What does the future hold for at-cost services charges?

Tax Executive, The, May-June, 2007 by Christopher Desmond, Wes Cornwell

Introduction

The Internal Revenue Service's new regulations under section 482 relating to intercompany services were intended to simplify the markup question for intercompany charges for routine services going forward. Have they? One of the biggest concerns many taxpayers will have with the new regulations is the administrative burden of charging their services at cost from year-to-year. The research summarized in this article shows that the Services Cost Method (SCM) set forth in the new regulations will not fully meet the expectations of taxpayers since one of its primary tests can fail in some years and not in others, simply because of changes in the business cycle. This creates heightened administrative burdens and audit risks that were likely not envisioned upon creation of the SCM.

As background, the final and temporary regulations on the treatment of services under section 482 provide taxpayers with the ability to charge intercompany services at cost to foreign affiliates under the Services Cost Method (SCM). In order to qualify for a charge out at cost under the SCM, the taxpayer must reasonably conclude in its "Business Judgment" (1) that "the performed services do not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure in the business of the renderer, recipient, or both." (2) In other words, the performed services must be deemed "routine" by the taxpayer.

Additionally, the taxpayer must: (i) match up the services against a list of specified services that may be charged at cost (3); or (ii) have a median arm's-length markup on total services costs of less than or equal to seven percent (the seven-percent threshold). (4) The second criterion was created because the IRS recognized that the list of specified covered services might not encompass all categories of routine services performed by taxpayers. (5)

The article focuses on the seven-percent threshold and whether it provides taxpayers with a stable decision point to charge services at cost or with a markup throughout time. Specifically, it reflects an analysis of statistics related to U.S. services companies for nearly 20 (6) years and evaluates whether there are any trends in the median markups of these services companies over time that may affect the seven-percent threshold under the new services regulations for taxpayers.

Analysis

The process again with an identification of the Standard Industrial Classification (SIC) codes that capture services companies similar to the typical routine management service functions performed by a multinational taxpayer in the United States. As part of this process, the SIC codes were aligned with the activities that frequently overlap with the categories and activities that encompass the Specified Covered Services list under the IRS's services regulations. (7) By combining a departmental approach from the taxpayer's perspective and the IRS's services regulations, a process was developed that identified the SIC codes that align with typical routine management service departments (e.g., tax, accounting, etc.). These are departments that many taxpayers would deem to be low margin or routine and would need to test if the median markup is less than or equal to seven percent to administer an at-cost charge under the SCM.

The SIC code search resulted in a variety of codes that identified virtually all U.S. services companies that may provide low-margin service functions. (8) The selected SIC codes lead to the identification of the first group, called "All Service Codes," that captures virtually all the services companies that perform activities similar to a multinational taxpayer's back office including: accounting, tax, legal, finance, human resources, treasury, IT, and marketing. This group also overlaps with the majority of the categories listed under the Specified Covered Services within the IRS's services regulations. An analysis of All Services Codes permits an assessment of the entire services' industry returns and median markups over the long-run (i.e., a 19-year period).

Next, the codes were refined to formulate two additional groups:

* All Corporate Service Codes--SIC codes that identify a group of companies that perform activities within each of the following departments: accounting, tax, legal, finance, and human resources; and

* All Marketing Service Codes--SIC codes that identify a group of companies that perform marketing services.

By separately analyzing the All Corporate Service Codes and All Marketing Service Codes groups, the cost markup trends can be examined as they would apply to the activities of certain departments over time.

For the fourth group, All Corporate Service Codes was further segmented into a select group of ten companies that represent the Specified Corporate Service Companies group. The process of identifying a select group of companies, similar to the Specified Corporate Service Companies, is common for a transfer pricing analysis. In fact, this level of granularity would be expected under the new services regulations to evaluate an at-cost charge under the SCM. The Specified Corporate Service Companies group covers the routine functions performed by typical accounting, tax, legal, finance, and human resources departments.