Subsidiaries
IRS Issues New Transfer Pricing Regulations
With commerce turning more and more global each day, it is very likely that most companies will be impacted by these new inter-company transfer pricing regulations, which will be effective for tax years starting after December 31, 2006.
These new regulations intend to clarify what a controlled group of companies can and cannot charge out to its affiliates and what methodologies are available to the taxpayer to determine the appropriate cost pool.
The new regulations state that the arm's length amount charged in a controlled service transaction must be determined under one of the following methods:
- Services Cost
- Comparable Uncontrolled
- Services Price
- Gross Services Margin
- Cost of Services Plus
- Comparable Profits
- Profit Split
The method used by the taxpayer depends on which method best applies to the specific circumstances of the inter-company transactions being considered. In order to use any of these methods, the IRS requires taxpayers to maintain adequate books and records evidencing their transactions with the controlled and uncontrolled parties that lead to the decision as to which method the taxpayer would use. Also, the taxpayer's records must include a statement evidencing the taxpayer's intention to apply the selected method to the arm's length transaction with its affiliated company.
It is advisable for taxpayers to plan ahead and perform the necessary research to determine which method best suits their controlled group before the regulations are in effect. This will also help the taxpayer evaluate whether their record keeping is appropriate to evidence their adoption of one of the following methods:
Services Cost Method
This method replaces the Simplified Cost-Based Method. The services cost method allows the taxpayer to charge out at cost all services that are either on a list of routine and non-core services published by the IRS, or that have a median comparable markup less than or equal to seven percent. These services are referred to as covered services. The taxpayer must also determine that these services do not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure in the business. Certain transactions are not covered services, such as:
- Manufacturing
- Production
- Extraction, exploration, or processing of natural resources
- Construction
- Reselling, distribution, acting as a sales or purchasing agent, or acting under a commission or other similar arrangement acting under a commission or other similar arrangement
- Research, development, or experimentation
- Engineering or scientific
- Financial transactions
- Insurance or reinsurance
Comparable Uncontrolled Services Price Method
This method evaluates whether the amount charged in a controlled group service transaction (controlled service) is arm's length by reference to the amount charged in a comparable uncontrolled service transaction (uncontrolled service). Normally, this method is used when the controlled services are either "identical to or have a high degree of similarity" to the services in the uncontrolled transaction. If there are differences between the controlled and uncontrolled transactions that would affect price, adjustments should be made to the price of the uncontrolled transaction.
Gross Services Margin Method
The gross services margin method evaluates whether the amount charged in a controlled services transaction is arm's length by reference to the gross profit margin realized in comparable uncontrolled transactions. This method is similar to the comparable uncontrolled services price method. However, in these types of transactions the amount charged is based on a gross margin, or commission, and not on standard prices.
Cost of Services Plus Method
The cost of services plus method evaluates whether the amount charged in a controlled services transaction is arm's length by reference to the gross services profit markup realized in comparable uncontrolled transactions. The cost of services plus method is ordinarily used in cases where the controlled service provider offers the same or similar services to both controlled and uncontrolled parties. This method is ordinarily not used in cases where the controlled services transaction involves a contingent-payment arrangement.
Comparable Profits Method
The comparable profits method evaluates whether the amount charged in a controlled transaction is arm's length based on objective measures of profitability derived from uncontrolled taxpayers that engage in similar business activities under similar circumstances.
Profit Split Method
The profit split method evaluates 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 contribution to that combined operating profit or loss. The relative value of each controlled taxpayer's contribution is determined in a manner that reflects the functions performed, risks assumed and resources employed by such controlled taxpayer in the relevant business activity. The residual profit split method is ordinarily used in controlled services transactions involving a combination of non-routine contributions by multiple controlled taxpayers.
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