPM for services evaluated whether the amount charged in a controlled services transaction is arm’s length by reference to objective measures of profitability (profit level indicators or PLIs) derived from financial information regarding uncontrolled taxpayers that engage in similar services transactions under similar circumstances. The CPM for services applied only where the renderer of controlled services is the tested party.

Section 1.482-9(e) of the 2003 proposed regulations provided that the profit level indicators (PLIs) provided for in existing §1.482-5(b)(4)(ii) may also be used under the CPM for services. The relative lack of uniformity in financial accounting standards for services, combined with potentially incomplete information regarding the cost accounting practices of the uncontrolled comparables, strongly suggest that PLIs that require accurate segmentation of costs may have limited reliability.

The 2003 proposed regulations stated that the degree of consistency in accounting practices between the controlled services transaction and the uncontrolled services transaction might affect the reliability of the results under the CPM for services. If appropriate adjustments to account for such differences are not possible, the reliability of the results under this method will be reduced.

Section 1.482-9(e)(2)(ii) of the 2003 proposed regulations provided for a new profit level indicator that may be particularly useful for controlled services transactions: the ratio of operating profits to total services costs, or the markup on total costs (also referred to as the “net cost plus”). Because this profit level indicator evaluates operating profits by reference to the markup on all costs related to the provision of services, it is more likely to use a cost base of the tested party that is comparable to the cost base used by uncontrolled parties in performing similar business activities.

The Treasury Department and the IRS received a number of comments concerning the CPM for services. Commentators questioned whether the definition of “total services costs,” which provides the net cost plus cost base under the CPM for services, included stock-based compensation. In response to these comments, the Treasury Department and the IRS clarify their intent that §1.482-5(c)(2)(iv) of the existing regulations apply to the CPM for services. Accordingly, new Example 3, Example 4, Example 5, and Example 6 are included in §1.482-9T(f)(3) of these temporary regulations. These examples show the application of existing §1.482-5(c)(2)(iv) to fact patterns that involve differences in the utilization of or accounting for stock-based compensation in the context of controlled services transactions.

One commentator expressed reservations concerning a statement in the preamble to the 2003 proposed regulations, which indicated that PLIs based on return on capital or assets might be unreliable for controlled services because the reliability of these PLIs decreases as operating assets play a less prominent role in generating operating profits. This commentator contended that such PLIs are reliable for all firms, including service providers. The Treasury Department and the IRS clarify that, although return on capital PLIs may produce reliable results in the case of certain service providers, in general, such PLIs are subject to the general reservation in existing §1.482-5(b)(4)(i) to the effect that the reliability of such PLIs increases as operating assets play a greater role in general operating profits.

Aside from the addition of the examples described above, the CPM for services provisions in these temporary regulations are substantially similar to the provisions in the 2003 proposed regulations.

The 2003 proposed regulations provided additional guidance concerning application of the comparable profit split and the residual profit split methods to controlled services transactions. Generally, these methods evaluated 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 2003 proposed regulations provided that the guidance regarding the profit split methods in existing §1.482-6, as amended by proposed §1.482-6(c)(3)(i)(B) and by other changes, applied to controlled services transactions. Section 1.482-9(g) of the 2003 proposed regulations also provided specific additional guidance concerning application of existing §1.482-6, as amended, to controlled services transactions.

The Treasury Department and the IRS received numerous comments on the profit split method. Commentators objected in particular to references in the 2003 proposed regulations to “interrelated” transactions in §1.482-6(c)(3)(i)(B)(1), and to “high-value services” and “highly integrated transactions” in §1.482-9(g)(1). Commentators viewed these terms as vague and subjective. Commentators also sought more specific guidance concerning the circumstances in which the residual profit split method would constitute the best method under the principles of existing §1.482-1(c). In addition, some commentators suggested that one hallmark of a nonroutine contribution in the context of controlled services is that the renderer bears substantial risks. Another commentator suggested that the arm’s length compensation for a function performed by an employee or group of employees should not in any event be evaluated under a profit split method. In this commentator’s view, such an activity should be classified as routine because the market return for the function is equivalent to the total compensation paid to the employees. Commentators also raised several objections to the factual assumptions in the proposed analysis concerning §1.482-9(g)(2) Example 2 of the 2003 proposed regulations.

The Treasury Department and the IRS agreed with a number of comments and, as a result, have made substantial changes to these provisions. Under these temporary regulations, all references to “interrelated” transactions in §1.482-6(c)(3)(i)(B)(1), as well as references to “high-value services” and “highly integrated transactions” in §1.482-9(g)(1) have been eliminated. Section 1.482-9T(g)(1) now states that the profit split method is “ordinarily used in controlled services transactions involving a combination of nonroutine contributions by multiple controlled taxpayers.” This change from the 2003 proposed regulations (which referred to “high-value” or “highly-integrated” transactions), conforms to the changes to §1.482-6T(c)(3)(i)(B)(1), as described below.

Section 1.482-6T(c)(3)(i)(B)(1) of these temporary regulations 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. Importantly, in this context, the term “routine” does not necessarily signify that a contribution is low value. In fact, comparable uncontrolled transactions may indicate that the returns to a routine contribution are very significant.

In response to the comments and in accordance with the revised definition of nonroutine contribution in these temporary regulations, the following references were eliminated as unnecessary: (1) contributions not fully accounted for by market returns; and (2) contributions so interrelated with other transactions that they cannot be reliably evaluated on a separate basis. These changes will bring added clarity to the temporary regulations.

The Treasury Department and the IRS believe that these revised provisions respond to the public comments and offer more specific guidance concerning the circumstances in which the profit split method would likely constitute the best method under existing §1.482-1(c). In particular, the term “high-value” is not included in temporary §1.482-9T(g)(1), thus eliminating any implication that the profit split method is a “default” method for controlled services that have value significantly in excess of cost. This shift in emphasis is also reflected in section B.2 of this preamble, which describes the deletion of language from several examples that some believed suggested that the residual profit split is a default method. The clear intent is that no method, including the profit split, is a default method for purposes of the best method rule. Rather, the profit split method applies if a controlled services transaction has one or more material elements for which it is not possible to determine a market-based return. The Treasury Department and the IRS believe that the above changes address the comments made and so do not believe that it is necessary for the regulations to adopt alternative definitions of nonroutine contribution put forward by commentators, such as definitions based on the degree of risk borne by the renderer of services or the extent to which an activity is performed solely by employees of the taxpayer.

Finally, based on the public comments, and in light of the changes described in this preamble, §1.482-9(g)(2) Example 2 of the 2003 proposed regulations has been withdrawn and replaced by a new example that more effectively illustrates application of the profit split method to nonroutine contributions by multiple controlled parties.

The 2003 proposed regulations provided that an unspecified method may provide the most reliable measure of an arm’s length result under the best method rule. Such an unspecified method must take into account that uncontrolled taxpayers compare the terms of a particular transaction to the realistic alternatives to that transaction.

No significant comments were received concerning the unspecified method provisions. Consistent with the general aim to coordinate the analyses under the various sections of the regulations under section 482 so that economically similar transactions will be evaluated similarly, however, §1.482-9T(h) has been modified to provide that in applying an unspecified method to services, the realistic alternatives to be considered include “economically similar transactions structured as other than services transactions.” 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. The Treasury Department and the IRS are considering similar changes to §§1.482-3(e)(1) and 1.482-4(d)(1) of the existing regulations. Public comments are requested regarding the advisability of such changes and the form they should take. Aside from this change, the unspecified method provisions in these temporary regulations are substantially similar to the provisions in the 2003 proposed regulations.

The contingent-payment contractual term provisions in the 2003 proposed regulations built on the fundamental principle that, in structuring controlled transactions, taxpayers are free to choose from among a wide range of risk allocations. This provision in the 2003 proposed regulations also 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. The 2003 proposed regulations provided detailed guidance concerning contingent-payment contractual terms, including economic substance considerations as well as documentation requirements.

Under §1.482-9(i)(2) of the 2003 proposed regulations, a contingent-payment arrangement was given effect if it met three basic requirements: (1) the arrangement is contained in a written contract executed prior to the start of the activity; (2) the contract makes payment contingent on a future benefit directly related to the outcome of the controlled services transaction; and (3) 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.

Commentators generally supported the contingent-payment terms provision as providing guidance concerning a contractual structure with particular relevance to controlled services transactions. However, they also raised three fundamental concerns regarding the scope and operation of this provision. First, the commentators questioned whether controlled taxpayers would need to identify uncontrolled comparables for any contingent-payment terms that they seek to adopt. Second, they pointed out that certain references to economic substance provisions and documentation requirements were either unclear or duplicative of provisions in existing §1.482-1(d)(3). Third, commentators expressed concern that the IRS might improperly impute contingent-payment terms as a means of addressing erroneous transfer pricing in situations that do not involve lack of economic substance, for example, non-arm’s length pricing of activities such as marketing or research and development.

The temporary regulations respond to each of these concerns. First, under §1.482-9(i)(1) of the 2003 proposed regulations, one factor that needed to be considered was whether an uncontrolled taxpayer would have paid a contingent fee if it engaged in a similar transaction under comparable circumstances. In response to comments, the temporary regulations eliminate this requirement and instead emphasize the importance of the economic substance principles under §1.482-1(d)(3) of the existing regulations. That is, whether a particular arrangement entered into by controlled parties has economic substance is not determined by reference to whether it corresponds to arrangements adopted by uncontrolled parties.

Second, in response to comments, the temporary regulations eliminate duplicative or unnecessary references to the economic substance rules. For example, §1.482-9T(i)(2)(ii) has been modified to provide that the contingent-payment arrangement as a whole, including both the contingency and the basis of payment, must be consistent with economic substance, as evaluated under existing §1.482-1(d)(3)(ii)(B). This section eliminates the additional requirement under the 2003 proposed regulations, that the arm’s length charge under a contingent-payment arrangement must be evaluated by reference to economic substance principles.

Third, the temporary regulations respond to the concern identified by commentators that the IRS might apply the contingent-payment provisions in an inappropriate manner, for example, to correct erroneous transfer pricing in prior taxable years that are not under examination. As discussed in more detail in section C of this preamble, the temporary regulations include an example to illustrate factual circumstances in which contractual terms pertaining to risk allocations (provided they are otherwise consistent with taxpayers’ conduct and arrangements) are fully respected, notwithstanding that on examination the activities were determined to have been priced on a non-arm’s length basis. Other concerns, relating to interaction of the contingent-payment terms provision with the commensurate with income standard, are also addressed in section C of this preamble.

New §1.482-9T(i)(5) Example 3 illustrates the application of these rules to a situation in which the contingency identified in a contingent-payment provision is not satisfied. The example responds to a request by commentators for additional guidance to address such a factual scenario.

Section 1.482-9(j) of the 2003 proposed regulations defined “total services costs” for purposes of the SCBM, the CPM for services, and the cost of services plus method where the gross services profit was restated in the form of a markup on total services costs.

Under the 2003 proposed regulations, total services costs included all costs directly identified with provision of the controlled services, as well as all other costs reasonably allocable to such services under §1.482-9(k). The Treasury Department and the IRS intended that, in this context, “costs” must comprise provision for 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 analytic platform, but neither would necessarily be conclusive in evaluating whether an item must be included in total services costs. The issue of determining total services costs is not a new one; it is relevant under the current 1968 regulations as well.

Commentators objected that §1.482-9(j) of the 2003 proposed regulations failed to list the specific items that were included in total services costs. Some commentators suggested that, absent more precise guidance in this regard, controlled taxpayers should be permitted to rely on the definition of costs applicable under GAAP or Federal income tax principles. Commentators also requested clarification whether total services costs included stock-based compensation.

The Treasury Department and the IRS view the definition of total services costs in the 2003 proposed regulations as having struck the correct balance between specificity and flexibility. In general, the accounting standards applicable to services do not provide a uniform means of determining all costs that relate to the provision of services. Consequently, the Treasury Department and the IRS conclude that total services costs for purposes of section 482 cannot be determined solely by reference to GAAP or other accounting standards or practices.

In response to comments, however, §1.482-9T(j) of the temporary regulations clarifies that all contributions in cash or in kind (including stock-based compensation) are included in total services costs. In addition, the third sentence of §1.482-9T(j) states that “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.” To better reflect, for example, the inclusion of stock-based compensation in total services costs, the term “provision” is adopted in place of the term “consideration” as used in the 2003 proposed regulations.

Commentators also observed that the definition of total services costs in the 2003 proposed regulations did not address situations in which the costs of a controlled service provider include significant charges from uncontrolled parties. Commentators posited that such third-party costs should be permitted to “pass through,” rather than being subject to a markup under the transfer pricing method used to analyze the controlled services transaction. The Treasury Department and the IRS agree that these comments raised an issue that needs to be addressed, but decided to do so in a manner different from that suggested by the commentators. In response to this comment, the temporary regulations add §1.482-9T(l)(4), which under certain circumstances allows a controlled services transaction that involves third-party costs to be evaluated on a disaggregated basis. See section A.11.e of this preamble.

Section 1.482-9(k) of the 2003 proposed regulations retained the flexible approach of existing §1.482-2(b)(3) through (6), which permitted taxpayers to use any reasonable allocation and apportionment of costs in determining an arm’s length charge for services. In evaluating whether the allocation used by the taxpayer is appropriate, the 2003 proposed regulations required that consideration be given to all bases and factors, including practices used by the taxpayer to apportion costs for other (non-tax) purposes. Such practices, although relevant, need not be given conclusive weight by the Commissioner in evaluating the arms length charge for controlled services.

Commentators urged that any technique that a taxpayer uses to allocate costs should be entitled to deference, provided it is consistent with GAAP. For the reasons expressed above concerning §1.482-9T(j), GAAP may provide an appropriate analytic platform but is not necessarily controlling in evaluating the arm’s length charge for controlled services.

In the case of administrative or support services, commentators suggested that the Commissioner should accept any reasonable allocation used by the taxpayer, for example, revenue, sales, or employee headcount. In general, the cost of a service that provides benefits to multiple parties must be allocated in a manner that reliably reflects the proportional benefit received by each of those parties. This standard is intended to be substantially equivalent to the standard in §§1.482-2(b)(2)(i) and 1.482-2(b)(6) of the existing regulations. In response to comments, §1.482-9T(b)(5)(i)(B) of these temporary regulations also provides rules whereby the costs of covered services subject to a shared services arrangement are allocated to participants in a manner that the taxpayer reasonably concludes will most reliably reflect each participant’s reasonably anticipated benefits from the services. See section A.1.c of this preamble.

Section 1.482-9(l) of the 2003 proposed regulations set forth a threshold test for determining whether an activity constituted a controlled services transaction subject to the general framework of §1.482-9. The 2003 proposed regulations broadly defined a controlled services transaction as any activity by a controlled taxpayer that resulted in a benefit to one or more other controlled taxpayers. An “activity” was in turn defined as the use by the renderer, or the making available to the recipient, of any property or other resources of the renderer.

One commentator interpreted this provision as indicating that any activity properly analyzed under one or more other provisions of the transfer pricing regulations should not be subject to §1.482-9 of the 2003 proposed regulations. Other commentators suggested that the “predominant character” of a transaction should control whether it is analyzed as a controlled service under §1.482-9 of the 2003 proposed regulations or under other provisions of the section 482 regulations.

Controlled taxpayers have a great deal of flexibility to structure transactions in various ways that are economically equivalent. In some cases, an overall transaction may include separate elements of differing characters, for example, a transfer of tangible property bundled together with the provision of a service. The structure adopted may sometimes be more reliably analyzed on either a disaggregated or an aggregated basis under the relevant section of the section 482 regulations, for example, either as a separate transfer of tangible property under the existing section 482 regulations in §1.482-3 and a separate controlled services transaction under these temporary regulations in §1.482-9T, or as an overall controlled services transaction under these temporary regulations. To the extent that a controlled transaction is structured so that it is most reliably evaluated as a controlled services transaction, it will be analyzed as such. To the extent that multiple elements of a single overall transaction potentially create an overlap between the section 482 regulations applicable to other types of transactions and these temporary regulations concerning controlled services transactions, the Treasury Department and the IRS believe that the appropriate coordination is achieved by applying the rules in §1.482-9T(m). See section A.12.a of this preamble.

Section 1.482-9(l)(3) of the 2003 proposed regulations provided rules for determining whether an activity provides a benefit. Under §1.482-9(l)(3)(i), a benefit is present if the activity directly results in a reasonably identifiable increment of economic or commercial value that enhances the recipient’s commercial position, or is reasonably anticipated to do so. Another requirement is that an uncontrolled taxpayer in circumstances comparable to those of the recipient would be willing to pay an uncontrolled party to perform the same or a similar activity, or be willing to perform for itself the same or similar activity. The 2003 proposed regulations thus made significant changes to the benefit test under the existing regulations, which is based on whether an uncontrolled party in the position of the renderer would expect payment for a particular activity. The 2003 proposed regulations adopted the so-called “specific benefit” approach, which mandates an arm’s length charge only if a particular activity provides an identifiable benefit to a particular taxpayer. In addition, §1.482-9(l)(3)(ii) of the 2003 proposed regulations provided that no benefit is present if an activity has only indirect or remote effects.

Commentators viewed the 2003 proposed regulations as providing insufficient guidance concerning methods that controlled taxpayers might use to allocate or share expenses or charges, in particular with respect to centralized services performed on a centralized basis for multiple affiliates.

In response to these comments, the temporary regulations authorize the use of shared services arrangements for centralized services that qualify for the SCM in §1.482-9T(b). By entering into such arrangements, taxpayers can, among other things, reduce the burden associated with analysis of centralized services, which would presumably include activities that provide benefits on only an occasional or intermittent basis. See section A.1.c of this preamble, concerning shared services arrangements.

One commentator suggested that, because the benefit test in the 2003 proposed regulations focused on the recipient, the arm’s length charge should also be analyzed from the perspective of the recipient and economic conditions in the recipient’s geographic market. The commentator misunderstands the application of the benefit test. Although the benefit test focuses on the recipient, evaluation of the arm’s length charge under the best method rule in a particular case (for example, under a profit split method) may require analysis of the recipient, the renderer, or both (depending, for example, on which party performs the simplest, most easily measurable functions).

The 2003 proposed regulations provided additional rules concerning application of the benefit test to particular circumstances, such as application to activities with indirect or remote effects, duplicative activities, shareholder activities, and passive association. These rules in the 2003 proposed regulations were substantially similar to the rules in existing §1.482-2(b)(2). For example, §1.482-9(l)(3)(ii) and (l)(3)(iii) provided that no benefit is present if an activity has only indirect or remote effects or merely duplicates an activity that the recipient has already performed on its own behalf. Section 1.482-9(l)(3)(iv) provided that shareholder activities do not confer a benefit on controlled parties and therefore do not give rise to an arm’s length charge. Shareholder activities were defined as activities that primarily benefit the owner-member of a controlled group in its capacity as owner, rather than other controlled parties.

In addition, §1.482-9(l)(3)(v) of the 2003 proposed regulations provided that certain “passive association” effects do not give rise to a benefit within the meaning of the regulations concerning controlled services. Passive association was defined as an increment of value that a controlled party obtains on account of its membership in the controlled group. Section 1.482-9(l)(3)(v) of the 2003 proposed regulations provided, however, that membership in a controlled group may be considered in evaluating comparability between controlled and uncontrolled transactions.

Concerning indirect or remote effects, one commentator suggested that if a centralized activity by a parent confers only occasional or intermittent benefits on a subsidiary, such benefits should be classified as indirect or remote. As to the shareholder provisions, commentators noted that the 2003 proposed regulations failed to address the potential that an activity that confers a reasonably identifiable increment of value on a controlled party might also be appropriately classified as a shareholder activity. As to the passive association provisions, commentators questioned whether membership in a controlled group is relevant to evaluation of comparability. Commentators raised the concern that virtually any uncontrolled transaction could potentially be considered unreliable, because it generally would not reflect the same efficiencies and synergies as the controlled services transaction.

Regarding the comments concerning indirect or remote effects, the Treasury Department and the IRS believe that to equate occasional or intermittent benefits in all cases with indirect or remote effects would conflict with the specific-benefit rule. That rule requires that any service that produces an identifiable and direct benefit warrants an arm’s length charge, even if the service is provided only occasionally or intermittently. Accordingly, the temporary regulations retain this provision without change.

In response to comments relating to shareholder activities, §1.482-9T(l)(3)(iv) of the temporary regulations refers to the “sole effect” rather than the “primary effect” of an activity. This change clarifies that a shareholder activity is one of which the sole effect is either to protect the renderer’s capital investment in one or more members of the controlled group, or to facilitate compliance by the renderer with reporting, legal, or regulatory requirements specifically applicable to the renderer, or both. As modified, the definition in temporary §1.482-9T(l)(3)(iv) now conforms to the general definition of benefit in §1.482-9T(l)(3)(i).

In response to commentators’ request for clarification regarding the passive association rules, new §1.482-9T(l)(5) Example 19 illustrates a situation in which group membership would be taken into account in evaluating comparability.

The Treasury Department and the IRS have inserted the word “generally” in the description of duplicative activities in §1.482-9T(l)(3)(iii). This change clarifies that although a duplicative activity does not generally give rise to a benefit, under certain circumstances, such an activity may provide an increment of value to the recipient by reference to the general rule in §1.482-9T(l)(3)(i). In such cases, the activity would be appropriately classified as a controlled services transaction.

The proposed regulations appear to have created confusion on the part of some taxpayers regarding the appropriate characterization of financial guarantees for tax purposes. The provision of a financial guarantee does not constitute a service for purposes of determining the source of the guarantee fees. See Centel Communications, Inc. v. Commissioner, 920 F.2d 1335 (7th Cir. 1990); Bank of America v. United States, 680 F.2d 142 (Ct. Cl. 1980). Nevertheless, some taxpayers have suggested that guarantees are services that could qualify for the cost safe harbor and that the provision of a guarantee has no cost. This position would mean that in effect guarantees are uniformly non-compensatory. The Treasury Department and the IRS do not agree with this uniform no charge rule for guarantees. As a result, financial transactions, including guarantees, are explicitly excluded from eligibility for the SCM by §1.482-9T(b)(3)(ii)(H). However, no inference is intended by this exclusion that financial transactions (including guarantees) would otherwise be considered the provision of services for transfer pricing purposes. The Treasury Department and the IRS subsequently intend to issue transfer pricing guidance regarding financial guarantees, in particular, along with other guidance concerning the treatment of global dealing operations. See Section A.12.e of this preamble for a discussion of coordination with global dealing operations. Such guidance will also include rules to determine the source of income from financial guarantees.

Commentators observed that the definition of “total services costs” in §1.482-9(j) of the 2003 proposed regulations did not address situations in which the costs of a controlled service provider included significant charges from uncontrolled parties. Commentators claimed that such third-party costs should be treated as “pass through” items that, in most cases, should not be subject to the markup (if any) applicable to costs incurred by the renderer in its capacity as service provider. This comment was potentially relevant to all cost-based methods in §1.482-9 of the 2003 proposed regulations. The Treasury Department and the IRS agreed that these comments raised an issue that needed to be addressed, but decided to do so in a manner different from that suggested by the commentators.

In response to this comment, these temporary regulations include a new §1.482-9T(l)(4). Under this provision, if total services costs include material third-party costs, the controlled services transaction may be analyzed either 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 §1.482-1(c). Consistent with the best method rule, in determining which approach provides the most reliable indication of the arm’s length result, the primary factors are the degree of comparability between the controlled services transaction and the uncontrolled comparables and the quality of the data and assumptions used. New §1.482-9T(l)(5) Example 20 and Example 21 provide illustrations of this rule.

The rule in §1.482-9T(l)(4) of the temporary regulations applies to all specified methods that use cost to evaluate the arm’s length charge for controlled services, including the SCM in §1.482-9T(b). A determination that a controlled services transaction is more reliably evaluated on a disaggregated basis may have an effect on the analysis of that transaction under other provisions of these regulations.

Section 1.482-9T(l)(5) of the temporary regulations provides numerous examples that illustrate applications of the rules in §1.482-9T(l). Changes have been made to certain of these examples to conform to the modifications described under the previous headings in this section.

Section 1.482-9(m) of the 2003 proposed regulations provided coordination rules applicable to a controlled services transaction that is combined with, or includes elements of, a non-services transaction. These coordination rules relied on the best method rule in existing §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 transaction structured as a controlled services transaction may include material elements that do not constitute controlled services. Section 1.482-9(m)(1) of the 2003 proposed regulations provided that, the decision whether to evaluate such a transaction in an integrated manner under the transfer pricing methods in §1.482-9 or to evaluate one or more elements separately under services and non-services methods depends on which of these approaches would provide the most reliable measure of an arm’s length result. If the non-services component(s) of an integrated transaction could be adequately accounted for in evaluating the comparability of the controlled transaction to the uncontrolled comparables, then the transaction could generally be evaluated solely as a controlled service under §1.482-9.

One commentator criticized this coordination rule as inherently subjective and proposed that a “predominant character” test be adopted instead. Another commentator interpreted certain statements in the preamble as indicating that any controlled transaction that was reliably analyzed under one of the transfer pricing methods applicable to tangible or intangible property would necessarily be outside the scope of the regulations regarding controlled services.

Upon further consideration, the Treasury Department and IRS believe that no changes are necessary to the coordination rule in §1.482-9T(m)(1) because these commentators have misconstrued the application of this rule to integrated transactions. The coordination rule in §1.482-9T(m)(1) focuses on the underlying economics of such transactions and the most reliable means of evaluating those economics under the best method rule. The Treasury Department and the IRS recognize that controlled taxpayers have substantial flexibility to structure transactions in a variety of economically equivalent ways. Provided that the structure adopted has economic substance, the coordination rule is designed to respect that structure and to seek the most reliable means of evaluating the arm’s length price. Consequently, if a taxpayer structures a transaction so that it constitutes a controlled service, the transaction will generally be analyzed under the principles of §1.482-9T, without regard to other provisions of the section 482 regulations.

Section 1.482-9(m)(2) of the 2003 proposed regulations provided that a transaction structured as a controlled service may result in the transfer of intangible property, may include an element that constitutes the transfer of intangible property, or may have an effect similar to the transfer of intangible property. In such cases, if the element of the transaction that related to intangible property was material, the arm’s length result for that element would be determined or corroborated under a method provided for in the regulations applicable to transfers of intangible property. See existing §1.482-4.

Commentators viewed this rule as potentially authorizing the Commissioner to recharacterize a controlled services transaction as a transaction that involved a transfer of intangible property. Such authority, commentators claimed, was inconsistent with existing §1.482-4(b), which defines an intangible as an item that has “substantial value independent of the services of any individual.” Commentators also contended that the coordination rules impermissibly extended the commensurate with income standard to controlled services transactions. Commentators suggested that, assuming each component of a controlled services transaction may be reliably accounted for under a specified transfer pricing method, no additional analysis is necessary concerning elements that arguably pertain to intangible property.

The Treasury Department and the IRS agree with the commentators that the phrase “may have an effect similar to the transfer of intangible property” could be interpreted as improperly expanding §1.482-4 of the existing regulations to non-intangible transactions. This is not the intent of this provision. Consequently, to make this clear, the temporary regulations omit this phrase.

Other concerns raised by commentators misinterpret the interaction between this coordination rule and the definition of intangibles in §1.482-4(b). Section 1.482-4(b) of the existing regulations contains a list of specified intangibles and a residual category of other similar items, all of which must have “substantial value independent of the services of any individual.” In contrast, the coordination rule in §1.482-9T(m)(2) applies after it is determined that an integrated transaction includes an intangible component that is material. Because the coordination rule in §1.482-9T(m)(2) applies only to transactions that incorporate a material intangible component, it is not inconsistent with existing §1.482-4(b), nor does it apply the commensurate with income standard of existing §1.482-4(f)(2) to transactions that do not have a material element that constitutes an intangible transfer.

Section 1.482-9(m)(6) Example 4 of the 2003 proposed regulations illustrated the application of this rule to a controlled services transaction that included an element constituting the transfer of an intangible. Several commentators questioned the factual assumptions in Example 4. Commentators contended that a controlled party performing R&D for another controlled party generally would not have rights in any know-how or technical data arising out of the R&D activity; instead the contract would specify that the party that paid for the research would obtain such rights.

The Treasury Department and the IRS agree with these comments and have concluded that the factual assumptions in this example are unclear. Consequently, Example 4 has been redrafted to illustrate a situation in which the controlled party performing the R&D is the owner of know-how or technical data that resulted from that R&D activity. The controlled party then transfers its rights to another controlled party. As revised, this example more clearly illustrates application of the rule in §1.482-9T(m)(2).

Section 1.482-9(m)(3) of the 2003 proposed regulations provided that services provided by a controlled participant under a qualified cost sharing arrangement are subject to existing §1.482-7. The Treasury Department and the IRS are in the process of comprehensively revising the regulations applicable to cost sharing. In the interim, and pending issuance of final regulations that coordinate these two provisions, the rule in §1.482-9T(m)(3) retains this coordination rule.

Section 1.482-9T(m)(4) is adopted in substantially the same form as in the 2003 proposed regulations. A transaction structured other than as a controlled services transaction may include material elements that constitute controlled services. Section 1.482-9T(m)(4) of these temporary regulations provides rules for evaluating such integrated transactions. As with the corresponding rules in the 2003 proposed regulations, these rules complement the more general rule in §1.482-9(m)(1), which relates to integrated transactions structured as controlled services transactions.

In §1.482-9(m)(5) of the 2003 proposed regulations, the section for coordination with the global dealing regulations was “reserved.” In response to comments, this provision is omitted in these temporary regulations, based on the view that reserved treatment is not appropriate. The Treasury Department and the IRS are presently working on new global dealing regulations. The intent of the Treasury Department and the IRS is that when final regulations are issued, those regulations, not §1.482-9T, will govern the evaluation of the activities performed by a global dealing operation within the scope of those regulations. Pending finalization of the global dealing regulations, taxpayers may rely on the proposed global dealing regulations, not the temporary services regulations, to govern financial transactions entered into in connection with a global dealing operation as defined in proposed §1.482-8. Therefore, proposed regulations under §1.482-9(m)(5)