Key Considerations when Applying the New Service Regulations – Treas. Reg. § 1.482-9T

Stricter customs rules can require different related-party pricing methodology

By Sean F. Foley, Robert D. Baldassarre, and Tamara Berner Gracon of KPMG LLP

The new Temporary Service Regulations released by the IRS under Code Section 482 in July of 2006 (“the Temporary Regulations”) represent a potentially significant change in the way services between related parties are to be priced. As transfer pricing professionals, we have been working with these regulations for the past year. This article highlights certain key provisions in the Temporary Regulations that, in our experience, raise significant issues for companies engaged in related-party services transactions and discusses how these issues can be addressed for tax years beginning after December 31, 2006 (the “2007 tax year”) and beyond. Specifically, the article focuses on 1) documentation requirements when applying the Services Cost Method, 2) recent modifications in the effective date of the Temporary Regulations as addressed in Notice 2007-5 (the “Notice”), 3) the treatment of U.S. headquarter expenses, 4) the inclusion of stock-based compensation in the cost base that must be charged-out under certain methods in the new regulations, and 5) practical applications of contingent-payment service arrangements.

Qualification and Documentation Requirements of the Services Cost Method

In addition to the above qualifications, taxpayers are obliged to fulfill certain documentation requirements to support the SCM election. These new documentation requirements initially created a fair amount of taxpayer confusion. In response, the IRS issued Notice 2007-5, which set forth several clarifications pertaining to the documentation requirements under Treas. Reg. § 1.482-9T(b)(3)(i).

Section 3.02 of the Notice confirms that under the Temporary Regulations the SCM is an elective method and reiterates that a statement evidencing the taxpayer’s intent to apply the SCM is required as a necessary condition when electing to apply the SCM. The statement must be included in the books and records under Treas. Reg. § 1.482-9T(b)(3)(i). Second, the Notice also confirms that there is no requirement for a taxpayer to attach such a statement to its tax return. Finally, Section 3.06 of the Notice clarifies that the documentation and support (books and records) required for services analyzed under the SCM (Treas. Reg. § 1.482-9T(b)(3)(i) need not be generated contemporaneously with the filing of the income tax return.

This last clarification means that supporting SCM documentation, which would include a statement that the taxpayer intended to apply the SCM and any comparable set establishing that the transactions are in fact low margin, can be prepared after the tax return is filed, apparently at any time up to and including a subsequent IRS audit of the year in question. This flexibility surrounding the documentation of the SCM can be useful for taxpayers, but also presents a potential trap for the unwary. For a taxpayer that did not prepare documentation supporting the SCM contemporaneously with the filing of its return, it is helpful that the taxpayer can prepare the necessary documentation to support the application of the SCM as needed, e.g., perhaps even as late as the time of an IRS audit. As long as the IRS agrees on audit that the services are SCM eligible, there may not be tax consequences for delaying the preparation of the SCM documentation. However, should the IRS disagree with characterization of the services as SCM eligible, such non-contemporaneous documentation would not provide penalty protection under Treas. Reg. § 1.6662-6. For that reason, a leading practice may be for a taxpayer to prepare the documentation before it files its tax return to mitigate potential penalty risk, no matter how remote.

Excerpted from the Tax Director's Guide to International Transfer Pricing. To read the rest of this article, please order your copy today.

About the Authors:

Sean F. Foley is the U.S. principal in charge of KPMG’s Global Transfer Pricing Services (GTPS) practice. Robert D. Baldassarre and Tamara Berner Gracon are tax managing directors with the GTPS practice. Foley ( is located in Washington, D.C., Baldassarre ( in Boston, and Gracon ( in Mountain View, Calif. KPMG LLP, the audit, tax and advisory firm (, is the U.S. member firm of KPMG International. KPMG International’s member firms have 113,000 professionals, including more than 6,800 partners, in 148 countries. The views and opinions are those of the authors and do not necessarily represent the views and opinions of KPMG LLP. The information contained herein is general in nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser.

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