On July 31 last, US Treasury and Internal Revenue Service (IRS) issued Final, Temporary Rules on Services Treatment Under Section 482, Allocation of Income and Deductions from Intangibles, Stewardship Expense, effective January 1 2007 (the temporary regulations). Effective generally for tax years beginning after December 31 2006, the temporary regulations will replace the current services regulations in Regulations Section 1.482-2(b) that were originally issued in 1968 (the 1968 regulations). The temporary regulations will predominantly follow the regulations that were issued on September 10 2003 (the proposed regulations).

Benefit test: temporary regulations

The definition of a "benefit" is of great importance to the operation of the temporary regulations, because only activities that produce a benefit to the related recipient require (and are allowed) compensation.

For the purposes of the temporary regulations, an activity is generally considered to provide a benefit to the recipient if the activity directly results in a reasonably identifiable increment of economic or commercial value that enhances the recipient's commercial position or may be reasonably anticipated to do so. For these purposes, the term "activity" is given a broad definition. The preamble to the proposed regulations stated that if the anticipated benefit does not accrue, the determination of whether a benefit is present is evaluated by reference to what was reasonable to expect at the time the activity was performed. The temporary regulations indicate further that a benefit is considered to be conferred if the recipient would be willing to pay a third party to perform the services or would have performed the services themselves.

This 'specific benefit' rule is a significant change from the 1968 regulations, which focus on whether the renderer would expect payment.

Benefit test: OECD guidelines/Dutch regulations

By comparison, paragraph 7.6 of the OECD guidelines determines whether intra-group services have been rendered based on the following rule:

There is a clear similarity between the temporary regulations and the OECD guidelines in respect of both the 'economic or commercial value' criterion as well as the 'willingness to pay or perform for itself'-standard. The Dutch transfer pricing regulations (Decree of March 30 2001, no IFZ2001/295M, the 2001 Decree) explicitly refer to both concepts.

Shareholder activities and corresponding expenses: temporary regulations

According to Section 1.482-9T(1)(2)(iv) of the temporary regulations, activities qualify as shareholder (or 'stewardship') activities if:

Shareholder activities are not considered to confer a benefit for related entities and therefore are not chargeable. Quite remarkable is the choice of wording for 'sole', replacing the word 'primary' known from the proposed regulations. This raises a practical problem, since companies may not track costs at a level of detail sufficient to isolate shareholder and non-shareholder activities accurately.

Activities in the nature of day-to-day management of a controlled group are explicitly excluded from the category of shareholder expenses because the temporary regulations do not view such expenses as protecting the renderer's capital investment. Expenses relating to a corporate reorganisation (including payments to outside law firms and investment bankers) could require a charge depending on the application of the benefit test (reference is made to temporary regulations section 1.482-9T(l)(3)(iv)).

The refining of the definition of shareholder costs in the temporary regulations may place taxpayers in a quandary, because the temporary regulations may require greater charge-outs of US headquarters costs than is the practice, while foreign tax authorities may adopt a different standard.

Shareholder activities and corresponding expenses: OECD guidelines/Dutch regulations

Having said that, it may be argued that a similar approach is advocated in paragraph 7.9 of the OECD guidelines, where a shareholder activity is described as one that is performed by a group member "solely because of its ownership interest in one or more other group members". However, it may be observed that the OECD definition focuses more on the reason for performing the activity, while the US approach refers to its effect. The OECD appears to take a similar view to that in the temporary regulations as regards day-to-day management and reorganization costs (see paragraph 7.9 and 7.12 of the OECD guidelines). The Netherlands takes a similar approach, based on the Dutch transfer pricing decrees.

The 2001 decree although it is, in principle, based on the OECD guidelines, does not explicitly address the issue of whether a service should solely benefit the shareholder to qualify as non-chargeable shareholder activities. Instead, it simply sets forth the above-mentioned basic definition that "an intra-group service is an activity performed for a group entity that adds economic or commercial value and for which the group entity concerned would normally have been willing to pay".

However, the 2001 decree was supplemented by the Dutch decree of August 21 2004, no IFZ2004/680M (the 2004 decree). The 2004 decree adopts a pragmatic approach by describing the activities that will be considered to have been performed in the function of shareholder and that, therefore, will not be regarded as group services.

• Activities connected with the company's legal structure.

• Compliance with the requirements of Book 2 of the Dutch Civil Code (for example, preparing annual financial statements and filing them with the local chamber of commerce).

• Compliance with the company's tax obligations under the General Tax Act.

• Activities related to the issuance, placement or splitting of the company's shares or similar notes listed on the bond market, and activities relating to requesting or maintaining the company's stock listing.

• Activities related to the introduction and enforcement of statutory requirements regarding the supervision of securities transactions.

• Activities related to the implementation and enforcement of statutory rules set forth in codes of conduct regarding the company's or the group's corporate governance. A group is considered to be the company and its directly-held and indirectly-held subsidiaries.

• Activities related to reporting to various stakeholders with respect to the company or the group.

According to the 2004 decree, there can also be "mixed" activities, which include activities performed by a division or person operating within the group that partly qualify as chargeable group services and partly as non-chargeable shareholder activities.

Remunerating a service provider: charging at cost

A significant rule introduced in the temporary regulations is a new specified method (in effect a kind of safe harbour rule), which is the services cost method (SCM), which allows covered services to be charged out at cost (that is, without a mark-up). To be a qualifying service under this rule (a so called "covered service") the service must either be specifically identified in an annual revenue procedure or require a median comparable mark-up on total services costs of 7% or less. In this respect, the services identified, in a proposed revenue procedure accompanying the regulations, include those typically referred to as "back office" or "headquarters" services, such as accounting, data entry, human resources, PR, and computer network support.

For services to be eligible for the SCM, taxpayers must reasonably conclude, in their business judgment, that the services do not contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure in either the renderer or the recipient's business.

The temporary regulations also define a list of "excluded transactions," which are not eligible for the SCM. These "blacklisted" transactions include:

• manufacturing

• production

• extraction, exploration, or processing of natural resources

• construction

• reselling, distributing, acting as a sales or purchasing agent, or acting under a commission or other similar arrangement

• research, development or experimentation

• engineering or scientific services

• financial transactions, including guarantees

• insurance or reinsurance

The effect of these categories of excluded transactions is that the SCM will be inapplicable to types of services that the US government considers as core services (such as R&D) and services where costs are not an appropriate reflection of value (such as can be the case with engineering services).

Paragraph 7.37 of the OECD guidelines provides that:

The 2001 decree indicates that remuneration for group services will generally only be considered to be at arm's length if an appropriate profit margin is charged. However, the 2004 decree describes that, on the basis of a cost/benefit analysis consistent with paragraph 7.37 of the OECD guidelines, it may be assessed which supporting services are eligible for a charge at all relevant costs only. In general, services such as bookkeeping, legal affairs, fiscal affairs and human resources can be considered to be such support services. An adjustment may be applied if the Dutch tax authorities are able to demonstrate with respect to the above mentioned services that:

• there are activities that belong to or add more than marginal value to the primary business processes of the group; or

• the respective services are also provided to non-related parties on a more than incidental basis.

With respect to the first bullet point above, whether a primary business process of the group is involved will be determined by the Dutch tax authorities, according to the 2004 decree, on the basis of the actual manner in which the business is carried out. In this assessment, the following aspects are considered to be of importance:

The following activities are generally deemed to belong to the primary business processes, which means that they may not be charged out at cost only:

• production

• purchase

• sales and marketing

• product development and other research and development

Compared with the list of transactions set out in the temporary regulations, the Dutch list of services that may not be charged out at cost only is a lot shorter. This fact, combined with the fact that the qualification of certain services as "core services" under the US rules, or as "primary business processes" under the Dutch rules requires subjective judgment, will, in practice, lead to discussions between the IRS and the Dutch tax authorities.

Remunerating a service provider: charging with a mark-up

The temporary regulations describe the following transfer pricing methods to determine the remuneration for intra-group services:

• Comparable uncontrolled services price method: This method is similar to the comparable uncontrolled price method (CUP) for tangible property transactions.

• Gross services margin method: This method is similar to the resale price method for tangible property transactions.

• Cost of services plus method: This method is similar to the cost plus method for tangible property transactions.

• Comparable profits method (CPM): This method is similar to the transactional net margin method (TNMM), which is equal to the ratio of operating profit to total services costs.

• Profit split method: this method incorporates the regular profit split method rules.

In the US, the "best-method rule" must be applied to select the appropriate (that is, the best) transfer pricing method for intra-group services.

Paragraph 7.31 of the OECD guidelines indicates a 'preference' for the CUP method and the cost plus method for determining an arm's-length charge for intra-group services.

In the Netherlands, taxpayers are generally free to choose a transfer pricing method, provided that the method adopted produces an arm's-length result for the transaction in question. In other words, the Netherlands does not have a best-method rule.

In practice, the net cost-plus method is most commonly used in the Netherlands for establishing arm's-length remuneration for intra-group services. Basically, this is a transactional net margin method analysis with 'net cost plus' as a profit level indicator (that is, operating profit as a percentage of total direct and indirect costs). The TNMM is often regarded as the European equivalent of the US CPM, although differences exist in terms of their practical application.

Delay

The IRS announced on December 20 2006 that mandatory implementation of the services cost method (SCM) won't go into effect until January 1 2008, but that the SCM's business judgement rule will apply beginning 2007. Notice 2007-5 permits taxpayers to continue using through 2007 the non-integral test.

Furthermore, the 2001 decree states that the Netherlands prefers a direct charge method for intra-group services. Taxpayers may also apply an indirect-charge method, if it produces a reliable result, in other words, a price that is commensurate with the arm's-length principle. The relationship with sales, headcount or staffing costs, for instance, might serve as a tool for allocating costs, when using an indirect charge method. An allocation key that depends on profit will not be deemed to be consistent with the arm's-length principle.

Remunerating a service provider: cost basis

Under the temporary regulations, the computation of total services costs is relevant to the CPM and the cost of services plus method. Taxpayers must also compute "total services costs" to apply the SCM. The term "total services costs" first appeared in the proposed regulations and is defined in the temporary regulations to 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".

The temporary regulations include a related requirement that stock option costs should be taken into account as part of the measure of comparability between the tested party and any identified comparable firms. Under the CPM, it is considered relevant that, where the tested party's cost base includes stock-based compensation, the absence of such costs in the cost base of potentially comparable companies would reduce comparability and require an adjustment to include such companies in the analysis.

The OECD guidelines describe that, when using the TNMM, attention should be paid to the fact that a comparable mark-up is applied to a comparable cost basis. In practice, this is also an important consideration for the Dutch tax authorities. The OECD guidelines do not provide any specific guidance regarding the costs that should be taken into account in charging services "at cost" other than that "all relevant costs" should be charged.

In the context of charging out services "at cost", the 2004 decree explains that 'relevant costs' means the direct and indirect costs that relate to the respective support services, including overhead costs. Relevant costs, therefore, also include financing cost and extraordinary expenses, such as hiring and firing expenses, reorganisation costs and benefits in kind. Which costs are relevant should follow from the functional analysis that forms the basis of the taxpayer's transfer pricing system.

The OECD guidelines and the Dutch regulations on service costs contain no specific reference to the costs of stock-based compensation, although the OECD has published in 2004 a study in which this issue is addressed (Employee stock option plans – Impact on Transfer Pricing). In practice, discussions may arise in the Netherlands, as all relevant costs should be included in the cost basis, including the costs of employees. Part of an employee's costs will be its salary, which may include a stock-based compensation element. Recent legislation in the Netherlands ends the (current) deductibility of employee stock options for corporate income tax purposes. The legislation is effective on January 1 2007, subject to a grandfathering rule. It is defensible to argue that US stock option costs if embedded in US service charges will continue to be deductible for Dutch corporate income tax purposes.

Not at one

Under the temporary regulations, the IRS may require US multinationals to charge for many centralised group services provided to foreign affiliates. While in some respects the US approach has been brought more into line with the OECD/Dutch approach, interpretation differences and a lack of clarity may remain.

Where the temporary regulations result in new or increased charges to foreign affiliates, this may result in increased scrutiny and, possibly, resistance from non-US tax authorities and, in the worst case, in double taxation.

Taxpayers may mitigate the potential tax exposures regarding all these issues by keeping detailed global transfer pricing documentation (including, at a minimum, functional analyses and written inter-company agreements) at both ends of the transactions involved, including details on the benefit of the services. The highest degree of certainty will be obtained if advance pricing agreements are concluded with the tax authorities.

Dave Rutges (rutges.dave@kpmg.nl), head of the KPMG global transfer pricing services (GTPS) practice, EMEA;
Eduard Sporken (sporken.eduard@kpmg.nl), senior manager of KPMG GTPS Amstelveen (Netherlands);
Mark Bonekamp (bonekamp.mark@kpmg.nl), KPMG Meijburg & Co
Joost Lagerberg (lagerberg.joost@kpmg.nl), KPMG Meijburg & Co

The authors would like to thank Stephen Blough, principal, KPMG Washington National Tax, GTPS for his contribution to the US aspects of this article.