In August 2006, the IRS issued Temporary (TD 9278 ) and Proposed (REG-146893-02) Regulations that provided a new transfer pricing method applicable to certain controlled services transactions, the services cost method (SCM). (See Albaral, Lemein, Levey, Carmichael, Cromwell, Litsky, McClellan, Nijhof, Williams, Bullington, Yablonicky, and Chivapornthip, “Intercompany Service and Intangible Transactions: Temporary Regulations Respond to Taxpayer Criticisms,”17 JOIT 15 (November 2006) .)

Under specified circumstances, the SCM allows the arm's-length charge for a controlled services transaction to be determined by reference to total services costs, without a markup. Two categories of covered services are potentially eligible for this method — “specified” covered services and “low-margin” covered services, both defined in Temp. Reg. 1.482-9T(b)(4) .

To demonstrate that a particular controlled service qualifies for the SCM, the taxpayer must reasonably conclude, 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 renderer, the recipient or both (“business judgment rule”) (Temp. Reg. 1.482-9T(b)(2) ). Specified covered services are those controlled services that the IRS identifies by means of a Revenue Procedure (discussed below). Low-margin covered services are controlled services transactions for which the arm's-length markup, determined by reference to comparable uncontrolled transactions, is seven percent or less.

Modification of Effective Date

The Temporary and Proposed Regulations are effective for tax years beginning after December 31, 2006 (with retroactive application for tax years beginning after September 10, 2003, at the taxpayer's election) (Temp. Reg. 1.482-9T(n) ). In response to comments, Notice 2007-5 moves the effective date of the Temporary Regulations, as they pertain to the identification of controlled services eligible to be priced at cost, back one year, subject to exceptions. The Temporary Regulations will thus apply to tax years after December 31, 2007, for all provisions related to the SCM in Temp. Reg. 1.482-9T(b) . The only SCM provision that has immediate effect (i.e., for tax years beginning after December 31, 2006) is the business judgment rule in Temp. Reg. 1.482-9T(b)(2) .

Taken from the WG&L Journal of International Taxation.