By Brian D. Lepard, Law Alumni Professor of Law
University of Nebraska College of Law, Lincoln, NE
The final regulations on the treatment of services for transfer pricing purposes under §482, issued in 2009, established a new method for valuing so-called "back office" services, known as the "services cost method" (SCM). The SCM can be very favorable to taxpayers, because it allows these services to be priced at cost, without any markup. This means that taxpayers receiving payments at cost for these services do not run the risk of the IRS adjusting transfer prices upward on audit, resulting in greater tax liability for them. However, taxpayers must meet stringent requirements in order to be eligible to apply the method.
General Principles of the SCM
The SCM is an innovation of the 2009 final regulations on services, appearing in Regs. §1.482-9. These provisions replaced long standing regulations dating back to 1968. Under the former regulations, in the case of services that were not an "integral part" of the business of the service provider or the service recipient, the arm's-length charge was deemed to be equal to "the costs or deductions incurred with respect to such services by the member or members rendering such services unless the taxpayer establishes a more appropriate charge" under the general arm's-length standard for services.1 There were many difficult-to-apply rules regarding the definition of "integral part," with both qualitative and quantitative tests, as well as other problems in administering these rules.
The new SCM was intended to alleviate these difficulties. According to the regulations, the method "evaluates whether the amount charged for certain services is arm's length by reference" to the "total services costs" as defined in Regs. §1.482-9(j) "with no markup."2 The regulations define "total services costs" as "all costs of rendering those services for which total services costs are being determined."3 They indicate that "total services costs include all costs in cash or in kind (including stock-based compensation) that, based on analysis of the facts and circumstances, are directly identified with, or reasonably allocated to" the services in accordance with the allocation principles of Regs. §1.482-9(k)(2).4
The regulations provide that if a taxpayer applies the SCM in accordance with the rules in Regs. §1.482-9(b), then that method "will be considered the best method for purposes of [Regs.] §1.482-1(c)," and the IRS's "allocations will be limited to adjusting the amount charged for such services to the properly determined amount of such total services costs."5 The Treasury Department introduced the method to reduce taxpayers' administrative costs and compliance burdens for services that have low margins, especially where the services involve activities that do not contribute significantly to business success or failure.6
The IRS clarified in Notice 2007-57 that the use of the SCM is not mandatory. Rather, taxpayers may choose to apply either it or one of the other methods provided for in the 2009 services regulations. These are the comparable uncontrolled services price method, the gross services margin method, the cost of services plus method, the comparable profits method, the profit split method, and unspecified methods.8
The regulations provide special rules for the application of the SCM to "shared services arrangements."9 Under the general rule, if the SCM is used to "evaluate the amount charged for covered services," and the services "are the subject of a shared services arrangement, then the arm's length charge to each participant for such services will be the portion of the total costs of the services otherwise determined" under the SCM "that is properly allocated to such participant pursuant to the arrangement."10
Four Requirements for Taxpayers to be Eligible to Use the SCM
Under the 2009 regulations, four requirements must be satisfied with respect to a service for the service to be eligible for application of the SCM.11 First, the service must be a "covered service."12 Second, the service must not be an "excluded activity."13 Third, the service must not be "precluded from constituting a covered service by the business judgment rule" described below.14 And fourth, adequate books and records must be maintained in accordance with certain rules.15 This article now discusses each requirement in turn.
Definition of "Covered Service"
The regulations define "covered service" for purposes of the first requirement as a controlled service transaction or a group of controlled service transactions that fall within the definition of (1) "specified covered services" or (2) "low margin covered services."16
"Specified covered services" are controlled services transactions that the IRS specifies by revenue procedure.17 The regulations provide that services will be included in a revenue procedure based on the IRS's determination "that the specified covered services are support services common among taxpayers across industry sectors and generally do not involve a significant median comparable markup on total services costs."18 The regulations note that the IRS may revise an initial list in a revenue procedure by publishing subsequent revenue procedures, normally with prospective effect only.19
In Announcement 2006-50,20 the IRS published for public comment a proposed revenue procedure containing a list of specified covered services that automatically would be eligible to be priced at cost under the SCM without independent analysis of comparable service providers, so long as the remaining requirements outlined above are met. The IRS stated in Notice 2007-5,21 published the next year, that the list of specified covered services would be expanded and each category would include "other similar activities." The expanded list was issued in Rev. Proc. 2007-13.22 Whereas the proposed revenue procedure contained 48 eligible categories, Rev. Proc. 2007-13 contains 101 categories. The broad headings into which these categories are divided are: payroll; premiums for unemployment, disability, and workers compensation; accounts receivable; account payable; general administrative; corporate and public relations; meeting coordination and travel planning; accounting and auditing; tax; health, safety, environmental and regulatory affairs; budgeting; treasury activities; statistical assistance; staffing and recruiting; training and employee development; benefits; information and technology (IT) services; legal services; insurance claims management; and purchasing.23 Rev. Proc. 2007-13 is generally effective for taxable years beginning after December 31, 2007, while giving taxpayers the option to apply it retroactively to certain taxable years.24 As of November 27, 2012, the IRS has not revised Rev. Proc. 2007-13.
"Low margin covered services" constitute the second category of "covered services." The regulations define them as "controlled services transactions for which the median comparable markup on total services costs is less than or equal to seven percent."25 For this purpose, the "median comparable markup on total services costs" is defined as "the excess of  the arm's length price of the controlled services transaction determined" under the general §482 regulations without regard to Regs. §1.482-9(b), using the interquartile range described in Regs. §1.482-1(e)(2)(iii)(C) (discussed in 551 T.M., Section 482 Allocations: General Principles in the Code and Regulations), and as necessary adjusting to the median of that interquartile range, over  total services costs, expressed as a percentage of total services costs.26 This can be expressed using the following formula:Median Comparable Markup on Total Services Costs = (Arm's Length Price Adjusted to Median of Interquartile Range - Total Services Costs) × Total Services Costs
Accordingly, under the regulations, "if the markup on costs for eligible services is seven percent or less, this category of services can be charged out at cost with no markup."27 The regulations give an example of this definition of low-margin services.28 In the example, the interquartile range of arm's-length markups on total services costs for accounting services is between 3% and 9%, and the median is 6%. The example indicates that because the median comparable markup on total services costs is 6%, which is less than 7%, the accounting services constitute "low margin covered services" within the meaning of Regs. §1.482-9(b)(3)(ii) and therefore are eligible for use of the SCM.
Definition of an "Excluded Activity"
A second requirement for eligibility of a service to be priced under the SCM is that the service in question must not be an "excluded activity." According to the regulations, the following types of activities are excluded activities: (1) manufacturing; (2) production; (3) extraction, exploration, or processing of natural resources; (4) construction; (5) reselling, distribution, acting as a sales or purchasing agent, or acting under a commission or other similar arrangement; (6) research, development, or experimentation; (7) engineering or scientific; (8) financial transactions, including guarantees; and (9) insurance or reinsurance.29
The Business Judgment Rule
The regulations furthermore provide that "a service cannot constitute a covered service unless the taxpayer reasonably concludes in its business judgment that the service does not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure in one or more trades or businesses of the controlled group."30 This is the so-called "business judgment rule." According to the regulations, in "evaluating the reasonableness of the conclusion required by" this rule, "consideration will be given to all the facts and circumstances."31
This business judgment rule is very favorable to taxpayers, as it allows taxpayers to determine the applicability of the SCM without substantial expenditures for comparability studies. The Treasury Department expects that the taxpayer's business judgment will be respected in all but unusual cases.32
The Treasury Department has further noted that the business judgment rule will allow the SCM to be applied to more services, stating: "This provision avoids the need to exclude from the SCM certain back office services that as a general matter and across a range of industry sectors are low margin, but that in the context of a particular business nonetheless constitute high margin services. That is, it permits the Treasury Department and the IRS to include a greater range of service categories under the SCM, even though in specific circumstances an otherwise covered service of a particular taxpayer will be ineligible."33 On the other hand, the reasonableness of a taxpayer's business judgment "may be subject to examination by the IRS in the course of an audit."34
Maintenance of Adequate Books and Records
The fourth requirement for use of the SCM is that adequate books and records be maintained according to specific rules. In particular, according to the regulations, permanent books of account and records must be "maintained for as long as the costs with respect to the covered services are incurred by the renderer."35 These books and records "must include a statement evidencing the taxpayer's intention to apply the [SCM] to evaluate the arm's length charge for such services."36 The books and records must be adequate to permit verification by the IRS "of the total services costs incurred by the renderer."37 They must include "a description of the services in question, identification of the renderer and the recipient of such services, and sufficient documentation to allow verification of the methods used to allocate and apportion such costs to the services in question" in accordance with Regs. §1.482-9(k).38
Opportunities and Challenges for Taxpayers in Applying the SCM
The SCM can be very advantageous for taxpayers, if they can meet the above requirements for its use. It allows low-margin, back office services to be priced at cost, without any markup. However, taxpayers must take steps to meet the four requirements in the regulations. For example, they should be prepared to demonstrate and document that they exercised reasonable business judgment in concluding that a service otherwise eligible to be priced at cost under the SCM does not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure in one or more trades or businesses of their controlled group.
Furthermore, practitioners should ensure that their clients maintain adequate books and records that meet the regulatory tests above and provide the required information if they intend to rely on the SCM. Taxpayers may take some solace in the fact that no particular documentation, for example by an executive officer of the taxpayer, is required to establish satisfaction of the business judgment rule. Rather, the Treasury Department has emphasized that "the business judgment rule is applied on a case-by-case basis and takes into account the taxpayer's facts and circumstances."39 Nevertheless, taxpayers should maintain appropriate books and records based on their unique situation.
For more information, in the Tax Management Portfolios, see Lepard, 551 T.M., Section 482 Allocations: General Principles in the Code and Regulations, Lepard, 552 T.M., Section 482 Allocations: Specific Allocation Methods and Rules in the Code and Regulations, and Lepard, 553 T.M., Section 482 Allocations: Judicial Decisions and IRS Practice, and in Tax Practice Series, see ¶3600, Section 482 - Allocations of Income and Deductions Between Related Taxpayers.
1 Former Regs. §1.482-2(b)(3).
2 Regs. §1.482-9(b)(1).
3 Regs. §1.482-9(j).
5 Regs. §1.482-9(b)(1).
6 See T.D. 9278, 71 Fed. Reg. 44466, 44467 (8/4/06).
7 2007-1 C.B. 269.
8 See Regs. §1.482-9(a).
9 See Regs. §1.482-9(b)(7).
10 Regs. §1.482-9(b)(7)(i).
11 See Regs. §1.482-9(b)(2).
12 See Regs. §1.482-9(b)(2)(i).
13 See Regs. §1.482-9(b)(2)(ii).
14 See Regs. §1.482-9(b)(2)(iii).
15 See Regs. §1.482-9(b)(2)(iv).
16 See Regs. §1.482-9(b)(3).
17 See Regs. §1.482-9(b)(3)(i).
18 Id. (emphasis added).
20 2006-2 C.B. 321.
21 2007-1 C.B. 269, §3.03.
22 2007-1 C.B. 295.
23 See id.
24 See id.
25 Regs. §1.482-9(b)(3)(ii).
27 T.D. 9278, 71 Fed. Reg. 44466, 44467 (8/4/06).
28 See Regs. §1.482-9(b)(8), Ex. 15.
29 Regs. §1.482-9(b)(4).
30 Regs. §1.482-9(b)(5) (emphasis added).
32 See T.D. 9278, 71 Fed. Reg. 44466, 44467 (8/4/06).
34 T.D. 9456, 74 Fed. Reg. 38830, 38832 (8/4/09).
35 Regs. §1.482-9(b)(6).
39 T.D. 9456, 74 Fed. Reg. 38830, 38832 (8/4/09).