tuesday, october 6, 2009 | 1:00 p.m. est

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TRANSFER PRICING UPDATE: FINAL IRS REGULATIONS ON INTERCOMPANY SERVICES AND OECD PROPOSED REVISIONS TO THE TP GUIDELINES

Tuesday, October 6, 2009 | 1:00 p.m. EST

WELCOME TO OUR WEBINAR

10/06/2009Transfer Pricing Update 2

Introduction of Speakers

Paul FlignorPrincipal EconomistDLA Piper

Contact Information:Phone: +1 312 984 5933Fax: +1 312 630 5309Mobile: +1 312 404 0437

E-mail Address:[email protected]

Office Address:203 North LaSalle Street, Suite 1900Chicago, IL 60601-1293 United States

Bernhard von ThadenPrincipal EconomistDLA Piper



Office Address:1999 Avenue of the Stars, Fourth FloorLos Angeles, CA 90067-6022United States

Paul B. BurnsOf Counsel, TaxDLA Piper



Office Address:1999 Avenue of the Stars, Fourth FloorLos Angeles, CA 90067-6022United States

Eric D. RyanPartner, TaxDLA Piper



Office Address:2000 University AvenueEast Palo Alto, CA 94303-2248United States


Agenda

U.S. Intercompany Services Regulations

History and Introduction to Services Regulations

The Services Cost Method (SCM)

Allocations and Shared Service Arrangements

Intellectual Property and Intercompany Services

OECD Proposed Revisions To TP Guidelines

Support of Arm’s Length Standard

“Most Appropriate Method”

Use of Profit-based Methods

Comparability Issues


History - Transfer Pricing for Services

Prior 1968 Regulations §1.482-2(b)– Effective through 2006

No specified TP methods

Integral / Non-Integral (four tests) regime for no mark-up

No mention of stock option compensation

2003 Proposed Regulations §1.482-9 – Never effective

Temp. and Prop. Regulations §1.482-9T – Effective after 2006

Specified TP methods

Services Cost Method for no mark-up

Stock options must be included in total services costs

2009 Final Regs. §1.482-9 – Years starting after July 31, 2009

Largely similar to 2006 Temp. and Prop. Regulations


Specified TP Methods for Services

1. Services Cost Method (SCM)

2. Comparable Uncontrolled Services Price Method (CUSP)

3. Gross Services Margin Method (GSM)

4. Cost of Services Plus Method (CSM)

5. Comparable Profits Method (CPM)

6. Profit Split Method (PSM)

7. Unspecified Methods


Services Cost Method (“SCM”)

SCM allocates costs without a mark-up.

The SCM is the taxpayer’s choice -- the IRS will not impose the SCM if the taxpayer prefers to employ a mark-up or other arm’s length approach.

Services must qualify as “covered services”-

Specified covered services – on a list provided by IRS (Announcement 2006-50 and Rev. Proc. 2007-13); OR

Low margin covered services – median markup is less than or equal to 7%; AND

Not an excluded category of high value services AND

Business Judgment Rule must be met

Taxpayer maintains documentation, including a statement evidencing the taxpayer’s intention to apply the SCM.


The Business Judgment Rule (“BJR”)

Taxpayer must reasonably conclude that services do not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of renderer, recipient, or both;

BJR is based on a taxpayer’s reasonable judgment. This may be challenged by the IRS.

The Final Regulations clarify that the BJR is based upon the consolidated business of the controlled group. Therefore, special purpose service entities may still qualify under the BJR for the SCM.

Selected examples:Hospitals – one entity enters data into patient record system for the

group; not a key competitive advantageData Entry Services - companies specialize in data processing; is a

key competitive advantageManufacturer - legal department not a key competitive itemNuclear power plants - legal department’s ordinary activities not a key

competitive item, but activities with Nuclear Regulatory Commission are key competitive items

The Final Regulations do not specify who at a taxpayer should apply the BJR, and do not specify how the conclusion should be documented. Obviously, a key item for Transfer Pricing Documentation.


Services Cost Method (“SCM”) - Comments

Comment: Rev. Proc. 2007-13 provides a list of 101 qualifying activities, which cover typical G&A type functions. Each major category of activities also includes “Other similar activities.” Therefore, it is likely taxpayers will take the position that all activities within most (if not all) G&A departments qualify for the SCM.

Best practice suggestion: Transfer pricing documentation should link individuals or departments with the appropriate item from the list of 101 activities.

Comment: Rev. Proc. 2007-13 does not cover sales or marketing activities. Marketing activities will likely qualify for the 7% or below median “low margin covered services” category, assuming an appropriate marketing comparables set is developed by the taxpayer. The IRS does not intend to maintain comparables sets for taxpayers.

Comment: The IRS may take the view that sales activities are an excluded category of high value services, and therefore do not qualify for the SCM.

Comment: Is there an inference that a taxpayer’s mark-up for excluded, high value service activities (e.g., R&D) should be more than 7%?

Comment: Stock option expense must be included in the cost base. Either GAAP 123R method or tax-based spread-at-exercise method may be used.


Final Regulations attempt to clarify definition of Stewardship

Activities that do not provide a benefit: Activities that recipient would not be willing to pay to uncontrolled party

because benefits are so indirect or remoteActivities that would duplicate an activity of the recipient, unless an

additional benefitShareholder activities: if the sole effect of the activity is either to protect

the renderer’s investment or facilitate compliance with regulatory requirements of renderer

Benefits from “passive association” (i.e., benefit results from the controlled taxpayer’s status as a member of the controlled group)

Twenty-one examples provided:Sub has Legal Dept. and Parent’s Legal Dept. also reviews transaction

documents; Sub has received a benefit since risks of transaction are reduced

Parent’s Internal Audit Dept. reviews Sub’s adherence to policies and US anti-bribery laws; activities are for Parent’s protection of investment and own compliance


Shared Service Arrangements (SSA)

The Final Regulations provide a mechanism for members of a multinational group to efficiently share the costs of services that are subject to the SCM and that benefit multiple members of the group. Must include two or more participants.

Must include all controlled taxpayers that reasonably anticipate a benefit from one or more services specified in the arrangement.

Each covered service must confer a benefit on at least one participant.

Costs must be allocated based on reasonably anticipated benefit (“RAB” shares).

Taxpayer must maintain specified documentation.

Key benefit of an SSA: If taxpayer reasonably concluded that the SSA allocated costs on a basis that most reliably reflects RAB shares, IRS is precluded from forcing the taxpayer to use a different allocation key.


Allocating SSA Costs Based on RAB Shares

Costs must be allocated based on RAB shares even if the anticipated benefits do not materialize.

Allocation key selected must provide the most reliable measure of the participants’ RAB shares, under best-method-rule principles. Final Regulations include several examples on selection of most

reliable allocation key – such as headcount, revenues, transactions, etc.

Examples do not provide a bright line % variance, but instead show situations where allocation keys are reasonable / not reasonable.

If there are multiple types of services provided under an SSA, taxpayers should consider whether different allocation keys for different types of services are appropriate.

Allocation must be applied on a consistent basis for all participants and for all services.


Coordination of SSA, SCM, and CSAs

Services which do not qualify for the SCM can be included in an SSA without disqualification, per Notice 2007-5. However, “the flexible rules under the SCM for establishing the joint benefits and selecting the allocation key are inapplicable” to those services, according to the Final Regulations’ preamble.

If a participant in a SSA is also a participant in a CSA, any amount allocated to that participant under the SSA can be further allocated between the intangible development activity and other activities of the participant if it benefits both.

Any amount of a SSA allocation that is allocated to the intangible development activity would then be subject to being further carved up in accordance with the CSA’s method for allocating IDCs.


Intercompany Services and IP Closely Linked

R&D Center

(Country A)

IP HoldCo(Country B)

Alternative Arrangements Key Questions:

Nature of incremental benefits to IP?

How to value the contribution?

___ IRS issued updated IP regs

contemporaneously with the Service regs

Address issues related to services that support IP – either directly or indirectly

Establishes standards when a services arrangement will be respected and when a royalty structure will be asserted

Contract R&D Svc

(NCP)

License

(Royalty)

vs.


Transfers of Intangible Property

§1.482-4(f)(3)

Ownership based on legal rights to IP applicable in relevant jurisdiction

If ‘economic substance’ of the transaction differs from legal rights, written intercompany agreement drives ownership question

If no written agreement, then controlled party who has ‘control’ of the IP will be considered sole owner

§1.482-4(f)(4)

A contribution that enhances the value of IP owned by another is subject to all the rules of 482

If the contribution is embedded in the contractual terms, then no separate charge required

If the contribution is not covered by agreement, then all methods in 482 may be used to value the contribution, and a service charge may be re-characterized as a royalty


Transfer of Intangibles: Economic Substance

For the form of the transaction to be respected, the buyer must have ‘economic substance’ per §1.482-1(d)(3)(iii)

Sufficient means to control risk

Financial capacity to bear risk

Conduct consistent with risk bearing

Without sufficient substance the service charge can be disregarded or re-characterized as a royalty

Key Questions:

What functions lead to ‘control’? Strategic decision making

How many and what types of people? Management personnel

Does the risk have to be managed directly? Generally no


OECD TP Guidelines: Key Points

Maintains a strong endorsement of the Arm’s Length Standard as the primary international framework for transfer pricing

Endorses a ‘Most Appropriate Method” (“MAM”) standard similar to the U.S. “Best Method Rule”

Elevates profit-based methods (profit split, TNMM) to an equal level of transactional methods per the MAM

Portfolio of methods, similar to U.S.

Strongly rejects use of industry averages and broad, large comp sets

Endorses use of regional comp sets where insufficient local comps existOECD has moved closer to the U.S. approach to transfer pricing


Support of the Arm’s Length Standard

Reaffirms strongly its support of the Arm’s Length Standard over ‘Formulary’ approaches

ALS is based on both the conditions that determine the controlled transaction and the profit that derives from the transfer price (§1.7)

Includes provision that the ALS is based on the options realistically available

Similar to U.S. regs, CSA, services, etc.

Some commentators have suggested this gives tax authorities the power to base adjustments on fictional transactions


Profit-based Methods Are Elevated, No Longer A ‘Last Resort’

Previous OECD TPG listed profit based methods as a “last resort”

In Proposed, methods are in a hierarchy similar to the U.S.

Profit methods meet the Most Appropriate Method rule when:

Net margin more reliable than gross margin

Material differences in operating expenses

Unique intangibles owned by both parties => profit split

Limited external data on gross margins

This is still a transactional method – discourages use of company wide data


Transactional Profit Split

Appropriate when intangibles owned by both parties, significant integration economies, or lack of external data

General principles Consistent functional analysis of both parties

Consistent derivation of combined profits and split factors

Consistent type (e.g., RPSM, global profit split, etc.)

Consistent over life of arrangement

Split factors based on: Value of functions performed (~§1.482-6)

Other factors (cost, assets, etc.)

Financial accounts should be used

Rejects ‘BALRM’ equal returns for each party

Discourages use of hindsight to restate split factors


Transactional Net Margin Method

Still similar to U.S. CPM

TNMM requires a two-sided functional analysis

PLIs: Sales, costs, assets. Discourages use of Berry Ratio

May use standard costs instead of actual

For ROA, use or book or market value of assets may be used.

TNMM is still transactional – try to use as narrow a scope as possible rather than company-wide data


Comparability Issues

Regional comparable data sets are acceptable

Strong preference for narrower, smaller and more similar sets than large, broad data sets closer to transactional approaches

Most repeated statement in the Proposed Guidelines

Closer in principle to the transactional approach

Rejects use of industry averages for all comp sets

Endorses limited use of adjustments

No automatic adjustments (e.g., working capital)

Must justify each adjustment per MAM standard


Comparables Search Process

Deductive approach (“Top-Down”)

Start with broad set of SIC codes

Eliminate companies based on comparability criteria

Easy to replicate – dependent on access to tools

Additive approach (“Bottom-Up”)

Identify a list of subject company competitors

Eliminate per screening criteria

Tend to generate more comparable sets – more subjective

All searches must be “Transparent, Systematic and Repeatable”


Conclusion

Final Questions?

tuesday, october 6, 2009 | 1:00 p.m. est

Documents

cost of services

covered services

services cost method

email address

method csm5

profit split method

comparable profits method

tp guidelinestuesday