U.S. Government Continues to Increase Focus on Transfer Pricing with Increased Controversy Expected

Excerpt from Practical US/International Tax Strategies by Bob Ackerman, David J. Canale, Karen Kirwan, Carlos Mallo, Mike Patton, Leigh Anne Pasak and Peyton Robinson (Ernst & Young LLP)


Transfer pricing will undoubtedly become a more significant focus of attention for the Internal Revenue Service (IRS) in their examinations of multinational corporations (MNCs). In a statement regarding international tax reform on May 4, 2009, President Obama announced that the IRS will “hire nearly 800 more IRS agents” to increase international tax enforcement efforts.

Concurrent with his remarks, the White House issued a press release commenting on the President’s proposal, indicating that the budget would provide the IRS with funds “to hire new agents, economists, lawyers, and specialists, increasing the IRS’s ability to crack down on offshore tax avoidance, often done through transfer pricing and financial products.” Despite the Administration’s recent announcements reflecting greater scrutiny of international tax issues, nevertheless, there may still be a public perception that the President’s plan will not cover transfer pricing. On May 5, 2009, the New York Times published an article citing different sources indicating that transfer pricing was the “one tax loophole open” in the plan. This perception—wholly without merit—may incite Congress to demand that the Treasury Department and the IRS enforce compliance with transfer pricing even more aggressively.

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The Administration Offers Its Long-Awaited International Tax Proposals

Excerpt from Practical US/International Tax Strategies by Joseph B. Darby III (Greenberg Traurig LLP)

Earlier this month, the Obama Administration issued its long-awaited (and in some quarters, deeply dreaded) proposals for changes to U.S. international taxation. The Proposals were delivered, not in the form of meaty and complex legislation, but rather in a short, breezy, and at times maddeningly vapid news release. Still, the stakes are so high and the timing so crucial that it is hard not to try to extract some kind of deeper meaning from this relatively cursory pronouncement. First the good news: The Proposals do not, as many feared, recommend an outright repeal of all “deferral” with respect to the U.S. federal income taxation imposed on U.S. taxpayers that own foreign corporations. At the moment, U.S.-owned foreign corporations are subject to the so-called “anti-deferral” tax regimes, contained in Subpart F of the Code (controlled foreign corporation or “CFC” rules) and in Code Section 1291 et. seq., (Passive Foreign Investment Corporation, or “PFIC” rules). The current tax rules operate such that, so long as the CFC or PFIC regimes do not apply, income earned by a foreign subsidiary is not taxed until the foreign earnings are actually distributed as a dividend to the U.S. shareholder. That basic tax regime, at least at the moment, appears to remain intact.

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Administration Offers Its Long-Awaited International Tax Proposals

Excerpt from Practical US/International Tax Strategies by Joseph B. Darby III (Greenberg Traurig LLP)

On May 4, 2009, the Obama Administration (Administration) issued its long-awaited (and in some quarters, deeply dreaded) proposals for changes to U.S. international taxation.

The Proposals were delivered, not in the form of meaty and complex legislation, but rather in a short, breezy, and at times maddeningly vapid news release. Still, the stakes are so high and the timing so crucial that it is hard not to try to extract some kind of deeper meaning from this relatively cursory pronouncement. First the good news: The Proposals do not, as many feared, recommend an outright repeal of all “deferral” with respect to the U.S. federal income taxation imposed on U.S. taxpayers that own foreign corporations. At the moment, U.S.-owned foreign corporations are subject to the so-called “anti-deferral” tax regimes, contained in Subpart F of the Code (controlled foreign corporation or “CFC” rules) and in Code Section 1291 et. seq., (Passive Foreign Investment Corporation, or “PFIC” rules). The current tax rules operate such that, so long as the CFC or PFIC regimes do not apply, income earned by a foreign subsidiary is not taxed until the foreign earnings are actually distributed as a dividend to the U.S. shareholder. That basic tax regime, at least at the moment, appears to remain intact.

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Stricter Reporting Requirements for U.S. Transferors of Property to Foreign Corporations

Excerpt from Practical US/International Tax Strategies by Andy Sikora and Joel Mitchell (BDO Seidman, LLP)


The Internal Revenue Service has issued revised Form 926, Return by a U.S. Transferor of Property to a Foreign Corporation, to report exchanges of property with or transfers of property to a foreign corporation. The updated form requires greater detail regarding the property transferred and the tax consequences associated with the transfer. Form 926 is required for any United States person, corporation, estate, or trust that has exchanged property with, or transferred property to, a foreign corporation during the transferor’s taxable year in a transaction described in section 6038B(a), 367(d), or 367(e). Among others, affected transfers include transfers of cash (special rules may apply), stock, accounts receivable, intangible property, inventory, and depreciable assets. Revised Form 926 was released by the Service in February 2009 and contains a revision date of December 2008.

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China Issues Detailed Guidance on Anti-Avoidance Rules

Exerpt from Practical China Tax and Finance Strategies, published by WorldTrade Executive, Inc.

China’s new 2007 Enterprise Income Tax Law, for the first time in Chinese tax history, introduced a set of anti-avoidance rules in its Special Tax Adjustments chapter, which include not only transfer pricing and advanced pricing agreement rules but also rules on cost sharing agreements, thin-capitalization, controlled foreign corporations, and general anti-avoidance.

On January 8, 2009, the SAT released long-awaited Circular Guoshuifa [2009] No 2, Implementation Measures of Special Tax Adjustments (Trial) that details rules on administrating all the aspects of those anti-avoidance rules. If the Special Tax Adjustments chapter represents the first anti-voidance legislation in China, Guoshuifa [2009] No 2 can be viewed as the first comprehensive operating manual of anti-avoidance administrations in China. All the provisions in Guoshuifa [2009] No 2 take retrospective effect from January 1, 2008.

As the starting point of the anti-avoidance administration, Guoshuifa [2009] No 2 restates that all enterprises shall file the following nine forms annually to report related party transactions:

Form 1 - Related party relationships
Form 2 - Summary of related party transactions
Form .3 - Purchases and sales
Form 4 - Labor services
Form 5 - Intangible assets
Form 6 - Fixed assets
Form 7 - Financing
Form 8 - Outbound investments
Form 9 - Outbound payments

Those forms require enterprises to indicate whether they have contemporaneous transfer pricing documentation in place. The forms need to be filed together with the annual enterprise income tax return. For the tax year of 2008, the filing deadline is May 31, 2009.

Read More for a Summary of Transfer Pricing Documentation

France and the United States Sign a Protocol Amending the Income Tax Treaty

Excerpt from Practical US/International Tax Strategies by Gauthier Blanluet, Andrew P. Solomon, Willard B. Taylor, Aditi Banerjee and Nicolas de Boynes (Sullivan & Cromwell LLP)

On January 13, 2009, France and the United States signed a protocol (the “Protocol”) amending the income tax treaty signed by the two countries in 1994, as amended by a 2004 protocol (the “Existing Treaty”).

The Protocol generally eliminates withholding tax on dividends paid to shareholders holding at least 80 percent of the distributing company and generally eliminates the branch profits tax. It also eliminates withholding on royalties for the use of intangible property. The Protocol provides for mandatory arbitration of certain cases that are not resolved by the competent authorities within a specified period of time, clarifies the treatment of certain fiscally transparent and pass-through entities, imposes stricter requirements for certain companies to qualify for the benefits of the treaty, and updates the rules for the exchange of taxpayer information between the tax authorities of each country. These changes will align the Existing Treaty more closely with more recent U.S. tax treaties.

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IRS Provides Temporary Relief under Subpart F in Response to the Liquidity Crisis

Excerpt from Practical US/International Tax Strategies by Edward Tanenbaum and Diana Wessells (Alston & Bird LLP)

Treasury and the IRS issued Notice 2008-91, which provides temporary and limited relief to a particular aspect of Section 956, in connection with the current liquidity crisis. Under Sections 951 and 956, a U.S. shareholder of a controlled foreign corporation (CFC) is subject to tax on the amount equal to the lesser of (1) the U.S. shareholder’s pro rata share of the average of the amounts of U.S. property held (directly or indirectly) by the CFC as of the close of each quarter of the taxable year, less the amount of earnings and profits previously included in the U.S. shareholder’s gross income, or (2) the U.S. shareholder’s pro rata share of the applicable earnings of the CFC. The effect of these provisions is to treat the U.S. shareholders of the CFC as receiving the amount invested in U.S. property as a constructive dividend. Section 956 is consistent with the other provisions of subpart F insofar as it is intended to prevent the tax-free repatriation of earnings.

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China’s New Thin Capitalization Rules: Specific Debt/Equity Ratios Established

Excerpt from Practical China Tax and Finance Strategies by Peter Guang Chen (Deloitte Tax LLP, New York City)

Article 46 of China’s new Enterprise Income Tax Law (EITL) provides that a Chinese enterprise’s ability to deduct interest payments on borrowings from related parties is subject to a “prescribed standard.” However, the EITL, which became effective January 1, 2008, did not address what this “prescribed standard” would be. Without a clear answer on an acceptable debt-to-equity ratio in China, many financing and tax planning plans had to be put on hold, particularly for those multinational corporate groups doing cross-border intercompany financing of their subsidiary operations in China.

This important issue was addressed recently in Circular 121 issued jointly by the Ministry of Finance and the State Administration of Taxation.

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Financial Bailout Package Contains International Tax Provisions

Excerpt from Practical US/International Tax Strategies by Lilo Hester, Ken Wood, Karen Jacobs, Eric Oman, Staci A. Scott and Carlos Probus (Ernst & Young LLP)

Earlier this month, President Bush signed into law the Emergency Economic Stabilization Act of 2008 (Division A), the Energy Improvement and Extension Act of 2008 (Division B), and the Tax Extenders and Alternative Minimum Tax Relief Act of 2008 (Division C) (H.R.1424), herein collectively referred to as the Act. The Act was passed by the Senate on October 1, 2008, and by the House of Representatives on October 3, 2008. The Act has been widely publicized as the “bailout bill” because it provides the U.S. government with authority to purchase up to $700 billion in “troubled,” illiquid assets owned by various financial institutions.

International tax provisions of the Act include:

• Elimination of the distinction between foreign oil and gas extraction income (FOGEI) and foreign oil related income (FORI) and the combination of FOGEI and FORI into one foreign oil basket, applying the existing FOGEI limitation.

• Extension for an additional tax year (through December 31, 2009) of the controlled foreign corporation (CFC) look-through provision of Section 954(c)(6).

• Extension for an additional tax year (through December 31, 2009) of the exception to treatment as foreign personal holding company income for income derived in the active conduct of a banking, finance, or similar business.

• Extension for an additional tax year (through December 31, 2009) of the exception to treatment of certain insurance income as subpart F income.

Read more on international tax provisions with respect to individuals

IRS Enhances Opportunity for U.S. Multinationals to Access Cash from Controlled Foreign Corporations

Excerpt from Practical US/International Tax Strategies by Douglas S. Stransky, Lewis J. Greenwald, Ameek Ashok Ponda and Eric J. Fuselier (Sullivan & Worcester)

On October 3, 2008, the U.S. Internal Revenue Service (IRS) issued Notice 2008-91, which expands the ability of a controlled foreign corporation (CFC) to make short-term loans to its U.S. parent to fund operations without creating an income inclusion for U.S. federal income tax purposes. This Notice applies for a CFC’s first two taxable years ending after October 3, 2008. Thus, for a CFC with a calendar taxable year, the Notice applies for calendar years 2008 and 2009. On October 16, 2008, the IRS issued a correction to provide that Notice 2008-91 will not apply to the taxable year of a CFC beginning after December 31, 2009.

Current Law
Generally, under Internal Revenue Code (Code) section 956, a loan made from a CFC to its U.S. parent is considered to be an investment in U.S. property because the CFC holds an “obligation” of the U.S. parent. Under this Code section, the average amount of the CFC’s investment in U.S. property held at the end of each quarter of the taxable year is potentially treated as a “deemed dividend” to the U.S. parent and, thus, taxable on the U.S. parent’s federal income tax return.
In some circumstances, however, the U.S. parent can have a loan outstanding from its CFC without triggering any income inclusion. Under Notice 88-108, for example, even if a CFC makes a loan to its U.S. parent that extends over a quarter end, there should be no income inclusion provided that this loan is outstanding less than 30 days.

But if the CFC were to hold any number of obligations that would (without regard to the 30-day exception) constitute U.S. property for aggregate periods totaling 60 or more days during a taxable year, this 30-day exception would not apply.

Notice 2008-91
In Notice 2008-91, the IRS has supplemented Notice 88- 108 so that a loan from a CFC to its U.S. parent would only constitute an obligation that results in an income inclusion if the loan is held for more than 60 days from the time it is incurred. Notice 2008-91 further provides that if a CFC holds obligations that would (without regard to the 60-day exception) constitute U.S. property for aggregate periods totaling 180 or more days during a taxable year, then this 60-day exception would not apply. Thus, Notice 2008-91 effectively extends the periods within which a taxpayer can hold an obligation without triggering the application of Code section 956. A CFC can apply Notice 2008-91 or Notice 88-108, but not both.

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Tax Auditors Look to Substance in Centralized IP Structures

Excerpt from August 2008 Issue of Practical US/International Tax Strategies by John Henshall (Deloitte & Touche LLP)

In the early 1990s the first businesses transformed corporate efficiency, and profitability, by taking a holistic view of their business and optimizing their supply chain networks—the complex web suppliers, production and R&D facilities, distribution centers, sales subsidiaries, channel partners and customers. Typically the best commercial structure involved a centralization of regional activity into “Principal” company supported by “contract” or “toll” manufacturers and “commissionaire” sales or “simple” distributors, supported by “shared service centers” to take care of back-office functions. Today most multinationals don’t derive a significant proportion of their profits from the physical act of making products but rather from the ideas they generate that lead those products, wherever products are made. As this state of affairs evolved so did the centralized business model and IP planning is now a signifi cant element in any business restructuring.

Business restructurings are by their nature an enormous strain on the organization and they are not undertaken purely for tax reasons. Tax is, however, taken into account when deciding where the centralized entity should locate; in most reorganizations high-tax countries then see high-profit activities moving away. These governments are fearful of the fiscal consequences of the more profitable element of their tax base moving offshore and will audit the transition vigorously.

Read More: Why Is Substance Important?

IRS Disallows Foreign Tax Credits Claimed for Cross-Border Trust

Excerpt from Practical US/International Tax Strategies by Lawrence Hill and Alexander Roberts (Dewey & LeBoeuf LLP)

Recently, the IRS issued a Chief Counsel Advice memorandum (CCA) advising the disallowance of foreign tax credits claimed by a U.S. corporation (U.S. Corporation) in connection with income and assets transferred to a cross-border trust (Trust) on the grounds that the Trust arrangement lacked economic substance. The IRS determined that the cross-border trust “served no legitimate non-tax purpose and was not reasonably expected to generate an economic profit for the taxpayer.” In the alternative, the IRS concluded that the series of transactions involved in the arrangement lacked economic substance as an integrated transaction. In addition, the IRS determined that the foreign tax credits should be denied under Section 269(a)(1) and (2) because the taxpayer formed and transferred funds to a subsidiary with the principal purpose of avoiding U.S. federal income tax.

Read More on IRS Challenges of Cross Border Trusts (free)

Documenting “Benefits” of Intercompany Services Becoming Increasingly Important in Europe as New U.S. Regulations are Implemented

Excerpt from Practical US/International Tax Strategies by Michelle M. Johnson (Ceteris. Inc.)

In late May (2008) the Tax Court of Lombardy reversed a previous judgment of the Provincial Tax Court of Milan regarding a taxpayer’s intercompany services charges. The Milan judgment had ruled in favor of the taxpayer by recognizing the deductibility of services charges related to the “provision of market information useful to manage the sales process and management control” by the parent company. These first degree judges had concluded that these services were “necessary” or at least “useful” in improving the management of the business of the Italian-controlled entity, thereby warranting the deduction.

The Tax Court of Lombardy overturned this decision in favor of the Italian tax authorities’ original position that no deduction should be allowed since there was an absence of a specific connection to the interests of the recipient. Even though the parent had calculated the services’ cost shares among its subsidiaries based on proportion of turnover, the appeal-level judges ruled that in the case of the Italian subsidiary this was not representative of the actual benefit received.

This ruling is just one example of issues that U.S.-headquartered taxpayers might encounter as they seek to comply with the new U.S. transfer pricing regulations for intercompany services. These new regulations are prompting U.S. taxpayers to examine their headquarters operations with greater scrutiny as they seek a more comprehensive approach to evaluating fully-loaded cost pools that may relate to activities that benefit non-U.S. subsidiaries. For many companies, implementing these new regulations has resulted in an increased amount of services charges made to foreign affiliates.

Read More: Best Practices to Reduce Your Risk of Disallowed Deductions (free)

Tax Issues Facing Supply Arrangements in Latin America

Excerpt from Practical Latin American Tax Strategies by Victor Cabrera, Jose Leiman, And Marc Skaletsky(KPMG LLP)

Over the past decade, many large multinational corporations (MNCs) have been moving their European and Asian operations from a decentralized group of stand alone full-fledged manufacturing and distribution (M&D) subsidiaries towards a “hub-and-spoke” system. Under these arrangements, the hub (the “Principal”) assumes functions and risks from the M&D subsidiaries. This centralization of functions and risks in the Principal hopefully brings a commensurate share of consolidated profits.1 The conversion of full-fledged M&D subsidiaries to a hub-and-spoke arrangement raises a series of non-tax and tax considerations and associated issues that must be resolved in order to implement the structure successfully.

Given the potential benefits of the hub-and-spoke structure, many MNCs have sought to implement the structure for their Latin American operations. However, when MNCs cast their sights on Latin America, they are quite often faced with a diverse and sprawling network of jurisdictions, each with its own rules and views on the operation of structures within their borders. Many MNCs doing business in Latin America learn that applying the European or Asian hub-and-spoke template to Latin America does not always result in a natural fit. MNCs that seek to implement a hub-and-spoke arrangement in Latin America must understand and plan for the specific regional issues they will face.

Read More about Specific Latin American Hub-and-Spoke Issues to Consider (free)

Japan GST/VAT Update:

Invoice Based System Recommended and A Rate Hike is Widely Expected

Excerpt from Practical Asian Tax Strategies by Edwin T. Whatley, Kazuo Taguchi and Gabriele Slattery (Baker & McKenzie, Japan)

GST/VAT Legislative Changes
There have been no significant changes to Japanese GST/VAT (referred to as “consumption tax” in Japan) legislation in the 12 months to May 2008. One legislative change, not specific to consumption tax that may have an effect on Japanese consumption taxpayers is the modification of some administrative aspects of the Japanese tax ruling system.

GST/VAT Rulings: Changes to Advance Ruling System
While formal rulings have, since the introduction of the tax ruling system in 2001, been binding on the National Tax Agency (“NTA”), Japan’s formal advance ruling system has thus far not been very useful in producing guidance for taxpayers. The authorities generally have taken a very narrow view of what types of questions fall within the scope of Japanese tax law issues upon which a ruling could be issued. In particular, the issuance of binding tax rulings has been limited to past transactions and future transactions which are certain to be conducted, the applicant’s name has been publicly disclosed and details of the ruling have been made public within 60 days in most cases. The tax authority has been under a “loose” obligation to issue a ruling within three months in principle.

Effective April 1, 2008, the tax ruling system has been modified in an effort to make the advance ruling system more useful for taxpayers.

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Latin American Reorganization: Be Aware of Tax Issues

Excerpt from Practical Latin American Tax Strategies by John A. Salerno and Julian R. Vasquez (PricewaterhouseCoopers LLP)

Multinationals considering the reorganization of their group legal entity or operational structures in Latin America need to be cognizant of the potential income tax implications related to the sale or transfer of shares or other equity interests in their affiliates.

While most companies are keenly aware of the tax implications relating to the sale of a direct or indirect subsidiary to a third party, many do not realize that an intra-group transfer of shares in connection with, for example, the formation of a regional holding company structure or post-deal integration planning, may also trigger tax in certain Latin American countries. Absent tax treaty protection the tax cost of the transfer of shares can be quite high.

In some cases the relevant taxable “transfer” is not so evident, and may occur, for example, as a result of the liquidation of a nonresident shareholder of a Latin American company. Domestic law or tax treaty-based strategies often exist to minimize or eliminate the local country income tax burden on capital gains. Thus, particularly in the case of transactions with related parties, slight modifications of a transactional structure may, in certain cases, yield a more favorable tax results.

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IRS Proposes New Regulations on Contract Manufacturing and Subpart F Income

Excerpt from Practical US/International Tax Strategies by Peter J. Connors, Stephen Lessard and Matthew A. Clausen (Orrick, Herrington & Sutcliffe LLP)

In response to the growing importance of contract manufacturing and other manufacturing arrangements, on February 28, 2008, the Treasury Department and the Internal Revenue Service (IRS) have proposed to modernize the foreign base company sales income (FBCSI) regulations. Under section 951(a)(1)(A)(i), a U.S. shareholder of a controlled foreign company (CFC) includes in gross income its pro rata share of the CFC’s subpart F income for the CFC’s taxable year that ends with or within the taxable year of the shareholder. Section 952(a)(2) defines subpart F income to include “foreign base company income.” Section 954(a)(2) defines foreign base company income to include FBCSI for the taxable year. While the proposed regulations are prospective in application, taxpayers may choose to apply these regulations “in their entirety to all open tax years” as if they were final regulations. This flexibility will be an important consideration in resolving disputes with the IRS.

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Sunset on the Horizon: Changes in Tax Planning for Foreign Investments

Excerpt from Practical US/International Tax Strategies by Isaac Grossman (Morrison Cohen LLP)

It doesn’t take long for investment professionals to adjust to changes in the tax rules governing investments. Application of the 15 percent long-term capital gains rates to individuals receiving qualified dividend income from domestic and certain foreign corporations is no longer news. As a result, investment decisions are based on the expectation that these rates will remain in effect. However, these changes among others will sunset after 2010, if no further legislation is adopted. Currently, it is not clear that further legislation will be on the national agenda when President Bush, the force behind many of these tax rate cuts, leaves the White House. Moreover, some would suggest that tax rates may be increased even sooner depending on the identity of the next president. If the rates sunset as currently drafted, the individual income tax rates will return to close to 40 percent and no special rate will be applied to dividends.

As many investments have a shelf life of several years, it is essential to think ahead of the curve and consider the impact of these upcoming changes.

In light of the expected increase in the tax rates for dividends from 15 percent to close to 40 percent, several basic assumptions for tax structuring investments must be reconsidered. First, the most basic decision in structuring a new operating or holding corporation both domestically and offshore is the proper capitalization of the corporation, i.e., the proper mix of debt and equity. Under current law, there is a tension between favoring debt or equity. Debt generally permits the issuing corporation to deduct current payments of interest to investors and interest payments often qualify for lower withholding tax rates than dividends. In addition, it is easier to return the principal amount of a debt instrument to the holder than to return the principal amount of an equity instrument to the holder due to the tax provisions relating to redemptions. Equity permits individual investors to pay capital gains rates on dividend payments and permits corporate recipients a dividends received deduction (for domestic investments) or indirect foreign tax credits (for foreign investments). When the tax rates sunset and individuals become taxable at ordinary rates on dividends, equity may become less tax effi cient for individual investors. Thus, the decision on capitalization will further favor debt.

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FAS 123R and Cross-Border Tax Issues

Excerpt from Practical US/International Tax Strategies by Albert W. Liguori, Michael Murphy and J.D. Ivy (Alvarez & Marsal Taxand, LLC)

Most public companies provide some form of stock compensation to their executives and employees and as a result must grapple with the tax and financial statement treatment of such equity compensation awards. Crossborder employment situations further complicate the tax and financial statement treatment of these awards.

The impact of recent developments in the transfer pricing arena as they relate to how equity compensation is treated under Statement of Financial Accounting Standards No. 123R (FAS 123R) and FAS 109 have now become natural opportunities for companies to determine not only whether they are in compliance with the financial statement and transfer pricing rules but also to undertake some tax-efficient planning.

Under FAS 123R, stock based compensation, which includes stock options and restricted stock units, must be valued at grant date and recognized as an expense for book purposes over the equity compensations’ vesting period. The vesting period is also known as the “service period” for which an employee earns the right to benefit from such equity compensation. Naturally, the amount expensed must be tax-effected. However, most foreign jurisdictions as well as the U.S. do not allow a tax deduction for equity compensation until the vesting is complete or the equity compensation is exercised. This difference in time (i.e., expense now, deduct later) results in deferred tax accounts. When accounting for these deferred taxes, it is important to know if and where a deduction will ultimately become available for the stock compensation, a task easier said than done.

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Accounting—In Practice—for Back Office and Headquarters Services After Changes to Intercompany Service Transactions

Excerpt from Practical US/International Tax Strategies' interview with Transfer Pricing Specialist Eric Ryan, DLA Piper

In 2006 the Treasury Department and the IRS issued temporary regulations under Code Section 482 that phased out the simplified cost based method for reporting intercompany service transactions, and replaced it with the Services Cost Method (SCM). In order to find out how companies are adapting to the changes, Tax Strategies talked with Eric Ryan, a Partner with DLA Piper, resident in the Palo Alto office. Mr. Ryan has been working closely with many companies, primarily in high tech sectors, to implement the new rules.

Strategies: What kinds of companies are most affected by the changes to the new transfer pricing methods provided under the temporary service regulations?

Ryan: The key companies that are affected by this are U.S. multinationals that, on a regular basis, are charging out to their foreign affiliates some portion of what they consider U.S. headquarters costs. These companies in particular have basically had to do a complete relook at what they were doing previously.

Strategies: What has been the general taxpayer reaction to the SCM or Services Cost Method and the temporary regulations that allow expenses to be charged to affiliates without a markup?

Ryan: With the exception of one or two items, I think it has actually been favorable. Of course the SCM—the no-markup approach—is an exception to the arm’s length standard because the tax authorities would otherwise assume that there’s a profit motivation in arm’s length dealings. So what the IRS tried to do here was to keep the categories of expenses that could be allocated out without a markup to non high value-added activities. There was an earlier version of these proposed regulations issued in 2003 that had a formula which was just not workable, and it took a lot of effort to figure out if you could qualify for the new markup. Now the IRS has issued this list of 101 things that companies can allocate without a markup and that list, which is in Rev. Proc. 2007-13, we are coming to find out, is fairly extensive for General and Administrative activities.

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