In September, the IRS proposed important changes to the cross-border transfer pricing rules. The proposal not only tailors existing transfer pricing methods to fit the particular shape of 'service' transactions better, but also shifts analytical emphasis away from a transaction's label and onto its economic characteristics. Greater harmony with OECD rules is intended. Under the new rules, contractual documentation of the respective rights and responsibilities for all kinds of transactions will be critical.
The proposal should also change the way multinational businesses allocate income from intangible property. Although the true dimensions of this conceptual shift remain to be seen, it would require multinationals to identify, isolate and value contributions made by group members to centrally owned intangibles as to well as various rights in the intangibles.
The potential implications of the proposals relating to intercompany services are clearer and pervasive. Multinationals should begin reviewing their intercompany relationships to assess the impact.
Several general changes merit attention. The proposal suggests a more prominent role for the residual profit split method, which has complex contours and implications. In addition, the proposal replaces the familiar 'general benefit' approach for allocating centralized service costs among group members with the OECD's 'specific benefit' approach. Multinationals will need to think less about which services can be charged out than about to which group members, and in what relative amounts, to allocate (and possibly mark up) such costs.
On another front, while ancillary services in a property transfer need not be separately allocated under the current rules, the proposed rules manifest particular sensitivity to multi-element transactions in a hunt for disguised valuable intangibles transfers. In many cases the rules require integrated transactions to be broken apart for separate arm's length evaluations. Deciding which cases require such separation could present a considerable challenge; conducting evaluations of integrated trans-actions, whether or not separated, could present another. A special corroboration rule applies to certain integrated transactions with intangible components (sweepingly defined as transactions that "result in or have an effect similar to a transfer of intangible property"). If the intangible element is "material", it must be evaluated or corroborated under the rules for intangibles.
The proposal's most striking specific change is replacing the familiar 'cost-only' safe harbor with a much narrower "simplified cost-based method" (SCBM) for low-margin services. SCBM requires identifying comparables data for non-core services and significantly com-presses the ability to charge no or low markups on such services. Multinationals will need to consider a new set of definitional issues to determine which, if any, services qualify, and with the reduced benefits may ultimately end up pricing most intercompany services at arm's length rates.
The treatment of loan guarantees has also been changed. Whether they remain "services" (as previously indicated by the IRS) is unclear, but they are categorically excluded from SCBM and thus may not be effectively provided free as under the current cost safe harbor. Given the potential difficulty of valuing guarantees under the arm's length benefit-based standard, multinationals may wish to voice their views on this topic, as well as the implicitly sharper focus on other "benefits" derived from group membership.
The IRS proposal explicitly recognizes that contingent payment arrangements can be an appropriate arm's length way to pay a related party for services. Taxpayers performing independent or contract R&D services (which might otherwise necessitate a high current markup) may find such an arrangement useful, but must be sure to reflect the arrangement in a written contract beforehand.
While the above changes are certainly newsworthy, the expansion of the imputed agreement provision may ultimately have the most impact. The IRS seems to have given itself hindsight carte blanche to recharacterize transactions on the basis of the IRS's view of their underlying economic substance.
Such a change could particularly trouble related parties who change ongoing relationships (by shifting risks, for example), and it could also effectively circumvent the statute of limitations on assessments.
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This article is designed to give general information on the developments covered, not to serve as legal advice related to specific situations or as a legal opinion. Counsel should be consulted for legal advice.
