SECTION 2. BACKGROUND

The section 482 regulations provide pricing methods for transactions between controlled parties, including transactions involving services. The existing regulations for transactions involving services were issued in 1968. Section 1.482–2(b) of the existing regulations provides a “cost safe harbor” that permits certain “non-integral” services to be priced at cost. In 2003, the Treasury Department and IRS issued proposed regulations that set forth

comments are given full consideration, they should be submitted by October 6, 2006. Despite substantial changes over the past 30 years in the nature of services performed by controlled parties, the existing cost safe harbor for services in current § 1.482–2(b) has not been modified since its original adoption in 1968. The Treasury Department in 2003 issued proposed regulations that set forth a simplified cost based method (SCBM) intended to preserve some benefits of the current § 1.482–2(b) cost safe harbor, such as appropriately reduced administrative and compliance burdens for low margin services. At the same time, the SCBM was intended to bring existing rules more in line with the arm’s length standard and to eliminate some of the problematic features of those rules.

A number of commentators suggested that the SCBM was counterproductive to its stated goals. Namely, commentators contended that to apply the SCBM, taxpayers would potentially need to expend substantial sums to prepare comparability studies, perhaps separately for each of numerous back office services. They contended that, although taxpayers have in-depth knowledge concerning their businesses and the relative value added by their back offices, the SCBM called for quantitative judgments that business people are not qualified to make by themselves, especially in the prevailing compliance environment. As a matter of proper accountability, taxpayers would be required as a practical matter to devote significant compliance resources to enlist outside consultants or otherwise to develop support for those judgments.

In light of the extensive public comments concerning the SCBM, the Treasury Department and the IRS have substantially redesigned the relevant provisions. Recognizing that the section 482 services regulations potentially affect a large volume of intragroup back office services that are common across many industries, it is in the interest of sound tax administration to minimize the compliance burdens applicable to such services, which would typically bear low arm’s length markups.

Accordingly, the temporary and proposed regulations eliminate the SCBM and replace it with the services cost method (SCM), as set forth in § 1.482–9T(b). The

SCM evaluates whether the price for covered services, as defined, is arm’s length by reference to the total services costs with no markup. Where the conditions on application of the method are met, the SCM will be considered the best method for purposes of § 1.482–1(c).

Section 1.482–9T(b)(4) provides for two categories of covered services eligible for the SCM, if the other conditions on application of the method are met. The first category consists of specified covered services identified in a revenue procedure published by the IRS. These specified covered services are so identified because they constitute support services of a type common across industry sectors that generally do not involve a significant arm’s length markup on total services costs. A second category of services, low margin covered services, constitutes services that have a median comparable arm’s length markup on total services costs of less than or equal to 7 percent.

The identification of specific activities that qualify for the SCM as a threshold matter should assist in maintaining appropriately reduced administrative burdens for low margin services. Since the Government has made the initial determination that these specified covered services are eligible to be priced under the SCM, taxpayers may rely upon this listing and need not perform their own independent analysis of comparable service providers.

Although specified covered services cover a wide range of support activities, the Treasury Department and the IRS recognize that the listing may not include the entire universe of low margin services. In the case of other low margin services, taxpayers may seek to demonstrate that the services qualify under the alternative mechanism in § 1.482–9T(b)(4)(ii), as services with a median comparable arm’s length markup on total services costs of less than or equal to 7 percent. Both specified covered services and low margin covered services must also meet the requirements of § 1.482–9T(b)(2) (services that the taxpayer reasonably concludes in its business judgment do not contribute significantly to the fundamental risks of success or failure) and must not be identified in § 1.482–9T(b)(3)(ii) (excluded transactions).

As explained above, this announcement contains an initial listing of specified cov

2006–34 I.R.B. 322 August 21, 2006

covered services are so identified because they constitute support services of a type common across industry sectors that generally do not involve a significant arm’s length markup on total services costs. A second category of services, low margin covered services, not addressed in this revenue procedure have a median comparable arm’s length markup on total services costs of less than or equal to 7 percent.