In the dawn years of transfer pricing, when the bulk of international trade focused on tangible goods, relatively little attention was devoted to the analysis of transactions involving services. The 1968 U.S. Treasury Regulations governing intercompany services focused on the allocation and apportionment of costs with respect to services undertaken for the benefit of the related parties, roughly in line with the current Services Cost Method, and provided a high level discussion of the services that were an integral part of the business activity of a member of a controlled group without elaborating on the methods to be used to test compliance with the arm's length standard (Section 1.482-2(b) (1968)). In the 1995 Transfer Pricing Guidelines from the Organization for Economic Cooperation and Development ("OECD"), the analysis of pricing of intracompany services occupied a mere 15 pages. In the mid-2000s, there was a renewed focus on the pricing of intercompany services. First to the stage were the U.S. Treasury Regulations in Section 1.482-9 promulgated in August of 2009, followed by several International Practice Units in 2014 through 2017, and then by the OECD with a revised Chapter VII in the 2017 OECD Guidelines. The increased attention is not surprising: over the last 20 years, from 1999 to 2019, the growth of trade in services far outpaced that of tangible goods (215% vs 137% for exports and 199% vs 143% for imports), with particularly robust performance in maintenance and repair, financial, and business services.
Taking advantage of a highly educated workforce outside the United States in countries such as Ireland, some companies have expanded their global reach by setting up service operations in these countries. Often, such service operations are not limited to routine functions. Instead, these new operations provide highly valued services that the company perhaps was unable to access in the United States or that were established pursuant to the company's strategic plan. In many instances, these new operations have significantly propelled the company's global success.
In April 2019, LB&I announced a new "captive services provider campaign," which is designed "to ensure that U.S. multinational companies are paying their captive service providers no more than arm's length prices." This campaign is focused on transactions in which a foreign captive subsidiary performs services exclusively for the parent or other members of the multinational group. As a direct (or indirect) result, IRS Exam teams have been thoroughly auditing these intercompany arrangements.
Highly valued services present similar pricing challenges as highly valued intangibles. For roughly the past 30 years, taxpayers and the IRS have been in perpetual dispute about how to value licensed or cost-shared intangibles. In litigation, taxpayers have generally relied on comparable licenses to value these intangibles, and the IRS has consistently relied on profits-based methods and disputed the comparability of any third-party license to the intercompany arrangement. Now, taxpayers are facing similar issues dealing with intercompany services.
One would think that transfer pricing issues that involve services should be easier and more straightforward to resolve than those concerning intangibles - after all, there are, typically, many more "moving parts" in an intangible valuation than in pricing a service. The Treasury regulations governing intercompany services lay out six specified methods, plus an unspecified method, to price the intercompany services, thereby providing, it would seem, a sufficient range of choices to fit the fact pattern and satisfy any fastidious analyst. The reality, however, is often more complicated.
Highly valued services often carry at least some degree of differentiation from similar services offered by unrelated providers. Such differentiation may come from accumulated knowledge about the enterprise, or from specific experiences of the team members, that make the in-house service more efficient. It may also come from the breadth of performed services relative to a wider (or narrower) scope offered by unrelated providers. Such differentiation may be material enough to require adjustments to the selected comparable set but which may be difficult to implement without an extensive empirical analysis of the pricing of services which, itself, is a challenge given the lack of data transparency that would be required for such an analysis. In certain cases, finding comparables is a hard task - for example, in the case of services addressing unique business requirements of an enterprise where the services are sufficiently rare to warrant the existence of an independent market. Where the good comparables cannot be found, one may have to resort to an unspecified method, or use the available comparables with significant adjustments or modifications in order to arrive at the reliable outcome. The perils of selecting comparables for highly valued services is that IRS Exam Teams may disagree with taxpayers' choices, thereby setting off protracted negotiations that cost the taxpayers time and money. Taxpayers may ultimately find that services are harder to value than hard-to-value intangibles.
In audit, IRS Exam Teams may challenge the taxpayer's position that the services are highly valued and instead may assert that the services at issue are not as valuable as the company had determined. As with intangibles, the IRS Exam Teams may proclaim, among other issues, that comparable agreements are in fact not comparable, that significant adjustments need to be made to the selected comparables, that the taxpayer's method is not the best method, or that functions performed outside the U.S. are routine. IRS Exam Teams are also likely to assert that additional (or embedded) intangibles were part of the service offering and need to be separately valued and compensated for. And, as with intangibles, the burden will be on the taxpayer to show the value that the foreign service operations provide the company and to prove that the intercompany arrangement is consistent with the arm's length standard.
These days, taxpayers also need to be concerned with the tax authority in the service provider's jurisdiction. The other tax authority may take the position that the services were more valuable than reported. As a result, the taxpayer may end up in the untenable position of having to defend its pricing in each jurisdiction without prejudicing it in the other. Depending on the jurisdictions involved, it may be better to seek competent authority relief earlier in the process.
The captive services provider campaign and the ensuing audits of intercompany services that have begun in force may signal the beginning of a new era of transfer pricing disputes between taxpayers and the IRS. With both taxpayers and the IRS having learned lessons from the intangible transfer pricing cases, it may take a heavy lift to resolve these disputes.
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