us-irs-announcements-irb-2006-34-pdf•Internal Revenue Bulletin 2006-34 (PDF rendition): IRS Announcements
Internal Revenue Bulletin 2006-34 (PDF rendition): IRS Announcements
us-irs-announcements-irb-2006-34-pdfInternal Revenue Bulletin 2006-34 (PDF rendition): IRS AnnouncementsGuidance
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Bulletin No. 200 6-34 August 21, 2006 HIGHLIGHTS OF THIS ISSUE These synopses are intended only as aids to the reader in identifying the subject matter covered. They may not be relied upon as authoritative interpretations. INCOME TAX T.D. 9267, page 313. REG–148864–03, page 320. Temporary and proposed regulations under section 6103 of the Code provide additional items of return information disclos- able to the Bureau of Economic Analysis of the Department of Commerce. T.D. 9278, page 256. REG–14689 3–02, page 317. Final, tem porary, and proposed regulations deal with transfer prices in p articular categories of transactions between related parties wi thin the meaning of section 482 of the Code. They provide g uidance regarding services transactions by updating regulati ons under section 482 issued in 1968. The regula- tions add ress determination of ownership of intangible prop- erty amon g related parties under section 482 and allocations with resp ect to “contributions” to the value of intangible prop- erty by a r elated party other than the owner. They also modify the trea tment of stewardship expenses under regulations sec- tion 1.8 61–8. The temporary regulations are effective for tax years be ginning after December 31, 2006. Notice 2006–71, page 316. This notice modifies Notice 2006–53, 2006–26 I.R.B. 1180, by extending the effective date of that publication from June 26, 2006, to December 1, 2006. Announcement 2006–50, page 321. This announcement includes a proposed revenue procedure that identifies particular services that are eligible to be eval- uated at cost according to the temporary regulations relating to services under section 482, which were released concur- rently with this announcement. After receiving comments on the proposed revenue procedure, the Service intends to final- ize the revenue procedure prior to December 31, 2006. ESTATE TAX T.D. 9267, page 313. REG–148864–03, page 320. Temporary and proposed regulations under section 6103 of the Code provide additional items of return information disclos- able to the Bureau of Economic Analysis of the Department of Commerce. GIFT TAX T.D. 9267, page 313. REG–148864–03, page 320. Temporary and proposed regulations under section 6103 of the Code provide additional items of return information disclos- able to the Bureau of Economic Analysis of the Department of Commerce. EMPLOYMENT TAX T.D. 9267, page 313. REG–148864–03, page 320. Temporary and proposed regulations under section 6103 of the Code provide additional items of return information disclos- able to the Bureau of Economic Analysis of the Department of Commerce. (Continued on the next page) Fi nding Lists begin on page ii. T.D. 9278, page 256. REG–146893–02, page 317. Final, temporary, and proposed regulations deal with transfer prices in particular categories of transactions between related parties within the meaning of section 482 of the Code. They provide guidance regarding services transactions by updating regulations under section 482 issued in 1968. The regula- tions address determination of ownership of intangible prop- erty among related parties under section 482 and allocations with respect to “contributions” to the value of intangible prop- erty by a related party other than the owner. They also modify the treatment of stewardship expenses under regulations sec- tion 1.861–8. The temporary regulations are effective for tax years beginning after December 31, 2006. EXCISE TAX T.D. 9267, page 313. REG–148864–03, page 320. Temporary and proposed regulations under section 6103 of the Code provide additional items of return information disclos- able to the Bureau of Economic Analysis of the Department of Commerce. August 21, 20062006–34 I.R.B. The IRS Mission Provide America’s taxpayers top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all. Introduction The Internal Revenue Bulletin is the authoritative instrument of the Commissioner of Internal Revenue for announcing official rulings and procedures of the Internal Revenue Service and for publishing Treasury Decisions, Executive Orders, Tax Conven- tions, legislation, court decisions, and other items of general interest. It is published weekly and may be obtained from the Superintendent of Documents on a subscription basis. Bulletin contents are compiled semiannually into Cumulative Bulletins, which are sold on a single-copy basis. It is the policy of the Service to publish in the Bulletin all sub- stantive rulings necessary to promote a uniform application of the tax laws, including all rulings that supersede, revoke, mod- ify, or amend any of those previously published in the Bulletin. All published rulings apply retroactively unless otherwise indi- cated. Procedures relating solely to matters of internal man- agement are not published; however, statements of internal practices and procedures that affect the rights and duties of taxpayers are published. Revenue rulings represent the conclusions of the Service on the application of the law to the pivotal facts stated in the revenue ruling. In those based on positions taken in rulings to taxpayers or technical advice to Service field offices, identifying details and information of a confidential nature are deleted to prevent unwarranted invasions of privacy and to comply with statutory requirements. Rulings and procedures reported in the Bulletin do not have the force and effect of Treasury Department Regulations, but they may be used as precedents. Unpublished rulings will not be relied on, used, or cited as precedents by Service personnel in the disposition of other cases. In applying published rulings and procedures, the effect of subsequent legislation, regulations, court decisions, rulings, and procedures must be considered, and Service personnel and others concerned are cautioned against reaching the same conclusions in other cases unless the facts and circumstances are substantially the same. The Bulletin is divided into four parts as follows: Part I.—19 86 Code. This part i ncludes rulings and decisions based on provisions of the Intern al Revenue Code of 1986. Part II.—Treaties and Tax Legislation. This part is divided into two subparts as follows: Subpart A, Tax Conventions and Other Related Items, and Subpart B, Leg- islation and Related Committee Reports. Part III.—Administrative, Procedural, and Miscellaneous. To the extent practicable, pertinent cross references to these subjects are contained in the other Parts and Subparts. Also included in this part are Bank Secrecy Act Administrative Rul- ings. Bank Secrecy Act Administrative Rulings are issued by the Department of the Treasury’s Office of the Assistant Sec- retary (Enforcement). Part IV .—Items of General Interest. This par t includes notices of proposed rulemakings, disbar- ment an d suspension lists, and announcements. The last Bulletin for each month includes a cumulative index for the matters published during the preceding months. These monthly indexes are cumulated on a semiannual basis, and are published in the last Bulletin of each semiannual period. The c ontents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate. For sale by the Superintendent of Documents, U.S.Government Printing Office, Washington, DC 20402. 2006–34 I.R.B.August 21, 2006 Place missing child here. August 21, 20062006–34 I.R.B. Part I. Rulings and Decisions Under the Internal Revenue Code of 1986 Section 482.—Allocation of Income and Deductions Among Taxpayers 26 CFR 1.482–1: Allocation of income and deduc- tions among taxpayers. T.D. 9278 DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 31 Treatment of Services Under Section 482; Allocation of Income and Deductions From Intangibles; and Apportionment of Stewardship Expense AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Final and temporary regula- tions. SUMMARY: This document contains fi- nal and temporary regulations that provide guidance regarding the treatment of con- trolled services transactions under section 482 and the allocation of income from intangibles, in particular with respect to contributions by a controlled party to the value of an intangible owned by another controlled party. This document also contains final and temporary regulations that modify the regulations under section 861 concerning stewardship expenses to be consistent with the changes made to the regulations under section 482. These final and temporary regulations poten- tially affect controlled taxpayers within the meaning of section 482. They provide updated guidance necessary to reflect eco- nomic and legal developments since the issuance of the current guidance. DATES:Effective Date:These regulations are effective on January 1, 2007. Applicability Dates:These regulations apply to taxable years beginning after De- cember 31, 2006. FOR FURTHER INFORMATION CONTACT: Thomas A. Vidano, (202) 435–5265, or Carol B. Tan, (202) 435–5265 for matters relating to section 482, or David Bergkuist (202) 622–3850 for matters relating to stewardship ex- penses (not toll-free numbers). SUPPLEMENTARY INFORMATION: Background Section 482 of the Internal Revenue Code generally provides that the Secre- tary may allocate gross income, deduc- tions and credits between or among two or more taxpayers owned or controlled by the same interests in order to prevent eva- sion of taxes or to clearly reflect income of a controlled taxpayer. Regulations un- der section 482 published in theFederal Register(33 FR 5849) on April 16, 1968, provided guidance with respect to a wide range of controlled transactions, including transfers of tangible and intangible prop- erty and the provision of services. Re- vised and updated transfer pricing regula- tions were published in theFederal Reg- ister(59 FR 34971, 60 FR 65553 and 61 FR 21955) on July 8, 1994, Decem- ber 20, 1995, and May 13, 1996. A no- tice of proposed rulemaking and notice of public hearing were published in theFed- eral Register(REG–146893–02, 2003–2 C.B. 967 [68 FR 53448]) on September 10, 2003. A correction to the notice of proposed rulemaking and notice of public hearingwaspublishedintheFederal Reg- ister(Published in the IRB as Announce- ment 2004–7, 2004–1 C.B. 365 [68 FR 70214]) on December 17, 2003. A public hearing was held onJanuary 14, 2004. The Treasury Department and the IRS received a substantial volume of com- ments on a wide range of issues addressed in the 2003 proposed regulations. These comments were very helpful and substan- tial changes have been incorporated in response. In order to achieve the goal of updating the 1968 regulations, while facilitating consideration of further public input in refining finalrules, these regula- tions are issued in temporary form with a delayed effective date for taxable years beginning after December 31, 2006. These regulations are issued a sig- nificant amount of time after proposed revisions to the regulations pertaining to cost sharing arrangements were is- sued. Commentators suggested that this type of timing sequence was important so that each regulation could be assessed properly. Commentators also suggested, among other things, that the services reg- ulations be reissued in temporary and proposed form. By issuing these regula- tions in temporary and proposed form, the Treasury Department and the IRS provide taxpayers an opportunity to submit addi- tional comments prior to the time these regulations become effective, allowing commentators to consider the potential interaction between these regulations and the cost sharing regulations. Explanation of Provisions A. Controlled Services 1. Services Cost Method—Temp. Treas. Reg. §1.482–9T(b) a. The simplified cost based method and public comments The 2003 proposed regulations set forth a simplified cost based method (SCBM). The SCBM was intended to preserve the salutary aspects of thecurrent §1.482–2(b) cost safe harbor that provide appropriately reduced administrative and compliance burdens for low margin services. At the same time, the existing rules would be brought more in line with the arm’s length standard, and various problematic features of those rules would be eliminated. The goal was to provide certainty concerning the pricing of low margin services, thus allowing the compliance efforts of both taxpayers and the IRS to concentrate on those services for which a robust transfer pricing analysis is particularly appropri- ate. The preamble to the 2003 proposed regulations also indicated that in certain cases, the allocation or sharing among group members of expenses or charges relating to corporate headquarters or other centralized service activities may be con- sistent with the proposed regulations, but 2006–34 I.R.B.256August 21, 2006 no further guidance was provided on such service sharing arrangements. A number of commentators argued that the SCBM was actually counterproductive to its stated goals. These commentators contended that to apply the SCBM, tax- payers would potentially need to expend substantial sums to prepare comparability studies, perhaps separately for each of the numerous categories of back office services. They contended that, although taxpayers have in-depth knowledge con- cerning 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. Commentators suggested a range of proposed alternatives to the SCBM regime. One such proposal was simply to return to the approach in the exist- ing regulations under §1.482–2(b). The 1968 regulations are fairly rudimentary in nature, particularly, in today’s tax com- pliance environment. In addition, those regulations were open to substantial ma- nipulation by taxpayers (both inbound and outbound). Moreover, there have been extensive and far-reaching developments in the services economy since the existing regulations were published in 1968, with real prospects that many intragroup ser- vices have values significantly in excess of their cost. As a result, in the course of con- sidering comments on the 2003 proposed regulations, the Treasury Department and the IRS have concluded that it would not be appropriate simply to readopt the stan- dard in the 1968 regulations. Additional proposals by commentators included de- velopment of a list of activities that would qualify to be priced at cost or detailed provisions regarding cost sharing arrange- ments for low value services performed on a centralized basis, and other options. The Treasury Department and the IRS may have decided not to return to the 1968 regulations, but have nonetheless taken the full range of comments on the 2003 pro- posed regulations seriously. Therefore, in light of the extensive comments on these issues, the Treasury Department and the IRS have substantially redesigned the rel- evant provisions. The Treasury Depart- ment and the IRS recognize that the section 482 services regulations potentially affect a large volume of intragroup back office services that are common across many in- dustries. It is in the interest of good tax administration to minimize the compliance burdens applicable to such services, espe- cially to the extent that the arm’s length markups are low and the activities do not significantly contribute to business suc- cess or failure. Accordingly, based on the comments, these temporary regulations eliminate the SCBM and replace it with the ser- vices 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 con- sidered the best method for purposes of §1.482–1(c). b. Services Cost Method: identification of covered services and other eligibility criteria Section 1.482–9T(b)(4) provides for two categories of covered services that are eligible for the SCM if the other con- ditions on application of the method are met. If the conditions are satisfied, cov- ered services in each category may be charged at cost with no markup. The first category consists of specified covered services identified in a revenue procedure published by the IRS. This revenue proce- dure approach is consistent with taxpayer comments. Services will be identified in such revenue procedure based upon the determination of the Treasury Department and the IRS that they constitute support services of a type common across industry sectors and generally do not involve a significant arm’s length markup on total services costs. Because the government performs the analysis necessary to deter- mine the eligibility of specified covered services, the compliance burden that was previously imposed by the SCBM is elim- inated for a broad class of commonly provided services. An initial proposed list of specified covered services is contained in an an- nouncement being published contempora- neously with these temporary regulations. This announcement will be published in the Internal Revenue Bulletin. For copies of the Internal Revenue Bulletin, see §601.601(d)(2)(ii)(b). The Treasury De- partment and the IRS solicit public input on whether the list of services sufficiently covers the full range of back office ser- vices typical within multinational groups, on the descriptions provided for these cov- ered services, and on other matters related to the announcement. It is contemplated that a final revenue procedure, reflecting appropriate comments, will be issued to coincide with the effective date of the temporary regulations for taxable years beginning after December 31, 2006. In the future, particular services may be added to, clarified in, or deleted from the list, depending on ongoing developments. The second category of covered ser- vices is certain low margin covered ser- vices. Taxpayers objected to the require- ment under the SCBM that all services qualify for that method based on a quanti- tative analysis, but based on comments the Treasury Department and the IRS believe that controlled taxpayers might nonethe- less want the discretion to show that par- ticular services—not otherwise covered by the revenue procedure—qualify for the SCM, using a modified quantitative approach. Low margin covered services consist of services for which the median comparable arm’s length markup on to- tal services costs is less than or equal to seven percent. As under the SCBM, the median comparable arm’s length markup on total services costs means the excess of the arm’s length price of the controlled services transaction over total services costs, expressed as a percentage of total services costs. For this purpose, the arm’s length price is determined under the gen- eral transfer pricing rules without regard to the SCM, using the interquartile range (including any adjustment to the median in the case of results outside such range). Again, if the markup on costs for eligible services is seven percent or less, this cate- gory of services can be charged out at cost with no markup. Under §1.482–9T(b)(2), specified cov- ered services or low margin covered ser- vices otherwise eligible for the SCM will qualify for the method if the taxpayer reasonably concludes in its business judg- ment that the services do not contribute August 21, 20062572006–34 I.R.B. significantly to key competitive advan- tages, core capabilities, or fundamental chances of success or failure in one or more trades or businesses of the renderer, the recipient, or both. Unlike the quantita- tive judgment called for under the SCBM, this is a business judgment preeminently within the business person’s own exper- tise. Exact precision is not needed and it is expected that the taxpayer’s judgment will be accepted in most cases. This con- dition is intended to focus transfer pricing compliance resourcesof both taxpayers and the IRS principally on significant val- uation issues. Thus, it is anticipated that in most cases the examination of relevant services will focus only on verification of total services costs and their appropriate allocation. These are issues even under the 1968 regulations. There will be little need in all but the most unusual cases to chal- lenge the taxpayer’s reasonable business judgment in concluding that such typical back office services donot contribute sig- nificantly to fundamental risks of success or failure. The condition effectively is reserved to allow the IRS to reject any attempt to claim that a core competency of the taxpayer’s business qualifies as a mere back office service. For illustrations of the role performed by this condition, see the contrasting pairs ofExample 1 andExample 2,Example 3andExample 4,Example 5andExample 6,Example 8 andExample 9,Example 10andExample 11,andExample 12andExample 13in §1.482–9T(b)(6). As indicated in this preamble, it is ex- pected that in all but unusual cases, the taxpayer’s business judgment will be re- spected. In evaluating the reasonableness of the taxpayer’s conclusion, the Commis- sioner will consider all the relevant facts and circumstances. This provision avoids the need to exclude from the SCM cer- tain back office services that as a general matter and across a range of industry sec- tors are low margin, but that in the context of a particular business nonetheless consti- tute high margin services. That is, it per- mits the Treasury Department and the IRS to include a greater range of service cate- gories under the SCM, even though in spe- cific circumstances an otherwise covered service of a particular taxpayer will be in- eligible. In addition, under §1.482–9T(b)(3)(i), a single procedural requirement applies un- der the SCM. The taxpayer must maintain documentation of covered services costs and their allocation. The documentation must include a statement evidencing the taxpayer’s intention to apply the SCM. In §1.482–9T(b)(3)(ii), the SCM pre- serves the same list of categories of con- trolled transactions that are not eligible to be priced under the method as under the SCBM. The Treasury Department and the IRS continue to believe that these trans- actions tend to be high margin transac- tions, transactions for which total services costs constitute an inappropriate reference point, or other types of transactions that should be subject to a more robust arm’s length analysis under the general section 482 rules. Comments are requested in this regard in light of the other substantial changes made in the regulations. Consistent with the purpose of provid- ing for appropriately reduced compliance burdens for services subject to the SCM, the temporary regulations retain provi- sions in §1.6662–6T(d)(2) similar to those associated with the SCBM. c. Shared services arrangements Section 1.482–9T(b)(5) of the tempo- rary regulations provides explicit guidance on shared services arrangements (SSAs). In general, an SSA must include two or more participants; must include as partici- pants all controlled taxpayers that benefit from one or more covered services sub- ject to the SSA; and must be structured such that each covered service (or group of covered services) confers a benefit on at least one participant. A participant is a controlled taxpayer that reasonably antic- ipates benefits fromcovered services sub- ject to the SSA and that substantially com- plies with the SSA requirements. Under an SSA, the arm’s length charge to each participant is the portion of the total costs of the services otherwise determined under the SCM that is properly allocated to such participant under the arrangement. For purposes of an SSA, two or more cov- ered services may be aggregated, provided that the aggregation is reasonable based on the facts and circumstances, including whether it reasonably reflects the relative magnitude of the benefits that the partic- ipants reasonably anticipate from the ser- vices in question. Such aggregation may, but need not, correspond to the aggregation used in applying other provisions of the SCM. If the taxpayer reasonably concludes that the SSA (including any aggregation for purposes of the SSA) results in an al- location of the costs of covered services that provides the most reliable measure of the participants’ respective shares of the reasonably anticipated benefits from those services, then the Commissioner may not adjust such allocation basis. In addition, as a procedural matter, the taxpayer must maintain documentation concerning the SSA, including a statement that it intends to apply the SCM under the SSA and information on the participants, the allocation basis, and grouping of ser- vices for purposes of the SSA. Guidance is also provided on the coordination of cost allocations under an SSA and cost allocations under a qualified cost sharing arrangement. d. Deleted provisions The SCM is considerably streamlined as compared to the SCBM. Upon further consideration, and in light of public com- ments, many of the conditions, contractual requirements, quantitative screens, and other technicalities associated with the SCBM have been eliminated. The Trea- sury Department and the IRS believe this streamlined approach serves the interests of both the government and taxpayers by reducing complexity and administrative burden. 2. Comparable Uncontrolled Services Price Method—Temp. Treas. Reg. §1.482–9T(c) The 2003 proposed regulations set forth the comparable uncontrolled services price (CUSP) method. This method evaluated whether the consideration in a controlled services transaction is arm’s length by comparison to the price charged in a com- parable uncontrolled services transaction. This method was closely analogous to the comparable uncontrolled price (CUP) method in existing §1.482–3(b). One commentator objected to the state- ment in §1.482–9(b)(1) of the 2003 pro- posed regulations that, to be evaluated under the CUSP method, a controlled ser- vice ordinarily needed to be “identical to or have a high degree of similarity” to the uncontrolled comparable transactions. The commentator viewed the comparabil- 2006–34 I.R.B.258August 21, 2006 ity analysis in the examples in proposed §1.482–9(b)(4) as more consistent with the standard in existing §1.482–3(b)(2)(ii)(A). The Treasury Department and the IRS agree that the comparability standards un- der the CUSP method for services should run parallel to those under the CUP method for sales of tangible property. Indeed, the provisions are parallel. The commentator misconstrues the purpose of the quoted provision. Although the provision contains gen- eral guidance on situations in which the method ordinarily applies, it is not in- tended to and does not alter the substan- tive comparability standards. Just like the CUP method, the standards under the CUSP method emphasize the rela- tive similarity of the controlled services to the uncontrolled transaction and the presence or absence of nonroutine intan- gibles. Section 1.482–9T(c)(2)(ii) of the temporary regulations also provides, con- sistent with the best method rule, that the CUSP method generally provides the most direct and reliable measure of an arm’s length result if the uncontrolled transac- tion either has no differences from the controlled services transaction or has only minor differences that have a definite and reasonably ascertainable effect on price, and appropriate adjustments may be made for such differences. If such adjustments cannot be made, or if there are more than minor differences between the controlled and uncontrolled transactions, the compa- rable uncontrolled services price method may be used, but the reliability of the results as a measure of the arm’s length price will be reduced. Further, if there are material differences for which reliable adjustments cannot be made, this method ordinarily will not provide a reliable mea- sure of an arm’s length result. The CUSP provisions in these tempo- rary regulations are substantially similar to the corresponding provisions in the 2003 proposed regulations. 3. Gross Services Margin Method—Temp. Treas. Reg. §1.482–9T(d) The 2003 proposed regulations pro- vided for a gross services margin method, which evaluated the amount charged in a controlled services transaction by refer- ence to the gross services profit margin in uncontrolled transactions that involve sim- ilar services. The method was analogous to the resale price method for transfers of tangible property in existing §1.482–3(c). Under the 2003 proposed regulations, this method would ordinarily be used where a controlled taxpayer performs activities in connection with a “related un- controlled transaction” between a member of the controlled group and an uncon- trolled taxpayer. For example, the method may be used where a controlled taxpayer renders services to another member of the controlled group in connection with a transaction between that other member and an uncontrolled party (agent ser- vices), or where a controlled taxpayer contracts to provide services to an uncon- trolled taxpayer and another member of the controlled group actually performs the services (intermediary function). The 2003 proposed regulations defined the terms “related uncontrolled transac- tion,” “applicable uncontrolled price,” and “appropriate gross services profit”. A “related uncontrolled transaction” is a transaction between a member of the controlled group and an uncontrolled tax- payer for which a controlled taxpayer performs either agent services or an in- termediary function. The “applicable uncontrolled price” is the sales price paid by the uncontrolled party in the related uncontrolled transaction. The “appropri- ate gross services profit” is the product of the applicable uncontrolled price and the gross services profit margin in comparable uncontrolled services transactions. The gross services profit margin takes into account all functions performed by other members of the controlled group and any other relevant factors. One commentator mistakenly inter- preted the term “related uncontrolled transaction” to suggest that the compara- ble transaction under this method is one that takes place between controlled parties. While this was not intended, the Treasury Department and the IRS agree that the nomenclature is potentially confusing, and as a result, these regulations substitute the term “relevant uncontrolled transaction” in lieu of “related uncontrolled transac- tion” wherever that appeared. In other respects, the gross services margin provi- sions in these temporary regulations are substantially similar to the provisions in the 2003 proposed regulations. 4. Cost of Services Plus Method—Temp. Treas. Reg. §1.482–9T(e) The 2003 proposed regulations set forth the cost of services plus method. This method evaluated the amount charged in a controlled services transaction by refer- ence to the gross services profit markup in comparable uncontrolled services trans- actions. The gross services profit is de- termined by reference to the markup as a percentage of comparable transactional costs in comparable uncontrolled transac- tions. This method would ordinarily ap- ply where the renderer of controlled ser- vices provides the same or similar services to both controlled and uncontrolled par- ties. In general, those are the only cir- cumstances in which a controlled taxpayer would likely have the detailed information concerning comparabletransactional costs necessary to apply this method reliably. The cost of services plus method in the 2003 proposed regulations was gen- erally analogous to the cost plus method for transfers of tangible property in exist- ing §1.482–3(d). The method implicitly recognized that financial accounting stan- dards applicable to services have not developed to the same degree as the stan- dards applicable to other categories of transactions, such as manufacturing or distribution of tangible property. For that reason, the method adopted the concept of “comparable transactional costs,” which the 2003 proposed regulations defined as all costs of providing the services taken into account in determining the gross services profit markup in comparable un- controlled services transactions. In this context, comparable uncontrolled transac- tions could be either services transactions between the controlled taxpayer and un- controlled parties (internal comparables), or services transactions between two un- controlled parties (external comparables). The 2003 proposed regulations also recognized that comparable transactional costs could be a subset of total services costs. Generally accepted accounting principles (GAAP) or Federal income tax accounting rules (if income tax data for comparable uncontrolled transactions are available) could provide an appropriate platform for analysis under this provision, but neither is necessarily conclusive. Commentators objected that the con- cept of comparable transactional costs was August 21, 20062592006–34 I.R.B. imprecise, and they suggested that such costs should in any event include only the direct costs associated with providing a particular service, as determined under GAAP or Federal income tax account- ing rules. As noted above, the financial accounting standards for services transac- tions are not as precise as the standards applicable to other types of transactions. The relative lack of uniformity in turn makes it impractical to derive a single def- inition of cost that would apply generally to controlled services transactions. Comparable transactional costs may potentially include direct and indirect costs, if such costs are included in the internal or external uncontrolled transac- tions that form the basis for comparison. Section 1.482–9T(e)(4)Example 1has been modified to clarify this concept. Several commentators objected to §1.482–9(d)(3)(ii)(A) of the 2003 pro- posed regulations. In their view, this provision required the results obtained under the cost of services plus method to be confirmed by means of a separate analysis under the comparable profits method (CPM) for services. If a confirm- ing analysis under the CPM for services were required in all cases, commentators reasoned, the cost of services plus method could not be viewed as a specified method in its own right. The Treasury Department and the IRS agree and clarify that the intent of the rules is not to require confirmation of the results under the cost of services plus method. In response to public comments, §1.482–9T(e)(3)(ii)(A) of these temporary regulations incorporates several changes. First, restatement of the price under this method in the form of a markup on total costs of the controlled taxpayer is nec- essary only if the cost of services plus method utilizes external comparables. If internal comparables are used, this calcu- lation need not be performed. Second, in situations where the price is restated, the sole purpose is to determine whether it is necessary to perform additional evaluation of functional comparability. For example, if the price under the cost of services plus method, when restated, in- dicates a markup on the renderer’s total services costs that is either low or negative, this may indicate differences in functions that have not been accounted for under the traditional comparability factors. A low or negative markup suggests the need for additional inquiry, the outcome of which may suggest that the cost of services plus method is not the most reliable measure of an arm’s length result under the best method rule. Conforming changes have been made in §1.482–9T(e)(4)Example 3 of these temporary regulations. 5. Comparable Profits Method for Services—Temp. Treas. Reg. §1.482–9T(f) The 2003 proposed regulations pro- vided for a Comparable Profits Method (CPM) for services, which was similar to the CPM in existing §1.482–5. In general, the CPM for services evaluated whether the amount charged in a con- trolled services transaction is arm’s length by reference to objective measures of prof- itability (profit level indicators or PLIs) derived from financial information regard- ing uncontrolled taxpayers that engage in similar services transactions under similar circumstances. The CPM for services ap- plied only where the renderer of controlled services is the tested party. Section 1.482–9(e) of the 2003 pro- posed regulations provided that the profit level indicators (PLIs) provided for in ex- isting §1.482–5(b)(4)(ii) may also be used under the CPM for services. The relative lack of uniformity in financial accounting standards for services, combined with po- tentially incomplete information regarding the cost accounting practices of the uncon- trolled comparables, strongly suggest that PLIs that require accurate segmentation of costs may have limited reliability. The 2003 proposed regulations stated that the degree of consistency in account- ing practices between the controlled ser- vices transaction and the uncontrolled ser- vices transaction mightaffect the reliabil- ity of the results under the CPM for ser- vices. If appropriate adjustments to ac- count for such differences are not possi- ble, the reliability of the results under this method will be reduced. Section 1.482–9(e)(2)(ii) of the 2003 proposed regulations provided for a new profit level indicator that may be particu- larly useful for controlled services trans- actions: the ratio of operating profits to total services costs, or the markup on to- tal costs (also referred to as the “net cost plus”). Because this profit level indicator evaluates operating profits by reference to the markup on all costs related to the pro- vision of services, it is more likely to use a cost base of the tested party that is compa- rable to the cost base used by uncontrolled parties in performing similar business ac- tivities. The Treasury Department and the IRS received a number of comments concern- ing the CPM for services. Commentators questioned whether the definition of “total services costs,” whichprovides the net cost plus cost base under the CPM for services, included stock-based compensation. In re- sponse to these comments, the Treasury Department and the IRS clarify their in- tent that §1.482–5(c)(2)(iv) of the existing regulations apply to the CPM for services. Accordingly, newExample 3,Example 4, Example 5,andExample 6are included in §1.482–9T(f)(3) of these temporary regu- lations. These examples show the applica- tion of existing §1.482–5(c)(2)(iv) to fact patterns that involve differences in the uti- lization of or accounting for stock-based compensation in the context of controlled services transactions. One commentator expressed reserva- tions concerning a statement in the pre- amble to the 2003 proposed regulations, which indicated that PLIs based on return on capital or assets might be unreliable for controlled services because the reliability of these PLIs decreases as operating assets play a less prominent role in generating operating profits. This commentator con- tended that such PLIs are reliable for all firms, including service providers. The Treasury Department and the IRS clarify that, although return on capital PLIs may produce reliable results in the case of cer- tain service providers, in general, such PLIs are subject to the general reservation in existing §1.482–5(b)(4)(i) to the effect that the reliabilityof such PLIs increases as operating assets play a greater role in general operating profits. Aside from the addition of the exam- ples described above, the CPM for services provisions in these temporary regulations are substantially similar to the provisions in the 2003 proposed regulations. 6. Profit Split Method—Temp. Treas. Reg. §§1.482–9T(g) and 1.482–6T(c)(3)(i)(B) The 2003 proposed regulations pro- vided additional guidance concerning 2006–34 I.R.B.260August 21, 2006 application of the comparable profit split and the residual profit split methods to controlled servicestransactions. Gen- erally, these methods evaluated whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is arm’s length by reference to the relative value of each controlled taxpayer’s contributions to the combined operating profit or loss. The 2003 proposed regulations provided that the guidance regard- ing the profit split methods in exist- ing §1.482–6, as amended by pro- posed §1.482–6(c)(3)(i)(B) and by other changes, applied to controlled services transactions. Section 1.482–9(g) of the 2003 proposed regulations also provided specific additional guidance concern- ing application of existing §1.482–6, as amended, to controlled services transac- tions. The Treasury Department and the IRS received numerous comments on the profit split method. Commentators objected in particular to references in the 2003 pro- posed regulations to “interrelated” trans- actions in §1.482–6(c)(3)(i)(B)(1), and to “high-value services” and “highly in- tegrated transactions” in §1.482–9(g)(1). Commentators viewed these terms as vague and subjective. Commentators also sought more specific guidance concerning the circumstances in which the resid- ual profit split method would constitute the best method under the principles of existing §1.482–1(c). In addition, some commentators suggested that one hallmark of a nonroutine contribution in the context of controlled services is that the renderer bears substantial risks. Another com- mentator suggested that the arm’s length compensation for afunction performed by an employee or group of employees should not in any event be evaluated under a profit split method. In this commen- tator’s view, such an activity should be classified as routine because the market return for the function is equivalent to the total compensation paid to the employees. Commentators also raised several objec- tions to the factual assumptions in the pro- posed analysis concerning §1.482–9(g)(2) Example 2of the 2003 proposed regula- tions. The Treasury Department and the IRS agreed with a number of comments and, as a result, have made substantial changes to these provisions. Under these temporary regulations, all references to “interrelated” transactions in §1.482–6(c)(3)(i)(B)(1), as well as references to “high-value ser- vices” and “highly integrated transac- tions” in §1.482–9(g)(1) have been elimi- nated. Section 1.482–9T(g)(1) now states that the profit split method is “ordinar- ily used in controlled services transac- tions involving a combination of nonrou- tine contributions by multiple controlled taxpayers.” This change from the 2003 proposed regulations (which referred to “high-value” or “highly-integrated” transactions), conforms to the changes to §1.482–6T(c)(3)(i)(B)(1), as described below. Section 1.482–6T(c)(3)(i)(B)(1) of these temporary regulations defines a non- routine contribution as “a contribution that is not accounted for as a routine con- tribution.” In other words, a nonroutine contribution is one for which the return cannot be determined by reference to market benchmarks. Importantly, in this context, the term “routine” does not nec- essarily signify that a contribution is low value. In fact, comparable uncontrolled transactions may indicate that the returns to a routine contribution are very signifi- cant. In response to the comments and in accordance with the revised definition of nonroutine contribution in these temporary regulations, the following references were eliminated as unnecessary: (1) contribu- tions not fully accounted for by market returns; and (2) contributions so interre- lated with other transactions that they can- not be reliably evaluated on a separate ba- sis. These changes will bring added clarity to the temporary regulations. The Treasury Department and the IRS believe that these revised provisions re- spond to the public comments and offer more specific guidance concerning the circumstances in which the profit split method would likely constitute the best method under existing §1.482–1(c). In particular, the term “high-value” is not included in temporary §1.482–9T(g)(1), thus eliminating any implication that the profit split method is a “default” method for controlled services that have value significantly in excess of cost. This shift in emphasis is also reflected in section B.2 of this preamble, which describes the deletion of language from several exam- ples that some believed suggested that the residual profit split is a default method. The clear intent is that no method, includ- ing the profit split, is a default method for purposes of the best method rule. Rather, the profit split method applies if a con- trolled services transaction has one or more material elements for which it is not possible to determine a market-based return. The Treasury Department and the IRS believe that the above changes ad- dress the comments made and so do not believe that it is necessary for the regu- lations to adopt alternative definitions of nonroutine contribution put forward by commentators, such as definitions based on the degree of risk borne by the renderer of services or the extent to which an ac- tivity is performed solely by employees of the taxpayer. Finally, based on the public comments, and in light of the changes described in this preamble, §1.482–9(g)(2)Example 2 of the 2003 proposed regulations has been withdrawn and replaced by a new exam- ple that more effectively illustrates appli- cation of the profit split method to nonrou- tine contributions by multiple controlled parties. 7. Unspecified Methods—§1.482–9T(h) The 2003 proposed regulations pro- vided that an unspecified method may provide the most reliable measure of an arm’s length result under the best method rule. Such an unspecified method must take into account thatuncontrolled tax- payers compare the terms of a particular transaction to the realistic alternatives to that transaction. No significant comments were received concerning the unspecified method pro- visions. Consistent with the general aim to coordinate the analyses under the var- ious sections of the regulations under section 482 so that economically similar transactions will be evaluated similarly, however, §1.482–9T(h) has been modified to provide that in applying an unspec- ified method to services, the realistic alternatives to be considered include “eco- nomically similar transactions structured as other than services transactions.” This provision allows flexibility to consider non-services alternatives to a services transaction, for example, a transfer or li- cense of intangible property, if such an ap- August 21, 20062612006–34 I.R.B. proach provides the most reliable measure of an arm’s length result. The Treasury Department and the IRS are considering similar changes to §§1.482–3(e)(1) and 1.482–4(d)(1) of the existing regulations. Public comments are requested regarding the advisability of such changes and the form they should take. Aside from this change, the unspecified method provi- sions in these temporary regulations are substantially similar to the provisions in the 2003 proposed regulations. 8. Contingent-Payment Contractual Terms—Temp. Treas. Reg. §1.482–9T(i) The contingent-payment contractual term provisions in the 2003 proposed reg- ulations built on the fundamental principle that, in structuring controlled transactions, taxpayers are free to choose from among a wide range of risk allocations. This provi- sion in the 2003 proposed regulations also acknowledged that contingent-payment terms—terms requiring compensation to be paid only if specified results are ob- tained—may be particularly relevant in the context of controlled services trans- actions. The 2003 proposed regulations provided detailed guidance concerning contingent-payment contractual terms, including economic substance consider- ations as well as documentation require- ments. Under §1.482–9(i)(2) of the 2003 pro- posed regulations, acontingent-payment arrangement was given effect if it met three basic requirements: (1) the arrangement is contained in a written contract executed prior to the start of the activity; (2) the con- tract makes payment contingent on a future benefit directly related to the outcome of the controlled services transaction; and (3) the contract provides for payment on a ba- sis that reflects the recipient’s benefit from the services rendered and the risks borne by the renderer. Commentators generally supported the contingent-payment terms provision as providing guidance concerning a contrac- tual structure with particular relevance to controlled services transactions. However, they also raised three fundamental con- cerns regarding the scope and operation of this provision. First, the commentators questioned whether controlled taxpay- ers would need to identify uncontrolled comparables for any contingent-payment terms that they seek to adopt. Second, they pointed out that certain references to economic substance provisions and documentation requirements were either unclear or duplicative of provisions in ex- isting §1.482–1(d)(3). Third, commenta- tors expressed concern that the IRS might improperly impute contingent-payment terms as a means of addressing erroneous transfer pricing in situations that do not involve lack of economic substance, for example, non-arm’s length pricing of ac- tivities such as marketing or research and development. The temporary regulations respond to each of these concerns. First, under §1.482–9(i)(1) of the 2003 proposed reg- ulations, one factor that needed to be considered was whether an uncontrolled taxpayer would have paid a contingent fee if it engaged in a similar transac- tion under comparable circumstances. In response to comments, the temporary regulations eliminate this requirement and instead emphasize the importance of the economic substance principles under §1.482–1(d)(3) of the existing regulations. That is, whether a particular arrange- ment entered into by controlled parties has economic substance is not determined by reference to whether it corresponds to arrangements adopted by uncontrolled parties. Second, in response to comments, the temporary regulations eliminate du- plicative or unnecessary references to the economic substance rules. For example, §1.482–9T(i)(2)(ii) has been modified to provide that the contingent-payment arrangement as a whole, including both the contingency and the basis of pay- ment, must be consistent with economic substance, as evaluated under existing §1.482–1(d)(3)(ii)(B). This section elimi- nates the additional requirement under the 2003 proposed regulations, that the arm’s length charge under a contingent-payment arrangement must be evaluated by refer- ence to economic substance principles. Third, the temporary regulations re- spondtotheconcernidentifiedbycom- mentators that the IRS might apply the contingent-payment provisions in an inap- propriate manner, for example, to correct erroneous transfer pricing in prior taxable years that are not under examination. As discussedinmoredetailinsectionCof this preamble, the temporary regulations include an example to illustrate factual circumstances in which contractual terms pertaining to risk allocations (provided they are otherwise consistent with taxpay- ers’ conduct and arrangements) are fully respected, notwithstanding that on exam- ination the activities were determined to have been priced on a non-arm’s length basis. Other concerns, relating to inter- action of the contingent-payment terms provision with the commensurate with income standard, are also addressed in section C of this preamble. New §1.482–9T(i)(5)Example 3illus- trates the application of these rules to a situation in which the contingency identi- fied in a contingent-payment provision is not satisfied. The example responds to a request by commentators for additional guidance to address such a factual sce- nario. 9. Total Services Costs—Temp. Treas. Reg. §1.482–9T(j) Section 1.482–9(j) of the 2003 pro- posed regulations defined “total services costs” for purposes of the SCBM, the CPM for services, and the cost of services plus method where the gross services profit was restated in the form of a markup on total services costs. Under the 2003 proposed regulations, total services costs included all costs di- rectly identified with provision of the con- trolled services, as well as all other costs reasonably allocable to such services un- der §1.482–9(k). The Treasury Depart- ment and the IRS intended that, in this context, “costs” must comprise provision for all resources expended, used, or made available to render the service. Generally accepted accounting principles (GAAP) or Federal income tax accounting rules may provide an appropriate analytic platform, but neither would necessarily be conclu- sive in evaluating whether an item must be included in total services costs. The issue of determining total services costs is not a new one; it is relevant under the current 1968 regulations as well. Commentatorsobjectedthat §1.482–9(j) of the 2003 proposed regulations failed to list the specific items that were included in total services costs. Some commentators suggested that, ab- sent more precise guidance in this regard, controlled taxpayers should be permitted 2006–34 I.R.B.262August 21, 2006 to rely on the definition of costs applicable under GAAP or Federal income tax principles. Commentators also requested clarification whethertotal services costs included stock-based compensation. The Treasury Department and the IRS view the definition of total services costs in the 2003 proposed regulations as having struck the correct balance between speci- ficity and flexibility. In general, the ac- counting standards applicable to services do not provide a uniform means of deter- mining all costs that relate to the provision of services. Consequently, the Treasury Department and the IRS conclude that total services costs for purposes of section 482 cannot be determined solely by reference to GAAP or other accounting standards or practices. In response to comments, however, §1.482–9T(j) of the temporary regula- tions clarifies that all contributions in cash or in kind (including stock-based com- pensation) are included in total services costs. In addition, the third sentence of §1.482–9T(j) states that “costs for this purpose should comprise provision for all resources expended, used, or made avail- able to achieve the specific objective for which the service is rendered.” To bet- ter reflect, for example, the inclusion of stock-based compensation in total services costs, the term “provision” is adopted in place of the term “consideration” as used in the 2003 proposed regulations. Commentators also observed that the definition of total services costs in the 2003 proposed regulations did not ad- dress situations in which the costs of a controlled service provider include sig- nificant charges from uncontrolled par- ties. Commentators posited that such third-party costs should be permitted to “pass through,” rather than being subject to a markup under the transfer pricing method used to analyze the controlled services transaction. The Treasury De- partment and the IRS agree that these comments raised an issue that needs to be addressed, but decided to do so in a manner different from that suggested by the commentators. In response to this comment, the temporary regulations add §1.482–9T(l)(4), which under certain cir- cumstances allows a controlled services transaction that involves third-party costs to be evaluated on a disaggregated basis. See section A.11.e of this preamble. 10. Allocation of Costs—Temp. Treas. Reg. §1.482–9T(k) Section 1.482–9(k) of the 2003 pro- posed regulations retained the flexible ap- proach of existing §1.482–2(b)(3) through (6), which permitted taxpayers to use any reasonable allocation and apportionment of costs in determining an arm’s length charge for services. In evaluating whether the allocation used by the taxpayer is ap- propriate, the 2003 proposed regulations required that consideration be given to all bases and factors, including practices used by the taxpayer to apportion costs for other (non-tax) purposes. Such practices, al- though relevant, need not be given conclu- sive weight by the Commissioner in evalu- ating the arms length charge for controlled services. Commentators urged that any tech- nique that a taxpayer uses to allocate costs should be entitled to deference, provided it is consistent with GAAP. For the reasons expressed above concerning §1.482–9T(j), GAAP may provide an appropriate ana- lytic platform but is not necessarily con- trolling in evaluating the arm’s length charge for controlled services. In the case of administrative or sup- port services, commentators suggested that the Commissioner should accept any reasonable allocation used by the tax- payer, for example, revenue, sales, or employee headcount. In general, the cost of a service that provides benefits to multiple parties must be allocated in a manner that reliably reflects the propor- tional benefit received by each of those parties. This standard is intended to be substantially equivalent to the standard in §§1.482–2(b)(2)(i) and 1.482–2(b)(6) of the existing regulations. In response to comments, §1.482–9T(b)(5)(i)(B) of these temporary regulations also provides rules whereby the costs of covered services sub- ject to a shared services arrangement are allocated to participants in a manner that the taxpayer reasonably concludes will most reliably reflect each participant’s reasonably anticipated benefits from the services. See section A.1.c of this pream- ble. 11. Controlled Services Transactions—Temp. Treas. Reg. §1.482–9T(l) a. Definition of activity—Temp. Treas. Reg. §1.482–9T(l)(2) Section 1.482–9(l) of the 2003 pro- posed regulations set forth a threshold test for determining whether an activity constituted a controlled services trans- action subject to the general framework of §1.482–9. The 2003 proposed regula- tions broadly defined a controlled services transaction as any activity by a controlled taxpayer that resulted in a benefit to one or more other controlled taxpayers. An “activity” was in turn defined as the use by the renderer, or the making available to the recipient, of any property or other resources of the renderer. One commentator interpreted this pro- vision as indicating that any activity prop- erly analyzed under one or more other pro- visions of the transfer pricing regulations should not be subject to §1.482–9 of the 2003 proposed regulations. Other com- mentators suggested that the “predominant character” of a transaction should control whether it is analyzed as a controlled ser- vice under §1.482–9 of the 2003 proposed regulations or under other provisions of the section 482 regulations. Controlled taxpayers have a great deal of flexibility to structure transactions in various ways that are economically equiv- alent. In some cases, an overall transac- tion may include separate elements of dif- fering characters, for example, a transfer of tangible property bundled together with the provision of a service. The structure adopted may sometimes be more reliably analyzed on either a disaggregated or an aggregated basis under the relevant sec- tion of the section 482 regulations, for ex- ample, either as a separate transfer of tan- gible property under the existing section 482 regulations in §1.482–3 and a separate controlled services transaction under these temporary regulations in §1.482–9T, or as an overall controlled services transaction under these temporary regulations. To the extent that a controlled transaction is struc- tured so that it is most reliably evaluated as a controlled services transaction, it will be analyzed as such. To the extent that multi- ple elements of a single overall transaction potentially create an overlap between the August 21, 20062632006–34 I.R.B. section 482 regulations applicable to other types of transactions and these temporary regulations concerning controlled services transactions, the Treasury Department and the IRS believe that the appropriate coordi- nation is achieved by applying the rules in §1.482–9T(m). See section A.12.a of this preamble. b. Benefit test—Temp. Treas. Reg. §1.482–9T(l)(3) Section 1.482–9(l)(3) of the 2003 pro- posed regulations provided rules for de- termining whether an activity provides a benefit. Under §1.482–9(l)(3)(i), a benefit is present if the activity directly results in a reasonably identifiable increment of eco- nomic or commercial value that enhances the recipient’s commercial position, or is reasonably anticipated to do so. An- other requirement is that an uncontrolled taxpayer in circumstances comparable to those of the recipient would be willing to pay an uncontrolled party to perform the same or a similar activity, or be willing to perform for itself the same or similar activity. The 2003 proposed regulations thus made significant changes to the ben- efit test under the existing regulations, which is based on whether an uncontrolled party in the position of the renderer would expect payment for a particular activity. The 2003 proposed regulations adopted the so-called “specific benefit” approach, which mandates an arm’s length charge only if a particular activity provides an identifiable benefit to a particular tax- payer. In addition, §1.482–9(l)(3)(ii) of the 2003 proposed regulations provided that no benefit is present if an activity has only indirect or remote effects. Commentators viewed the 2003 pro- posed regulations as providing insufficient guidance concerning methods that con- trolled taxpayers might use to allocate or share expenses or charges, in particular with respect to centralized services per- formed on a centralized basis for multiple affiliates. In response to these comments, the temporary regulations authorize the use of shared services arrangements for cen- tralized services that qualify for the SCM in §1.482–9T(b). By entering into such arrangements, taxpayers can, among other things, reduce the burden associated with analysis of centralized services, which would presumably include activities that provide benefits on only an occasional or intermittent basis. See section A.1.c of this preamble, concerning shared services arrangements. One commentator suggested that, be- cause the benefit test in the 2003 proposed regulations focused on the recipient, the arm’s length charge should also be ana- lyzed from the perspective of the recipi- ent and economic conditions in the recipi- ent’s geographic market. The commenta- tor misunderstands the application of the benefit test. Although the benefit test fo- cuses on the recipient, evaluation of the arm’s length charge under the best method rule in a particular case (for example, un- der a profit split method) may require anal- ysis of the recipient, the renderer, or both (depending, for example, on which party performs the simplest, most easily measur- able functions). c. Specific applications of the benefit test—Temp Treas. Reg. §1.482–9T(l)(3)(ii) through (v) The 2003 proposed regulations pro- vided additional rules concerning appli- cation of the benefit test to particular circumstances, such as application to ac- tivities with indirect or remote effects, duplicative activities, shareholder ac- tivities, and passive association. These rules in the 2003 proposed regulations were substantially similar to the rules in existing §1.482–2(b)(2). For example, §1.482–9(l)(3)(ii) and (l)(3)(iii) provided that no benefit is present if an activity has only indirect or remote effects or merely duplicates an activitythat the recipient has already performed on its own be- half. Section 1.482–9(l)(3)(iv) provided that shareholder activities do not confer a benefit on controlled parties and there- fore do not give rise to an arm’s length charge. Shareholder activities were de- fined as activities that primarily benefit the owner-member of a controlled group in its capacity as owner, rather than other controlled parties. In addition, §1.482–9(l)(3)(v) of the 2003 proposed regulations provided that certain “passive association” effects do not give rise to a benefit within the mean- ing of the regulations concerning con- trolled services. Passive association was defined as an increment of value that a controlled party obtains on account of its membership in the controlled group. Section 1.482–9(l)(3)(v) of the 2003 pro- posed regulations provided, however, that membership in a controlled group may be considered in evaluating comparabil- ity between controlled and uncontrolled transactions. Concerning indirect or remote effects, one commentator suggested that if a cen- tralized activity by a parent confers only occasional or intermittent benefits on a subsidiary, such benefits should be clas- sified as indirect or remote. As to the shareholder provisions, commentators noted that the 2003 proposed regulations failed to address the potential that an ac- tivity that confers a reasonably identifiable increment of value on a controlled party might also be appropriately classified as a shareholder activity. As to the pas- sive association provisions, commentators questioned whether membership in a con- trolled group is relevant to evaluation of comparability. Commentators raised the concern that virtually any uncontrolled transaction could potentially be considered unreliable, because it generally would not reflect the same efficiencies and synergies as the controlled services transaction. Regarding the comments concerning indirect or remote effects, the Treasury Department and the IRS believe that to equate occasional or intermittent benefits in all cases with indirect or remote effects would conflict with the specific-benefit rule. That rule requires that any service that produces an identifiable and direct benefit warrants an arm’s length charge, even if the service is provided only oc- casionally or intermittently. Accordingly, the temporary regulations retain this pro- vision without change. In response to comments relating to shareholder activities, §1.482–9T(l)(3)(iv) of the temporary regulations refers to the “sole effect” rather than the “primary effect” of an activity. This change clari- fies that a shareholder activity is one of which the sole effect is either to protect the renderer’s capital investment in one or more members of the controlled group, or to facilitate compliance by the renderer with reporting, legal, or regulatory re- quirements specifically applicable to the renderer, or both. As modified, the def- inition in temporary §1.482–9T(l)(3)(iv) 2006–34 I.R.B.264August 21, 2006 now conforms to the general definition of benefit in §1.482–9T(l)(3)(i). In response to commentators’ request for clarification regarding the passive as- sociation rules, new §1.482–9T(l)(5)Ex- ample 19illustrates a situation in which group membership would be taken into ac- count in evaluating comparability. The Treasury Department and the IRS have inserted the word “generally” in the description of duplicative activities in §1.482–9T(l)(3)(iii). This change clarifies that although a duplicative activity does not generally give rise to a benefit, under certain circumstances, such an activity may provide an increment of value to the recipient by reference to the general rule in §1.482–9T(l)(3)(i). In such cases, the activity would be appropriately classified as a controlled services transaction. d. Guarantees, including financial guarantees The proposed regulations appear to have created confusion on the part of some taxpayers regarding the appropriate characterization of financial guarantees for tax purposes. The provision of a finan- cial guarantee does not constitute a service for purposes of determining the source of the guarantee fees. SeeCentel Communi- cations, Inc. v. Commissioner, 920 F.2d 1335 (7th Cir. 1990);Bank of America v. United States, 680 F.2d 142 (Ct. Cl. 1980). Nevertheless, some taxpayers have suggested that guarantees are services that could qualify for the cost safe harbor and that the provision of a guarantee has no cost. This position would mean that in effect guarantees are uniformly non-com- pensatory. The Treasury Department and the IRS do not agree with this uniform no charge rule for guarantees. As a result, fi- nancial transactions, including guarantees, are explicitly excluded from eligibility for the SCM by §1.482–9T(b)(3)(ii)(H). However, no inference is intended by this exclusion that financial transactions (in- cluding guarantees) would otherwise be considered the provision of services for transfer pricing purposes. The Treasury Department and the IRS subsequently intend to issue transfer pricing guidance regarding financial guarantees, in particu- lar, along with other guidance concerning the treatment of global dealing operations. See Section A.12.e of this preamble for a discussion of coordination with global dealing operations. Such guidance will also include rules to determine the source of income from financial guarantees. e. Third-party costs—Temp. Treas. Reg. §1.482–9T(l)(4) Commentators observed that the defini- tion of “total services costs” in §1.482–9(j) of the 2003 proposed regulations did not address situations in which the costs of a controlled service provider included significant charges from uncontrolled par- ties. Commentators claimed that such third-party costs should be treated as “pass through” items that, in most cases, should not be subject to the markup (if any) ap- plicable to costs incurred by the renderer in its capacity as service provider. This comment was potentially relevant to all cost-based methods in §1.482–9 of the 2003 proposed regulations. The Treasury Department and the IRS agreed that these comments raised an issue that needed to be addressed, but decided to do so in a manner different from that suggested by the commentators. In response to this comment, these temporary regulations include a new §1.482–9T(l)(4). Under this provision, if total services costs include material third-party costs, the controlled services transaction may be analyzed either as a single transaction or as two separate trans- actions, depending on which approach provides the most reliable measure of the arm’s length result under the best method rule in existing §1.482–1(c). Consistent with the best method rule, in determining which approach provides the most reliable indication of the arm’s length result, the primary factors are the degree of compa- rability between the controlled services transaction and the uncontrolled com- parables and the quality of the data and assumptions used. New §1.482–9T(l)(5) Example 20andExample 21provide illus- trations of this rule. The rule in §1.482–9T(l)(4) of the tem- porary regulations applies to all specified methods that use cost to evaluate the arm’s length charge for controlled services, in- cluding the SCM in §1.482–9T(b). A determination that a controlled services transaction is more reliably evaluated on a disaggregated basis may have an effect on the analysis of that transaction under other provisions of these regulations. f. Examples, Temp. Treas. Reg. §1.482–9T(l)(5) Section 1.482–9T(l)(5) of the tempo- rary regulations provides numerous exam- ples that illustrate applications of the rules in §1.482–9T(l). Changes have been made to certain of these examples to conform to the modifications described under the pre- vious headings in this section. 12. Coordination with Other Transfer Pricing Rules—Temp. Treas. Reg. §1.482–9T(m) Section 1.482–9(m) of the 2003 pro- posed regulations provided coordination rules applicable to a controlled services transaction that is combined with, or includes elements of, a non-services transaction. These coordination rules relied on the best method rule in exist- ing §1.482–1(c)(1) to determine which method or methods would provide the most reliable measure of an arm’s length result for a particular controlled transac- tion. a. Services transactions that include other types of transactions—Temp. Treas. Reg. §1.482–9T(m)(1) A transaction structured as a controlled services transaction may include material elements that do not constitute controlled services. Section 1.482–9(m)(1) of the 2003 proposed regulations provided that, the decision whether to evaluate such a transactioninanintegratedmannerunder the transfer pricing methods in §1.482–9 or to evaluate one or more elements sep- arately under services and non-services methods depends on which of these ap- proaches would provide the most reliable measure of an arm’s length result. If the non-services component(s) of an in- tegrated transaction could be adequately accounted for in evaluating the compara- bility of the controlled transaction to the uncontrolled comparables, then the trans- action could generally be evaluated solely as a controlled service under §1.482–9. One commentator criticized this coor- dination rule as inherently subjective and proposed that a “predominant character” August 21, 20062652006–34 I.R.B. test be adopted instead. Another commen- tator interpreted certain statements in the preamble as indicating that any controlled transaction that was reliably analyzed un- der one of the transfer pricing methods ap- plicable to tangible or intangible property would necessarily be outside the scope of the regulations regarding controlled ser- vices. Upon further consideration, the Trea- sury Department and IRS believe that no changes are necessary to the coordi- nation rule in §1.482–9T(m)(1) because these commentators have misconstrued the application of this rule to integrated transactions. The coordination rule in §1.482–9T(m)(1) focuses on the under- lying economics of such transactions and the most reliable means of evaluating those economics under the best method rule. The Treasury Department and the IRS recognize that controlled taxpayers have substantial flexibility to structure transactions in a variety of economically equivalent ways. Provided that the struc- ture adopted has economic substance, the coordination rule is designed to respect that structure and to seek the most reli- able means of evaluating the arm’s length price. Consequently, if a taxpayer struc- tures a transaction so that it constitutes a controlled service, the transaction will generally be analyzed under the principles of §1.482–9T, without regard to other pro- visions of the section 482 regulations. b. Services transactions that effect a transfer of intangible property—Temp. Treas. Reg. §1.482–9T(m)(2) Section 1.482–9(m)(2) of the 2003 pro- posed regulations provided that a transac- tion structured as a controlled service may result in the transfer of intangible prop- erty, may include an element that consti- tutes the transfer of intangible property, or may have an effect similar to the transfer of intangible property. In such cases, if the el- ement of the transaction that related to in- tangible property was material, the arm’s length result for that element would be de- termined or corroborated under a method provided for in the regulations applicable to transfers of intangible property. See ex- isting §1.482–4. Commentators viewed this rule as po- tentially authorizing the Commissioner to recharacterize a controlled services transaction as a transaction that involved a transfer of intangible property. Such authority, commentators claimed, was inconsistent with existing §1.482–4(b), which defines an intangible as an item that has “substantial value independent of the services of any individual.” Commentators also contended that thecoordination rules impermissibly extended the commensu- rate with income standard to controlled services transactions. Commentators sug- gested that, assuming each component of a controlled services transaction may be reliably accounted for under a specified transfer pricing method, no additional analysis is necessary concerning elements that arguably pertain to intangible prop- erty. The Treasury Department and the IRS agree with the commentators that the phrase “may have an effect similar to the transfer of intangible property” could be interpreted as improperly expanding §1.482–4 of the existing regulations to non-intangible transactions. This is not the intent of this provision. Consequently, to make this clear, the temporary regula- tions omit this phrase. Other concerns raised by commenta- tors misinterpret the interaction between this coordination rule and the definition of intangibles in §1.482–4(b). Section 1.482–4(b) of the existing regulations contains a list of specified intangibles and a residual category of other similar items, all of which must have “substantial value independent of the services of any individual.” In contrast, the coordination rule in §1.482–9T(m)(2) applies after it is determined that an integrated transaction includes an intangible component that is material. Because the coordination rule in §1.482–9T(m)(2) applies only to transac- tions that incorporate a material intangible component, it is not inconsistent with existing §1.482–4(b), nor does it apply the commensurate with income standard of existing §1.482–4(f)(2) to transactions that do not have a material element that constitutes an intangible transfer. Section 1.482–9(m)(6)Example 4of the 2003 proposed regulations illustrated the application of this rule to a controlled services transaction that included an ele- ment constituting the transfer of an intan- gible. Several commentators questioned the factual assumptions inExample 4. Commentators contended that a controlled party performing R&D for another con- trolled party generally would not have rights in any know-how or technical data arising out of the R&D activity; instead the contract would specify that the party that paid for the research would obtain such rights. The Treasury Department and the IRS agree with these comments and have con- cluded that the factual assumptions in this example are unclear. Consequently,Exam- ple 4has been redrafted to illustrate a sit- uation in which the controlled party per- forming the R&D is the owner of know- how or technical data that resulted from that R&D activity. The controlled party then transfers its rights to another con- trolled party. As revised, this example more clearly illustrates application of the rule in §1.482–9T(m)(2). c. Services subject to a qualified cost sharing arrangement—Temp. Treas. Reg. §1.482–9T(m)(3) Section 1.482–9(m)(3) of the 2003 pro- posed regulations provided that services provided by a controlled participant under a qualified cost sharing arrangement are subject to existing §1.482–7. The Trea- sury Department and the IRS are in the process of comprehensively revising the regulations applicable to cost sharing. In the interim, and pending issuance of final regulations that coordinate these two pro- visions, the rule in §1.482–9T(m)(3) re- tains this coordination rule. d. Other types of transaction that include a services transaction—Temp. Treas. Reg. §1.482–9T(m)(4) Section 1.482–9T(m)(4) is adopted in substantially the same form as in the 2003 proposed regulations. A transaction struc- tured other than as a controlled services transaction may include material elements that constitute controlled services. Section 1.482–9T(m)(4) of these temporary regu- lations provides rules for evaluating such integrated transactions. As with the corre- sponding rules in the 2003 proposed reg- ulations, these rules complement the more general rule in §1.482–9(m)(1), which re- lates to integrated transactions structured as controlled services transactions. 2006–34 I.R.B.266August 21, 2006 e. Global dealing operations In §1.482–9(m)(5) of the 2003 pro- posed regulations, the section for coordi- nation with the global dealing regulations was “reserved.” In response to comments, this provision is omitted in these tem- porary regulations, based on the view that reserved treatment is not appropri- ate. The Treasury Department and the IRS are presently working on new global dealing regulations. The intent of the Treasury Department and the IRS is that when final regulations are issued, those regulations, not §1.482–9T, will govern the evaluation of the activities performed by a global dealing operation within the scope of those regulations. Pending final- ization of the global dealing regulations, taxpayers may rely on the proposed global dealing regulations, not the temporary services regulations, to govern financial transactions entered into in connection with a global dealing operation as defined in proposed §1.482–8. Therefore, pro- posed regulations under §1.482–9(m)(5) issued elsewhere in the Bulletin clarify that a controlled services transaction does not include a financial transaction entered into in connection with a global dealing operation. B. Income Attributable to Intangibles—Temp. Treas. Reg. §1.482–4T(f)(3) and (4) The 2003 proposed regulations sub- stantially replaced §1.482–4(f)(3) of the existing regulations, which dealt with is- sues relating to the allocation of income from intangibles. The 2003 proposed reg- ulations adopted new §1.482–4(f)(3) and (f)(4), which provided modified rules for determining the owner of an intangible for purposes of section 482 and also provided rules for determining the arm’s length compensation in situations where a con- trolled party other than the owner makes contributions to the value of an intangible. 1. Ownership of Intangible Property—Temp. Treas. Reg. §1.482–4T(f)(3) Section 1.482–4(f)(3)(i)(A) of the 2003 proposed regulations contained modified rules for determining the owner of intan- gible property for purposes of section 482. In general, under these rules, the controlled party that was identified as the owner of a legally protected intangible under the intellectual property laws of the relevant jurisdiction or other legal provision was treated as the owner ofthat intangible for purposes of section 482. The 2003 proposed regulations also clarified that a license or other right to use an intangible may constitute an item of intangible property for purposes of section 482. This provision, which con- templated the identification of a single owner for each discrete set of rights that constitutes an intangible, replaced provi- sions in the existing regulations that could be interpreted as providing for multiple owners of an intangible. See Proposed §1.482–4(f)(3)(i) and (f)(3)(iv),Example 4. The 2003 proposed regulations also adopted a provision that parallels the re- quirement in the existing regulations, to the effect that ownership for purposes of section 482 must be consistent with the economic substance of the controlled transaction. Intellectual property law gen- erally places relatively few limitations on the ability of members of a controlled group to assign or transfer legal ownership among themselves. As a result, this rule is a safeguard against purely formal assign- ments of ownership that, if given effect for purposes of section 482, could produce results that are inconsistent with the arm’s length standard. Under §1.482–4(f)(3)(i)(A) of the 2003 proposed regulations, in situations where it was not possible to identify the owner of an intangible under the intellectual property law of the relevant jurisdiction, contractual term, or other legal provi- sion, the controlled taxpayer with prac- tical control over the intangible would be treated as the owner for purposes of section 482. This provision replaced the so-called “developer-assister” rule in ex- isting §1.482–4(f)(3)(ii)(B). In the case of non-legally protected intangibles, the de- veloper-assister rule assigned ownership of an intangible to the controlled taxpayer that bore the largest portion of the costs of development. The 2003 proposed regulations did not adopt the developer-assister rule, so they also eliminated related provisions pertaining to assistance to the owner of in- tangible property. In place of those rules, the 2003 proposed regulations contained new provisions relating to contributions to the value of intangible property owned by another controlled party. See Proposed §1.482–4(f)(4)(i). These rules are dis- cussed in greater detail in section B.2 of this preamble. Section 1.482–4(f)(3)(i)(B) of the 2003 proposed regulations excluded certain in- tangibles that are subject to the cost shar- ing provisions of §1.482–7. The Treasury Department and the IRS are currently re- vising the existing regulations related to cost sharing. When final cost sharing reg- ulations are issued, §1.482–4(f)(3) and (4) will take into account the changes made to the cost sharing provisions. Extensive comments were received concerning the revised approach to de- termining ownership of intangibles under section 482. To varying degrees, many commentators supported the new own- ership standard, noting that it should be easier to apply and should produce more certainty of results in this area. Other commentators, however, took issue with the proposed rules. Some of these com- mentators took the position that legal ownership does not provide an appropriate basis for determining ownership under section 482, while others believed that the determination of ownership under section 482 should include a full-scale application of substantive intellectual property law, including relevant statutory provisions as well as judicial doctrines and common law principles that may bear on the issue of ownership. After considering the public comments, the Treasury Department and the IRS con- clude that legal ownership provides the ap- propriate framework for determining own- ership of intangibles under section 482. In this specific context, the Treasury De- partment and the IRS intend that the “le- gal owner” under these rules will be the controlled party that possesses title to the intangible, based on consideration of the facts and circumstances. This analysis would take into account applications filed with a central government registry (such as the U.S. Patent and Trademark Office or the Copyright Office in the United States), any contractual provisions in effect be- tween the controlled parties, and other le- gal provisions. Legal ownership, under- stood in this manner, provides a practi- cal and administrable framework for deter- August 21, 20062672006–34 I.R.B. mining ownership of intangibles for pur- poses of section 482. The suggestions that the ownership rules under section 482 should in effect incorporate by reference the substantive intellectual property rules have not been adopted. In the view of the Treasury Department and the IRS, it would be counterproductive to require an in-depth application of intellectual property law in determining which controlled party is treated as the owner under section 482. The primary function of intellectual prop- erty law is to define the rights of a legal entity, which in some cases might be a controlled group, as compared with one or more uncontrolled parties that have competing claims to the same item of intangible property. For this reason, ap- plication of the substantive provisions of intellectual property law would not be useful, and might in fact produce inappro- priate results, given that under section 482 the relevant determination is which of sev- eral controlled parties should be classified as the owner of an intangible. The Treasury Department and the IRS anticipate that ownership of an intangi- ble as determined under the legal owner standard will not conflict with the simul- taneous requirement that ownership under section 482 be determined in accordance with the economic substance. For ex- ample, if the economic substance of the controlled parties’ dealings conflicts with treatment of the legal owner as the owner under section 482, the Commissioner may determine ownership by reference to the economic substance of the transaction. In other cases, ownership for purposes of section 482 should be consistent with the ownership determined by reference to either legal ownership or practical control. The Treasury Department and the IRS also believe that the 2003 proposed regu- lations properly adopted a practical control standard for “non-legally protected” intan- gibles. The control standard should not displace valid contractual terms intended to specify that a particular controlled party is the owner of an existing intangible or an intangible under development. Because a contractual term constitutes a “legal provi- sion,” the intangible would be analyzed as a legally protected intangible, as opposed to a non-legally protected intangible sub- ject to the practical control rule. Commentators suggested that certain statements in the 2003 proposed regu- lations incorrectly equated a licensee of intangible property with a distributor of tangible property. In response to these comments, the Treasury Department and the IRS have revised the examples in §1.482–4T(f)(4)(ii) to avoid any impli- cation that these regulations equate or distinguish these business relationships. 2. Contributions to the Value of an Intangible—Temp. Treas. Reg. §1.482–4T(f)(4) Under §1.482–4(f)(4)(i) of the 2003 proposed regulations, the rules of section 482 were applied to determine the arm’s length compensation for any activity that was reasonably anticipated to increase the value of an intangible owned by an- other controlled party. Such an activity was defined as a “contribution” under this provision. This provision replaced cer- tain rules in the existing regulations that required arm’s length compensation to be provided for any assistance by a controlled party to the owner of the intangible. This new guidance concerning con- tributions to the value of an intangible was intended to provide a more refined frameworkthantherulesinexisting §1.482–4(f)(3), in particular by reducing the potential for inappropriate, all-or-noth- ing results. Moreover, because the revised rules afforded heightened deference to contractual arrangements, they were in- tended to give controlled taxpayers in- centives to document transactions on a contemporaneous basis and to adhere to the contractual terms agreed upon at the outset of the arrangement. Section 1.482–4(f)(4)(i) of the 2003 proposed regulations provided that com- pensation for a contribution may be em- bedded within the terms of another trans- action, may be stated separately as a fee for services, or may be provided for as a reduction in the royalty or the transfer price of tangible property. The regulations also recognized that ifa controlled party’s activities are reasonably anticipated to enhance only the value of its own rights under a license or exclusive distribution arrangement, no compensation is due un- der the arm’s length standard. The rules addressed the most commonly encoun- tered factual scenarios that potentially give rise to contributions on the part of a controlled party. Section 1.482–4(f)(4)(i) of the 2003 proposed regulations provided that in gen- eral a separate allocation is not appropriate if the compensation for a contribution was embedded within the terms of a related controlled transaction. In such cases, the contribution is taken into account in evaluating the comparability of the con- trolled transaction to the uncontrolled comparables and in determining the arm’s length consideration for the controlled transaction that includes the embedded contribution. This rule potentially interacted with §1.482–3(f) of the existing regulations, concerning transfers of tangible property together with an embedded intangible. For example, assume that a reseller of trademarked goods performs activities that are classified ascontributions within the meaning of §1.482–4(f)(4). If no sep- arate compensation for these activities is provided for by a contractual term, then ordinarily no allocation would be appro- priate either for the embedded trademark or for the underlying activities. Both el- ements would, however, be taken into account in evaluating the comparability of the controlled transfer to the uncontrolled comparables and in determining the arm’s length consideration for the controlled transfer of the trademarked goods. See §1.482–4T(f)(4)(ii)Example 2. Commentators objected to certain as- pects ofExample 2,Example 3,Example 5,andExample 6in §1.482–4(f)(4)(ii) of the 2003 proposed regulations. Those ex- amples stated that, if it is not possible to identify uncontrolled transactions that in- corporated a similar range of interrelated elements as the nonroutine contributions by the controlled parties, it may be appro- priate to apply a residual profit split analy- sis. In the opinion of commentators, these statements implied that profit split meth- ods were preferred methods in any case that involved a contribution to the value of an intangible. The Treasury Department and the IRS agree with these comments. There was no intention to imply any such treatment of the residual profit split method. As a re- sult, these statements in the examples have been eliminated. In addition, the examples in the temporary regulations specifically refer to the best method rule and cross-ref- 2006–34 I.R.B.268August 21, 2006 erence newExample 10,Example 11,and Example 12in §1.482–8, which show ap- plication of the best method rule to intan- gible development activities. See also sec- tion A.6 of this preamble, concerning def- inition of nonroutine contribution for pur- poses of the profit split methods. In addition, and in response to comments, a newExample 5in §1.482–1T(d)(3)(ii)(C) illustrates fac- tual circumstances in which contractual terms pertaining to intangible develop- ment activities are respected, although on examination the activities are found to be priced on a non-arm’s length basis. To- gether, these changes clarify that, subject to the best method rule and satisfaction of economic substancerequirements, con- trolled parties may adopt contractual terms that provide for marketing, research and development, or other intangible develop- ment activities to be compensated based on reimbursement of specified costs plus a profit element. The underlying contractual compensation terms will be given effect for purposes of section 482 as long as they have economic substance. Commentators sought clarification re- garding the term “incremental marketing activities,” which was used in several ex- amples in §1.482–4(f)(4)(ii) of the 2003 proposed regulations. In the examples, the term “incremental marketing activities” referred to activities by a controlled party that are quantitatively greater (in terms of volume, expense, etc.) than the activities undertaken by compara- ble uncontrolled parties in the transactions used to analyze the controlled transaction. Such activities must be taken into account by either evaluating a separate transaction that accounts for such incremental activ- ities or analyzing the underlying transac- tion and making necessary adjustments to the uncontrolled transactions to incorpo- rate such activities into the comparability analysis. Discrete changes were made to the examples to clarify these principles. As a result, apart from this additional clar- ification, these comments are not adopted. Commentators proposed that the Trea- sury Department and the IRS adopt dis- counted cash-flow analysis (DCF) as a specified method for analysis of contribu- tions. The Treasury Department and the IRS find it unnecessary to do so because they already recognize DCF as one of several approaches that may be reliably applied to evaluate intangible property. This method may be particularly useful, either as an unspecified method or in con- junction with one of the specified meth- ods, in evaluating contributions within the meaning of §1.482–4T(f)(4)(i). Further consideration is being given to the sugges- tion to adopt DCF as a specified method in its own right. C. Contractual Terms Imputed from Economic Substance—§1.482–1(d)(3)(ii)(C), Examples 3, 4, 5, and 6 Central to the approach taken in the 2003 proposed regulations were the concepts that controlled taxpayers have substantial freedom to adopt contractual terms, and that such contractual terms are given effect under section 482, provided they are in accord with the economic sub- stance of the controlled parties’ dealings. An important corollary of these princi- ples, however, applies where controlled parties fail to specify contractual terms, or specify terms that are not consistent with economic substance. In such cases, the Commissioner may impute contractual terms to accord with the economic sub- stance of the controlled parties’ activities. See §1.482–1(d)(3) of the existing regula- tions. Commentators raised several concerns regarding the potential interaction be- tween the economic substance rules in existing §1.482–1(d)(3) and certain pro- visions in the 2003 proposed regulations, including those relating to contributions to the value of intangibles and contin- gent-payment contractual terms. Some commentators suggested that application of these provisions together with the exist- ing economic substance rules could create incentives for the Commissioner to make inappropriate adjustments,e.g.,toimpute contingent-payment terms or transfers of intangibles in any situation in which non-arm’s length pricing was identified. ItbearsemphasisthattheCommis- sioner may invoke his authority under §1.482–1(d)(3)(ii) in only two situations: (1) controlled taxpayers fail to specify con- tractual terms for the transaction; or (2) controlled taxpayers specify contractual terms that are not in accordance with eco- nomic substance. Clearly, if contributions within the meaning of §1.482–4T(f)(4)(i) are present, the contractual terms of the controlled transaction should address those contributions in a manner that ac- cords with economic substance. If this is not the case, the Commissioner must impute an arrangement that best conforms to the economic substance of the trans- action. In given facts and circumstances, it may be possible to rely on evidence that the taxpayer brings forward. In other circumstances, the Commissioner will im- pute an arrangement based on economic substance, taking into account the facts and circumstances, the parties’ conduct, and other relevant evidence, including any that the taxpayer brings forward on exam- ination. SeeExample 3,Example 4,and Example 6in §1.482–1T(d)(3)(ii)(C). Inresponsetocomments, §1.482–1T(d)(3)(ii)(C) includes a newExample 5, which illustrates the interaction of the economic substance rule with general transfer pricing rules in the context of intangible development activities. In the example, the contractual terms specify that intangible development activities are priced by reference to reimbursement of specified costs plus a markup or profit component. On exami- nation, the Commissioner determines that the specified compensation falls outside the arm’s length range, as determined by comparison to uncontrolled transac- tions. The example illustrates that this determination, without more, does not support a conclusion that the contractual terms lacked economic substance. If, however, the compensation paid is outside the arm’s length range by a substantial amount, the Commissioner may take that fact into account in determining whether the contractual arrangement as a whole possessed economic substance. The examples in §1.482–1(d)(3)(ii)(C) of the 2003 proposed regulations described alternative constructions that the Com- missioner might adopt if the contractual terms for the controlled transaction were not in accordance with economic sub- stance: These alternatives included: (1) imputation of a separate services arrange- ment, with contingent-payment terms; (2) imputation of a long-term, exclusive distribution arrangement; or (3) requiring compensation for termination of an im- puted long-term license arrangement. The Treasury Department and the IRS believe that one or more of these arrangements August 21, 20062692006–34 I.R.B. may be appropriate, depending on the facts of the specific case. Commentators expressed concerns re- garding the scope of the Commissioner’s authority to impute arrangements based on economic substance. Some commentators suggested that a single set of contractual terms should apply in any situation where the Commissioner determines that the controlled parties’ contractual terms lack economic substance. Another commenta- tor recommended that the Commissioner should impute only contractual terms similar to those observed in comparable uncontrolled transactions. After much consideration, the Treasury Department and the IRS have not adopted these com- ments. The determination of the economic substance of a transaction between related parties necessarily turns on an examina- tion of all the facts and circumstances. Under the regulations, the taxpayer is in control of this issue in the first instance to the extent it expressly sets forth the eco- nomic substance in contractual terms and its conduct and arrangements are consis- tent with these terms. Otherwise, the IRS is forced to try and impute the economic substance based on whatever facts and circumstances are available, including any information the taxpayer brings forward on examination. Commentators also suggested that un- der the 2003 proposed regulations, the Commissioner’s authority to impute con- tingent-payment contractual terms was unnecessarily broad. In the commenta- tors’ view, this authority would lead the Commissioner to apply commensurate with income principles to controlled trans- actions that have no significant intangible property component. The Commissioner’s authority to impute contingent-payment contractual terms was appropriately tai- loredtoresultinapplicationofeconomic substance principles in those situations where it was warranted. The Treasury Department and the IRS believe that the commensurate with income principle of the statute is consistent with the arm’s length principle and fundamentally relates to the underlying economic substance and true risk allocations inherent in the relevant controlled transactions. Related parties may, with economic substance, agree to compensate one another for ser- vices with compensation payable only in future periods contingent on the suc- cess or failure of the services to produce the contemplated results. Related parties may expressly enter into those contractual terms and, in the absence of express terms or where the related parties’ conduct and arrangements are inconsistent with their contractual terms, the IRS may in ap- propriate facts and circumstances impute contingent-payment contractual terms. D. Stewardship Expenses —§1.861–8T The temporary regulations would modify the present regulations under §1.861–8(e)(4) to conform to, and to be consistent with, the revised language re- lating to controlled services transactions as set forth in §1.482–9T(l). E. Effective Date —§1.482–9T(n) In order to achieve the goal of updat- ing the 1968 regulations, while facilitating consideration of further public input in re- fining final rules, these regulations are is- sued in temporary form with a delayed ef- fective date for taxable years beginning af- ter December 31, 2006. Controlled tax- payers may also elect to apply these tem- porary regulations to any taxable year be- ginning after September 10, 2003, the date of publication of the 2003 proposed reg- ulations. Where such an election is made, the temporary regulations will apply in full to such taxable year and all subsequent taxable years of the taxpayer making the election. Such an election must be made by attaching a statement to the taxpayer’s timely filed U.S. tax return (including ex- tensions) for its first taxable year after De- cember 31, 2006. These regulations are issued after pro- posed revisions to the regulations pertain- ing to cost sharing arrangements. By issu- ing regulations in temporary and proposed form concerning controlled services and the allocation of income from intangibles, the Treasury Department and the IRS also provide taxpayers an opportunity to submit comments that take into account the poten- tial interaction between these two sets of regulations. The initial list of specified covered ser- vices for purposes of the SCM is being is- sued for public input in the form of an an- nouncement in tandem with these tempo- rary regulations. This announcement will be published in the Internal Revenue Bul- letin. For copies of the Internal Revenue Bulletin, see §601.601(d)(2)(ii)(b). The Treasury Department and the IRS intend to take all public comments into account and issue a final revenue procedure that will be effective coincident with the delayed effective date of these temporary regula- tions. Special Analyses It has been determined that this Trea- sury decision is not asignificant regula- tory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been deter- mined that section 553(b) of the Admin- istrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. For the applicability of the Regulatory Flexi- bility Act (5 U.S.C. chapter 6) refer to the Special Analyses section of the preamble to the cross-reference notice of proposed rulemaking published in this issue of the Bulletin. Pursuant to section 7805(f) of the Internal Revenue Code, these tempo- rary regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business. Drafting Information The principal authors of these regula- tions are Thomas A. Vidano and Carol B. Tan, Office of Associate Chief Coun- sel (International) for matters relating to section 482, and David Bergkuist, Office of Associate Chief Counsel (International) for matters relating to stewardship. ***** Amendment to the Regulations Accordingly, 26 CFR parts 1 and 31 are amended as follows: PART 1—INCOME TAXES Paragraph 1. The authority citation for part 1 is amended by adding an entry in numerical order to read in part as follows: Authority: 26 U.S.C. 7805 * * * Section 1.482–9 also issued under 26 U.S.C. 482. * * * Par. 2. Section 1.482–0 is amended as follows: 1. The section heading is revised. 2. The entries for 1.482–1(a)(1), (b)(2)(i),(d)(3)(ii)(C),(d)(3)(v), 2006–34 I.R.B.270August 21, 2006 (f)(2)(ii)(A), (f)(2)(ii)(B), (g)(4)(iii), (i) and (j) are revised. 3. The entries for §1.482–2(b) are re- vised. 4. The entries for §1.482–4(f)(3), (f)(4) and (f)(5) are revised and new entries for §1.482–4(f)(6) and (f)(7) are added. 5.The entries for 1.482–6(c) (2)(ii)(B)(1), (c)(2)(ii)(D), (c)(3)(i)(A), (c)(3)(i)(B) and (c)(3)(ii)(D) are revised and the entry for 1.482–6(d) is added. 6. The entry for 1.482–8(a) is revised. 7. The entries for 1.482–9 are added. The additions and revisions read as fol- lows: §1.482–0 Outline of regulations under section 482. ***** §1.482–1 Allocation of income and deductions among taxpayers (a)(1) [Reserved]. For further guid- ance, see §1.482–0T, the entry for §1.482–1T(a)(1). ***** (b) * * * (2) * * * (i) [Reserved]. For further guid- ance, see §1.482–0T, the entry for §1.482–1T(b)(2)(i). ***** (d) * * * (3) * * * (ii) * * * (C) [Reserved]. For further guid- ance, see §1.482–0T, the entry for §1.482–1T(d)(3)(ii)(C). (v) [Reserved]. For further guid- ance, see §1.482–0T, the entry for §1.482–1T(d)(3)(v). ***** (f) * * * (2) * * * (ii) * * * (A) [Reserved]. For further guid- ance, see §1.482–0T, the entry for §1.482–1T(f)(2)(ii)(A). (iii) * * * (B) [Reserved]. For further guid- ance, see §1.482–0T, the entry for §1.482–1T(f)(2)(iii)(B). ***** (g) * * * (4) * * * (iii) [Reserved]. For further guid- ance, see §1.482–0T, the entry for §1.482–1T(g)(4)(iii). ***** (i) [Reserved]. For further guidance, see §1.482–0T, the entry for §1.482–1T(i). ***** (j) [Reserved]. For further guidance, see §1.482–0T, the entry for §1.482–1T(j). §1.482–2 Determination of taxable income in specific situations. ***** (b) [Reserved]. For further guidance, see §1.482–0T, the entry for §1.482–2T(b). ***** §1.482–4 Methods to determine taxable income in connection with a transfer of intangible property. ***** (f) * * * (3) [Reserved]. For further guid- ance, see §1.482–0T, the entry for §1.482–4T(f)(3). (4) [Reserved]. For further guid- ance, see §1.482–0T, the entry for §1.482–4T(f)(4). (5) Consideration not artificially lim- ited. (6) Lump sum payments (i) In general. (ii) Exceptions. (iii) Example. (7) [Reserved]. For further guid- ance, see §1.482–0T, the entry for §1.482–4T(f)(7). §1.482–6 Profit split method. ***** (c) * * * (2) * * * (ii) * * * (B)*** (1) [Reserved]. For further guid- ance, see §1.482–0T, the entry for §1.482–6T(c)(2)(ii)(B)(1). ***** (D) [Reserved]. For further guid- ance, see §1.482–0T, the entry for §1.482–6T(c)(2)(ii)(D). (3) * * * (i) * * * (A) [Reserved]. For further guid- ance, see §1.482–0T, the entry for §1.482–6T(c)(3)(i)(A). (B) [Reserved]. For further guid- ance, see §1.482–0T, the entry for §1.482–6T(c)(3)(i)(B). (ii) * * * (D) [Reserved]. For further guid- ance, see §1.482–0T, the entry for §1.482–6T(c)(3)(ii)(D). ***** (d) Effective date. [Reserved]. For fur- ther guidance, see §1.482–0T, the entry for §1.482–6T(d). §1.482–8 Examples of the best method rule. (a) Introduction. ***** §1.482–9 Methods to determine taxable income in connection with a controlled services transaction.[Reserved]. For further guidance, see §1.482–0T, the entries for §1.482–9T. Par. 3. Section 1.482–0T is added to read as follows: §1.482–0T Outline of regulations under section 482. This section contains major captions for §§1.482–1T, 1.482–2T, 1.482–4T, 1.482–6T, 1.482–8T, and §1.482–9T. §1.482–1T Allocation of income and deductions among taxpayers. (a) In general. (1) Purpose and scope. (2) through (b)(1) [Reserved]. For fur- ther guidance, see §1.482–0, the entry for §1.482–1(a)(2) through (b)(1). (b)(2) Arm’s length methods. (i) Methods. (b)(2)(ii) through (d)(3)(ii)(B) [Re- served]. For further guidance, see §1.482–0, the entry for §1.482–1(b)(2)(ii) through (c)(3)(ii)(B). (C) Examples. (d)(3)(iii) and (iv) [Reserved]. For fur- ther guidance, see §1.482–0, the entry for §1.482–1(d)(3)(iii) and (iv). August 21, 20062712006–34 I.R.B. (v) Property or services. (d)(4) through (f)(2)(i) [Reserved]. For further guidance, see §1.482–0, the entry for §1.482–1(d)(4) through (f)(2)(i). (ii) Allocation based on taxpayer’s ac- tual transactions. (A) In general. (f)(2)(ii)(B) through (f)(2)(iii)(A) [Reserved].For further guid- ance, see §1.482–0, the entry for§1.482–1(f)(2)(ii)(B)through (f)(2)(iii)(A). (B) Circumstanceswarranting consid- eration of multiple year data. (f)(2)(iii)(C) through (g)(3) [Reserved]. For further guidance, see §1.482–0, the entry for §1.482–1(f)(2)(iii)(C) through (g)(3). (4) Setoffs. (i) In general. (g)(4)(ii) [Reserved]. For further guidance, see §1.482–0, the entry for §1.482–1(g)(4)(ii). (iii) Examples. (g)(4)(iii)Example 2through (h) [Reserved]. For further guidance, see §1.482–0, the entry for §1.482–1(g)(4)(iii) Example 2through (h). (i) Definitions. (j) Effective dates. §1.482–2T Determination of taxable income in specific situations. (a) [Reserved]. For further guidance, see §1.482–0, the entry for §1.482–2(a). (b) Rendering of services. (c) [Reserved]. For further guidance, see §1.482–0, the entry for §1.482–2(c). (d) [Reserved]. For further guidance, see §1.482–0, the entry for §1.482–2(d). (e) Effective date. (1) In general. (2) Election to apply regulation to ear- lier years. (3) Expiration date. §1.482–4T Methods to determine taxable income in connection with a transfer of intangible property. (a) through (f)(2) [Reserved]. For fur- ther guidance, see §1.482–0, the entry for §1.482–4(a) through (f)(2). (3) Ownership of intangible property. (i) Identification of owner. (A) In general. (B) Cost sharing arrangements. (ii) Examples. (4) Contribution to the value of an in- tangible owned by another. (i) In general. (ii) Examples. (f)(5) and (f)(6) [Reserved]. For fur- ther guidance, see §1.482–0, the entry for §1.482–4(f)(5) and (f)(6). (7) Effective date. (i) In general. (ii) Election to apply regulation to ear- lier years. (iii) Expiration date. §1.482–6T Profit split method. (a) through (c)(2)(ii)(A) [Reserved]. For further guidance, see §1.482–0, the en- try for §1.482–6(a) through (c)(2)(ii)(A). (B) Comparability. (1) In general. (c)(2)(ii)(B)(2) through (C) [Reserved]. For further guidance, see §1.482–0, the entry for §1.482–6(c)(2)(ii)(B)(2) through (C). (D) Other factors affecting reliability. (c)(3)(i) [Reserved].For further guidance, see §1.482–0, the entry for §1.482–6(c)(3)(i). (A) Allocate income to routine contri- butions. (B) Allocate residual profit. (1) Nonroutine contributions generally. (2) Nonroutine contributions of intangi- ble property. (c)(3)(ii)(A) through (C) [Reserved]. For further guidance, see §1.482–0, the entry for §1.482–6(c)(3)(ii)(A) through (C). (D) Other factors affecting reliability. (c)(3)(iii) [Reserved]. For further guidance, see §1.482–0, the entry for §1.482–6(c)(3)(iii). (d) Effective date. (1) In general. (2) Election to apply regulation to ear- lier taxable years. (3) Expiration date. §1.482–8T Examples of the best method rule. (a) [Reserved]. For further guidance, see §1.482–0, the entry for §1.482–8(a). (b) [Reserved]. For further guidance, see §1.482–0, the entry for §1.482–8(b). (c) Effective date. (1) In general. (2) Election to apply regulation to ear- lier taxable years. (3) Expiration date. §1.482–9T Methods to determine taxable income in connection with a controlled services transaction. (a) In general. (b) Services cost method. (1) In general. (2) Not services that contribute signif- icantly to fundamental risks of business success or failure. (3) Other conditions on application of services cost method. (i) Adequate books and records. (ii) Excluded transactions. (4) Covered services. (i) Specified covered services. (ii) Low margin covered services. (5) Shared services arrangement. (i) In general. (ii) Requirements for shared services arrangement. (A) Eligibility. (B) Allocation. (C) Documentation. (iii) Definition and special rules. (A) Participant. (B) Aggregation. (C) Coordination with cost sharing ar- rangements. (6) Examples. (c) Comparable uncontrolled services price method. (1) In general. (2) Comparability and reliability con- siderations. (i) In general. (ii) Comparability. (A) In general. (B) Adjustments for differences be- tween controlled and uncontrolled trans- actions. (iii) Data and assumptions. (3) Arm’s length range. (4) Examples. (5) Indirect evidence of the price of a comparable uncontrolled services transac- tion. (i) In general. (ii) Example. (d) Gross services margin method. (1) In general. (2) Determination of arm’s length price. (i) In general. (ii) Relevant uncontrolled transaction. (iii) Applicable uncontrolled price. (iv) Appropriate gross services profit. 2006–34 I.R.B.272August 21, 2006 (v) Arm’s length range. (3) Comparability and reliability con- siderations. (i) In general. (ii) Comparability. (A) Functional comparability. (B) Other comparability factors. (C) Adjustments for differences be- tween controlled and uncontrolled trans- actions. (D) Buy-sell distributor. (iii) Data and assumptions. (A) In general. (B) Consistency in accounting. (4) Examples. (e) Cost of services plus method. (1) In general. (2) Determination of arm’s length price. (i) In general. (ii) Appropriate gross services profit. (iii) Comparable transactional costs. (iv) Arm’s length range. (3) Comparability and reliability con- siderations. (i) In general. (ii) Comparability. (A) Functional comparability. (B) Other comparability factors. (C) Adjustments for differences be- tween the controlled and uncontrolled transactions. (iii) Data and assumptions. (A) In general. (B) Consistency in accounting. (4) Examples. (f) Comparable profits method. (1) In general. (2) Determination of arm’s length re- sult. (i) Tested party. (ii) Profit level indicators. (iii) Comparability and reliability con- siderations-Data and assumptions-Consis- tency in accounting. (3) Examples. (g) Profit split method. (1) In general. (2) Examples. (h) Unspecified methods. (i) Contingent-payment contractual terms for services. (1) Contingent-payment contractual terms recognized in general. (2) Contingent-payment arrangement. (i) General Requirements. (A) Written contract. (B) Specified contingency. (C) Basis for payment. (ii) Economic Substance and Conduct. (3) Commissioner’s authority to impute contingent-payment terms. (4) Evaluation of arm’s length charge. (5) Examples. (j) Total services costs. (k) Allocation of costs. (1) In general. (2) Appropriate method of allocation and apportionment. (i) Reasonable method standard. (ii) Use of general practices. (3) Examples. (l) Controlled services transaction. (1) In general. (2) Activity. (3) Benefit. (i) In general. (ii) Indirect or remote benefit. (iii) Duplicative activities. (iv) Shareholder activities. (v) Passive association. (4) Disaggregation of Transactions. (5) Examples. (m) Coordination with transfer pricing rules for other transactions. (1) Services transactions that include other types of transactions. (2) Services transactions that effect a transfer of intangible property. (3) Services subject to a qualified cost sharing arrangement. (4) Other types of transactions that in- clude controlled services transactions. (5) Examples. (n) Effective date. (1) In general. (2) Election to apply regulations to ear- lier taxable years. (3) Expiration date. Par. 4. Section 1.482–1 is amended as follows: 1.Paragraphs (a)(1), (b)(2)(i), (d)(3)(ii)(C)Example 3, (d)(3)(v), (f)(2)(ii)(A), (f)(2)(iii)(B), (g)(4)(i), (g)(4)(iii) and paragraph (i) are revised. 2. Paragraph (d)(3)(ii)(C)Examples 4 through6are added. 3. Paragraph (j)(6) is added. The addition and revisions read as fol- lows: §1.482–1 Allocation of income and deductions among taxpayers. (a)(1) [Reserved]. For further guid- ance, see §1.482–1T(a)(1). ***** (b)***(1)*** (b)(2)(i) [Reserved]. For further guid- ance, see §1.482–1T(b)(2)(i). ***** (d) * * * (3) * * * (ii) * * * (C) * * * Example 3. [Reserved]. For further guidance, see §1.482–1T(d)(3)(ii)(C),Ex- ample 3. Examples 4through6. [Reserved]. For further guidance, see 1.482–1T (d)(3)(ii)(C)Examples 4through6. ***** (v) [Reserved]. For further guidance, see §1.482–1T(d)(3)(v). ***** (f) * * * (2) * * * (ii)(A) [Reserved]. For further guid- ance, see §1.482–1T(f)(2)(ii)(A). ***** (iii) * * * (B) [Reserved]. For further guidance, see §1.482–1T(f)(3)(iii)(B). ***** (g) * * * (4) * * * (i) * * * [Reser ved]. For further guidance, see §1.482 –1T(g)(4)(i). (iii) * * * Example 1.[Reserved ]. For further guidance, see §1.482 –1T(g)(4)(iii),Exam- ple 1. ***** (i) Introductory text. [Reserved]. For further guidance, see the introductory text in §1.482–1T(i). ***** (j) * * * (6) [Reserved]. For further guidance, see §1.482–1T(j)(6). Par. 5. Section 1.482–1T is added to read as follows: §1.482–1T Allocation of income and deductions among taxpayers (temporary). (a)In general—(1)Purpose and scope. The purpose of section 482 is to ensure that taxpayers clearly reflect income attribut- able to controlled transactions and to pre- vent the avoidance of taxes with respect to such transactions. Section 482 places a controlledtaxpayeronataxparitywithan uncontrolled taxpayer by determining the August 21, 20062732006–34 I.R.B. true taxable income of the controlled tax- payer. This section sets forth general prin- ciples and guidelines to be followed un- der section 482. Section 1.482–2 provides rules for the determination of the true tax- able income of controlled taxpayers in spe- cific situations, including controlled trans- actions involving loans or advances or the use of tangible property. Sections 1.482–3 through 1.482–6 provide rules for the de- termination of the true taxable income of controlled taxpayers in cases involving the transfer of property. Section 1.482–7T sets forth the cost sharing provisions applicable to taxable years beginning on or after Oc- tober 6, 1994, and before January 1, 1996. Section 1.482–7 sets forth the cost sharing provisions applicable to taxable years be- ginning on or after January 1, 1996. Sec- tion 1.482–8 provides examples illustrat- ing the application of the best method rule. Finally, §1.482–9T provides rules for the determination of the true taxable income of controlled taxpayers in cases involving the performance of services. (a)(2) through (b)(1) [Reserved]. For further guidance, see §1.482–1(a)(2) through (b)(1). (b)(2) Arm’s length methods—(i) Methods. Sections 1.482–2 through 1.482–6 and §1.482–9T provide specific methods to be used to evaluate whether transactions between or among members of the controlled group satisfy the arm’s lengthstandardand,iftheydonot,tode- termine the arm’s length result. Section 1.482–7 provides the specific method to be used to evaluate whether a qualified cost sharing arrangement produces results consistent with an arm’s length result. (b)(2)(ii) through (d)(3)(ii)(C),Exam- ples 1,and2[Reserved]. For further guidance, see §1.482–1(b)(2)(ii) through (d)(3)(ii)(C),Examples 1and2. Example 3.Contractual terms imputed from eco- nomic substance. (i) FP, a foreign producer of wrist- watches, is the registered holder of the YY trademark in the United States and in other countries world- wide. In year 1, FP enters the United States mar- ket by selling YY wristwatches to its newly orga- nized United States subsidiary, USSub, for distribu- tion in the United States market. USSub pays FP a fixed price per wristwatch. USSub and FP undertake, without separate compensation, marketing activities to establish the YY trademark in the United States market. Unrelated foreign producers of trademarked wristwatches and their authorized United States dis- tributors respectively undertake similar marketing ac- tivities in independent arrangements involving dis- tribution of trademarked wristwatches in the United States market. In years 1 through 6, USSub markets and sells YY wristwatches in the United States. Fur- ther, in years 1 through 6, USSub undertakes incre- mental marketing activities in addition to the activi- ties similar to those observed in the independent dis- tribution transactions in the United States market. FP does not directly or indirectly compensate USSub for performing these incremental activities during years 1 through 6. Assume that, aside from these incremen- tal activities, and after any adjustments are made to improve the reliability of the comparison, the price paid per wristwatch by the independent, authorized distributors of wristwatches would provide the most reliable measure of the arm’s length price paid per YY wristwatch by USSub. (ii) By year 7, the wristwatches with the YY trade- mark generate a premium return in the United States market,ascomparedtowristwatchesmarketedbythe independent distributors. In year 7, substantially all the premium return from the YY trademark in the United States market is attributed to FP, for exam- ple through an increase in the price paid per watch by USSub, or by some other means. (iii) In determining whether an allocation of in- come is appropriate in year 7, the Commissioner may consider the economic substance of the arrangements between USSub and FP, and the parties’ course of conduct throughout their relationship. Based on this analysis, the Commissioner determines that it is unlikely that,ex ante, an uncontrolled taxpayer operating at arm’s length would engage in the incre- mental marketing activities to develop or enhance an intangible owned by another party unless it re- ceived contemporaneous compensation or otherwise had a reasonable anticipation of receiving a future benefit from those activities. In this case, USSub’s undertaking the incremental marketing activities in years 1 through 6 is a course of conduct that is inconsistent with the parties’ attribution to FP in year 7 of substantially all the premium return from the enhanced YY trademark in the United States market. Therefore, the Commissioner may impute one or more agreements between USSub and FP, consis- tent with the economic substance of their course of conduct, which would afford USSub an appropriate portion of the premium return from the YY trademark wristwatches. For example, the Commissioner may impute a separate services agreement that affords USSub contingent-payment compensation for its incremental marketing activities in years 1 through 6, which benefited FP by contributing to the value of the trademark owned by FP. In the alternative, the Commissioner may impute a long-term, exclu- sive agreement to exploit the YY trademark in the United States that allows USSub to benefit from the incremental marketing activities it performed. As another alternative, the Commissioner may require FP to compensate USSub for terminating USSub’s imputed long-term, exclusive agreement to exploit the YY trademark in the United States, an agreement that USSub made more valuable at its own expense and risk. The taxpayer may present additional facts that could indicate which of these or other alternative agreements best reflects the economic substance of the underlying transactions, consistent with the parties’ course of conduct in the particular case. Example 4.Contractual terms imputed from eco- nomic substance. (i) FP, a foreign producer of athletic gear, is the registered holder of the AA trademark in the United States and in other countries world- wide. In year 1, FP enters into a licensing agree- ment that affords its newly organized United States subsidiary, USSub, exclusive rights to certain man- ufacturing and marketing intangibles (including the AA trademark) for purposes of manufacturing and marketing athletic gear in the United States under the AA trademark. The contractual terms of this agree- ment obligate USSub to pay FP a royalty based on sales, and also obligate both FP and USSub to under- take without separate compensation specified types and levels of marketing activities. Unrelated foreign businesses license independent United States busi- nesses to manufacture and market athletic gear in the United States, using trademarks owned by the unre- lated foreign businesses. The contractual terms of these uncontrolled transactions require the licensees to pay royalties based on sales of the merchandise, and obligate the licensors and licensees to undertake without separate compensation specified types and levels of marketing activities. In years 1 through 6, USSub manufactures and sells athletic gear under the AA trademark in the United States. Assume that, af- ter adjustments are made to improve the reliability of the comparison for any material differences relating to marketing activities, manufacturing or marketing intangibles, and other comparability factors, the roy- alties paid by independent licensees would provide the most reliable measure of the arm’s length royalty owed by USSub to FP, apart from the additional facts in paragraph (ii) of this example. (ii) In years 1 through 6, USSub performs incre- mental marketing activities with respect to the AA trademark athletic gear, in addition to the activities re- quired under the terms of the license agreement with FP, that are also incremental as compared to those ob- served in the comparables. FP does not directly or indirectly compensate USSub for performing these incremental activities during years 1 through 6. By year 7, AA trademark athletic gear generates a pre- mium return in the United States, as compared to sim- ilar athletic gear marketed by independent licensees. In year 7, USSub and FP enter into a separate ser- vices agreement under which FP agrees to compen- sate USSub on a cost basis for the incremental mar- keting activities that USSub performed during years 1 through 6, and to compensate USSub on a cost basis for any incremental marketing activities it may per- form in year 7 and subsequent years. In addition, the parties revise the license agreement executed in year 1, and increase the royalty to a level that attributes to FP substantially all the premium return from sales of the AA trademark athletic gear in the United States. (iii) In determining whether an allocation of in- come is appropriate in year7, the Commissioner may consider the economic substance of the arrangements between USSub and FP and the parties’ course of conduct throughout their relationship. Based on this analysis, the Commissioner determines that it is un- likely that,ex ante, an uncontrolled taxpayer operat- ing at arm’s length would engage in the incremental marketing activities to develop or enhance an intan- gible owned by another party unless it received con- temporaneous compensationorotherwisehadarea- sonable anticipation of a future benefit. In this case, USSub’s undertaking the incremental marketing ac- tivities in years 1 through 6 is a course of conduct that is inconsistent with the parties’ adoption in year 7 of contractual terms by which FP compensates USSub 2006–34 I.R.B.274August 21, 2006 on a cost basis for the incremental marketing activi- ties that it performed. Therefore, the Commissioner may impute one or more agreements between USSub and FP, consistent with the economic substance of their course of conduct, which would afford USSub an appropriate portion of the premium return from the AA trademark athletic gear. For example, the Com- missioner may impute a separate services agreement that affords USSub contingent-payment compensa- tion for the incremental activities it performed during years 1 through 6, which benefited FP by contributing to the value of the trademark owned by FP. In the al- ternative, the Commissioner may impute a long-term, exclusive United States license agreement that allows USSub to benefit from the incremental activities. As another alternative, the Commissioner may require FP to compensate USSub for terminating USSub’s imputed long-term United States license agreement, a license that USSub made more valuable at its own ex- pense and risk. The taxpayer may present additional facts that could indicate which of these or other al- ternative agreements best reflects the economic sub- stance of the underlying transactions, consistent with the parties’ course of conduct in this particular case. Example 5.Non-arm’s length compensation.(i) The facts are the same as in paragraph (i) ofEx- ample 4.AsinExample 4, assume that, after ad- justments are made to improve the reliability of the comparison for any material differences relating to marketing activities, manufacturing or marketing in- tangibles, and other comparability factors, the roy- alties paid by independent licensees would provide the most reliable measure of the arm’s length royalty owed by USSub to FP, apart from the additional facts described in paragraph (ii) of this example. (ii) In years 1 through 4, USSub performs certain incremental marketing activities with respect to the AA trademark athletic gear, in addition to the ac- tivities required under the terms of the basic license agreement, that are also incremental as compared with those activities observed in the comparables. At the start of year 1, FP enters into a separate services agreement with USSub, which states that FP will compensateUSSubquarterly,inanamountequalto specified costs plus X%, for these incremental mar- keting functions. Further, these written agreements reflect the intent of the parties that USSub receive such compensation from FP throughout the term of the agreement, without regard to the success or failure of the promotional activities. During years 1 though 4, USSub performs marketing activities pur- suant to the separate services agreement and in each year USSub receives the specified compensation from FP on a cost of services plus basis. (iii) In evaluating year 4, the Commissioner per- forms an analysis of independent parties that perform promotional activities comparable to those performed by USSub and that receive separately-stated compen- sation on a current basis without contingency. The Commissioner determines that the magnitude of the specified cost plus X% is outside the arm’s length range in each of years 1 through 4. Based on an eval- uation of all the facts and circumstances, the Com- missioner makes an allocation to require payment of compensation to USSub for the promotional activ- ities performed in year 4, based on the median of the interquartile range of the arm’s length markups charged by the uncontrolled comparables described in §1.482–1(e)(3). (iv) Given that based on facts and circumstances, the terms agreed by the controlled parties were that FP would bear all risks associated with the promo- tional activities performed by USSub to promote the AA trademark product in the United States market, and given that the parties’ conduct during the years examined was consistent with this allocation of risk, the fact that the cost of services plus markup on USSub’s services was outside the arm’s length range does not, without more, support imputation of additional contractual terms based on alternative views of the economic substance of the transaction, such as terms indicating that USSub, rather than FP, bore the risk associated with these activities. In other facts and circumstances, had the compensation paid to USSub been significantly outside the arm’s length range, that might lead the Commissioner to exam- ine further whether, despite the contractual terms that require cost-plus reimbursement of USSub, the economic substance of the transaction was not consistent with FP’s bearing the risk associated with promotional activities in the United States market. Example 6.Contractual terms imputed from eco- nomic substance. (i) Company X is a member of a controlled group that has been in operation in the pharmaceutical sector for many years. In years 1 through 4, Company X undertakes research and de- velopment activities. As a result of those activities, Company X developed a compound that may be more effective than existing medications in the treatment of certain conditions. (ii)CompanyYisacquiredinyear4bythecon- trolled group that includes Company X. Once Com- pany Y is acquired, Company X makes available to Company Y a large amount of technical data concern- ing the new compound, which Company Y uses to register patent rights with respect to the compound in several jurisdictions, making Company Y the legal owner of such patents. Company Y then enters into licensing agreements with group members that afford Company Y 100% of the premium return attributable to use of the intangible by its subsidiaries. (iii) In determining whether an allocation is ap- propriate in year 4, the Commissioner may consider the economic substance of the arrangements between Company X and Company Y, and the parties’ course of conduct throughout their relationship. Based on this analysis, the Commissioner determines that it is unlikely that an uncontrolled taxpayer operating at arm’s length would make available the results of its research and development or perform services that re- sulted in transfer of valuable know how to another party unless it received contemporaneous compen- sation or otherwise had a reasonable anticipation of receiving a future benefitfrom those activities. In this case, Company X’s undertaking the research and development activities and then providing technical data and know-how to Company Y in year 4 is incon- sistent with the registration and subsequent exploita- tion of the patent by Company Y. Therefore, the Com- missioner may impute one or more agreements be- tween Company X and Company Y consistent with the economic substance of their course of conduct, which would afford Company X an appropriate por- tion of the premium return from the patent rights. For example, the Commissioner may impute a separate services agreement that affords Company X contin- gent-payment compensation for its services in year 4 for the benefit of Company Y, consisting of making available to Company Y technical data, know-how, and other fruits of research and development con- ducted in previous years. These services benefited Company Y by giving rise to and contributing to the value of the patent rights that were ultimately regis- tered by Company Y. In the alternative, the Commis- sioner may impute a transfer of patentable intangible rights from Company X to Company Y immediately preceding the registration of patent rights by Com- pany Y. The taxpayer may present additional facts that could indicate which of these or other alternative agreements best reflects the economic substance of the underlying transactions, consistent with the par- ties’ course of conduct in the particular case. (d)(3)(iii) and (iv) [Reserved]. For fur- ther guidance, see §1.482–1(d)(3)(iii) and (d)(3)(iv). (d)(3)(v)Property or services.Evalu- ating the degree of comparability between controlled and uncontrolled transactions requires a comparison of the property or services transferred in the transactions. This comparison may include any intangi- bles that are embedded in tangible property or services being transferred. The com- parability of the embedded intangibles will be analyzed using the factors listed in §1.482–4(c)(2)(iii)(B)(1) (comparable in- tangible property). The relevance of prod- uct comparability in evaluating the relative reliability of the results will depend on the method applied. For guidance concerning the specific comparability considerations applicable to transfers of tangible and intangible property and performance of services, see §§1.482–3 through 1.482–6 and §1.482–9T; see also §1.482–3(f), §1.482–4T(f)(4), and §1.482–9T(m), deal- ing with the coordination of the intangible and tangible property and performance of services rules. (d)(4) through (f)(2)(i) [Reserved]. For further guidance, see §1.482–1(d)(4) through (f)(2)(i). (f)(2)(ii)Allocation based on tax- payer’s actual transactions—(A)In gen- eral. The Commissioner will evaluate the results of a transaction as actually structured by the taxpayer unless its struc- ture lacks economic substance. However, the Commissioner may consider the al- ternatives available to the taxpayer in determining whether the terms of the con- trolled transaction would be acceptable to an uncontrolled taxpayer faced with the same alternatives and operating un- der comparable circumstances. In such cases the Commissioner may adjust the consideration charged in the controlled transaction based on the cost or profit August 21, 20062752006–34 I.R.B. of an alternative as adjusted to account for material differences between the al- ternative and the controlled transaction, but will not restructure the transaction as if the alternative had been adopted by the taxpayer. See §1.482–1(d)(3) (factors for determining comparability; contractual terms and risk); §§1.482–3(e), 1.482–4(d), and 1.482–9T(h) (unspecified methods). (f)(2)(ii)(B) through (f)(2)(iii)(A) [Reserved].For further guidance, see§1.482–1(f)(2)(ii)(B)through (f)(2)(iii)(A). (f)(2)(iii)(B)Circumstances warrant- ing consideration of multiple year data. The extent to which it is appropriate to consider multiple year data depends on the method being applied and the issue being addressed. Circumstances that may warrant considerationofdatafrommul- tiple years include the extent to which complete and accuratedata are available for the taxable year under review, the ef- fect of business cycles in the controlled taxpayer’s industry, or the effects of life cycles of the product or intangible be- ing examined. Data from one or more years before or after the taxable year un- der review must ordinarily be considered for purposes of applying the provisions of paragraph (d)(3)(iii) of this section (risk), paragraph (d)(4)(i) of this section (market share strategy), §1.482–4(f)(2) (periodic adjustments), §1.482–5 (com- parable profits method), §1.482–9T(f) (comparable profits method for services), and §1.482–9T(i) (contingent-payment contractual terms for services). On the other hand, multiple year data ordinarily will not be considered for purposes of ap- plying the comparable uncontrolled price method of §1.482–3(b) or the compara- ble uncontrolled services price method of §1.482–9T(c) (except to the extent that risk or market share strategy issues are present). (f)(2)(iii)(C) through (g)(3) [Re- served]. For further guidance, see §1.482–1(f)(2)(iii)(C) through (g)(3). (g)(4)Setoffs—(i)In general.Ifan allocation is made under section 482 with respect to a transaction between con- trolled taxpayers, the Commissioner will take into account the effect of any other non-arm’s length transaction between the same controlled taxpayers in the same taxable year which will result in a setoff against the original section 482 allocation. Such setoff, however, will be taken into account only if the requirements of para- graph (g)(4)(ii) of this section are satisfied. If the effect of the setoff is to change the characterization or source of the income or deductions, or otherwise distort taxable income, in such a manner as to affect the U.S. tax liability of any member, adjust- ments will be made to reflect the correct amount of each category of income or deductions. For purposes of this setoff provision, the term arm’s length refers to the amount defined in paragraph (b) of this section (Arm’s length standard), without regard to the rules in §1.482–2(a) that treat certain interest rates as arm’s length rates of interest. (g)(4)(ii) [Reserved]. For further guid- ance, see §1.482–1(g)(4)(ii). (g)(4)(iii)Examples. The following ex- amples illustrate this paragraph (g)(4): Example 1. P, a U.S. corporation, renders con- structionservicestoS,itsforeignsubsidiaryinCoun- try Y, in connection with the construction of S’s fac- tory. An arm’s length charge for such services de- termined under §1.482–9T would be $100,000. Dur- ing the same taxable year P makes available to S the use of a machine to be used in the construction of the factory, and the arm’s length rental value of the machine is $25,000. P bills S $125,000 for the ser- vices, but does not charge S for the use of the ma- chine. No allocation will be made with respect to the undercharge for the machine if P notifies the district director of the basis of the claimed setoff within 30 days after the date of the letter from the district direc- tor transmitting the examination report notifying P of the proposed adjustment, establishes that the excess amount charged for services was equal to an arm’s length charge for the use of the machine and that the taxable income and income tax liabilities of P are not distorted, and documents the correlative allocations resulting from the proposed setoff. (g)(4)(iii)Example 2through (h) [Reserved]. For further guidance, see §1.482–1(g)(4)(iii)Example 2through (h). (i)Definitions. The definitions set forth in paragraphs (i)(1) through (i)(10) of this section apply to this section and §§1.482–2T through 1.482–9T. (i)(1) through (i)(10) [Reserved]. For further guidance, see §1.482–1(i)(1) through (i)(10). (j)(1) through (j)(5) [Reserved]. For further guidance, see §1.482–1(j)(1) through (j)(5). (j)(6)(i) The provisions of paragraphs (a)(1), (b)(2)(i), (d)(3)(ii)(C)Example 3,Example 4,Example 5,andExample 6, (d)(3)(v), (f)(2)(ii)(A), (f)(2)(iii)(B), (g)(4)(i), (g)(4)(iii), and (i) of this section are generally applicable for taxable years beginning after December 31, 2006. (ii) A person may elect to apply the provisions of paragraphs (a)(1), (b)(2)(i), (d)(3)(ii)(C)Example 3,Example 4, Example 5,andExample 6,(d)(3)(v), (f)(2)(ii)(A), (f)(2)(iii)(B), (g)(4)(i), (g)(4)(iii), and (i) of this section to earlier taxable years in accordance with the rules set forth in §1.482–9T(n)(2). (iii) The applicability of §1.482–1T ex- pires on or before July 31, 2009. Par. 6. Section 1.482–2 is amended as follows: 1. Paragraph (b) is revised. 2. Paragraph (e) is added. The addition and revision read as fol- lows: §1.482–2 Determination of taxable income in specific situations. ***** (b)Rendering of services. [Reserved]. For further guidance, see §1.482–2T(b). ***** (e)Effective date. [Reserved]. For fur- ther guidance, see §1.482–2T(e). Par. 7. Section 1.482–2T is added to read as follows: §1.482–2T Determination of taxable income in specific situations (temporary). (a) [Reserved]. For further guidance, see §1.482–2(a). (b)Rendering of services.Forrules governing allocations under section 482 to reflect an arm’s length charge for con- trolled transactions involving the render- ing of services, see §1.482–9T. (c) [Reserved]. For further guidance, see §1.482–2(c). (d) [Reserved]. For further guidance, see §1.482–2(d). (e)Effective date—(1)In general.The provision of paragraph (b) of this section is generally applicable for taxable years beginning after December 31, 2006. (2)Election to apply regulation to ear- lier taxable years. A person may elect to apply the provisions of paragraph (b) of this section to earlier taxable years in accordance with the rules set forth in §1.482–9T(n)(2). (3)Expiration date. The applicability of §1.482–2T expires on or before July 31, 2009. 2006–34 I.R.B.276August 21, 2006 Par. 8. Section 1.482–4 is amended as follows: 1. Paragraph (f)(3) is revised. 2. Paragraphs (f)(4) and (f)(5) are re- designated as paragraphs (f)(5) and (f)(6), respectively. 3. New paragraphs (f)(4) and (f)(7) are added. The revision and additions read as fol- lows: §1.482–4 Methods to determine taxable income in connection with a transfer of intangible property. ***** (f) * * * (3) [Reserved]. For further guidance, see §1.482–4T(f)(3). (4) [Reserved]. For further guidance, see §1.482–4T(f)(4). ***** (7) [Reserved]. For further guidance, see §1.482–4T(f)(7). Par. 9. Section 1.482–4T is added to read as follows: §1.482–4T Methods to determine taxable income in connection with a transfer of intangible property (temporary). (a) through (f)(2) [Reserved]. For fur- ther guidance, see §1.482–4(a) through (f)(2). (f)(3)Ownership of intangible prop- erty—(i)Identification of owner—(A)In general. The legal owner of an intangible pursuant to the intellectual property law of the relevant jurisdiction, or the holder of rights constituting an intangible pursuant to contractual terms (such as the terms of a license) or other legal provision, will be considered the sole owner of the respec- tive intangible for purposes of this section unless such ownership is inconsistent with the economic substance of the underlying transactions. See §1.482–1(d)(3)(ii)(B) (identifying contractual terms). If no owner of the respective intangible is iden- tified under the intellectual property law of the relevant jurisdiction, or pursuant to contractual terms (including terms im- puted pursuant to §1.482–1(d)(3)(ii)(B)) or other legal provision, then the con- trolled taxpayer who has control of the intangible, based on all the facts and cir- cumstances, will be considered the sole owner of the intangible for purposes of this section. (B)Cost sharing arrangements. The rule in paragraph (f)(3)(i)(A) of this section will apply to interests in covered intangibles, as defined in §1.482–7(b)(4)(iv), only as provided in §1.482–7 (sharing of costs). (ii)Examples. The principles of this paragraph (f)(3) are illustrated by the fol- lowing examples: Example 1. FP, a foreign corporation, is the regis- tered holder of the AA trademark in the United States. FP licenses to its U.S. subsidiary, USSub, the exclu- sive rights to manufacture and market products in the United States under the AA trademark. FP is the owner of the trademark pursuant to intellectual prop- erty law. USSub is the owner of the license pursuant to the terms of the license, but is not the owner of the trademark. See paragraphs (b)(3)and(4)ofthissec- tion (defining an intangible as, among other things, a trademark or a license). Example 2. The facts are the same as inExam- ple 1. As a result of its sales and marketing activi- ties, USSub develops a list of several hundred credit- worthy customers that regularly purchase AA trade- marked products. Neither the terms of the contract between FP and USSub nor the relevant intellectual property law specify which party owns the customer list. Because USSub has knowledge of the contents of the list, and has practical control over its use and dissemination, USSub is considered the sole owner of the customer list for purposes of this paragraph (f)(3). (4)Contribution to the value of an in- tangible owned by another—(i)In general. The arm’s length consideration for a con- tribution by one controlled taxpayer that develops or enhances the value, or may be reasonably anticipated to develop or en- hance the value, of an intangible owned by another controlled taxpayer will be de- termined in accordance with the applica- ble rules under section 482. If the consid- eration for such a contribution is embed- ded within the contractual terms for a con- trolled transaction that involves such in- tangible, then ordinarily no separate allo- cation will be made with respect to such contribution. In such cases, pursuant to §1.482–1(d)(3), the contribution must be accounted for in evaluating the compara- bility of the controlled transaction to un- controlled comparables, and accordingly in determining the arm’s length consider- ation in the controlled transaction. (ii)Examples. The principles of this paragraph (f)(4) are illustrated by the fol- lowing examples: Example 1. A, a member of a controlled group, allows B, another member of the controlled group, to use tangible property, such as laboratory equipment, in connection with B’s development of an intangi- ble that B owns. By furnishing tangible property, A makes a contribution to the development of an intan- gible owned by another controlled taxpayer, B. Pur- suant to paragraph (f)(4)(i) of this section, the arm’s length charge for A’s furnishing of tangible property will be determined under the rules for use of tangible property in §1.482–2(c). Example 2. (i) Facts. FP, a foreign producer of wristwatches, is the registered holder of the YY trademark in the United States and in other countries worldwide. FP enters into an exclusive, five-year, renewable agreement with its newly organized U.S. subsidiary, USSub. The contractual terms of the agreement grant USSub the exclusive right to re-sell trademark YY wristwatches in the United States, obligate USSub to pay a fixed price per wristwatch throughout the entire term of the contract, and ob- ligate both FP and USSub to undertake without separate compensation specified types and levels of marketing activities. (ii) The consideration for FP’s and USSub’s mar- keting activities, as well as the consideration for the exclusive right to re-sell YY trademarked merchan- dise in the United States, are embedded in the trans- fer price paid for the wristwatches. Accordingly, pur- suant to paragraph (f)(4)(i) of this section, ordinarily no separate allocation would be appropriate with re- spect to these embedded contributions. (iii) Whether an allocation is warranted with re- spect to the transfer price for the wristwatches is de- termined under §1.482–1, 1.482–3, and this section through §1.482–6. The comparability analysis would include consideration of all relevant factors, includ- ing the nature of the intangible embedded in the wrist- watches and the nature of the marketing activities re- quired under the agreement. This analysis would also take into account that the compensation for the activ- ities performed by USSub and FP, as well as the con- sideration for USSub’s use of the YY trademark, is embedded in the transfer price for the wristwatches, rather than provided for in separate agreements. See §1.482–3(f) and 1.482–9T(m)(4). Example 3. (i) Facts. FP, a foreign producer of athletic gear, is the registered holder of the AA trade- mark in the United States and in other countries. In year 1, FP licenses to a newly organized U.S. sub- sidiary, USSub, the exclusive rights to use certain manufacturing and marketing intangibles to manu- facture and market athletic gear in the United States under the AA trademark. The license agreement obli- gates USSub to pay a royalty based on sales of trade- marked merchandise. The license agreement also ob- ligates FP and USSub to perform without separate compensation specified types and levels of marketing activities. In year 1, USSub manufactures and sells athletic gear under the AA trademark in the United States. (ii) The consideration for FP’s and USSub’s re- spective marketing activities is embedded in the con- tractual terms of the license for the AA trademark. Accordingly, pursuant to paragraph (f)(4)(i) of this section, ordinarily no separate allocation would be appropriate with respect to the embedded contribu- tions in year 1. See §1.482–9T(m)(4). (iii) Whether an allocation is warranted with respect to the royalty under the license agreement would be analyzed under §1.482–1 and this section through §1.482–6. The comparability analysis would include consideration of all relevant factors, such as August 21, 20062772006–34 I.R.B. the term and geographical exclusivity of the license, the nature of the intangibles subject to the license, and the nature of the marketing activities required to be undertaken pursuant to the license. Pursuant to paragraph (f)(4)(i) of this section, the analysis would also take into account the fact that the com- pensation for the marketing services is embedded in the royalty paid for use of the AA trademark, rather than provided for in a separate services agreement. For illustrations of application of the best method rule, see §1.482–8TExample 10,Example 11,and Example 12. Example 4. (i) Facts. The year 1 facts are the same as inExample 3, with the following exceptions. In year 2, USSub undertakes certain incremental mar- keting activities, in addition to those required by the contractual terms of the license for the AA trademark executed in year 1. The parties do not execute a sepa- rate agreement with respect to these incremental mar- keting activities performed by USSub. The license agreement executed in year 1 is of sufficient dura- tion that it is reasonable to anticipate that USSub will obtain the benefit of its incremental activities, in the form of increased sales or revenues of trademarked products in the U.S. market. (ii) To the extent that it was reasonable to antic- ipate that USSub’s incremental marketing activities would increase the value only of USSub’s intangible (that is, USSub’s license to use the AA trademark for a specified term), and not the value of the AA trade- mark owned by FP, USSub’s incremental activities do not constitute a contribution for which an allocation is warranted under paragraph (f)(4)(i) of this section. Example 5. (i) Facts. The year 1 facts are the same as inExample 3. In year 2, FP and USSub en- ter into a separate services agreement that obligates USSub to perform certain incremental marketing ac- tivities to promote AA trademark athletic gear in the United States, above and beyond the activities spec- ified in the license agreement executed in year 1. In year 2, USSub begins to perform these incremental activities, pursuant to the separate services agreement with FP. (ii) Whether an allocation is warranted with re- spect to USSub’s incremental marketing activities covered by the separate services agreement would be evaluated under §§1.482–1 and 1.482–9T, including a comparison of the compensation provided for the services with the results obtained under a method pursuant to §1.482–9T, selected and applied in ac- cordance with the best method rule of §1.482–1(c). (iii) Whether an allocation is warranted with re- spect to the royalty under the license agreement is determined under §1.482–1 and this section through §1.482–6. The comparability analysis would include consideration of all relevant factors, such as the term and geographical exclusivity of the license, the nature of the intangibles subject to the license, and the nature of the marketing activities required to be undertaken pursuant to the license. The comparability analysis would take into account that the compensation for the incremental activities by USSub is provided for in the separate services agreement, rather than embedded in the royalty paid for use of the AA trademark. For il- lustrations of application of the best method rule, see §1.482–8TExample 10,Example 11,andExample 12. Example 6. (i) Facts. The year 1 facts are the same as inExample 3.Inyear2,FPandUSSubenter into a separate services agreement that obligates FP to perform incremental marketing activities, not speci- fied in the year 1 license, by advertising AA trade- marked athletic gear in selected international sport- ing events, such as the Olympics and the soccer World Cup. FP’s corporate advertising department develops and coordinates these special promotions. The sep- arate services agreement obligates USSub to pay an amount to FP for the benefit to USSub that may rea- sonably be anticipated as the result of FP’s incremen- tal activities. The separate services agreement is not a qualified cost sharing arrangement under §1.482–7. FP begins to perform the incremental activities in year 2 pursuant to the separate services agreement. (ii) Whether an allocation is warranted with respect to the incremental marketing activities per- formed by FP under the separate services agreement would be evaluated under §1.482–9T. Under the circumstances, it is reasonable to anticipate that FP’s activities would increase the value of USSub’s license as well as the value of FP’s trademark. Accordingly, the incremental activities by FP may constitute in part a controlled services transaction for which USSub must compensate FP. The analysis of whether an allocation is warranted would include a comparison of the compensation provided for the services with the results obtained under a method pursuant to §1.482–9T, selected and applied in ac- cordance with the best method rule of §1.482–1(c). (iii) Whether an allocation is appropriate with respect to the royalty under the license agree- ment would be evaluated under §1.482–1 through §1.482–6 of this section. The comparability analysis would include consideration of all relevant factors, such as the term and geographical exclusivity of USSub’s license, the nature of the intangibles subject to the license, and the marketing activities required to be undertaken by both FP and USSub pursuant to the license. This comparability analysis would take into account that the compensation for the incremental activities performed by FP was provided for in the separate services agreement, rather than embedded in the royalty paid for use of the AA trademark. For illustrations of application of the best method rule, see §1.482–8T,Example 10,Example 11,and Example 12. (f)(5) and (f)(6) [Reserved]. For further guidance, see §1.482–4(f)(5) and (f)(6). (f)(7)Effective date.(i)In general.The provisions of paragraphs (f)(3) and (f)(4) are generally applicable for taxable years beginning after December 31, 2006. (ii)Election to apply regulation to ear- lier taxable years. A person may elect to apply the provisions of paragraphs (f)(3) and (f)(4) of this section to earlier taxable years in accordance with the rules set forth in §1.482–9T(n)(2). (iii)Expiration date. The applicability of §1.482–4T expires on or before July 31, 2009. Par. 10. Section 1.482–6 is amended by revising paragraphs (c)(2)(ii)(B)(1), (c)(2)(ii)(D), (c)(3)(i)(A), (c)(3)(i)(B), and (c)(3)(ii)(D) to read as follows: The revisions and addition read as fol- lows: §1.482–6 Profit split method. ***** (c) * * * (2) * * * (ii) * * * (B) * * * (1) * * * [Reserved]. For further guidance, see §1.482–6T(c)(2) (ii)(B)(1). ***** (D) [Reserved]. For further guidance, see §1.482–6T(c)(2)(ii)(D). ***** (3) * * * (i) * * * (A) [Reserved]. For further guidance, see §1.482–6T(c)(3)(i)(A). (B) [Reserved]. For further guidance, see §1.482–6T(c)(3)(i)(B). (ii) * * * (D) [Reserved]. For further guidance, see §1.482–6T(c)(3)(ii)(D). ***** Par. 11. Section 1.482–6T is added to read as follows: §1.482–6T Profit split method (temporary). (a) through (c)(2)(ii)(A) [Reserved]. For further guidance, see §1.482–6(a) through (c)(2)(ii)(A). (c)(2)(ii)(B)Comparability—(1)In general. The degree of comparability between the controlled and uncontrolled taxpayers is determined by applying the comparability provisions of §1.482–1(d). The comparable profit split compares the division of operating profits among the controlled taxpayers to the division of operating profits among uncontrolled tax- payers engaged in similar activities under similar circumstances. Although all of the factors described in §1.482–1(d)(3) must be considered, comparability under this method is particularly dependent on the considerations described under the compa- rable profits method in §1.482–5(c)(2) or §1.482–9T(f)(2)(iii) because this method is based on a comparison of the operating profit of the controlled and uncontrolled taxpayers. In addition, because the con- tractual terms of the relationship among 2006–34 I.R.B.278August 21, 2006 the participants in the relevant business ac- tivity will be a principal determinant of the allocation of functions and risks among them, comparability under this method also depends particularly on the degree of similarity of the contractual terms of the controlled and uncontrolled taxpayers. Finally, the comparable profit split may not be used if the combined operating profit (as a percentage of the combined assets) of the uncontrolled comparables varies significantly from that earned by the controlled taxpayers. (c)(2)(ii)(B)(2) through (C) [Re- served]. For further guidance, see §1.482–6(c)(2)(ii)(B)(2) through (C). (c)(2)(ii)(D)Other factors affecting reliability. Like the methods described in §§1.482–3, 1.482–4, 1.482–5 and 1.482–9T, the comparable profit split re- lies exclusively on external market bench- marks. As indicated in §1.482–1(c)(2)(i), as the degree of comparability between the controlled and uncontrolled transactions increases, the relative weight accorded the analysis under this method will increase. In addition, the reliability of the analysis under this method may be enhanced by the fact that all parties to the controlled trans- action are evaluated under the comparable profit split. However, the reliability of the results of an analysis based on information from all parties to a transaction is affected by the reliability of the data and the as- sumptions pertaining to each party to the controlled transaction. Thus, if the data and assumptions are significantly more reliable with respect to one of the parties than with respect to the others, a different method, focusing solely on the results of that party, may yield more reliable results. (c)(3)(i) [Reserved]. For further guid- ance, see §1.482–6(c)(3)(i). (c)(3)(i)(A)Allocate income to routine contributions. The first step allocates op- erating income to each party to the con- trolled transactions to provide a market re- turn for its routine contributions to the rel- evant business activity. Routine contribu- tions are contributions of the same or a similar kind to those made by uncontrolled taxpayers involved in similar business ac- tivities for which it is possible to identify market returns. Routine contributions or- dinarily include contributions of tangible property, services and intangibles that are generally owned by uncontrolled taxpay- ers engaged in similar activities. A func- tional analysis is required to identify these contributions according to the functions performed, risks assumed, and resources employed by each of the controlled tax- payers. Market returns for the routine con- tributions should be determined by refer- ence to the returns achieved by uncon- trolled taxpayers engaged in similar ac- tivities, consistent with the methods de- scribed in §§1.482–3, 1.482–4, 1.482–5 and 1.482–9T. (B)Allocate residual profit—(1)Non- routine contributions generally.The allocation of income to the controlled taxpayer’s routine contributions will not reflect profits attributable to each con- trolled taxpayer’s contributions to the rel- evant business activity that are not routine (nonroutine contributions). A nonroutine contribution is a contribution that is not accounted for as a routine contribution. Thus, in cases where such nonroutine contributions are present there normally will be an unallocated residual profit af- ter the allocation of income described in paragraph (c)(3)(i)(A) of this section. Un- der this second step, the residual profit generally should be divided among the controlled taxpayers based upon the rela- tive value of their nonroutine contributions to the relevant business activity. The rela- tive value of the nonroutine contributions of each taxpayer should be measured in a manner that most reliably reflects each nonroutine contribution made to the con- trolled transaction and each controlled taxpayer’s role in the nonroutine contri- butions. If the nonroutine contribution by one of the controlled taxpayers is also used in other business activities (such as trans- actions with other controlled taxpayers), an appropriate allocation of the value of the nonroutine contribution must be made among all the business activities in which it is used. (2)Nonroutine contributions of intan- gible property. In many cases, nonrou- tine contributions of a taxpayer to the rel- evant business activity may be contribu- tions of intangible property. For purposes of paragraph (c)(3)(i)(B)(1) of this section, the relative value of nonroutine intangible property contributed by taxpayers may be measured by external market benchmarks that reflect the fair market value of such intangible property. Alternatively, the rel- ative value of nonroutine intangible prop- erty contributions may be estimated by the capitalized cost of developing the intangi- ble property and all related improvements and updates, less an appropriate amount of amortization based on the useful life of each intangible. Finally, if the intangi- ble development expenditures of the par- ties are relatively constant over time and the useful life of the intangible property contributed by all parties is approximately the same, the amount of actual expendi- tures in recent years may be used to esti- mate the relative value of nonroutine intan- gible property contributions. (c)(3)(ii)(A) through (C) [Re- served]. For further guidance, see §1.482–6(c)(3)(ii)(A) through (C). (c)(3)(ii)(D)Other factors affecting reliability. Like the methods described in §§1.482–3, 1.482–4, 1.482–5 and 1.482–9T, the first step of the residual profit split relies exclusively on exter- nal market benchmarks. As indicated in §1.482–1(c)(2)(i), as the degree of com- parability between the controlled and uncontrolled transactions increases, the relative weight accorded the analysis un- der this method will increase. In addition, to the extent the allocation of profits in the second step is not based on external market benchmarks, the reliability of the analysis will be decreased in relation to an analysis under a method that relies on market benchmarks. Finally, the reliabil- ity of the analysis under this method may be enhanced by the fact that all parties to the controlled transaction are evaluated under the residual profit split. However, the reliability of the results of an analysis based on information from all parties to a transaction is affected by the reliability of the data and the assumptions pertaining to each party to the controlled transaction. Thus, if the data and assumptions are sig- nificantly more reliable with respect to one of the parties than with respect to the others, a different method, focusing solely on the results of that party, may yield more reliable results. (c)(3)(iii) [Reserved]. For further guid- ance, see §1.482–6(c)(3)(iii). (d)Effective date—(1)In general.The provisions of paragraphs (c)(2)(ii)(B)(1) and (D), (c)(3)(i)(A) and (B), and (c)(3)(ii)(D) of this section are gener- ally applicable for taxable years beginning after December 31, 2006. (2)Election to apply regulation to ear- lier taxable years. A person may elect August 21, 20062792006–34 I.R.B. to apply the provisions of paragraphs (c)(2)(ii)(B)(1) and (D), (c)(3)(i)(A) and (B), and (c)(3)(ii)(D) of this section to earlier taxable years in accordance with the rules set forth in §1.482–9T(n)(2). (3)Expiration date. The applicability of §1.482–6T expires on or before July 31, 2009. Par. 12. Section 1.482–8 is amended as follows: 1. Designating the undesignated intro- ductory text as paragraph (a) and adding a paragraph heading. 2. Adding paragraph (b) designation, heading andExamples 10through12. The additions read as follows: §1.482–8 Examples of the best method rule. (a)Introduction.*** (b)Examples.*** Examples 10through12.[Reserved]. For further guidance, see 1.482–8T(b)Ex- amples 10through12. Par. 13. Section 1.482–8T is added to read as follows: §1.482–8T Examples of the best method rule (temporary). (a) [Reserved]. For further guidance, see §1.482–8(a). (b) [Reserved]. For further guidance, see §1.482–8(b),Examples 1through9. Example 10.Cost of services plus method pre- ferred to other methods. (i) FP designs and man- ufactures consumer electronic devices that incorpo- rate advanced technology. In year 1, FP introduces Product X, an entertainment device targeted primar- ily at the youth market. FP’s wholly-owned, exclu- sive U.S. distributor, USSub, sells Product X in the U.S. market. USSub hires an independent marketing firm, Agency A, to promote Product X in the U.S. market. Agency A has successfully promoted other electronic products on behalf of other uncontrolled parties. USSub executes a one-year, renewable con- tract with Agency A that requires it to develop the market for Product X, within an annual budget set by USSub. In years 1 through3, Agency A develops ad- vertising, buys media, and sponsors events featuring Product X. Agency A receives a markup of 25% on all expenses of promoting Product X, with the exception of media buys, which are reimbursed at cost. During year 3, sales of Product X decrease sharply, as Prod- uct X is displaced by competitors’ products. At the end of year 3, sales of Product X are discontinued. (ii) Prior to the start of year 4, FP develops a new entertainment device, Product Y. Like Product X, Product Y is intended for sale to the youth mar- ket, but it is marketed under a new trademark dis- tinct from that used for Product X. USSub decides to perform all U.S. market promotion for Product Y. USSub hires key Agency A staff members who han- dled the successful Product X campaign. To pro- mote Product Y, USSub intends to use methods sim- ilar to those used successfully by Agency A to pro- mote Product X (print advertising, media, event spon- sorship, etc.). FP and USSub enter into a one-year, renewable agreement concerning promotion of Prod- uct Y in the U.S. market. Under the agreement, FP compensates USSub for promoting Product Y, based on a cost of services plus markup of A%. Third-party media buys by USSub in connection with Product Y are reimbursed at cost. (iii) Assume that under the contractual arrange- ments between FP and USSub, the arm’s length con- sideration for Product Y and the trademark or other intangibles may be determined reliably under one or more transfer pricing methods. At issue in this exam- ple is the separate evaluation of the arm’s length com- pensation for the year 4 promotional activities per- formed by USSub pursuant to its contract with FP. (iv) USSub’s accounting records contain reliable data that separately state the costs incurred to pro- mote Product Y. A functional analysis indicates that USSub’s activities to promote Product Y in year 4 are similar to activities performed by Agency A during years 1 through 3 under the contract with FP. In other respects, no material differences exist in the market conditions or the promotional activities performed in year 4, as compared to those years 1 through 3. (v) It is possible to identify uncontrolled distribu- tors or licensees of electronic products that perform, as one component of their business activities, pro- motional activities similar to those performed by USSub. However, it is unlikely that publicly avail- able accounting data from these companies would allow computation of the comparable transactional costs or total services costs associated with the mar- keting or promotional activities that these entities perform, as one component of business activities. If that were possible, the comparable profits method for services might provide a reliable measure of an arm’s length result. The functional analysis of the marketing activities performed by USSub in year 4 indicates that they are similar to the activities per- formed by Agency A in years 1 through 3 for Product X. Because reliable information is available concern- ing the markup on costs charged in a comparable uncontrolled transaction, the most reliable measure of an arm’s length price is the cost of services plus method in §1.482–9T(e). Example 11.CPM for services preferred to other methods. (i) FP manufactures furniture and acces- sories for residential use. FP sells its products to re- tailers in Europe under the trademark, “Moda.” FP holds all worldwide rights to the trademark, includ- ing in the United States. USSub is FP’s wholly- owned subsidiary in the U.S. market and the exclu- sive U.S. distributor of FP’s merchandise. Histori- cally, USSub dealt only with specialized designers in the U.S. market and advertised in trade publications targeted to this market. Although items sold in the U.S. and Europe are physically identical, USSub’s U.S. customers generally resell the merchandise as non-branded merchandise. (ii) FP retains an independent firm to evaluate the feasibility of selling FP’s trademarked merchandise in the general wholesale and retail market in the United States. The study concludes that this seg- ment of the U.S. market, which is not exploited by USSub, may generate substantial profits. Based on this study, FP enters into a separate agreement with USSub, which provides that USSub will develop this market in the United States for the benefit of FP. USSub separately accounts for personnel expenses, overhead, and out-of-pocket costs attributable to the initial stage of the marketing campaign (Phase I). USSub receives as compensation its costs, plus a markup of X%, for activities in Phase I. At the end of Phase I, FP will evaluate the program. If success appears likely, USSub will begin full-scale distribu- tion of trademarked merchandise in the new market segment, pursuant to agreements negotiated with FP at that time. (iii) Assume that under the contractual arrange- ments in effect between FP and USSub, the arm’s length consideration for the merchandise and the trademark or other intangibles may be determined reliably under one or more transfer pricing methods. At issue in this example is the separate evaluation of the arm’s length compensation for the marketing activities conducted by USSub in years 1 and follow- ing. (iv) A functional analysis reveals that USSub’s activities consist primarily of modifying the promo- tional materials created by FP, negotiating media buys, and arranging promotional events. FP sepa- rately compensates USSub for all Phase I activities, and detailed accounting information is available regarding the costs of these activities. The Phase I activities of USSub are similar to those of uncon- trolled companies that perform, as their primary business activity, a range of advertising and media relations activities on a contract basis for uncon- trolled parties. (v) No information is available concerning the comparable uncontrolled prices for services in trans- actions similar to those engaged in by FP and USSub. Nor is any information available concerning uncon- trolled transactions that would allow application of the cost of services plus method. It is possible to iden- tify uncontrolled distributors or licensees of home furnishings that perform, as one component of their business activities, promotional activities similar to those performed by USSub. However, it is unlikely that publicly available accounting data from these companies would allow computation of the compa- rable transactional costs or total services costs as- sociated with the marketing or promotional activi- ties that these entities performed, as one component of their business activities. On the other hand, it is possible to identify uncontrolled advertising and me- dia relations companies, the principal business activ- ities of which are similar to the Phase I activities of USSub. Under these circumstances, the most reliable measure of an arm’s length price is the comparable profits method of §1.482–9T(f). The uncontrolled ad- vertising comparables’ treatment of material items, such as classification of items as cost of goods sold or selling, general, and administrative expenses, may differ from that of USSub. Such inconsistencies in accounting treatment between the uncontrolled com- parables and the tested party, or among the compara- bles, are less important when using the ratio of operat- ing profit to total services costs under the comparable profits method for services in §1.482–9T(f). Under this method, the operating profit of USSub from the Phase I activities is compared to the operating profit of uncontrolled parties that perform general advertis- 2006–34 I.R.B.280August 21, 2006 ing and media relations as their primary business ac- tivity. Example 12.Residual profit split preferred to other methods. (i) USP is a manufacturer of athletic apparel sold under the AA trademark, to which FP owns the worldwide rights. USP sells AA trademark apparel in countries throughout the world, but prior to year 1, USP did not sell its merchandise in Country X. In year 1, USP acquires an uncontrolled Country X company which becomes its wholly-owned sub- sidiary, XSub. USP enters into an exclusive distri- bution arrangement with XSub in Country X. Before being acquired by USP in year 1, XSub distributed athletic apparel purchased from uncontrolled suppli- ers and resold that merchandise to retailers. After be- ing acquired by USP in year 1, XSub continues to dis- tribute merchandise from uncontrolled suppliers and also begins to distribute AA trademark apparel. Un- der a separate agreement with USP, XSub uses its best efforts to promote the AA trademark in Country X, with the goal of maximizing sales volume and rev- enues from AA merchandise. (ii) Prior to year 1, USP executed long-term en- dorsement contracts with several prominent profes- sional athletes. These contracts give USP the right to use the names and likenesses of the athletes in any country in which AA merchandise is sold during the term of the contract. These contracts remain in ef- fect for five years, startinginyear1. Beforebeing acquired by USP, XSub renewed a long-term agree- ment with SportMart, an uncontrolled company that owns a nationwide chain of sporting goods retailers in Country X. XSub has been SportMart’s primary supplier from the time that SportMart began opera- tions. Under the agreement, SportMart will provide AA merchandise preferred shelf-space and will fea- ture AA merchandise at no charge in its print ads and seasonal promotions. In consideration for these com- mitments, USP and XSub grant SportMart advance access to new products and the right to use the profes- sional athletes under contract with USP in SportMart advertisements featuring AA merchandise (subject to approval of content by USP). (iii) Assume that it is possible to segregate all transactions by XSub that involve distribution of merchandise acquired from uncontrolled distributors (non-controlled transactions). In addition, assume that, apart from the activities undertaken by USP and XSub to promote AA apparel in Country X, the arm’s length compensation for other functions performed by USP and XSub in the Country X market in years 1 and following can be reliably determined. At issue in thisExample 12is the application of the residual profit split analysis to determine the appropriate division between USP and XSub of the balance of the operating profits from the Country X market, that is the portion attributable to nonroutine contributions to the marketing and promotional activities. (iv) A functional analysis of the marketing and promotional activities conducted in the Country X market, as described in this example, indicates that both USP and XSub made nonroutine contribu- tions to the business activity. USP contributed the long-term endorsement contracts with professional athletes. XSub contributed its long-term contractual rights with SportMart, which were made more valu- able by its successful, long-term relationship with SportMart. (v) Because both USP and XSub made valuable, nonroutine contributions to the marketing and pro- motional activities in Country X, neither the com- parable uncontrolled services price method, the cost of services plus method, nor the comparable profits method for services will provide a reliable measure of an arm’s length result. On account of the valu- able, nonroutine contributions made by both parties, the most reliable measure of an arm’s length result is the residual profit split method in §1.482–9T(g). The residual profit split analysis would take into ac- count both routine and nonroutine contributions by USP and XSub, in order to determine an appropri- ate allocation of the combined operating profits in the Country X market from the sale of AA merchandise and from related promotional and marketing activi- ties. (c)Effective date—(1)In general.The provisions of §1.482–8TExample 10,Ex- ample 11,andExample 12are generally applicable for taxable years beginning af- ter December 31, 2006. (2)Election to apply regulation to ear- lier taxable years. A person may elect to apply the provisions of §1.482–8TExam- ple 10,Example 11,andExample 12to ear- lier taxable years in accordance with the rules set forth in §1.482–9T(n)(2). (3)Expiration date. The applicability of §1.482–8T expires on or before July 31, 2009. Par. 14. Section 1.482–9T is added to read as follows: §1.482–9T Methods to determine taxable income in connection with a controlled services transaction (temporary). (a)In general. The arm’s length amount charged in a controlled services transaction must be determined under one of the methods provided for in this section. Each method must be applied in accordance with the provisions of §1.482–1, including the best method rule of §1.482–1(c), the comparability analysis of §1.482–1(d), and the arm’s length range of §1.482–1(e), except as those provisions are modified in this section. The methods are— (1) The services cost method, described in paragraph (b) of this section; (2) The comparable uncontrolled ser- vices price method, described in paragraph (c)ofthissection; (3) The gross services margin method, described in paragraph (d) of this section; (4) The cost of services plus method, described in paragraph (e) of this section; (5) The comparable profits method, de- scribed in §1.482–5 and in paragraph (f) of this section; (6) The profit split method, described in §1.482–6 and in paragraph (g) of this section; and (7) Unspecified methods, described in paragraph (h) of this section. (b)Services cost method—(1)In gen- eral. The services cost method evaluates whether the amount charged for covered services meeting the requirements of para- graphs (b)(2) and (b)(3) of this section is arm’s length by reference to the total ser- vices costs (as defined in paragraph (j) of this section) with no markup. If covered services meet the conditions of this para- graph (b), then the services cost method will be considered the best method for pur- poses of §1.482–1(c), and the Commis- sioner’s allocations will be limited to ad- justing the amount charged for such ser- vices to the properly determined amount of such total services costs. (2)Not services that contribute signif- icantly to fundamental risks of business success or failure. Services are not cov- ered services unless the taxpayer reason- ably concludes in its business judgment that the covered services do not contribute significantly to key competitive advan- tages, core capabilities, or fundamental risks of success or failure in one or more trades or businesses of the renderer, the recipient, or both. In evaluating the rea- sonableness of the conclusion required by this paragraph (b)(2), consideration will be given to all the facts and circumstances. (3)Other conditions on application of services cost method. The arm’s length amount charged in a controlled services transaction may be evaluated under the ser- vices cost method if it meets the require- mentsofparagraph(b)(3)(i)ofthissection and is not described in paragraph (b)(3)(ii) of this section. (i)Adequate books and records.Per- manent books of account and records are maintained for as long as the costs with re- spect to the covered services are incurred by the renderer. Such books and records must include a statement evidencing the taxpayer’s intention to apply the services cost method to evaluate the arm’s length charge for such services. Such books and records must be adequate to permit ver- ification by the Commissioner of the to- tal services costs incurred by the renderer, August 21, 20062812006–34 I.R.B. including a description of the services in question, identification of the renderer and the recipient of such services, and suffi- cient documentation to allow verification of the methods used to allocate and appor- tion such costs to the services in question in accordance with paragraph (k) of this section. (ii)Excluded transactions. The follow- ing categories of transactions, in whole or part, are not covered services: (A) Manufacturing; (B) Production; (C) Extraction, exploration or process- ing of natural resources; (D) Construction; (E) Reselling, distribution, acting as a sales or purchasing agent, or acting under a commission or other similar arrangement; (F) Research, development, or experi- mentation; (G) Engineering or scientific; (H) Financial transactions, including guarantees; and (I) Insurance or reinsurance. (4)Covered services. For purposes of this paragraph (b), covered services consist of a controlled transaction or a group of controlled service transactions (see §1.482–1(f)(2)(i) (aggregation of transactions)) that meets the definition of specified covered services or low margin covered services. (i)Specified covered services. Speci- fied covered services are controlled ser- vices transactions that the Commissioner specifies by revenue procedure. Services will be included in such revenue pro- cedure based upon the Commissioner’s determination that the specified covered services are support services common among taxpayers across industry sectors and generally do not involve a signifi- cant median comparable markup on total services costs. For the definition of the median comparable markup on total ser- vices costs, see paragraph (b)(4)(ii) of this section. The Commissioner may add to, subtract from, or otherwise revise the specified covered services described in the revenue procedure by subsequent revenue procedure, which amendments will ordi- narily be prospective only in effect. (ii)Low margin covered services.Low margin covered services are controlled ser- vices transactions for which the median comparable markup on total services costs is less than or equal to seven percent. For purposes of this paragraph (b), the median comparable markup on total services costs means the excess of the arm’s length price of the controlled services transaction deter- mined under the general section 482 reg- ulations without regard to this paragraph (b), using the interquartile range described in §1.482–1(e)(2)(iii)(C) and as necessary adjusting to the median of such interquar- tile range, over total services costs, ex- pressed as a percentage of total services costs. (5)Shared services arrangement—(i) In general. If covered services are the sub- ject 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 deter- mined under the services cost method of this paragraph (b) that is properly allocated to such participant pursuant to the arrange- ment. (ii)Requirements for shared services arrangement. A shared services arrange- ment must meet the requirements de- scribed in this paragraph (b)(5). (A)Eligibility. To be eligible for treat- ment under this paragraph (b)(5), a shared services arrangement must— (1) Include two or more participants; (2) Include as participants all controlled taxpayers that reasonably anticipate a ben- efit (as defined under paragraph (l)(3)(i) of this section) from one or more covered ser- vices specified in the shared services ar- rangement; and (3) Be structured such that each covered service (or each reasonable aggregation of services within the meaning of paragraph (b)(5)(iii)(B) of this section) confers a ben- efit on at least one participant in the shared services arrangement. (B)Allocation. The costs for covered services must be allocated among the par- ticipants based on their respective shares of the reasonably anticipated benefits from those services, without regard to whether the anticipated benefits are in fact real- ized. Reasonably anticipated benefits are benefits as defined in paragraph (l)(3)(i) of this section. The allocation of costs must provide the most reliable measure of the participants’ respective shares of the reasonably anticipated benefits under the principles of the best method rule. See §1.482–1(c). The allocation must be ap- plied on a consistent basis for all partici- pants and services. The allocation to each participant in each taxable year must rea- sonably reflect that participant’s respec- tive share of reasonably anticipated bene- fits for such taxable year. If the taxpayer reasonably concluded that the shared ser- vices arrangement (including any aggre- gation pursuant to paragraph (b)(5)(iii)(B) of this section) allocated costs for covered services on a basis that most reliably re- flects the participants’ respective shares of the reasonably anticipated benefits attrib- utable to such services, as provided for in this paragraph (b)(5), then the Commis- sioner may not adjust such allocation ba- sis. (C)Documentation. The taxpayer must maintain sufficient documentation to es- tablish that the requirements of this para- graph (b)(5) are satisfied, and include— (1) A statement evidencing the tax- payer’s intention to apply the services cost method to evaluate the arm’s length charge for covered services pursuant to a shared services arrangement; (2) A list of the participants and the renderer or renderers of covered services under the shared services arrangement; (3) A description of the basis of allo- cation to all participants, consistent with the participants’ respective shares of rea- sonably anticipated benefits; and (4) A description of any aggregation of covered services for purposes of the shared services arrangement, and an indication whether this aggregation (if any) differs from the aggregation used to evaluate the median comparable markup for any low margin covered services described in para- graph (b)(4)(ii) of this section. (iii)Definitions and special rules—(A) Participant. A participant is a controlled taxpayer that reasonably anticipates ben- efits from covered services subject to a shared services arrangement that substan- tially complies with the requirements de- scribed in this paragraph (b)(5). (B)Aggregation.Twoormorecovered servicesmaybeaggregatedinareasonable manner taking into account all the facts and circumstances, including whether the relative magnitude of reasonably antici- pated benefits of the participants sharing the costs of such aggregated services may be reasonably reflected by the allocation basis employed pursuant to paragraph (b)(5)(ii)(B) of this section. The aggregation of services under a shared services arrangement may differ 2006–34 I.R.B.282August 21, 2006 from the aggregation used to evaluate the median comparable markup for any low margin covered services described in paragraph (b)(4)(ii) of this section, pro- vided that such alternative aggregation can be implemented on a reasonable basis, including appropriately identifying and isolating relevant costs, as necessary. (C)Coordination with cost sharing ar- rangements. To the extent that an alloca- tion is made to a participant in a shared services arrangement that is also a partic- ipant in a cost sharing arrangement sub- ject to §1.482–7, such amount with re- spect to covered services is first allocated pursuant to the shared services arrange- ment under this paragraph (b)(5). Costs allocated pursuant to a shared services ar- rangement may (if applicable) be further allocated between the intangible develop- ment activity under §1.482–7 and other ac- tivities of the participant. (6)Examples. The application of this section is illustrated by the following ex- amples. No inference is intended whether the presence or absence of one or more facts is determinative of the conclusion in any example. For purposes ofExam- ples 1through14, assume that Company P and its subsidiaries, Company Q and Company R, are corporations and mem- bers of the same group of controlled en- tities (PQR Controlled Group). For pur- poses ofExamples 15through17,assume that Company P and its subsidiary, Com- pany S, are corporations and members of the same group of controlled entities (PS Controlled Group). For purposes ofEx- amples 18through26, assume that Com- pany P and its subsidiaries, Company X, Company Y, and Company Z, are corpo- rations and members of the same group of controlled entities (PXYZ Group) and that Company P and its subsidiaries sat- isfy all of the requirements for a shared ser- vices arrangement specified in paragraphs (b)(5)(ii) and (iii) of this section. Example 1.Data entry services. (i) Company P, Company Q and Company R own and operate hospi- tals. Company P also owns and operates a computer system for maintaining medical information gathered by doctors and nurses during interviews and treat- ment of patients. Company P uses a scanning device to convert medicalinformation from various paper records into a digital format. Company Q and Com- pany R do not have a computer system that allows them to input or maintain this information, but they have access to this information through their com- puter systems. Since Company Q and Company R do not have the requisite computer infrastructure, Com- pany P maintains this medical information for itself as well as for Company Q and Company R. (ii) Assume that these services relating to data en- try are specified covered services within the mean- ing of paragraph (b)(4)(i) of this section. Under the facts and circumstances of the business of the PQR Controlled Group, the taxpayer could reasonably con- clude that these services do not contribute signifi- cantly to the controlled group’s key competitive ad- vantages, core capabilities, or fundamental risks of success or failure in the group’s business. If these services meet the other requirements of paragraph (b) of this section, Company P will be eligible to charge these services to Company Q and Company R in ac- cordance with the services cost method. Example 2.Data entry services. (i) Company P owns and operates severalgambling establishments. Company Q and Company R own and operate travel agencies. Company P provides its customers with a “player’s card,” which is a smart card device used in Company P’s gambling establishments to track a player’s bets, winnings, losses, hotel accommoda- tions, and food and drink purchases. Using their cus- tomer lists, Company Q and Company R request mar- keting information about their customers that Com- pany P has gathered from these player’s cards. Com- pany Q and Company R use the smart card data to sell customized vacation packages to their customers, taking into account their individual preferences and spending patterns. Annual reports for the PQR Con- trolled Group state that these smart card data con- stitute an important element of the group’s overall strategic business planning, including advertising and accommodations. (ii) Assume that these services relating to data en- try are specified covered services within the meaning of paragraph (b)(4)(i) of this section. Under the facts and circumstances, the taxpayer is unable to reason- ably conclude that these services do not contribute significantly to the controlled group’s key compet- itive advantages, core capabilities, or fundamental risks of success or failurein the group’s business. Company P is not eligible to charge these services to Company Q and Company R in accordance with the services cost method. Example 3.Recruiting services. (i) Company P, Company Q and Company R are manufacturing com- panies that sell their products to unrelated retail es- tablishments. Company P’s human resources depart- ment recruits mid-level managers and engineers for itself as well as for Company Q and Company R by attending job fairs and other recruitment events. For recruiting higher-level managers and engineers, each of these companies uses recruiters from unrelated ex- ecutive search firms. (ii) Assume that these services relating to recruit- ing are specified covered services within the mean- ing of paragraph (b)(4)(i) of this section. Under the facts and circumstances of the business of the PQR Controlled Group, the taxpayer could reasonably con- clude that these services do not contribute signifi- cantly to the controlled group’s key competitive ad- vantages, core capabilities, or fundamental risks of success or failure in the group’s business. If these services meet the other requirements of paragraph (b) of this section , Company P will be eligible to charge these services to Company Q and Company R in ac- cordance with the services cost method. Example 4.Recruiting services.(i)CompanyP, Company Q and Company R are agencies that repre- sent celebrities in the entertainment industry. Among the most important resources of these companies are the highly compensated agents who have close per- sonal relationships with celebrities in the entertain- ment industry. Company P implements a recruit- ing plan to hire highly compensated agents for it- self, and other highly compensated agents for each of its wholly-owned subsidiaries in foreign countries, Company Q and Company R. (ii) Assume that these services relating to recruit- ing are specified covered services within the meaning of paragraph (b)(4)(i) of this section. Under the facts and circumstances, the taxpayer is unable to reason- ably conclude that these services do not contribute significantly to the controlled group’s key compet- itive advantages, core capabilities, or fundamental risks of success or failure in the group’s business. Company P is not eligible to charge these services to Company Q and Company R in accordance with the services cost method. Example 5.Credit analysis services.(i)Com- pany P is a manufacturer and distributor of clothing for retail stores. Company Q and Company R are dis- tributors of clothing for retail stores. As part of its operations, personnel in Company P perform credit analysis on its customers. Most of the customers have a history of purchases from Company P, and the credit analysis involves a review of the recent payment his- tory of the customer’s account. For new customers, the personnel in Company P perform a basic credit check of the customer, using reports from a business credit reporting agency. On behalf of Company Q and Company R, Company P performs credit analysis on customers who order clothing from Company Q and Company R, using the same method as Company P uses for itself. (ii) Assume that these services relating to credit analysis are specified covered services within the meaning of paragraph (b)(4)(i)ofthissection.Under the facts and circumstances of the business of the PQR Controlled Group, the taxpayer could reason- ably conclude that these services do not contribute significantly to the controlled group’s key compet- itive advantages, core capabilities, or fundamental risks of success or failure in the group’s business. If these services meet the other requirements of this paragraph (b), Company P will be eligible to charge these services to Company Q and Company R in accordance with the services cost method. Example 6.Credit analysis services.(i)Com- pany P, Company Q and Company R lease furniture to retail customers who present a significant credit risk and are generally unable to lease furniture from other providers. As part of its leasing operations, personnel in Company P perform credit analysis on each of the potential lessees. The personnel have de- veloped special expertise in determining whether a particular customer who presents a significant credit risk (as indicated by credit reporting agencies) will be likely to make the requisite lease payments on a timely basis. In order to compensate for the special- ized analysis of a customer’s default risk, as well as the default risk itself, Company P charges more than the market lease rate charged to customers with av- erage credit ratings. Also, as part of its operations, Company P performs similar credit analysis services August 21, 20062832006–34 I.R.B. for Company Q and Company R, which charge cor- respondingly high monthly lease payments. (ii) Assume that these services relating to credit analysis are specified covered services within the meaning of paragraph (b)(4)(i) of this section. Under the facts and circumstances, the taxpayer is unable to reasonably conclude that these services do not contribute significantly to the controlled group’s key competitive advantages, core capabilities, or fundamental risks of success or failure in the group’s business. Company P is not eligible to charge these services to Company Q and Company R in accor- dance with the services cost method. Example 7.Credit analysis services.(i)Com- pany P is a large full-service bank, which provides products and services to corporate and consumer mar- kets, including unsecured loans, secured loans, lines of credit, letters of credit, conversion of foreign cur- rency, consumer loans, trust services, and sales of cer- tificates of deposit. Company Q makes routine con- sumer loans to individuals, such as auto loans and home equity loans. Company R makes only business loans to small businesses. (ii) Company P performs credit analysis and pre- pares credit reports for itself, as well as for Com- pany Q and Company R. Company P, Company Q and Company R regularly employ these credit reports in the ordinary course of business in making decisions regarding extensions of credit to potential customers (including whether to lend, rate of interest, and loan terms). (iii) Assume that these services relating to credit analysis are specified covered services within the meaning of paragraph (b)(4)(i) of this section. Un- der the facts and circumstances, the credit analysis services constitute part of a “financial transaction” described in paragraph (b)(3)(ii)(H) of this section. Company P is not eligible to charge these services to Company Q and Company R in accordance with the services cost method. Example 8.Data verification services.(i)Com- pany P, Company Q and Company R are manufac- turers of industrial supplies. Company P’s account- ing department performs periodic reviews of the ac- counts payable information of Company P, Company Q and Company R, and identifies any inaccuracies in the records, such as double-payments and dou- ble-charges. (ii) Assume that these services relating to verifi- cation of data are specified covered services within the meaning of paragraph (b)(4)(i) of this section. Under the facts and circumstances of the business of the PQR Controlled Group, the taxpayer could rea- sonably conclude that these services do not contribute significantly to the controlled group’s key compet- itive advantages, core capabilities, or fundamental risks of success or failure in the group’s business. If these services meet the other requirements of this paragraph (b), Company P will be eligible to charge these services to Company Q and Company R in ac- cordance with the services cost method. Example 9.Data verification services.(i)Com- pany P gathers from unrelated customers information regarding accounts payable and accounts receivable and utilizes its own computer system to analyze that information for purposes of identifying errors in pay- ment and receipts (data mining). Company P is com- pensated for these services based on a fee that reflects a percentage of amounts collected by customers as a result of the data mining services. These activi- ties constitute a significant portion of Company P’s business. Company P performs similar activities for Company Q and Company R by analyzing their ac- counts payable and accounts receivable records. (ii) Assume that these services relating to data mining are specified covered services within the meaning of paragraph (b)(4)(i) of this section. Under the facts and circumstances, the taxpayer is unable to reasonably conclude that these services do not contribute significantly to the controlled group’s key competitive advantages, core capabilities, or fundamental risks of success or failure in the group’s business. Company P is not eligible to charge these services to Company Q and Company R in accor- dance with the services cost method. Example 10.Legal services. (i) Company P is a domestic corporation with two wholly-owned for- eign subsidiaries, Company Q and Company R. Com- pany P and its subsidiaries manufacture and distribute equipment used by industrial customers. Company P maintains an in-house legal department consisting of attorneys experienced in a wide range of business and commercial matters. Company Q and Company R maintain small legal departments, consisting of at- torneys experienced in matters that most frequently arise in the normal course of business of Company Q and Company R in their respective jurisdictions. (ii) Company P seeks to maintain in-house legal staff with the ability to address the majority of legal matters that arise in the United States with respect to the operations of Company P, as well as any U.S. re- porting or compliance obligations of Company Q or Company R. The in-house legal staffs of Company Q and Company R are much more limited. It is neces- sary for Company P to retain several local law firms to handle litigation and business disputes arising from the activities of Company Q and Company R. Al- though Company Q and Company R pay the fees of these law firms, the hiring authority and general over- sight of the firms’ representation is in the legal depart- ment of Company P. (iii) In determining what portion of the legal ex- penses of Company P may be allocated to Company Q and Company R, Company P first excludes any ex- penses relating to legal services that constitute share- holder activities and other items that are not prop- erly analyzed as controlled services. Assume that the remaining services relating to general legal func- tions performed by in-house legal counsel are spec- ified covered services within the meaning of para- graph (b)(4)(i) of this section. Under the facts and circumstances of the business of the PQR Controlled Group, the taxpayer could reasonably conclude that these latter services do not contribute significantly to the controlled group’s key competitive advantages, core capabilities, or fundamental risks of success or failure in the group’s business. If these services meet the other requirements of this paragraph (b), Com- pany P will be eligible to charge these services to Company Q and Company R in accordance with the services cost method. Example 11.Legal services. (i) Company P is a domestic holding company whose operating compa- nies generate electric power for consumers by operat- ing nuclear plants. Company P has several domestic operating companies, including Companies Q and R. Assume that, although Company P owns 100% of the stock of Companies Q and R, the companies do not elect to file a consolidated Federal income tax return with Company P. (ii) Company P maintains an in-house legal de- partment consisting of experienced attorneys in the areas of Federal utilities regulation, Federal labor and environmental law, securities law, and general commercial law. Companies Q and R maintain their own, smaller in-house legal staffs comprised of ex- perienced attorneys in the areas of state and local utilities regulation, state labor and employment law, and general commercial law. The legal department of Company P performs general oversight of the legal affairs of the company and determines whether a particular matter would be more efficiently handled by the Company P legal department, by the legal staffs in the operating companies, or in rare cases, by retained outside counsel. In general, Company P has succeeded in minimizing duplication and overlap of functions between the legal staffs of the various companies or by retained outside counsel. (iii) The domestic nuclear power plant operations of Companies Q and R are subject to extensive reg- ulation by the U.S. Nuclear Regulatory Commission (NRC). Operators are required to obtain pre-construc- tion approval, operating licenses, and, at the end of the operational life of the nuclear reactor, nuclear de- commissioning certificates. Company P files consol- idated financial statements on behalf of itself, as well as Companies Q and R, with the United States Securi- ties and Exchange Commission (SEC). In these SEC filings, Company P discloses that failure to obtain any of these licenses (and the related periodic renewals) or agreeing to licenses on terms less favorable than those granted to competitors would have a material adverse impact on the operations of Company Q or Company R. Company P maintains a group of experi- enced attorneys that exclusively represents Company Q and Company R before the NRC. Although Com- pany P occasionally hires an outside law firm or in- dustry expert to assist on particular NRC matters, the majority of the work is performed by the specialized legal staff of Company P. (iv) Certain of the legal services performed by Company P constitute duplicative or shareholder ac- tivities that do not confer a benefit on the other com- panies and therefore do not need to be allocated to the other companies, while certain other legal services are eligible to be charged to Company Q and Com- pany R in accordance with the services cost method. (v) Assume that the specialized legal services re- lating to nuclear licenses performed by in-house le- gal counsel of Company P are specified covered ser- vices within the meaning of paragraph (b)(4)(i) of this section. Under the facts and circumstances, the tax- payer is unable to reasonably conclude that these ser- vices do not contribute significantly to the controlled group’s key competitive advantages, core capabili- ties, or fundamental risks of success or failure in the group’s business. Company P is not eligible to charge these services to Company Q and Company R in ac- cordance with the services cost method. Example 12.Group of services.(i)CompanyP, Company Q and Company R are manufacturing com- panies that sell their products to unrelated retail es- tablishments. Company P has an enterprise resource planning (ERP) system that maintains data relating to accounts payable and accounts receivable informa- tion for all three companies. Company P’s personnel perform the daily operations on this ERP system such 2006–34 I.R.B.284August 21, 2006 as inputting data relating to accounts payable and ac- counts receivable into the system and extracting data relating to accounts receivable and accounts payable in the form of reports or electronic media and provid- ing those data to all three companies. Periodically, Company P’s computer specialists also modify the ERP system to adapt to changing business functions in all three companies. Company P’s computer spe- cialists make these changes by either modifying the underlying software program or by purchasing addi- tional software or hardware from unrelated third party vendors. (ii) Assume that these services relating to ac- counts payable and accounts receivable are specified covered services within the meaning of paragraph (b)(4)(i) of this section. Under the facts and cir- cumstances of the business of the PQR Controlled Group, the taxpayer could reasonably conclude that these services do not contribute significantly to the controlled group’s key competitive advantages, core capabilities, or fundamental risks of success or fail- ure in the group’s business. If these services meet the other requirements of this paragraph (b), Company P will be eligible to charge these services to Company Q and Company R in accordance with the services cost method. (iii) Assume that the services performed by Com- pany P’s computer specialists that relate to modify- ing the ERP system are specifically excluded from the services described in a revenue procedure refer- enced in paragraph (b)(4) of this section as develop- ing hardware or software solutions (such as systems integration, website design, writing computer pro- grams, modifying general applications software, or recommending the purchase of commercially avail- able hardware or software). Company P is not eligi- ble to charge these services to Company Q and Com- pany R in accordance with the services cost method. Example 13.Group of services.(i)CompanyP manufactures and sells widgets under an exclusive contract to Customer 1. Company Q and Company R sell widgets under exclusive contracts to Customer 2 and Customer 3, respectively. At least one year in advance, each of these customers can accurately forecast its need for widgets. Using these forecasts, each customer over the course of the year places or- ders for widgets with the appropriate company, Com- pany P, Company Q or Company R. A customer’s ac- tual need for widgets seldom deviates from that cus- tomer’s forecasted need. (ii) It is most efficient for the PQR Controlled Group companies to manufacture and store an inven- tory of widgets in advance of delivery. Although all three companies sell widgets, only Company P main- tains a centralized warehouse for widgets. Pursuant to a contract, Company P provides storage of these widgets to Company Q and Company R at an arm’s length price. (iii) Company P’s personnel also obtain orders from all three companies customers to draw up pur- chase orders for widgets as well as make payment to suppliers for widget replacement parts. In addition, Company P’s personnel use data entry to input infor- mation regarding orders and sales of widgets and re- placement parts for all three companies into a central- ized computer system. Company P’s personnel also maintain the centralized computer system and extract data for all three companies when necessary. (iv) Assume that these services relating to track- ing purchases and sales of inventory are specified covered services within the meaning of paragraph (b)(4)(i) of this section. Under the facts and circum- stances of the business of the PQR Controlled Group, the taxpayer could reasonably conclude that these ser- vices do not contribute significantly to the controlled group’s key competitive advantages, core capabili- ties, or fundamental risksof success or failure in the group’s business. If these services meet the other requirements of this paragraph (b), Company P will be eligible to charge these services to Company Q and Company R in accordance with the services cost method. Example 14.Group of services. (i) Company P, Company Q and Company R assemble and sell gad- gets to unrelated customers. Each of these companies purchases the components necessary for assembly of the gadgets from unrelated suppliers. As a service to its subsidiaries, Company P’s personnel obtain or- ders for components from all three companies, pre- pare purchase orders, and make payment to unrelated suppliers for the components. In addition, Company P’s personnel use data entry to input information re- garding orders and sales of gadgets for all three com- panies into a centralized computer. Company P’s per- sonnel also maintain the centralized computer sys- tem and extract data for all three companies on an as-needed basis. The services provided by Company P personnel, in conjunction with the centralized com- puter system, constitute a state-of-the-art inventory management system that allows Company P to order components necessary for assembly of the gadgets on a “just-in-time” basis. (ii) Unrelated suppliers deliver the components directly to Company P, Company Q and Company R. Each of the companies stores the components in its own facilities for use in filling specific customer orders. The companies do not maintain any inven- tory that is not identified in specific customer orders. Because of the efficiencies associated with services provided by personnel of Company P, all three com- panies are able to significantly reduce their inven- tory-related costs. Company P’s Chief Executive Of- ficer makes a statement in one of its press conferences with industry analysts that its inventory management system is critical to the company’s success. (iii) Assume that these services that relate to tracking purchase and sales of inventory are spec- ified covered services within the meaning of para- graph (b)(4)(i) of this section. Under the facts and circumstances, the taxpayer is unable to reasonably conclude that these services do not contribute sig- nificantly to the controlled group’s key competitive advantages, core capabilities, or fundamental risks of success or failure in the group’s business. Company P is not eligible to charge these services to Company Q and Company R in accordance with the services cost method. Example 15.Low margin covered services.Com- pany P renders certain accounting services to Com- pany S. Company P uses the services cost method for the accounting services, and determines the amount charged as Company P’s total cost of rendering the services, with no markup. Based on an application of the section 482 regulations without regard to this paragraph (b), the interquartile range of arm’s length markups on total services costs is between 3% and 6%, and the median is 4%. Because the median com- parable markup on total services costs is 4%, which is less than 7%, the accounting services constitute low margin covered services within the meaning of para- graph (b)(4)(ii) of this section. Example 16.Low margin covered services.Com- pany P performs logistics-coordination services for its subsidiaries, including Company S. Company P uses the services cost method for the logistics ser- vices, and determines the amount charged as Com- pany P’s total cost of rendering the services, with no markup. Based on an application of the section 482 regulations without regard to this paragraph (b), the interquartile range of arm’s length markups on total services costs is between 6% and 13%, and the me- dian is 9%. Because the median comparable markup on total services costs is 9%, which exceeds 7%, the logistics-coordination services do not constitute low margin covered services within the meaning of para- graph (b)(4)(ii) of this section. With respect to the de- termination and application of the interquartile range, see §1.482–1(e)(2)(iii)(C). Example 17.Low margin covered services. Company P performs certain custodial and mainte- nance services for certain office properties owned by Company S. Company P uses the services cost method for the services, and determines the amount charged as Company P’s total cost of providing the services plus no markup. Uncontrolled com- parables perform a similar range of custodial and maintenance services for uncontrolled parties and charge those parties an annual fee based on the total square footage of the property. These transactions meet the criteria for application of the comparable uncontrolled services price method of paragraph (c) of this section. The arm’s length price for the cus- todial and maintenance services is determined under the general section 482 regulations without regard to this paragraph (b), using the interquartile range described in §1.482–1(e)(2)(iii)(C) and as necessary adjusting to the median of such interquartile range. Based on reliable accounting information, the total services costs (as defined in paragraph (j) of this section) attributable to the custodial and maintenance services are subtracted from such price. The result- ing excess of such price of the controlled services transaction over total services costs, as expressed as a percentage of total services costs, is determined to be 4%. Because the median comparable markup on total services costs as determined by an application of the section 482 regulations without regard to this paragraph (b) is 4%, which is less than 7%, the custo- dial and maintenance services constitute low margin covered services within the meaning of paragraph (b)(4)(ii) of this section. Example 18.Shared services arrangement and reliable measure of reasonably anticipated benefit (allocation key). (i) Company P operates a central- ized data processing facility that performs automated invoice processing and order generation for all of its subsidiaries, Companies X, Y, Z, pursuant to a shared services arrangement. (ii) In evaluating the shares of reasonably antic- ipated benefits from the centralized data processing services, the total value of the merchandise on the in- voices and orders may not provide the most reliable measure of reasonably anticipated benefits shares, be- cause value of merchandise sold does not bear a rela- tionship to the anticipated benefits from the underly- ing covered services. August 21, 20062852006–34 I.R.B. (iii) The total volume of orders and invoices pro- cessed may provide a more reliable basis for eval- uating the shares of reasonably anticipated benefits from the data processing services. Alternatively, de- pending on the facts and circumstances, total central processing unit time attributable to the transactions of each subsidiary may provide a more reliable basis on which to evaluate the shares of reasonably anticipated benefits. Example 19.Shared services arrangement and reliable measure of reasonably anticipated benefit (allocation key). (i) Company P operates a central- ized center that performs human resources functions, such as administration of pension, retirement, and health insurance plans that are made available to employees of its subsidiaries, Companies X, Y, Z, pursuant to a shared services arrangement. (ii) In evaluating the shares of reasonably antici- pated benefits from these centralized services, the to- tal revenues of each subsidiary may not provide the most reliable measure of reasonably anticipated ben- efit shares, because total revenues do not bear a rela- tionship to the shares of reasonably anticipated bene- fits from the underlying services. (iii) Employee headcount or total compensation paid to employees may provide a more reliable ba- sis for evaluating the sharesof reasonablyanticipated benefits from the covered services. Example 20.Shared services arrangement and reliable measure of reasonably anticipated benefit (allocation key). (i) Company P performs human resource services (service A) on behalf of the PXYZ Group that qualify for the services cost method. Under that method, Company P determines the amount charged for these services pursuant to a shared services arrangement based on an applica- tion of paragraph (b)(5) of this section. Service A constitutes a specified covered service described in a revenue procedure pursuant to paragraph (b)(4)(i) of this section. The total services costs for service A otherwise determined under the services cost method is 300. (ii) Companies X, Y and Z reasonably anticipate benefits from service A. Company P does not reason- ably anticipate benefits from service A. Assume that if relative reasonably anticipated benefits were pre- cisely known, the appropriate allocation of charges pursuant to §1.482–9T(k) to Company X, Y and Z for service A is as follows: CompanyService A TotalCost300 X 150 Y 75 Z 75 (iii) The total number of employees (employee headcount) in each company is as follows: Company X - 600 employees Company Y - 250 employees Company Z - 250 employees (iv) Company P allocates the 300 total services costs of service A based on employee headcount as follows: Service A TotalCost300 Company Allocation Key: (Headcount)Amount X600164 Y 250 68 Z 250 68 (v) Based on these facts, Company P may reason- ably conclude that the employee headcount allocation basis most reliably reflects the participants’ respec- tive shares of the reasonably anticipated benefits at- tributable to service A. Example 21.Shared services arrangement and reliable measure of reasonably anticipated benefit (allocation key). (i) Company P performs accounts payable services (service B) on behalf of the PXYZ Group and determines the amount charged for the services under such method pursuant to a shared services arrangement based on an application of paragraph (b)(5) of this section. Service B is a specified covered service described in a revenue procedure pursuant to paragraph (b)(4)(i) of this sec- tion. The total services costs for service B otherwise determined under the services cost method is 500. (ii) Companies X, Y and Z reasonably anticipate benefits from service B. Company P does not reason- ably anticipate benefits from service B. Assume that if relative reasonably anticipated benefits were pre- cisely known, the appropriate allocation of charges pursuant to §1.482–9T(k) to Companies X, Y and Z for service B is as follows: Company Service B TotalCost500 X 125 Y 205 Z170 (iii) The total number of employees (employee headcount) in each company is as follows: Company X - 600 Comp any Y - 200 Company Z - 200 2006–34 I.R.B.286August 21, 2006 (iv) The total number of transactions (transaction volume) with uncontrolled customers by each company is as follows: Company X - 2,000 Company Y - 4,000 Company Z - 3,500 (v) If Company P allocated the 500 total services costs of service B based on employee headcount, the resulting allocation would be as follows: Service B TotalCost500 Company Allocation Key: (Headcount)Amount X600300 Y200100 Z200100 (vi) In contrast, if Company P used volume of transactions with uncontrolled customers as the allocation basis under the shared services arrangement, the allocation would be as follows: Service B TotalCost5 00 Company Allocation Key: (Transaction Volume)Amount X2,000 105 Y4,000211 Z 3,500 184 (vi)Basedonthesefacts,CompanyPmayrea- sonably conclude that the transaction volume, but not the emplo yee headcount, allocation basis most reli- ably reflects the participants’ respective shares of the reasonably anticipated benefits attributable to service B. Example 22.Shared services arrangement and aggregation. (i) Company P performs human re- source s ervices (service A) and accounts payable services (service B) on behalf of the PXYZ Group that qualify for the services cost method. Company P determines the amount charged for these services under suc h method pursuant to a shared services arrangement based on an application of paragraph (b)(5) of this section. Service A and service B are specifi ed covered services described in a revenue procedure pursuant to paragraph (b)(4)(i) of this sec- tion. The total services costs otherwise determined under th e services cost method for service A is 300 and for service B is 500; total services costs for services A and B are 800. Company P determines that aggregation of services A and B for purposes of the arran gement is appropriate. (ii) Companies X, Y and Z reasonably anticipate benefits from services A and B. Company P does not reasonab ly anticipate benefits from services A and B. Assume that if relative reasonably anticipated bene- fits were precisely known, the appropriate allocation of total charges pursuant to §1.482–9T(k) to Compa- nies X, Y and Z for services A and B is as follows: Company Service sAandB Total Cost 800 X 350 Y100 Z 350 (iii) The total volume of transactions with uncontrolled customers in each company is as follows: Company X - 2,000 Company Y - 4,000 Company Z - 4,000 (iv) The total number of employees in each company is as follows: Company X - 600 Company Y - 200 Comp any Z - 200 August 21, 20062872006–34 I.R.B. (v) If Company P allocated the 800 total services costs of services A and B based on transaction volume or employee headcount, the resulting allocation would be as follows: Aggregated Services AB Total Cost 800 Company Allocation Key: (Transaction Volume)Amount Allocation Key: (Headcount)Amount X2,000160600480 Y4,000320200160 Z4,000320200160 (vi) In contrast, if aggregated services AB were allocated by reference to the total U.S. dollar value of sales to uncontrolled parties (trade sales) by each company, the following results would obtain: Aggregated Services AB Total Cost 800 Company Allocation Key: (Trade Sales)Amount X $400 million 314 Y $120 million 94 Z $500 million 392 (vii)Basedonthesefacts,CompanyPmayrea- sonably conclude that the trade sales, but not the transaction volume or the employee headcount, al- location basis most reliably reflects the participants’ respective shares of the reasonably anticipated bene- fits attributable to services AB. Example 23.Shared services arrangement and aggregation. (i) Company P performs services A through P on behalf of the PXYZ Group that qual- ify for the services cost method. Company P deter- mines the amount charged for these services under such method pursuant to a shared services arrange- ment based on an application of paragraph (b)(5) of this section. All of these services A through Z con- stitute either specified covered services or low mar- gin covered services described in paragraph (b)(4) of this section. The total services costs for services A through Z otherwise determined under the services cost method is 500. Company P determines that ag- gregation of services A through Z for purposes of the arrangement is appropriate. (ii) Companies X and Y reasonably anticipate benefits from services A through Z and Company Z reasonably anticipates benefits from services A through X but not from services Y or Z (Company Z performs services similar to services Y and Z on its own behalf). Company P does not reasonably an- ticipate benefits from services A through Z. Assume that if relative reasonably anticipated benefits were precisely known, the appropriate allocation of total charges pursuant to §1.482–9T(k) to Company X, Y and Z for services A through Z is as follows: Services A - MServices N - PServices A - P CompanyCost 490Cost 10 Total Cost 500 X90 595 Y240 5245 Z160160 (iii) The total volume of transactions with uncontrolled customers in each company is as follows: Company X - 2,000 Company Y - 4,500 Company Z - 3,500 (iv) Company P allocates the 500 total services costs of services A through Z based on transaction volume as follows: Aggregated services A - Z Total Costs 500 Company Allocation Key: (Transaction Volume)Amount X2,000100 Y 4,500225 Z 3,500175 (v) Based on these facts, Company P may reason- ably conclude that the transaction volume allocation basis most reliably reflects the participants’ respec- tive shares of the reasonably anticipated benefits at- tributable to services A through Z. Example 24.Renderer reasonably anticipates benefits. (i) Company P renders services on behalf of the PXYZ Group that qualify for the services cost method. Company P determines the amount charged for these services under such method. Company P’s share of reasonably anticipated benefits from ser- 2006–34 I.R.B.288August 21, 2006 vices A, B, C, and D is 20% of the total reasonably anticipated benefits of all participants. Company P’s total services cost for services A, B, C, and D charged within the Group is 100. (ii) Based on an application of paragraph (b)(5) of this section, Company P charges 80 which is allocated amongCompaniesX,YandZ.Nochargeismade to Company P under the shared services arrangement for activities that it performs on its own behalf. Example 25.Coordination with cost sharing ar- rangement. (i) Company P performs human resource services (service A) on behalf of the PXYZ Group that qualify for the services cost method. Company P determines the amount charged for these services under such method pursuant to a shared services arrangement based on an application of paragraph (b)(5) of this section. Service A constitutes a speci- fied covered service described in a revenue procedure pursuant to paragraph (b)(4)(i) of this section. The total services costs for service A otherwise deter- mined under the services cost method is 300. (ii) Company X, Y, Z and P reasonably anticipate benefits from service A. Using a basis of allocation that is consistent with the controlled participants’ re- spective shares of the reasonably anticipated benefits from the shared services, the total charge of 300 is al- located as follows: X – 100 Y– 50 Z– 25 P – 125 (iii) In addition to performing services, P un- dertakes 500 of R&D and incurs manufacturing and other costs of 1,000. (iv) Companies P and X enter into a cost shar- ing arrangement in accordance with §1.482–7. Un- der the arrangement, Company P will undertake all intangible development activities. All of Company P’s research and development (R&D) activity is de- voted to the intangible development activity under the cost sharing arrangement. Company P will manufac- ture, market, and otherwise exploit the product in its defined territory. Companies P and X will share in- tangible development costs in accordance with their reasonably anticipated benefits from the intangibles, and Company X will make payments to Company P as required under §1.482–7. Company X will manu- facture, market, and otherwise exploit the product in the rest of the world. (v) A portion of the charge under the shared ser- vices arrangement is in turn allocable to the intangi- ble development activity undertaken by Company P. The most reliable estimate of the proportion alloca- ble to the intangible development activity is deter- mined to be 500 (CompanyP’s R&D expenses) di- vided by 1,500 (Company P’s total non-covered ser- vices costs), or one-third. Accordingly, one-third of Company P’s charge of 125, or 42, is allocated to the intangible development activity. Companies P and X must share the intangible development costs of the cost shared intangibles (including the charge of 42 that is allocated under the shared services arrange- ment) in proportion to their respective shares of rea- sonably anticipated benefits under the cost sharing ar- rangement. That is, the reasonably anticipated benefit shares under the cost sharing arrangement are deter- mined separately from reasonably anticipated benefit shares under the shared services arrangement. Example 26.Coordination with cost sharing ar- rangement. (i) The facts and analysis are the same as inExample 25, except that Company X also per- forms intangible development activities related to the cost sharing arrangement. Using a basis of allocation that is consistent with the controlled participants’ re- spective shares of the reasonably anticipated benefits from the shared services, the 300 of service costs is allocated as follows: X – 100 Y– 50 Z– 25 P – 125 (ii) In addition to performing services, Company P undertakes 500 of R&D and incurs manufacturing and other costs of 1,000. Company X undertakes 400 of R&D and incurs manufacturing and other costs of 600. (iii) Companies P and X enter into a cost sharing arrangement in accordance with §1.482–7. Under the arrangement, both Companies P and X will undertake intangible development activities. All of the research and development activity conducted by Companies P and X is devoted to the intangible development activ- ity under the cost sharing arrangement. Both Com- panies P and X will manufacture, market, and other- wise exploit the product in their respective territories and will share intangible development costs in accor- dance with their reasonably anticipated benefits from the intangibles, and both will make payments as re- quired under §1.482–7. (iv) A portion of the charge under the shared ser- vices arrangement is in turn allocable to the intangi- ble development activities undertaken by Companies P and X. The most reliable estimate of the portion al- locable to Company P’s intangible development ac- tivity is determined to be 500 (Company P’s R&D ex- penses) divided by 1,500 (P’s total non-covered ser- vices costs), or one-third. Accordingly, one-third of Company P’s allocated services cost method charge of 125, or 42, is allocated to its intangible develop- ment activity. (v) In addition, it is necessary to determine the portion of the charge under the shared services ar- rangement to Company X that should be further al- located to Company X’s intangible development ac- tivities under the cost sharing arrangement. The most reliable estimate of the portion allocable to Company X’s intangible development activity is 400 (Company X’s R&D expenses) divided by 1,000 (Company X’s costs), or 40%. Accordingly, 40% of the 100 that was allocated to Company X, or 40, is allocated in turn to Company X’s intangible development activ- ities. Company X makes a payment to Company P of 100 under the shared services arrangement and in- cludes 40 of services cost method charges in the pool of intangible development costs. (vi) The parties’ respective contributions to in- tangible development costs under the cost sharing ar- rangement are as follows: P: 500 + (0.333 * 125) = 542 X: 400 + (0.40 * 100) = 440 (c)Comparable uncontrolled services price method—(1)In general. The compa- rable uncontrolled services price method evaluates whether the amount charged in a controlled services transaction is arm’s length by reference to the amount charged in a comparable uncontrolled services transaction. The comparable uncontrolled services price method is ordinarily used where the controlled services either are identical to or have a high degree of sim- ilarity to the services in the uncontrolled transaction. (2)Comparability and reliability con- siderations—(i)In general.Whether results derived from application of this method are the most reliable measure of the arm’s length result must be determined using the factors described under the best method rule in §1.482–1(c). The applica- tion of these factors under the comparable uncontrolled services price method is dis- cussed in paragraphs (c)(2)(ii) and (iii) of this section. (ii)Comparability—(A)In general. The degree of comparability between con- trolled and uncontrolled transactions is determined by applying the provisions of §1.482–1(d). Although all of the factors described in §1.482–1(d)(3) must be con- sidered, similarity of the services rendered, and of the intangibles (if any) used in per- forming the services, generally will have the greatest effects on comparability under this method. In addition, because even minor differences in contractual terms or economic conditions could materially affect the amount charged in an uncon- trolled transaction, comparability under this method depends on close similarity with respect to these factors, or adjust- ments to account for any differences. The results derived from applying the compa- rable uncontrolled services price method generally will be the most direct and re- liable measure of an arm’s length price for the controlled transaction if an un- controlled transaction has no differences from the controlled transaction that would affect the price, or if there are only minor differences that have a definite and reason- ably ascertainable effect on price and for which appropriate adjustments are made. If such adjustments cannot be made, or if there are more than minor differences between the controlled and uncontrolled transactions, the comparable uncontrolled services price method may be used, but August 21, 20062892006–34 I.R.B. the reliability of the results as a measure of the arm’s length price will be reduced. Further, if there are material differences for which reliable adjustments cannot be made, this method ordinarily will not pro- vide a reliable measure of an arm’s length result. (B)Adjustments for differences between controlled and uncontrolled transactions. If there are differences between the con- trolled and uncontrolled transactions that would affect price, adjustments should be made to the price of the uncontrolled trans- action according to the comparability pro- visions of §1.482–1(d)(2). Specific ex- amples of factors that may be particularly relevant to application of this method in- clude— (1) Quality of the services rendered; (2) Contractual terms (for example, scope and terms of warranties or guaran- tees regarding the services, volume, credit and payment terms, allocation of risks, including any contingent-payment terms and whether costs were incurred without a provision for current reimbursement); (3) Intangibles (if any) used in render- ing the services; (4) Geographic market in which the ser- vices are rendered or received; (5) Risks borne (for example, costs in- curred to render the services, without pro- vision for current reimbursement); (6) Duration or quantitative measure of services rendered; (7) Collateral transactions or ongo- ing business relationships between the renderer and the recipient, including ar- rangement for the provision of tangible property in connection with the services; and (8) Alternatives realistically available to the renderer and the recipient. (iii)Data and assumptions.There- liability of the results derived from the comparable uncontrolled services price method is affected by the completeness and accuracy of the data used and the re- liability of the assumptions made to apply the method. See §1.482–1(c) (best method rule). (3)Arm’s length range.See §1.482–1(e)(2) for the determination of an arm’s length range. (4)Examples. The principles of this paragraph (c) are illustrated by the follow- ing examples: Example 1.Internal comparable uncontrolled services price. Company A, a United States corpo- ration, performs shipping,stevedoring, and related services for controlled and uncontrolled parties on a short-term or as-needed basis. Company A charges uncontrolled parties in Country X a uniform fee of $60 per container to place loaded cargo containers in Country X on oceangoing vessels for marine transportation. Company A also performs identical services in Country X for its wholly-owned sub- sidiary, Company B, and there are no substantial differences between the controlled and uncontrolled transactions. In evaluating the appropriate measure of the arm’s length price for the container-load- ing services performed for Company B, because Company A renders substantially identical services in Country X to both controlled and uncontrolled parties, it is determined that the comparable uncon- trolled services price constitutes the best method for determining the arm’s length price for the controlled services transaction. Based on the reliable data pro- vided by Company A concerning the price charged for services in comparable uncontrolled transactions, a loading charge of $60 per cargo container will be considered the most reliable measure of the arm’s length price for the services rendered to Company B. See paragraph (c)(2)(ii)(A) of this section. Example 2.External comparable uncontrolled services price. (i) The facts are the same as inEx- ample 1, except that Company A performs services for Company B, but not for uncontrolled parties. Based on information obtained from unrelated par- ties (which is determined to be reliable under the comparability standards set forth in paragraph (c)(2) of this section), it is determined that uncontrolled parties in Country X perform services comparable to those rendered by Company A to Company B, and that such parties charge $60 per cargo container. (ii) In evaluating the appropriate measure of an arm’s length price for the loading services that Com- pany A renders to Company B, the $60 per cargo container charge is considered evidence of a com- parable uncontrolled services price. See paragraph (c)(2)(ii)(A) of this section. Example 3.External comparable uncontrolled services price. The facts are the same as inExam- ple 2, except that uncontrolled parties in Country X render similar loading and stevedoring services, but only under contracts that have a minimum term of one year. If the difference in the duration of the services has a material effect on prices, adjustments to account for these differences must be made to the results of the uncontrolled transactionsaccording to the provisions of §1.482–1(d)(2), and such adjusted results may be used as a measure of the arm’s length result. Example 4.Use of valuable intangibles.(i) Company A, a United States corporation in the biotechnology sector, renders research and develop- ment services exclusively to its affiliates. Company B is Company A’s wholly-owned subsidiary in Coun- try X. Company A renders research and development services to Company B. (ii) In performing its research and development services function, Company A uses proprietary software that it developed internally. Company A uses the software to evaluate certain genetically engineered compounds developed by Company B. Company A owns the copyright on this software and does not license it to uncontrolled parties. (iii) No uncontrolled parties can be identified that perform services identicalor with a high degree of similarity to those performed by Company A. Be- cause there are material differences for which reliable adjustments cannot be made, the comparable uncon- trolled services price method is unlikely to provide a reliable measure of the arm’s length price. See para- graph (c)(2)(ii)(A) of this section. Example 5.Internal comparable.(i)Company A, a United States corporation, and its subsidiaries render computer consulting services relating to sys- tems integration and networking to business clients in various countries. Company A and its subsidiaries render only consulting services, and do not manu- facture computer hardware or software nor distribute such products. The controlled group is organized ac- cording to industry specialization, with key industry specialists working for Company A. These personnel typically form the core consulting group that teams with consultants from the local-country subsidiaries to serve clients in the subsidiaries’ respective coun- tries. (ii) Company A and its subsidiaries sometimes undertake engagements directly for clients, and sometimes work as subcontractors to unrelated parties on more extensive supply-chain consulting engagements for clients. In undertaking the latter engagements with third party consultants, Company A typically prices its services based on consulting hours worked multiplied by a rate determined for each category of employee. The company also charges, at no markup, for out-of-pocket expenses such as travel, lodging, and data acquisition charges. The Company has established the following schedule of hourly rates: CategoryRate Project managers $400 per hour Technical staff $300 per hour (iii) Thus, for example, a project involving 100 hours of the time of project managers and 400 hours of technical staff time would result in the follow- ing project fees (without regard to any out-of-pocket expenses): ([100 hrs. × $400/hr.] + [400 hrs. × $300/hr.]) = $40,000 + $120,000 = $160,000. (iv) Company B, a Country X subsidiary of Com- pany A, contracts to perform consulting services for a Country X client in the banking industry. In undertak- ing this engagement, Company B uses its own consul- tants and also uses Company A project managers and technical staff that specialize in the banking industry for 75 hours and 380 hours, respectively. In determin- ing an arm’s length charge, the price that Company A 2006–34 I.R.B.290August 21, 2006 charges for consulting services as a subcontractor in comparable uncontrolled transactions will be consid- ered evidence of a comparable uncontrolled services price. Thus, in this case, a payment of $144,000, (or [75 hrs. × $400/hr.] + [380 hrs. × $300/hr.] = $30,000 + $114,000) may be used as a measure of the arm’s length price for the work performed by Com- pany A project mangers and technical staff. In ad- dition, if the comparable uncontrolled services price method is used, then, consistent with the practices employed by the comparables with respect to similar types of expenses, Company B must reimburse Com- pany A for appropriate out-of-pocket expenses. See paragraph (c)(2)(ii)(A) of this section. Example 6.Adjustments for differences.(i)The facts are the same as inExample 5, except that the en- gagement is undertaken with the client on a fixed fee basis. That is, prior to undertaking the engagement Company B and Company A estimate the resources required to undertake the engagement, and, based on hourly fee rates, charge the client a single fee for com- pletion of the project. Company A’s portion of the engagement results in fees of $144,000. (ii) The engagement, once undertaken, requires 20% more hours by each of Companies A and B than originally estimated. Nevertheless, the unrelated client pays the fixed fee that was agreed upon at the start of the engagement. Company B pays Company A $144,000, in accordance with the fixed fee arrange- ment. (iii) Company A often enters into similar fixed fee engagements with clients. In addition, Company A’s records for similar engagements show that when it ex- periences cost overruns, it does not collect additional fees from the client for the difference between pro- jected and actual hours. Accordingly, in evaluating whether the fees paid by Company B to Company A are arm’s length, it is determined that no adjustments to the intercompany service charge are warranted. See §1.482–1(d)(3)(ii) and paragraph (c)(2)(ii)(A) of this section. (5)Indirect evidence of the price of a comparable uncontrolled services transac- tion—(i)In general. The price of a com- parable uncontrolled services transaction may be derived based on indirect measures of the price charged in comparable uncon- trolled services transactions, but only if— (A) The data are widely and routinely used in the ordinary course of business in the particular industry or market segment for purposes of determining prices actually charged in comparable uncontrolled ser- vices transactions; (B) The data are used to set prices in the controlled services transaction in the same way they are used to set prices in uncontrolled services transactions of the controlled taxpayer, or in the same way they are used by uncontrolled taxpayers to set prices in uncontrolled services transac- tions; and (C) The amount charged in the con- trolled services transaction may be re- liably adjusted to reflect differences in quality of the services, contractual terms, market conditions, risks borne (including contingent-payment terms), duration or quantitative measure of services rendered, and other factors that may affect the price to which uncontrolled taxpayers would agree. (ii)Example. The following example illustrates this paragraph (c)(5): Example.Indirect evidence of comparable un- controlled services price. (i) Company A is a United States insurance com- pany. Company A’s wholly-owned Country X sub- sidiary, Company B, performs specialized risk anal- ysis for Company A as well as for uncontrolled par- ties. In determining the price actually charged to un- controlled entities for performing such risk analysis, Company B uses a proprietary, multi-factor computer program, which relies on the gross value of the poli- cies in the customer’s portfolio, the relative compo- sition of those policies, their location, and the esti- mated number of personnel hours necessary to com- plete the project. Uncontrolled companies that per- form comparable risk analysis in the same industry or market-segment use similar proprietary computer programs to price transactions with uncontrolled cus- tomers (the competitors’ programs may incorporate different inputs, or may assign different weights or values to individual inputs, in arriving at the price). (ii) During the taxable year subject to audit, Company B performed risk analysis for uncontrolled parties as well as for Company A. Because prices charged to uncontrolled customers reflected the com- position of each customer’s portfolio together with other factors, the prices charged in Company B’s un- controlled transactions do not provide a reliable basis for determining the comparable uncontrolled services price for the similar services rendered to Company A. However, in evaluatingan arm’s length price for the studies performed by Company B for Company A, Company B’s proprietary computer program may be considered as indirect evidence of the comparable uncontrolled services price that would be charged to perform the services for Company A. The reliability of the results obtained by application of this internal computer program as a measure of an arm’s length price for the services will be increased to the extent that Company A used the internal computer program to generate actual transaction prices for risk-analysis studies performed for uncontrolled parties during the same taxable year under audit; Company A used data that are widely and routinely used in the ordinary course of business in the insurance industry to de- termine the price charged; and Company A reliably adjusted the price charged in the controlled services transaction to reflect differences that may affect the price to which uncontrolled taxpayers would agree. (d)Gross services margin method—(1) In general. The gross services margin method evaluates whether the amount charged in a controlled services trans- action is arm’s length by reference to the gross profit margin realized in com- parable uncontrolled transactions. This method ordinarily is used in cases where a controlled taxpayer performs services or functions in connection with an uncon- trolled transaction between a member of the controlled group and an uncontrolled taxpayer. This method may be used where a controlled taxpayer renders services (agent services) to another member of the controlled group in connection with a transaction between that other mem- ber and an uncontrolled taxpayer. This method also may be used in cases where a controlled taxpayer contracts to provide services to an uncontrolled taxpayer (in- termediary function) and another member of the controlled group actually performs a portion of the services provided. (2)Determination of arm’s length price—(i)In general. The gross services margin method evaluates whether the price charged or amount retained by a controlled taxpayer in the controlled ser- vices transaction in connection with the relevant uncontrolled transaction is arm’s length by determining the appropriate gross profit of the controlled taxpayer. (ii)Relevant uncontrolled transaction. The relevant uncontrolled transaction is a transaction between a member of the con- trolled group and an uncontrolled taxpayer as to which the controlled taxpayer per- forms agent services or an intermediary function. (iii)Applicable uncontrolled price.The applicable uncontrolled price is the price paid or received by the uncontrolled tax- payer in the relevant uncontrolled transac- tion. (iv)Appropriate gross services profit. The appropriate gross services profit is computed by multiplying the applicable uncontrolled price by the gross services profit margin in comparable uncontrolled transactions. The determination of the ap- propriate gross services profit will take into account any functions performed by other members of the controlled group, as well as any other relevant factors described in §1.482–1(d)(3). The comparable gross services profit margin may be determined by reference to the commission in an un- controlled transaction, where that commis- sion is stated as a percentage of the price charged in the uncontrolled transaction. (v)Arm’s length range.See §1.482–1(e)(2) for determination of the arm’s length range. (3)Comparability and reliability con- siderations—(i)In general.Whether August 21, 20062912006–34 I.R.B. results derived from application of this method are the most reliable measure of the arm’s length result must be determined using the factors described under the best method rule in §1.482–1(c). The appli- cation of these factors under the gross services margin method is discussed in paragraphs (d)(3)(ii) and (iii) of this sec- tion. (ii)Comparability—(A)Functional comparability. The degree of compara- bility between an uncontrolled transaction and a controlled transaction is determined by applying the comparability provisions of §1.482–1(d). A gross services profit provides compensation for services or functions that bear a relationship to the relevant uncontrolled transaction, includ- ing an operating profit in return for the investment of capital and the assump- tion of risks by the controlled taxpayer performing the services or functions un- der review. Therefore, although all of the factors described in §1.482–1(d)(3) must be considered, comparability under this method is particularly dependent on similarity of services or functions per- formed, risks borne, intangibles (if any) used in providing the services or functions, and contractual terms, or adjustments to account for the effects of any such differ- ences. If possible, the appropriate gross services profit margin should be derived from comparable uncontrolled transac- tions by the controlled taxpayer under review, because similar characteristics are more likely found among different trans- actions by the same controlled taxpayer than among transactions by other parties. In the absence of comparable uncontrolled transactions involving the same controlled taxpayer, an appropriate gross services profit margin may be derived from trans- actions of uncontrolled taxpayers involv- ing comparable services or functions with respect to similarly related transactions. (B)Other comparability factors.Com- parability under this method is not depen- dent on close similarity of the relevant un- controlled transaction to the related trans- actions involved in the uncontrolled com- parables. However, substantial differences in the nature of the relevant uncontrolled transaction and the relevant transactions involved in the uncontrolled comparables, such as differences in the type of prop- erty transferred or service provided in the relevant uncontrolled transaction, may in- dicate significant differences in the ser- vices or functions performed by the con- trolled and uncontrolled taxpayers with re- spect to their respective relevant transac- tions. Thus, it ordinarily would be ex- pected that the services or functions per- formed in the controlled and uncontrolled transactions would be with respect to rel- evant transactions involving the transfer of property within the same product cate- gories or the provision of services of the same general type (for example, informa- tion-technology systems design). Further- more, significant differences in the intan- gibles (if any) used by the controlled tax- payer in the controlled services transac- tion as distinct from the uncontrolled com- parables may also affect the reliability of the comparison. Finally, the reliability of profit measures based on gross services profit may be adversely affected by fac- tors that have less effect on prices. For example, gross services profit may be af- fected by a variety of other factors, includ- ing cost structures or efficiency (for exam- ple, differences in the level of experience of the employees performing the service in the controlled and uncontrolled transac- tions). Accordingly, if material differences in these factors are identified based on ob- jective evidence, the reliability of the anal- ysis may be affected. (C)Adjustments for differences between controlled and uncontrolled transactions. If there are material differences between the controlled and uncontrolled transac- tions that would affect the gross services profit margin, adjustments should be made to the gross services profit margin, ac- cording to the comparability provisions of §1.482–1(d)(2). For this purpose, consid- eration of the total services costs associ- ated with functions performed and risks assumed may be necessary because dif- ferences in functions performed are of- ten reflected in these costs. If there are differences in functions performed, how- ever, the effect on gross services profit of such differences is not necessarily equal to the differences in the amount of related costs. Specific examples of factors that may be particularly relevant to this method include— (1) Contractual terms (for example, scope and terms of warranties or guaran- tees regarding the services or function, volume, credit and payment terms, and allocation of risks, including any contin- gent-payment terms); (2) Intangibles (if any) used in perform- ing the services or function; (3) Geographic market in which the ser- vices or function are performed or in which the relevant uncontrolled transaction takes place; and (4) Risks borne, including, if applica- ble, inventory-type risk. (D)Buy-sell distributor. If a controlled taxpayer that performs an agent service or intermediary function is comparable to a distributor that takes title to goods and re- sells them, the gross profit margin earned by such distributor on uncontrolled sales, stated as a percentage of the price for the goods, may be used as the comparable gross services profit margin. (iii)Data and assumptions—(A)In general. The reliability of the results derived from the gross services margin method is affected by the completeness and accuracy of the data used and the reliability of the assumptions made to ap- ply this method. See §1.482–1(c) (best method rule). (B)Consistency in accounting. The de- gree of consistency in accounting practices between the controlled transaction and the uncontrolled comparables that materially affect the gross services profit margin af- fects the reliability of the results under this method. (4)Examples. The principles of this paragraph (d) are illustrated by the follow- ing examples: Example 1.Agent services. Company A and Company B are members of a controlled group. Company A is a foreign manufacturer of industrial equipment. Company B is a U.S. company that acts as a commission agent for Company A by ar- ranging for Company A to make direct sales of the equipment it manufactures to unrelated purchasers in the U.S. market. Company B does not take title to the equipment but instead receives from Company A commissions that are determined as a specified percentage of the sales price for the equipment that is charged by Company A to the unrelated purchaser. Company B also arranges for direct sales of similar equipment by unrelated foreign manufacturers to unrelated purchasers in the U.S. market. Company B charges these unrelatedforeign manufacturers a commissionfeeof5%ofthesalespricechargedby the unrelated foreign manufacturers to the unrelated U.S. purchasers for the equipment. Information regarding the comparableagent services provided by Company B to unrelated foreign manufacturers is sufficiently complete to conclude that it is likely that all material differences between the controlled and uncontrolled transactions have been identified and adjustments for such differences have been made. 2006–34 I.R.B.292August 21, 2006 If the comparable gross services profit margin is 5% of the price charged in the relevant transactions involved in the uncontrolled comparables, then the appropriate gross services profit that Company B may earn and the arm’s length price that it may charge Company A for its agent services is equal to 5% of the applicable uncontrolled price charged by Company A in sales of equipment in the relevant uncontrolled transactions. Example 2.Agent services.Thefactsarethe same as inExample 1, except that Company B does not act as a commission agent for unrelated parties and it is not possible to obtain reliable information concerning commission rates charged by uncon- trolled commission agents that engage in comparable transactions with respect to relevant sales of property. It is possible, however, to obtain reliable information regarding the gross profit margins earned by unre- lated parties that briefly take title to and then resell similar property in uncontrolled transactions, in which they purchase the property from foreign man- ufacturers and resell the property to purchasers in the U.S. market. Analysis of the facts and circumstances indicates that, aside from certain minor differences for which adjustments can be made, the uncontrolled parties that resell property perform similar functions and assume similar risks as Company B performs and assumes when it acts as a commission agent for Company A’s sales of property. Under these circumstances, the gross profit margin earned by the unrelated distributors on the purchase and resale of property may be used, subject to any adjustments for any material differences between the controlled and uncontrolled transactions, as a comparable gross ser- vices profit margin. The appropriate gross services profit that Company B may earn and the arm’s length price that it may charge Company A for its agent services is therefore equal to this comparable gross services margin, multiplied by the applicable uncon- trolledpricechargedbyCompanyAinitssalesof equipment in the relevant uncontrolled transactions. Example 3.Agent services. (i) Company A and Company B are members of a controlled group. Company A is a U.S. corporation that renders computer consulting services, including systems integration and networking, to business clients. (ii) In undertaking engagements with clients, Company A in some cases pays a commission of 3% of its total fees to unrelated parties that assist Company A in obtaining consulting engagements. Typically, such fees are paid to non-computer con- sulting firms that provide strategic management services for their clients. When Company A ob- tains a consulting engagement with a client of a non-computer consulting firm, Company A does not subcontract with the other consulting firm, nor does the other consulting firm play any role in Company A’s consulting engagement. (iii) Company B, a Country X subsidiary of Com- pany A, assists Company A in obtaining an engage- ment to perform computer consulting services for a Company B banking industry client in Country X. Although Company B has an established relationship with its Country X client and was instrumental in ar- ranging for Company A’s engagement with the client, Company A’s particular expertise was the primary consideration in motivating the client to engage Com- pany A. Based on the relative contributions of Com- panies A and B in obtaining and undertaking the en- gagement, Company B’s role was primarily to facili- tate the consulting engagement between Company A and the Country X client. Information regarding the commissions paid by Company A to unrelated par- ties for providing similar services to facilitate Com- pany A’s consulting engagements is sufficiently com- plete to conclude that it is likely that all material dif- ferences between these uncontrolled transactions and the controlled transaction between Company B and Company A have been identified and that appropriate adjustments have been madefor any such differences. If the comparable gross services margin earned by un- related parties in providing such agent services is 3% of total fees charged in the relevant transactions in- volved in the uncontrolled comparables, then the ap- propriate gross services profit that Company B may earn and the arm’s length price that it may charge Company A for its agent services is equal to this com- parable gross services margin (3%), multiplied by the applicable uncontrolled price charged by Company A in its relevant uncontrolled consulting engagement with Company B’s client. Example 4.Intermediary function. (i) The facts are the same as inExample 3, except that Company B contracts directly with its Country X client to pro- vide computer consulting services and Company A performs the consulting services on behalf of Com- pany B. Company A does not enter into a consulting engagement with Company B’s Country X client. In- stead, Company B charges its Country X client an un- controlled price for the consulting services, and Com- pany B pays a portion of the uncontrolled price to Company A for performing the consulting services on behalf of Company B. (ii) Analysis of the relative contributions of Com- panies A and B in obtaining and undertaking the con- sulting contract indicates that Company B functioned primarily as an intermediary contracting party, and the gross services margin method is the most reli- able method for determining the amount that Com- pany B may retain as compensation for its intermedi- ary function with respect to Company A’s consulting services. In this case, therefore, because Company B entered into the relevant uncontrolled transaction to provide services, Company B receives the applica- ble uncontrolled price that is paid by the Country X client for the consulting services. Company A techni- cally performs services for Company B when it per- forms, on behalf of Company B, the consulting ser- vices Company B contracted to provide to the Coun- try X client. The arm’s length amount that Company A may charge Company B for performing the consult- ing services on Company B’s behalf is equal to the applicable uncontrolled price received by Company B in the relevant uncontrolled transaction, less Com- pany B’s appropriate gross services profit, which is the amount that Company B may retain as compen- sation for performing the intermediary function. (iii) Reliable data concerning the commissions that Company A paid to uncontrolled parties for as- sisting it in obtaining engagements to provide con- sulting services similar to those it has provided on behalf of Company B provide useful information in applying the gross services margin method. How- ever, consideration should be given to whether the third party commission data may need to be adjusted to account for any additional risk that Company B may have assumed as a result of its function as an in- termediary contracting party, compared with the risk it would have assumed if it had provided agent ser- vices to assist Company A in entering into an en- gagement to provide its consulting service directly. In this case, the information regarding the commissions paid by Company A to unrelated parties for provid- ing agent services to facilitate its performance of con- sulting services for unrelated parties is sufficiently complete to conclude that all material differences be- tween these uncontrolled transactions and the con- trolled performance of an intermediary function, in- cluding possible differences in the amount of risk as- sumed in connection with performing that function, have been identified and thatappropriate adjustments have been made. If the comparable gross services margin earned by unrelated parties in providing such agent services is 3% of total fees charged in Com- pany B’s relevant uncontrolled transactions, then the appropriate gross services profit that Company B may retain as compensation for performing an intermedi- ary function (and the amount, therefore, that is de- ducted from the applicable uncontrolled price to ar- rive at the arm’s length price that Company A may charge Company B for performing consulting ser- vices on Company B’s behalf) is equal to this com- parable gross services margin (3%), multiplied by the applicable uncontrolled price charged by Company B in its contract to provide services to the uncontrolled party. Example 5.External comparable. (i) The facts are the same as inExample 4, except that neither Company A nor Company B engages in transactions with third parties that facilitate similar consulting en- gagements. (ii) Analysis of the relative contributions of Com- panies A and B in obtaining and undertaking the con- tract indicates that Company B’s role was primarily to facilitate the consulting arrangement between Com- pany A and the Country X client. Although no reli- able internal data are available regarding comparable transactions with uncontrolled entities, reliable data exist regarding commission rates for similar facilitat- ing services between uncontrolled parties. These data indicate that a 3% commission (3% of total engage- ment fee) is charged in such transactions. Informa- tion regarding the uncontrolled comparables is suffi- ciently complete to conclude that it is likely that all material differences between the controlled and un- controlled transactions have been identified and ad- justed for. If the appropriate gross services profit mar- ginis3%oftotalfees,thenanarm’slengthresultof the controlled services transaction is for Company B to retain an amount equal to 3% of total fees paid to it. (e)Cost of services plus method—(1)In general. The cost of services plus method evaluates whether the amount charged in a controlled services transaction is arm’s length by reference to the gross services profit markup realized in comparable uncontrolled transactions. The cost of services plus method is ordinarily used in cases where the controlled service renderer provides the same or similar services to both controlled and uncontrolled parties. This method is ordinarily not used in cases where the controlled services transaction August 21, 20062932006–34 I.R.B. involves a contingent-payment arrange- ment, as described in paragraph (i)(2) of this section. (2)Determination of arm’s length price—(i)In general. The cost of services plus method measures an arm’s length price by adding the appropriate gross ser- vices profit to the controlled taxpayer’s comparable transactional costs. (ii)Appropriate gross services profit. The appropriate gross services profit is computed by multiplying the controlled taxpayer’s comparable transactional costs by the gross services profit markup, ex- pressed as a percentage of the compara- ble transactional costs earned in compara- ble uncontrolled transactions. (iii)Comparable transactional costs. Comparable transactional costs consist of the costs of providing the services under review that are taken into account as the basis for determining the gross services profit markup in comparable uncontrolled transactions. Depending on the facts and circumstances, such costs typically in- clude all compensation attributable to employees directly involved in the per- formance of such services, materials and supplies consumed or made available in rendering such services, and may include as well other costs of rendering the ser- vices. Comparable transactional costs must be determined on a basis that will facilitate comparison with the comparable uncontrolled transactions. For that reason, comparable transactional costs may not necessarily equal total services costs, as defined in paragraph (j) of this section, and in appropriate cases may be a subset of total services costs. Generally accepted accounting principles or Federal income tax accounting rules (where Federal in- come tax data for comparable transactions or business activities are available) may provide useful guidance but will not con- clusively establish the appropriate compa- rable transactional costs for purposes of this method. (iv)Arm’s length range.See §1.482–1(e)(2) for determination of an arm’s length range. (3)Comparability and reliability con- siderations—(i)In general.Whetherre- sults derived from the application of this method are the most reliable measure of the arm’s length result must be determined using the factors described under the best method rule in §1.482–1(c). (ii)Comparability—(A)Functional comparability. The degree of comparabil- ity between controlled and uncontrolled transactions is determined by applying the comparability provisions of §1.482–1(d). A service renderer’s gross services profit provides compensation for performing services related to the controlled services transaction under review, including an operating profit for the service renderer’s investment of capital and assumptions of risks. Therefore, although all of the factors described in §1.482–1(d)(3) must be considered, comparability under this method is particularly dependent on simi- larity of services or functions performed, risks borne, intangibles (if any) used in providing the services or functions, and contractual terms, or adjustments to ac- count for the effects of any such differ- ences. If possible, the appropriate gross services profit markup should be derived from comparable uncontrolled transac- tions of the same taxpayer participating in the controlled services transaction because similar characteristics are more likely to be found among services provided by the same service provider than among ser- vices provided by other service providers. In the absence of such services transac- tions, an appropriate gross services profit markup may be derived from compara- ble uncontrolled services transactions of other service providers. If the appropriate gross services profit markup is derived from comparable uncontrolled services transactions of other service providers, in evaluating comparability the controlled taxpayer must consider the results under this method expressed as a markup on total services costs of the controlled tax- payer, because differences in functions performed may be reflected in differences in service costs other than those included in comparable transactional costs. (B)Other comparability factors.Com- parability under this method is less de- pendent on close similarity between the services provided than under the compa- rable uncontrolled services price method. Substantial differences in the services may, however, indicate significant functional differences between the controlled and uncontrolled taxpayers. Thus, it ordinar- ily would be expected that the controlled and uncontrolled transactions would in- volve services of the same general type (for example, information-technology systems design). Furthermore, if a signif- icant amount of the controlled taxpayer’s comparable transactional costs consists of service costs incurred in a tax account- ing period other than the tax accounting period under review, the reliability of the analysis would be reduced. In addition, significant differences in the value of the services rendered, due for example to the use of valuable intangibles, may also affect the reliability of the comparison. Finally, the reliability of profit measures based on gross services profit may be ad- versely affected by factors that have less effect on prices. For example, gross ser- vices profit may be affected by a variety of other factors, including cost structures or efficiency-related factors (for example, differences in the level of experience of the employees performing the service in the controlled and uncontrolled transactions). Accordingly, if material differences in these factors are identified based on objec- tive evidence, the reliability of the analysis may be affected. (C)Adjustments for differences be- tween the controlled and uncontrolled transactions. If there are material dif- ferences between the controlled and un- controlled transactions that would affect the gross services profit markup, adjust- ments should be made to the gross services profit markup earned in the comparable uncontrolled transaction according to the provisions of §1.482–1(d)(2). For this purpose, consideration of the compara- ble transactional costs associated with the functions performed and risks assumed may be necessary, because differences in the functions performed are often reflected in these costs. If there are differences in functions performed, however, the effect on gross services profit of such differences is not necessarily equal to the differences in the amount of related comparable trans- actional costs. Specific examples of the factors that may be particularly relevant to this method include— (1) The complexity of the services; (2) The duration or quantitative mea- sure of services; (3) Contractual terms (for example, scope and terms of warranties or guaran- tees provided, volume, credit and payment terms, allocation of risks, including any contingent-payment terms); (4) Economic circumstances; and (5) Risks borne. 2006–34 I.R.B.294August 21, 2006 (iii)Data and assumptions—(A)In general. The reliability of the results de- rived from the cost of services plus method is affected by the completeness and accu- racy of the data used and the reliability of the assumptions made to apply this method. See §1.482–1(c) (Best method rule). (B)Consistency in accounting.The degree of consistency in accounting prac- tices between the controlled transaction and the uncontrolled comparables that materially affect the gross services profit markup affects the reliability of the results under this method. Thus, for example, if differences in cost accounting practices would materially affect the gross services profit markup, the ability to make reliable adjustments for such differences would affect the reliability of the results obtained under this method. Further, reliability under this method depends on the extent to which the controlled and uncontrolled transactions reflect consistent reporting of comparable transactional costs. For purposes of this paragraph (e)(3)(iii)(B), the term comparable transactional costs includes the cost of acquiring tangible property that is transferred (or used) with the services, to the extent that the arm’s length price of the tangible property is not separately evaluated as a controlled transaction under another provision. (4)Examples. The principles of this paragraph (e) are illustrated by the follow- ing examples: Example 1.Internal comparable.(i)CompanyA designs and assembles information-technology net- works and systems. When Company A renders ser- vices for uncontrolled parties, it receives compensa- tion based on time and materials as well as certain other related costs necessary to complete the project. This fee includes the cost of hardware and software purchased from uncontrolled vendors and incorpo- rated in the final network or system, plus a reason- able allocation of certain specified overhead costs in- curred by Company A in providing these services. Reliable accounting records maintained by Company A indicate that Company A earned a gross services profit markup of 10% on its time, materials and spec- ified overhead in providing design services during the year under examination on information technology projects for uncontrolled entities. (ii) Company A designed an information-technol- ogy network for its Country X subsidiary, Company B. The services rendered to Company B are similar in scope and complexity to services that Company A rendered to uncontrolled parties during the year under examination. Using Company A’s accounting records (which are determined to be reliable under paragraph (e)(3) of this section), it is possible to iden- tify the comparable transactional costs involved in the controlled services transaction with reference to the costs incurred by Company A in rendering simi- lar design services to uncontrolled parties. Company A’s records indicate that it does not incur any addi- tional types of costs in rendering similar services to uncontrolled customers. The data available are suffi- ciently complete to conclude that it is likely that all material differences between the controlled and un- controlled transactions have been identified and ad- justed for. Based on the gross services profit markup data derived from Company A’s uncontrolled trans- actions involving similar design services, an arm’s length result for the controlled services transaction is equal to the price that will allow Company A to earn a 10% gross services profit markup on its comparable transactional costs. Example 2.Inability to adjust for differences in comparable transactional costs. The facts are the same as inExample 1, except that Company A’s staff that rendered the services to Company B consisted primarily of engineers in training status or on tem- porary rotation from other Company A subsidiaries. In addition, the Company B network incorporated in- novative features, including specially designed soft- ware suited to Company B’s requirements. The use of less-experienced personnel and staff on temporary ro- tation, together with the special features of the Com- pany B network, significantly increased the time and costs associated with the project as compared to time and costs associated with similar projects completed for uncontrolled customers. These factors constitute material differences between the controlled and the uncontrolled transactions that affect the determina- tion of Company A’s comparable transactional costs associated with the controlled services transaction, as well as the gross services profit markup. More- over, it is not possible to perform reliable adjustments for these differences on the basis of the available ac- counting data. Under these circumstances, the relia- bility of the cost of services plus method as a measure of an arm’s length price is substantially reduced. Example 3.Operating loss by reference to to- tal services costs. The facts and analysis are the same as inExample 1, except that an unrelated Company C, instead of Company A, renders similar services to uncontrolled parties and publicly avail- able information indicates that Company C earned a gross services profit markup of 10% on its time, materials and certain specified overhead in provid- ing those services. As inExample 1, Company A still provides services for its Country X subsidiary, Company B. In accordancewith the requirements in paragraph (e)(3)(ii) of this section, the taxpayer performs additional analysis and restates the results of Company A’s controlled services transaction with its Country X subsidiary, Company B, in the form of a markup on Company A’stotal services costs. This analysis by reference to total services costs shows that Company A generated an operating loss on the controlled services transaction, which indi- cates that functional differences likely exist between the controlled services transaction performed by Company A and uncontrolled services transactions performed by Company C, and that these differences may not be reflected in the comparable transactional costs. Upon further scrutiny, the presence of such functional differences between the controlled and uncontrolled transactions may indicate that the cost of services plus method does not provide the most reliable measure of an arm’s length result under the facts and circumstances. Example 4.Internal comparable .(i)Company A, a U.S. corporation, and its subsidiaries perform computer consulting services relating to systems in- tegration and networking for business clients in vari- ous countries. Company A and its subsidiaries render only consulting services and do not manufacture or distribute computer hardware or software to clients. The controlled group is organized according to indus- try specialization, with key industry specialists work- ing for Company A. These personnel typically form the core consulting group that teams with consultants from the local-country subsidiaries to serve clients in the subsidiaries’ respective countries. (ii) On some occasions, Company A and its sub- sidiaries undertake engagements directly for clients. On other occasions, they work as subcontractors for uncontrolled parties on more extensive consulting en- gagements for clients. In undertaking the latter en- gagements with third-party consultants, Company A typically prices its services at four times the compen- sation costs of its consultants, defined as the consul- tants’ base salary plus estimated fringe benefits, as defined in this table: CategoryRates Project managers $100 per hour Technical staff $ 75 per hour (iii) In uncontrolled transactions, Company A also charges the customer, at no markup, for out-of-pocket expenses such as travel, lodging, and data acquisition charges. Thus, for example, a project involving 100 hours of time from project managers, and 400 hours of technical staff time would result in total compensation costs to Company A of (100 hrs. × $100/hr.) + (400 hrs. × $75/hr.) = $10,000 + $30,000 = $40,000. Applying the markup of 300%, the total fee charged would thus be (4 × $40,000), or $160,000, plus out-of-pocket expenses. (iv) Company B, a Country X subsidiary of Com- pany A, contracts to render consulting services to a Country X client in the banking industry. In undertak- ing this engagement, Company B uses its own consul- tants and also uses the services of Company A project managers and technical staff that specialize in the banking industry for 75 hours and 380 hours, respec- tively. The data available are sufficiently complete to conclude that it is likely that all material differ- ences between the controlled and uncontrolled trans- actions have been identified and adjusted for. Based on reliable data concerning the compensation costs to Company A, an arm’s length result for the con- August 21, 20062952006–34 I.R.B. trolled services transaction is equal to $144,000. This is calculated as follows: [4 × (75 hrs. × $100/hr.)] + [4 × (380 hrs. × $75/hr.)] = $30,000 + $114,000 = $144,000, reflecting a 4x markup on the total com- pensation costs for Company A project managers and technical staff. In addition, consistent with Com- pany A’s pricing of uncontrolled transactions, Com- pany B must reimburse Company A for appropriate out-of-pocket expenses incurred in performing the services. (f)Comparable profits method—(1)In general. The comparable profits method evaluates whether the amount charged in a controlled transaction is arm’s length, based on objective measures of profitabil- ity (profit level indicators) derived from uncontrolled taxpayers that engage in sim- ilar business activities under similar cir- cumstances. The rules in §1.482–5 relat- ing to the comparable profits method apply to controlled services transactions, except as modified in this paragraph (f). (2)Determination of arm’s length re- sult—(i)Tested party. This paragraph (f) applies where the relevant business activ- ity of the tested party as determined un- der §1.482–5(b)(2) is the rendering of ser- vices in a controlled services transaction. Where the tested party determined under §1.482–5(b)(2) is instead the recipient of the controlled services, the rules under this paragraph (f) are not applicable to deter- mine the arm’s length result. (ii)Profit level indicators. In addition to the profit level indicators provided in §1.482–5(b)(4), a profit level indicator that may provide a reliable basis for compar- ing operating profits of the tested party in- volved in a controlled services transaction and uncontrolled comparables is the ratio of operating profit to total services costs (as defined in paragraph (j) of this section). (iii)Comparability and reliabil- ity considerations—Data and assump- tions—Consistency in accounting.Con- sistency in accounting practices between the relevant business activity of the tested party and the uncontrolled ser- vice providers is particularly important in determining the reliability of the results under this method, but less than in ap- plying the cost of services plus method. Adjustments may be appropriate if ma- terially different treatment is applied to particular cost items related to the relevant business activity of the tested party and the uncontrolled service providers. For example, adjustments may be appropriate where the tested party and the uncontrolled comparables use inconsistent approaches to classify similar expenses as “cost of goods sold” and “selling, general, and administrative expenses.” Although dis- tinguishing between these two categories may be difficult, the distinction is less important to the extent that the ratio of operating profit to total services costs is used as the appropriate profit level indi- cator. Determining whether adjustments are necessary under these or similar cir- cumstances requires thorough analysis of the functions performed and consideration of the cost accounting practices of the tested party and the uncontrolled compa- rables. Other adjustments as provided in §1.482–5(c)(2)(iv) may also be necessary to increase the reliability of the results under this method. (3)Examples. The principles of this paragraph (f) are illustrated by the follow- ing examples: Example 1. Ratio of operating profit to total ser- vices costs as the appropriate profit level indicator. (i) A Country T parent firm, Company A, and its Coun- try Y subsidiary, Company B, both engage in man- ufacturing as their principal business activity. Com- pany A also performs certain advertising services for itself and its affiliates. In year 1, Company A renders advertising services to Company B. (ii) Based on the facts and circumstances, it is de- termined that the comparable profits method will pro- vide the most reliable measure of an arm’s length re- sult. Company A is selected as the tested party. No data are available for comparable independent man- ufacturing firms that render advertising services to third parties. Financial data are available, however, for ten independent firms that render similar adver- tising services as their principal business activity in CountryX.Thetenfirmsaredeterminedtobecom- parable under §1.482–5(c). Neither Company A nor the comparable companies use valuable intangibles in rendering the services. (iii) Based on the available financial data of the comparable companies, it cannot be determined whether these comparable companies report costs for financial accounting purposes in the same manner as the tested party. The publicly available financial data of the comparable companies segregate total services costs into cost of goods sold and sales, general and administrative costs, with no further segmentation of costs provided. Due to the limited information avail- able regarding the cost accounting practices used by the comparable companies, the ratio of operating profits to total services costs is determined to be the most appropriate profit level indicator. This ratio includes total services costs to minimize the effect of any inconsistency in accounting practices between Company A and the comparable companies. Example 2. Application of the operating profit to total services costs profit level indicator. (i) Com- pany A is a foreign subsidiary of Company B, a U.S. corporation. Company B is under examination for its year 1 taxable year. Company B renders manage- ment consulting services to Company A. Company B’s consulting function includes analyzing Company A’s operations, benchmarking Company A’s financial performance against companies in the same indus- try,andtotheextentnecessary, developing a strategy to improve Company A’s operational performance. The accounting records of Company B allow reliable identification of the total services costs of the consult- ing staff associated with the management consulting services rendered to Company A. Company A reim- burses Company B for its costs associated with ren- dering the consulting services, with no markup. (ii) Based on all the facts and circumstances, it is determined that the comparable profits method will provide the most reliable measure of an arm’s length result. Company B is selected as the tested party, and its rendering of management consulting services is identified as the relevant business activity. Data are available from ten domestic companies that operate in the industry segment involving management con- sulting and that perform activities comparable to the relevant business activity of Company B. These com- parables include entities that primarily perform man- agement consulting services for uncontrolled parties. The comparables incur similar risks as Company B incurs in performing the consulting services and do not make use of valuable intangibles or special pro- cesses. (iii) Based on the available financial data of the comparables, it cannot be determined whether the comparables report their costs for financial account- ing purposes in the same manner as Company B re- ports its costs in the relevant business activity. The available financial data for the comparables report only an aggregate figure for costs of goods sold and operating expenses, and do not segment the underly- ing services costs. Due to this limitation, the ratio of operating profits to total services costs is determined to be the most appropriate profit level indicator. (iv) For the taxable years 1 through 3, Company B shows the following results for the services per- formed for Company A: year 1year 2year 3Average Revenues1,200,0001,100,0001,300,0001,200,000 Cost of Goods Sold100,000100,000N/A66,667 Operating Expenses1,100,0001,000,0001,300,0001,133,333 Operating Profit0000 2006–34 I.R.B.296August 21, 2006 (v) After adjustments have been made to ac- count for identified material differences between the relevant business activity of Company B and the comparables, the average ratio for the taxable years 1 through 3 of operating profit to total services costs is calculated for each of the uncontrolled service providers. Applying each ratio to Company B’s av- erage total services costs from the relevant business activity for the taxable years 1 through 3 would lead to the following comparable operating profit (COP) for the services rendered by Company B: Uncontrolled Service ProviderOP/Total Service Costs Company B COP Company 1 15.75% $189,000 Company 2 15.00% $180,000 Company 314.00% $168,000 Company 413.30% $159,600 Company 5 12.00% $144,000 Company 611.30% $135,600 Company 7 11.25% $135,000 Company 811.18% $134,160 Company 911.11% $133,320 Company 10 10.75% $129,000 (vi) The available data are not sufficiently com- plete to conclude that it is likely that all material differences between the relevant business activity of Company B and the comparables have been identi- fied. Therefore, an arm’s length range can be estab- lished only pursuant to §1.482–1(e)(2)(iii)(B). The arm’s length range is established by reference to the interquartile range of the results as calculated under §1.482–1(e)(2)(iii)(C), which consists of the results ranging from $168,000, to $134,160. Company B’s reported average operating profit of zero ($0) falls outside this range. Therefore, an allocation may be appropriate. (vii) Because Company B reported income of zero,todeterminetheamount,ifany,ofthealloca- tion, Company B’s reported operating profit for year 3 is compared to the comparable operating profits derived from the comparables’ results for year 3. The ratio of operating profit to total services costs in year 3 is calculated for each of the comparables and applied to Company B’s year 3 total services costs to derive the following results: Uncontrolled Service ProviderOP/Total Service Costs (For year 3) Company B COP Company 1 15.00% $195,000 Company 2 14.75% $191,750 Company 314.00% $182,000 Company 4 13.50% $175,500 Company 5 12.30% $159,900 Company 6 11.05% $143,650 Company 711.03% $143,390 Company 811.00% $143,000 Company 9 10.50% $136,500 Company 10 10.25% $133,250 (viii) Based on these results, the median of the comparable operating profits for year 3 is $151,775. Therefore, Company B’sincome for year 3 is in- creased by $151,775, the difference between Com- pany B’s reported operating profit for year 3 of zero and the median of the comparable operating profits for year 3. Example 3.Material difference in accounting for stock-based compensation. (i) Taxpayer, a U.S. cor- poration the stock of which is publicly traded, per- forms controlled services for its wholly-owned sub- sidiaries. The arm’s length price of these controlled services is evaluated under the comparable profits method for services in this paragraph, by reference to the net cost plus profit level indicator (PLI). Tax- payer is the tested party under paragraph (f)(2)(i) of this section. The Commissioner identifies the most narrowly identifiable business activity of the tested party for which data are available that incorporate the controlled transaction (the relevant business activity). The Commissioner also identifies four uncontrolled domestic service providers, Companies A, B, C, and D, each of which performs exclusively activities simi- lar to the relevant business activity of Taxpayer that is subject to analysis under this paragraph (f). The stock of Companies A, B, C, and D is publicly traded on a U.S. stock exchange. Assume that Taxpayer makes an election to apply these regulations to earlier tax- able years. (ii) Stock options are granted to the employees of Taxpayer that engage in the relevant business activ- ity. Assume that, as determined under a method in accordance with U.S. generally accepted accounting principles, the fair value of such stock options attrib- utable to the employees’ performance of the relevant business activity is 500 for the taxable year in ques- tion. In evaluating the controlled services, Taxpayer includes salaries, fringe benefits, and related compen- sation of these employees in “total services costs,” as defined in paragraph (j) of this section. Taxpayer does not include any amount attributable to stock options in total services costs, nor does it deduct that amount in determining “reported operating profit” within the meaning of §1.482–5(d)(5), for the year under exam- ination. (iii) Stock options are granted to the employees of Companies A, B, C, and D. Under a fair value method in accordance with U.S. generally accepted account- ing principles, the comparables include in total com- pensation the value of the stock options attributable to the employees’ performance of the relevant business activity for the annual financial reporting period, and treat this amount as an expense in determining oper- ating profit for financial accounting purposes. The treatment of employee stock options is summarized in the following table: August 21, 20062972006–34 I.R.B. Salaries and other Non-Option Compensation Stock Options Fair Value Stock Options Expensed Taxpayer1,000 500 0 Company A7,0002,0002,000 Company B4,300 250250 Company C10,000 4,5004,500 Company D 15,000 2,0002,000 (iv) A material difference exists in account- ing for stock-based compensation, as defined in §1.482–7(d)(2)(i). Analysis indicates that this dif- ference would materially affect the measure of an arm’s length result under this paragraph (f). In making an adjustment to improve comparability under §§1.482–1(d)(2) and 1.482–5(c)(2)(iv), the Commissioner includes in total services costs of the tested party the total compensation costs of 1,500 (including stock option fair value). In addition, the Commissioner calculates the net cost plus PLI by reference to the financial-accounting data of Com- panies A, B, C, and D, which take into account compensatory stock options. Example 4.Material difference in utilization of stock-based compensation. (i) The facts are the same as in paragraph (i) ofExample 3. (ii) No stock options are granted to the employees of Taxpayer that engage in the relevant business ac- tivity. Thus, no deduction for stock options is made in determining “reported operating profit” within the meaning of §1.482–5(d)(5), for the taxable year un- der examination. (iii) Stock options are granted to the employees of Companies A, B, C, and D, but none of these compa- nies expense stock optionsfor financial accounting purposes. Under a method in accordance with U.S. generally accepted accounting principles, however, Companies A, B, C, and D disclose the fair value of the stock options for financial accounting purposes. The utilization and treatment of employee stock op- tions is summarized in the following table: Salaries and other Non-Option Compensation Stock Options Fair Value Stock Options Expensed Taxpayer1,0000N/A Company A7,0002,0000 Company B4,300 250 0 Company C12,000 4,500 0 Company D 15,000 2,0000 (iv) A material difference in the utilization of stock-based compensation exists within the meaning of §1.482–7(d)(2)(i). Analysis indicates that these differences would materially affect the measure of an arm’s length result under this paragraph (f). In evaluating the comparable operating profits of the tested party, the Commissioner uses Taxpayer’s total services costs, which include total compensation costs of 1,000. In considering whether an adjust- ment is necessary to improve comparability under §§1.482–1(d)(2) and 1.482–5(c)(2)(iv), the Com- missioner recognizes that the total compensation provided to employees of Taxpayer is comparable to the total compensation provided to employees of Companies A, B, C, and D. Because Companies A, B, C, and D do not expense stock-based compensa- tion for financial accounting purposes, their reported operating profits must be adjusted in order to improve comparability with the tested party. The Commis- sioner increases each comparable’s total services costs, and also reduces its reported operating profit, by the fair value of the stock-based compensation incurred by the comparable company. (v) The adjustments to the data of Companies A, B, C, and D described in paragraph (iv) of thisExam- ple 4are summarized in the following table: Salaries and other Non-Option Compensation Stock Option Fair Value Total Services Costs (A) Operating Profit (B) Net Cost Plus PLI (B/A) Per financial statements: Company A7,0002,000 25,000 6,00024.00% Company B4,300 25012,5002,500 20.00% Company C12,000 4,500 36,00011,000 30.56% Company D 15,000 2,00027,0007,000 25.93% As adjusted: Company A7,0002,00027,0004,00014.80% Company B4,300 25012,7502,25017.65% Company C12,000 4,50040,5006,50016.05% Company D 15,000 2,00029,000 5,000 17.24% 2006–34 I.R.B.298August 21, 2006 Example 5.Non-material difference in utilization of stock-based compensation. The facts are the same as in paragraph (i) ofExample 3. (ii) Stock options are granted to the employees of Taxpayer that engage in the relevant business activity. Assume that, as determined under a method in accor- dance with U.S. generally accepted accounting prin- ciples, the fair value of such stock options attributable to the employees’ performance of the relevant busi- ness activity is 50 for the taxable year. Taxpayer in- cludes salaries, fringe benefits, and all other compen- sation of these employees (including the stock option fair value) in “total services costs,” as defined in para- graph (j) of this section, and deducts these amounts in determining “reported operating profit” within the meaning of §1.482–5(d)(5), for the taxable year un- der examination. (iii) Stock options are granted to the employees of Companies A, B, C, and D, but none of these compa- nies expense stock options for financial accounting purposes. Under a method in accordance with U.S. generally accepted accounting principles, however, Companies A, B, C, and D disclose the fair value of the stock options for financial accounting purposes. The utilization and treatment of employee stock op- tions is summarized in the following table: Salaries and other Non-Option Compensation Stock Options Fair Value Stock Options Expensed Taxpayer1,000 5050 Company A7,0001000 Company B4,300400 Company C10,0001300 Company D 15,00075 0 (iv) Analysis of the data reported by Companies A, B, C, and D indicates that an adjustment for dif- ferences in utilization of stock-based compensation would not have a material effect on the determination of an arm’s length result. Salaries and other Non-Option Compensation Stock Option Fair Value Total Services Costs (A) Operating Profit (B) Net Cost Plus PLI (B/A) Per financial statements: Company A7,000100 25,000 6,00024.00% Company B4,30040 12,5002,500 20.00% Company C12,00013036,00011,000 30.56% Company D 15,00075 27,0007,000 25.93% As adjusted: Company A7,000100 25,1005,90023.51% Company B4,30040 12,540 2,46019.62% Company C12,00013036,13010,87030.09% Company D 15,0007527,0756,92525.58% (v) Under the circumstances, the difference in uti- lization of stock-based compensation would not ma- terially affect the determination of the arm’s length result under this paragraph (f). Accordingly, in calcu- lating the net cost plus PLI, no comparability adjust- ment is made to the data of Companies A, B, C, or D pursuant to §§1.482–1(d)(2) and 1.482–5(c)(2)(iv). Example 6.Material difference in comparables’ accounting for stock-based compensation.(i)The facts are the same as in paragraph (i) ofExample 3. (ii) Stock options are granted to the employees of Taxpayer that engage in the relevant business activity. Assume that, as determined under a method in accor- dance with U.S. generally accepted accounting prin- ciples, the fair value of such stock options attributable to employees’ performance of the relevant business activity is 500 for the taxable year. Taxpayer includes salaries, fringe benefits, and all other compensation of these employees (including the stock option fair value) in “total services costs,” as defined in para- graph (j) of this section and deducts these amounts in determining “reported operating profit” within the meaning of §1.482–5(d)(5), for the taxable year un- der examination. (iii) Stock options are granted to the employees ofCompaniesA,B,C,andD.CompaniesAand B expense the stock options for financial account- ing purposes inaccordance with U.S. generally ac- cepted accounting principles. Companies C and D do not expense the stock options for financial account- ing purposes. Under a method in accordance with U.S. generally accepted accounting principles, how- ever, Companies C and D disclose the fair value of these options in their financial statements. The uti- lization and accounting treatment of options are de- picted in the following table: August 21, 20062992006–34 I.R.B. Salaries and other Non-Option Compensation Stock Options Fair Value Stock Options Expensed Taxpayer1,000 500500 Company A7,0002,0002,000 Company B4,300 250250 Company C12,000 4,500 0 Company D 15,000 2,0000 (iv) A material difference in accounting for stock- based compensation exists, within the meaning of §1.482–7(d)(2)(i). Analysis indicates that this dif- ference would materially affect the measure of the arm’s length result under paragraph (f) of this sec- tion. In evaluating the comparable operating profits of the tested party, the Commissioner includes in to- tal services costs Taxpayer’s total compensation costs of 1,500 (including stock option fair value of 500). In considering whether anadjustment is necessary to improve comparability under §§1.482–1(d)(2) and 1.482–5(c)(2)(iv), the Commissioner recognizes that the total employee compensation (including stock op- tions provided by Taxpayer and Companies A, B, C, and D) provides a reliable basis for comparison. Be- cause Companies A and B expense stock-based com- pensation for financial accounting purposes, whereas Companies C and D do not, an adjustment to the com- parables’ operating profit is necessary. In computing the net cost plus PLI, the Commissioner uses the fi- nancial-accounting data of Companies A and B, as reported. The Commissioner increases the total ser- vices costs of Companies C and D by amounts equal to the fair value of their respective stock options, and reduces the operating profits of Companies C and D accordingly. (v) The adjustments described in paragraph (iv) of thisExample 6are depicted in the following table. For purposes of illustration, the unadjusted data of Companies A and B are also included. Salaries and other Non-Option Compensation Stock Option Fair Value Total Services Costs (A) Operating Profit (B) Net Cost Plus PLI (B/A) Per financial statements: Company A7,0002,00027,0004,00014.80% Company B4,300 25012,7502,25017.65% As adjusted: Company C12,000 4,50040,5006,50016.05% Company D 15,000 2,00029,000 5,000 17.24% (g)Profit split method—(1)In general. The profit split method evaluates whether the allocation of the combined operating profit or loss attributable to one or more controlled transactions is arm’s length by reference to the relative value of each controlled taxpayer’s contribution to that combined operating profit or loss. The rel- ative value of each controlled taxpayer’s contribution is determined in a manner that reflects the functions performed, risks assumed and resources employed by such controlled taxpayer in the relevant busi- ness activity. For application of the profit split method (both the comparable profit split and the residual profit split), see §1.482–6. The residual profit split method is ordinarily used in controlled services transactions involving a combination of nonroutine contributions by multiple con- trolled taxpayers. (2)Examples. The principles of this paragraph (g) are illustrated by the follow- ing examples: Example 1.Residual profit split.(i)CompanyA, ac orporation resident in Country X, auctions spare parts by means of an interactive database. Company A maintains a database that lists all spare parts avail- a ble for auction. Company A developed the soft- ware used to run the database. Company A’s data- base is managed by Company A employees in a data c enter located in Country X, where storage and ma- nipulation of data also take place. Company A has a wholly-owned subsidiary, Company B, located in Country Y. Company B performs marketing and ad- vertising activities to promote Company A’s interac- tive database. Company B solicits unrelated compa- nies to auction spare parts on Company A’s database, and solicits customers interestedinpurchasingspare parts online. Company B owns and maintains a com- puter server in Country Y, where it receives informa- tion on spare parts available for auction. Company B has also designed a specialized communications net- work that connects its data center to Company A’s data center in Country X. The communications net- work allows Company B to enter data from uncon- trolled companies on Company A’s database located in Country X. Company B’s communications net- work also allows uncontrolled companies to access Company A’s interactive database and purchase spare parts. Company B bore the risks and cost of develop- ing this specialized communications network. Com- pany B enters into contracts with uncontrolled com- panies and provides the companies access to Com- pa ny A’s database through the Company B network. (ii) Analysis of the facts and circumstances indicates that both Company A and Company B po ssess valuable intangibles that they use to conduct the spare parts auction business. Company A bore the economic risks of developing and maintaining s oftware and the interactive database. Company B bore the economic risks of developing the necessary technology to transmit information from its server t o Company A’s data center, and to allow uncon- trolled companies to access Company A’s database. Company B helped to enhance the value of Com- pany A’s trademark and to establish a network of customers in Country Y. In addition, there are no market comparables forthe transactions between Company A and Company B to reliably evaluate them separately. Given the facts and circumstances, the Commissioner determines that a residual profit split method will provide the most reliable measure of an arm’s length result. (iii) Under the residual profit split method, profits are first allocated based on the routine contributions of each taxpayer. Routine contributions include gen- eral sales, marketing or administrative functions per- formed by Company B for Company A for which it is possible to identify market returns. Any residual profits will be allocated based on the nonroutine con- tributions of each taxpayer. Since both Company A and Company B provided nonroutine contributions, 2006–34 I.R.B.300August 21, 2006 the residual profits are allocated based on these con- tributions. Example 2.Residual profit split.(i)Company A, a Country 1 corporation, provides specialized services pertaining to the processing and storage of Level 1 hazardous waste (for purposes of this example, the most dangerous type of waste). Un- der long-term contracts with private companies and governmental entities in Country 1, Company A performs multiple services, including transportation of Level 1 waste, development of handling and storage protocols, recordkeeping, and supervision of waste-storage facilities owned and maintained by the contracting parties. Company A’s research and development unit has also developed new and unique processes for transport and storage of Level 1 waste that minimize environmental and occupational ef- fects. In addition to this novel technology, Company A has substantial know-how and a long-term record of safe operations in Country 1. (ii) Company A’s subsidiary, Company B, has been in operation continuously for a number of years in Country 2. Company B has successfully com- pleted several projects in Country 2 involving Level 2 and Level 3 waste, including projects with govern- ment-owned entities. Company B has a license in Country 2 to handle Level 2 waste (Level 3 does not require a license). Company B has established a rep- utation for completing these projects in a responsible manner. Company B has cultivated contacts with pro- curement officers, regulatory and licensing officials, and other government personnel in Country 2. (iii) Country 2 government publishes invitations to bid on a project to handle the country’s burgeon- ing volume of Level 1 waste, all of which is gener- ated in government-owned facilities. Bidding is lim- ited to companies that are domiciled in Country 2 and that possess a license from the government to handle Level 1 or Level 2 waste. In an effort to submit a win- ning bid to secure the contract, Company B points to its Level 2 license and its record of successful com- pletion of projects, and also demonstrates to these of- ficials that it has access to substantial technical exper- tise pertaining to processing of Level 1 waste. (iv) Company A enters into a long-term techni- cal services agreement with Company B. Under this agreement, Company A agrees to supply to Com- pany B project managers and other technical staff who have detailed knowledge of Company A’s pro- prietary Level 1 remediation techniques. Company A commits to perform under any long-term contracts enteredintobyCompanyB.CompanyBagreesto compensate Company A based on a markup on Com- pany A’s marginal costs (pro ratacompensation and current expenses of Company A personnel). In the bid on the Country 2 contract for Level 1 waste re- mediation, Company B proposes to use a multi-dis- ciplinary team of specialists from Company A and Company B. Project managers from Company A will direct the team, which will also include employees of Company B and will make use of physical assets and facilities owned by Company B. Only Company A and Company B personnel will perform services under the contract. Country 2 grants Company B a license to handle Level 1 waste. (v) Country 2 grants Company B a five-year, ex- clusive contract to provide processing services for all Level 1 hazardous waste generated in County 2. Un- der the contract, Company B is to be paid a fixed price per ton of Level 1 waste that it processes each year. Company B undertakes that all services provided will meet international standards applicable to processing of Level 1 waste. Company B begins performance under the contract. (vi) Analysis of the facts and circumstances in- dicates that both Company A and Company B make nonroutine contributions to the Level 1 waste pro- cessing activity in Country 2. In addition, it is de- termined that reliable comparables are not available for the services that Company A provides under the long-term contract, in part because those services in- corporate specialized knowledge and process intan- gibles developed by Company A. It is also deter- mined that reliable comparables are not available for the Level 2 license in Country 2, the successful track record, the government contacts with Country 2 offi- cials, and other intangibles that Company B provided. In view of these facts, the Commissioner determines that the residual profit split method for services in paragraph (g) of this section provides the most reli- able means of evaluating the arm’s length results for the transaction. In evaluating the appropriate returns to Company A and Company B for their respective contributions, the Commissioner takes into account that the controlled parties incur different risks, be- cause the contract between the controlled parties pro- vides that Company A will be compensated on the ba- sis of marginal costs incurred, plus a markup, whereas the contract between Company B and the government of Country 2 provides that Company B will be com- pensated on a fixed-price basis per ton of Level 1 waste processed. (vii) In the first stage of the residual profit split, an arm’s length return is determined for routine ac- tivities performed by Company B in Country 2, such as transportation, recordkeeping, and administration. In addition, an arm’s length return is determined for routine activities performed by Company A (admin- istrative, human resources, etc.) in connection with providing personnel to Company B. After the arm’s length return for these functions is determined, resid- ual profits may be present. In the second stage of the residual profit split, any residual profit is allocated by reference to the relative value of the nonroutine con- tributions made by each taxpayer. Company A’s non- routine contributions include its commitment to per- form under the contract and the specialized technical knowledge made available through the project man- agers under the services agreement with Company B. Company B’s nonroutine contributions include its li- censes to handle Level 1 and Level 2 waste in Country 2, its knowledge of and contacts with procurement, regulatory and licensing officials in the government of Country 2, and its record in Country 2 of success- fully handling non-Level 1 waste. (h)Unspecified methods. Methods not specified in paragraphs (b) through (g) of this section may be used to evaluate whether the amount charged in a controlled services transaction is arm’s length. Any method used under this paragraph (h) must be applied in accordance with the provi- sions of §1.482–1. Consistent with the specified methods, an unspecified method should take into account the general prin- ciple that uncontrolled taxpayers evaluate the terms of a transaction by considering the realistic alternatives to that transaction, including economically similar transac- tions structured as other than services transactions, and only enter into a particu- lar transaction if none of the alternatives is preferable to it. For example, the compa- rable uncontrolled services price method compares a controlled services transac- tion to similar uncontrolled transactions to provide a direct estimate of the price to which the parties would have agreed had they resorted directly to a market alterna- tive to the controlled services transaction. Therefore, in establishing whether a con- trolled services transaction achieved an arm’s length result, an unspecified method should provide information on the prices or profits that the controlled taxpayer could have realized bychoosing a realis- tic alternative to the controlled services transaction (for example, outsourcing a particular service function, rather than performing the function itself). As with any method, an unspecified method will not be applied unless it provides the most reliable measure of an arm’s length result under the principles of the best method rule. See §1.482–1(c). Therefore, in accordance with §1.482–1(d) (compara- bility), to the extent that an unspecified method relies on internal data rather than uncontrolled comparables, its reliability will be reduced. Similarly, the reliability of a method will be affected by the relia- bility of the data and assumptions used to apply the method, including any projec- tions used. Example. (i) Company T, a U.S. corporation, develops computer software programs including a real estate investment program that performs finan- cial analysis of commercial real properties. The primary business activity of Companies U, V and W is commercial real estate development. For business reasons, Company T doesnotsellthecomputer program to its customers (on a compact disk or via download from Company T’s server through the In- ternet). Instead, Company T maintains the software program on its own server and allows customers to access the program through the Internet by using a password. The transactions between Company T and Companies U, V and W are structured as con- trolled services transactions whereby Companies U, V and W obtain access via the Internet to Company T’s software program for financial analysis. Each year, Company T provides a revised version of the computer program including the most recent data on the commercial real estate market, rendering the old version obsolete. (ii) In evaluating whether the consideration paid by Companies U, V and W to Company T was arm’s length, the Commissioner may consider, subject August 21, 20063012006–34 I.R.B. to the best method rule of §1.482–1(c), Company T’s alternative of selling the computer program to Companies U, V and W on a compact disk or via download through the Internet. The Commissioner determines that the controlled services transactions between Company T and Companies U, V and W are comparable to the transfer of a similar software program on a compact disk or via download through the Internet between uncontrolled parties. Subject to adjustments being made for material differences between the controlled services transactions and the comparable uncontrolled transactions, the uncon- trolled transfers of tangible property may be used to evaluate the arm’s length results for the controlled services transactions between Company T and Com- panies U, V and W. (i)Contingent-payment contractual terms for services—(1)Contingent-pay- ment contractual terms recognized in general. In the case of a contingent-pay- ment arrangement, the arm’s length result for the controlled services transaction gen- erally would not require payment by the recipient to the renderer in the tax account- ing period in which the service is rendered if the specified contingency does not occur in that period. If the specified contingency occurs in a tax accounting period subse- quent to the period in which the service is rendered, the arm’s length result for the controlled services transaction generally would require payment by the recipient to the renderer on a basis that reflects the recipient’s benefitfrom the services ren- dered and the risks borne by the renderer in performing the activities in the absence of a provision that unconditionally obli- gates the recipient to pay for the activities performed in the tax accounting period in which the service is rendered. (2)Contingent-payment arrangement. For purposes of this paragraph (i), an arrangement will be treated as a contin- gent-payment arrangement if it meets all of the requirements in paragraph (i)(2)(i) of this section and is consistent with the economic substance and conduct require- ment in paragraph (i)(2)(ii) of this section. (i)General requirements—(A)Written contract. The arrangement is set forth in a written contract entered into prior to, or contemporaneous with the start of the ac- tivity or group of activities constituting the controlled services transaction. (B)Specified contingency. The contract states that payment is contingent (in whole or in part) upon the happening of a fu- ture benefit (within the meaning of para- graph (l)(3) of this section) for the recip- ient directly related to the controlled ser- vices transaction. (C)Basis for payment. The contract provides for payment on a basis that re- flects the recipient’s benefit from the services rendered and the risks borne by the renderer. Whether the specified con- tingency bears a direct relationship to the controlled services transaction, and whether the basis for payment reflects the recipient’s benefit and the renderer’s risk, is evaluated based on all the facts and circumstances. (ii)Economic substance and con- duct. The arrangement, including the contingency and the basis for payment, is consistent with the economic sub- stance of the controlled transaction and the conduct of the controlled parties. See §1.482–1(d)(3)(ii)(B). (3) Commissioner’s authority to impute contingent-payment terms. Consistent with the authority in §1.482–1(d)(3)(ii)(B), the Commissioner may impute contingent-payment contrac- tual terms in a controlled services trans- action if the economic substance of the transaction is consistent with the existence of such terms. (4)Evaluation of arm’s length charge. Whether the amount charged in a contin- gent-payment arrangement is arm’s length will be evaluated in accordance with this section and other applicable regulations under section 482. In evaluating whether the amount charged in a contingent-pay- ment arrangement for the manufacture, construction, or development of tangible or intangible property owned by the recip- ient is arm’s length, the charge determined under the rules of §§1.482–3 and 1.482–4 for the transfer of similar property may be considered. See §1.482–1(f)(2)(ii). (5)Examples. The principles of this paragraph (i) are illustrated by the follow- ing examples: Example 1. (i) Company X is a member of a con- trolled group that has operated in the pharmaceuti- cal sector for many years.In year 1, Company X en- ters into a written services agreement with Company Y, another member of the controlled group, whereby Company X will perform certain research and devel- opment activities for Company Y. The parties enter into the agreement before Company X undertakes any of the research and development activities covered by the agreement. At the time the agreement is entered into, the possibility that any new products will be de- veloped is highly uncertain and the possible market or markets for any products that may be developed are not known and cannot be estimated with any reliabil- ity. Under the agreement, Company Y will own any patent or other rights that result from the activities of Company X under the agreement and Company Y will make payments to Company X only if such activities result in commercial sales of one or more derivative products. In that event, Company Y will pay Company X, for a specified period, x% of Com- pany Y’s gross sales of each of such products. Pay- ments are required with respect to each jurisdiction in which Company Y has sales of such a derivative product, beginning with the first year in which the sale of a product occurs in the jurisdiction and con- tinuing for six additional years with respect to sales of that product in that jurisdiction. (ii) As a result of research and development ac- tivities performed by Company X for Company Y in years 1 through 4, a compound is developed that may be more effective than existing medications in the treatment of certain conditions. Company Y reg- isters the patent rights with respect to the compound in several jurisdictions in year 4. In year 6, Company Y begins commercial sales of the product in Jurisdic- tion A and, in that year, Company Y makes the pay- ment to Company X that is required under the agree- ment. Sales of the product continue in Jurisdiction A in years 7 through 9 and Company Y makes the pay- ments to Company X in years 7 through 9 that are required under the agreement. (iii) The years under examination are years 6 through 9. In evaluating whether the contingent-pay- ment terms will be recognized, the Commissioner considers whether the conditions of paragraph (i)(2) of this section are met and whether the arrangement, including the specified contingency and basis of payment, is consistent with the economic substance of the controlled services transaction and with the conduct of the controlled parties. The Commissioner determines that the contingent-payment arrangement is reflected in the written agreement between Com- pany X and Company Y; that commercial sales of products developed under the arrangement represent future benefits for Company Y directly related to the controlled services transaction; and that the basis for the payment provided for in the event such sales occur reflects the recipient’s benefit and the ren- derer’s risk. Consistent with §1.482–1(d)(3)(ii)(B) and (iii)(B), the Commissioner determines that the parties’ conduct over the term of the agreement has been consistent with their contractual allocation of risk; that Company X has the financial capacity to bear the risk that its research and development ser- vices may be unsuccessful and that it may not receive compensation for such services; and that Company X exercises managerial and operational control over the research and development, such that it is rea- sonable for Company X to assume the risk of those activities. Based on all these facts, the Commissioner determines that the contingent-payment arrangement is consistent with economic substance. (iv) In determining whether the amount charged under the contingent-payment arrangement in each of years 6 through 9 is arm’s length, the Commis- sioner evaluates under this section and other applica- ble rules under section 482 the compensation paid in each year for the research and development services. This analysis takes into account that under the contin- gent-payment terms Company X bears the risk that it might not receive payment for its services in the event that those services do not result in marketable 2006–34 I.R.B.302August 21, 2006 products and the risk that the magnitude of its pay- ment depends on the magnitude of product sales, if any. The Commissioner also considers the alterna- tives reasonably available to the parties in connection with the controlled services transaction. One such al- ternative, in view of Company X’s willingness and ability to bear the risk and expenses of research and development activities, would be for Company X to undertake such activities on its own behalf and to li- cense the rights to products successfully developed as a result of such activities. Accordingly, in evalu- ating whether the compensation of x% of gross sales that is paid to Company X during the first four years of commercial sales of derivative products is arm’s length, the Commissioner may consider the royalties (or other consideration) charged for intangibles that are comparable to those incorporated in the deriva- tive products and that resulted from Company X’s research and development activities under the contin- gent-payment arrangement. Example 2. (i)ThefactsarethesameasinEx- ample 1, except that no commercial sales ever mate- rialize with regard to the patented compound so that, consistent with the agreement, Company Y makes no payments to Company X in years 6 through 9. (ii) Based on all the facts and circumstances, the Commissioner determines that the contingent-pay- ment arrangement is consistent with economic substance, and the result (no payments in years 6 through 9) is consistent with an arm’s length result. Example 3. (i)ThefactsarethesameasinEx- ample 1, except that, in the event that Company X’s activities result in commercial sales of one or more derivative products by Company Y, Company Y will pay Company X a fee equal to the research and devel- opment costs borne by Company X plus an amount equal to x% of such costs, with the payment to be made in the first year in which any such sales occur. The x% markup on costs is within the range, ascer- tainable in year 1, of markups on costs of indepen- dent contract researchers that are compensated under terms that unconditionally obligate the recipient to pay for the activities performed in the tax account- ing period in which the service is rendered. In year 6, Company Y makes the single payment to Company X that is required under the arrangement. (ii) The years under examination are years 6 through 9. In evaluating whether the contingent-pay- ment terms will be recognized, the Commissioner considers whether the requirements of paragraph (i)(2) of this section were met at the time the written agreement was entered into and whether the ar- rangement, including the specified contingency and basis for payment, is consistent with the economic substance of the controlled services transaction and with the conduct of the controlled parties. The Com- missioner determines that the contingent-payment terms are reflected in the written agreement between Company X and Company Y and that commercial sales of products developed under the arrangement represent future benefits for Company Y directly re- lated to the controlled services transaction. However, in this case, the Commissioner determines that the basis for payment provided for in the event such sales occur (costs of the services plus x%, representing the markup for contract research in the absence of any nonpayment risk) does not reflect the recipient’s benefit and the renderer’s risks in the controlled services transaction. Based on all the facts and cir- cumstances, the Commissioner determines that the contingent-payment arrangement is not consistent with economic substance. (iii) Accordingly, the Commissioner determines to exercise its authority to impute contingent-pay- ment contractual termsthat accord with economic substance, pursuant to paragraph (i)(3) of this section and §1.482–1(d)(3)(ii)(B). In this regard, the Com- missioner takes into account that at the time the ar- rangement was entered into, the possibility that any new products would be developed was highly uncer- tain and the possible market or markets for any prod- ucts that may be developed were not known and could not be estimated with any reliability. In such circum- stances, it is reasonable to conclude that one possible basis of payment, in order to reflect the recipient’s benefit and the renderer’s risks, would be a charge equal to a percentage of commercial sales of one or more derivative products that result from the research and development activities. The Commissioner in this case may impute terms that require Company Y to pay Company X a percentage of sales of the prod- ucts developed under the agreement in each of years 6 through 9. (iv) In determining an appropriate arm’s length charge under such imputed contractual terms, the Commissioner conducts an analysis under this sec- tion and other applicable rules under section 482, and considers the alternatives reasonably available to the parties in connection with the controlled ser- vices transaction. One such alternative, in view of Company X’s willingness and ability to bear the risks and expenses of research and development activities, would be for Company X to undertake such activities on its own behalf and to license the rights to products successfully developed as a result of such activities. Accordingly, for purposes of its determination, the Commissioner may consider the royalties (or other consideration) charged for intan- gibles that are comparable to those incorporated in the derivative products that resulted from Company X’s research and development activities under the contingent-payment arrangement. (j)Total services costs. For purposes of this section, total services costs means all costs of rendering those services for which total services costs are being de- termined. Total services costs include all costsincashorinkind(includingstock- based compensation) that, based on anal- ysis of the facts and circumstances, are directly identified with, or reasonably al- located in accordance with the principles of paragraph (k)(2) of this section to, the services. In general, costs for this pur- pose should comprise provision for all re- sources expended, used, or made available to achieve the specific objective for which the service is rendered. Reference to gen- erally accepted accounting principles or Federal income tax accounting rules may provide a useful starting point but will not necessarily be conclusive regarding inclu- sion of costs in total services costs. Total services costs do not include interest ex- pense, foreign income taxes (as defined in §1.901–2(a)), or domestic income taxes. (k)Allocation of costs—(1)In general. In any case where the renderer’s activity that results in a benefit (within the mean- ing of paragraph (l)(3) of this section) for one recipient in a controlled services trans- action also generates a benefit for one or more other members of a controlled group (including the benefit, if any, to the ren- derer), and the amount charged under this section in the controlled services transac- tion is determined under a method that makes reference to costs, costs must be al- located among the portions of the activity performed for the benefit of the first men- tioned recipient and such other members of the controlled group under this paragraph (k). The principles of this paragraph (k) must also be used whenever it is appropri- ate to allocate and apportion any class of costs (for example, overhead costs) in or- der to determine the total services costs of rendering the services. In no event will an allocation of costs based on a generalized or non-specific benefit be appropriate. (2)Appropriate method of alloca- tion and apportionment—(i)Reasonable method standard. Any reasonable method may be used to allocate and apportion costs under this section. In establishing the appropriate method of allocation and apportionment, consideration should be given to all bases and factors, including, for example, total services costs, total costs for a relevant activity, assets, sales, compensation, space utilized, and time spent. The costs incurred by support- ing departments may be apportioned to other departments on the basis of rea- sonable overall estimates, or such costs may be reflected in the other departments’ costs by applying reasonable departmental overhead rates. Allocations and appor- tionments of costs must be made on the basis of the full cost, as opposed to the incremental cost. (ii)Use of general practices. The prac- tices used by the taxpayer to apportion costs in connection with preparation of statements and analyses for the use of man- agement, creditors, minority shareholders, joint venturers, clients, customers, poten- tial investors, or other parties or agencies in interest will be considered as poten- tial indicators of reliable allocation meth- ods, but need not be accorded conclusive weight by the Commissioner. In determin- August 21, 20063032006–34 I.R.B. ing the extent to which allocations are to be made to or from foreign members of a con- trolled group, practices employed by the domestic members in apportioning costs among themselves will also be considered if the relationships with the foreign mem- bers are comparable to the relationships among the domestic members of the con- trolled group. For example, if for purposes of reporting to public stockholders or to a governmental agency, a corporation ap- portions the costs attributable to its execu- tive officers among the domestic members of a controlled group on a reasonable and consistent basis, and such officers exercise comparable control over foreign members of the controlled group, such domestic ap- portionment practice will be considered in determining the allocations to be made to the foreign members. (3)Examples. The principles of this paragraph (k) are illustrated by the follow- ing examples: Example 1. Company A pays an annual license fee of 500x to an uncontrolled taxpayer for unlimited use of a database within the corporate group. Un- der the terms of the license with the uncontrolled tax- payer, Company A is permitted to use the database for its own use and in rendering research services to its subsidiary, Company B. Company B obtains ben- efits from the database that are similar to those that it would obtain if it had independently licensed the database from the uncontrolled taxpayer. Evaluation of the arm’s length charge (under a method in which costs are relevant) to Company B for the controlled services that incorporate use of the database must take into account the full amount of the license fee of 500x paid by Company A, as reasonably allocated and ap- portioned to the relevant benefits, although the incre- mental use of the database for the benefit of Company B did not result in an increase in the license fee paid by Company A. Example 2. (i) Company A is a consumer prod- ucts company located in the United States. Compa- nies B and C are wholly-owned subsidiaries of Com- pany A and are located in Countries B and C, respec- tively. Company A and its subsidiaries manufacture products for sale in their respective markets. Com- pany A hires a consultant who has expertise regard- ing a manufacturing process used by Company A and its subsidiary, Company B. Company C, the Country C subsidiary, uses a different manufacturing process, and accordingly will not receive any benefit from the outside consultant hired by Company A. In allocating and apportioning the cost of hiring the outside consul- tant (100), Company A determines that sales consti- tute the most appropriate allocation key. (ii) Company A and its subsidiaries have the fol- lowing sales: CompanyABCTotal Sales400100200700 (iii) Because Company C does not obtain any ben- efit from the consultant, none of the costs are allo- cated to it. Rather, the costs of 100 are allocated and apportioned ratably to Company A and Company B as the entities that obtain a benefit from the campaign, based on the total sales of those entities (500). An ap- propriate allocation of the costs of the consultant is as follows: CompanyABTotal Allocation400100 500500 Amount8020100 (l)Controlled services transaction—(1) In general. A controlled services trans- action includes any activity (as defined in paragraph (l)(2) of this section) by one member of a group of controlled taxpay- ers (the renderer) that results in a benefit (as defined in paragraph (l)(3) of this sec- tion) to one or more other members of the controlled group (the recipient(s)). (2)Activity. An activity includes the performance of functions, assumptions of risks, or use by a renderer of tangible or in- tangible property or other resources, capa- bilities, or knowledge, such as knowledge of and ability to take advantage of partic- ularly advantageous situations or circum- stances. An activity also includes making available to the recipient any property or other resources of the renderer. (3)Benefit—(i)In general. An activity is considered to provide a benefit to the re- cipient if the activity directly results in a reasonably identifiable increment of eco- nomic or commercial value that enhances the recipient’s commercial position, or that may reasonably be anticipated to do so. An activity is generally considered to confer a benefit if, taking into account the facts and circumstances, an uncontrolled taxpayer in circumstances comparable to those of the recipient would be willing to pay an un- controlled party to perform the same or similar activity on either a fixed or contin- gent-payment basis, or if the recipient oth- erwise would have performed for itself the same activity or a similar activity. A bene- fit may result to the owner of an intangible if the renderer engages in an activity that is reasonably anticipated to result in an in- crease in the value of that intangible. Para- graphs (l)(3)(ii) through (v) of this section provide guidelines that indicate the pres- ence or absence of a benefit for the activi- ties in the controlled services transaction. (ii)Indirect or remote benefit. An ac- tivity is not considered to provide a ben- efit to the recipient if, at the time the ac- tivity is performed, the present or reason- ably anticipated benefit from that activity is so indirect or remote that the recipient would not be willing to pay, on either a fixed or contingent-payment basis, an un- controlled party to perform a similar ac- tivity, and would not be willing to per- form such activity for itself for this pur- pose. The determination whether the ben- efit from an activity is indirect or remote is based on the nature of the activity and the situation of the recipient, taking into con- sideration all facts and circumstances. (iii)Duplicative activities. If an activity performed by a controlled taxpayer dupli- cates an activity that is performed, or that reasonably may be anticipated to be per- formed, by another controlled taxpayer on or for its own account, the activity is gen- erally not considered to provide a benefit to the recipient, unless the duplicative ac- tivity itself providesan additional benefit to the recipient. (iv)Shareholder activities. An activity is not considered to provide a benefit if the sole effect of that activity is either to pro- tect the renderer’s capital investment in the recipient or in other members of the con- 2006–34 I.R.B.304August 21, 2006 trolled group, or to facilitate compliance by the renderer with reporting, legal, or regulatory requirements applicable specif- ically to the renderer, or both. Activities in the nature of day-to-day management gen- erally do not relate to protection of the ren- derer’s capital investment. Based on anal- ysis of the facts and circumstances, activ- itiesinconnectionwith a corporate reor- ganization may be considered to provide a benefit to one or more controlled taxpay- ers. (v)Passive association. A controlled taxpayer generally will not be considered to obtain a benefit where that benefit re- sults from the controlled taxpayer’s sta- tusasamemberofacontrolledgroup. A controlled taxpayer’s status as a member of a controlled group may, however, be taken into account for purposes of evaluat- ing comparability between controlled and uncontrolled transactions. (4)Disaggregation of transactions.A controlled services transaction may be analyzed as two separate transactions for purposes of determining the arm’s length consideration, if that analysis is the most reliable means of determining the arm’s length consideration for the controlled services transaction. See the best method rule under §1.482–1(c). (5)Examples. The principles of this paragraph (l) are illustrated by the follow- ing examples. In each example, assume that Company X is a U.S. corporation and Company Y is a wholly-owned subsidiary of Company X in Country B. Example 1. In general. In developing a world- wide advertising and promotional campaign for a consumer product, Company X pays for and obtains designation as an official sponsor of the Olympics. This designation allows Company X and all its subsidiaries, including Company Y, to identify them- selves as sponsors and to use the Olympic logo in advertising and promotional campaigns. The Olympic sponsorship campaign generates benefits to Company X, Company Y, and other subsidiaries of Company X. Example 2.Indirect or remote benefit. Based on recommendations contained in a study performed by its internal staff, Company X implements certain changes in its management structure and the compen- sation of managers of divisions located in the United States. No changes were recommended or considered for Company Y in Country B. The internal study and the resultant changes in its management may increase the competitiveness and overall efficiency of Com- pany X. Any benefits to Company Y as a result of the study are, however, indirect or remote. Consequently, Company Y is not considered to obtain a benefit from the study. Example 3.Indirect or remote benefit. Based on recommendations contained in a study performed by its internal staff, Company X decides to make changes to the managementstructure and manage- ment compensation of its subsidiaries, in order to increase their profitability. As a result of the rec- ommendations in the study, Company X implements substantial changes in the management structure and management compensation scheme of Company Y. The study and the changes implemented as a result of the recommendations are anticipated to increase the profitability of Company X and its subsidiaries. The increased management efficiency of Company Y that results from these changes is considered to be a spe- cific and identifiable benefit, rather than remote or speculative. Example 4.Duplicative activities. At its corpo- rate headquarters in the United States, Company X performs certain treasury functions for Company X and for its subsidiaries, including Company Y. These treasury functions include raising capital, arranging medium and long-term financing for general corpo- rate needs, including cash management. Under these circumstances, the treasury functions performed by Company X do not duplicate the functions performed by Company Y’s staff. Accordingly, Company Y is considered to obtain a benefit from the functions per- formed by Company X. Example 5.Duplicative activities. The facts are the same as inExample 4, except that Company Y’s functions include ensuring that the financing require- ments of its own operations are met. Analysis of the facts and circumstances indicates that Company Y independently administers all financing and cash- management functions necessary to support its op- erations, and does not utilize financing obtained by Company X. Under the circumstances, the treasury functions performed by Company X are duplicative of similar functions performed by Company Y’s staff, and the duplicative functions do not enhance Com- pany Y’s position. Accordingly, Company Y is not considered to obtain a benefit from the duplicative ac- tivities performed by Company X. Example 6.Duplicative activities. Company X’s in-house legal staff has specialized expertise in sev- eral areas, including intellectual property law. Com- pany Y is involved in negotiations with an unrelated party to enter into a complex joint venture that in- cludes multiple licenses and cross-licenses of patents and copyrights. Company Y retains outside counsel that specializes in intellectual property law to review the transaction documents. Outside counsel advises that the terms for the proposed transaction are advan- tageous to Company Y and that the contracts are valid and fully enforceable. Before Company Y executes the contracts, the legal staff of Company X also re- views the transaction documents and concurs in the opinion provided by outside counsel. The activities performed by Company X substantially duplicate the legal services obtained by Company Y, but they also reduce the commercial risk associated with the trans- action in a way that confers an additional benefit on Company Y. Example 7.Shareholder activities. Company X is a publicly held corporation. U.S. laws and regula- tions applicable to publicly held corporations such as Company X require the preparation and filing of peri- odic reports that show, among other things, profit and loss statements, balance sheets, and other material fi- nancial information concerning the company’s opera- tions. Company X, Company Y and each of the other subsidiaries maintain their own separate accounting departments that record individual transactions and prepare financial statements in accordance with their local accounting practices. Company Y, and the other subsidiaries, forward the results of their financial per- formance to Company X, which analyzes and com- piles these data into periodic reports in accordance with U.S. laws and regulations. Because Company X’s preparation and filing of the reports relate solely to its role as an investor of capital or shareholder in Company Y or to its compliance with reporting, legal, or regulatory requirements, or both, these activities constitute shareholder activities and therefore Com- pany Y is not considered to obtain a benefit from the preparation and filing of the reports. Example 8.Shareholder activities.Thefactsare thesameasinExample 7, except that Company Y’s accounting department maintains a general ledger recording individual transactions, but does not pre- pare any financial statements (such as profit and loss statements and balance sheets). Instead, Company Y forwards the general ledger data to Company X, and Company X analyzes and compiles financial statements for Company Y, as well as for Company X’s overall operations, for purposes of complying with U.S. reporting requirements. Company Y is subject to reporting requirements in Country B sim- ilar to those applicable to Company X in the United States. Much of the data that Company X analyzes and compiles regarding Company Y’s operations for purposes of complying with the U.S. reporting re- quirements are made available to Company Y for its use in preparing reports that must be filed in Country B. Company Y incorporatesthese data, after minor adjustments for differences in local accounting prac- tices, into the reports that it files in Country B. Under these circumstances, because Company X’s analysis and compilation of Company Y’s financial data does not relate solely to its role as an investor of capital or shareholder in Company Y, or to its compliance with reporting, legal, or regulatory requirements, or both, these activities do not constitute shareholder activities. Example 9.Shareholder activities. Members of Company X’s internal audit staff visit Company Y on a semiannual basis in order to review the subsidiary’s adherence to internal operating procedures issued by Company X and its compliance with U.S. anti-bribery laws, which apply to Company Y on account of its ownership by a U.S. corporation. Because the sole effect of the reviews by Company X’s audit staff is to protect Company X’s investment in Company Y, or to facilitate Company X’s compliance with U.S. anti-bribery laws, or both, the visits are shareholder activities and therefore Company Y is not considered to obtain a benefit from the visits. Example 10.Shareholder activities. Country B recently enacted legislation that changed the foreign currency exchange controls applicable to foreign shareholders of Country B corporations. Company X concludes that it may benefit from changing the cap- ital structure of Company Y, thus taking advantage of the new foreign currency exchange control laws in Country B. Company X engages an investment banking firm and a law firm to review the Country B legislation and to propose possible changes to the capital structure of Company Y. Because Company August 21, 20063052006–34 I.R.B. X’s retention of the firms facilitates Company Y’s ability to pay dividends and other amounts and has the sole effect of protecting Company X’s investment in Company Y, these activities constitute shareholder activities and Company Y is not considered to obtain a benefit from the activities. Example 11.Shareholder activities. The facts are the same as inExample 10, except that Company Y bears the full cost of retaining the firms to evaluate the new foreign currency control laws in Country B and to make appropriate changes to its stock ownership by Company X. Company X is considered to obtain a benefit from the rendering by Company Y of these activities, which would be shareholder activities if conducted by Company X (seeExample 10). Example 12.Shareholder activities. The facts are thesameasinExample 10, except that the new laws relate solely to corporate governance in Country B, and Company X retains the law firm and investment banking firm in order to evaluate whether restructur- ing would increase Company Y’s profitability, reduce the number of legal entities in Country B, and in- crease Company Y’s ability to introduce new prod- ucts more quickly in Country B. Because Company X retained the law firm and the investment banking firm primarily to enhance Company Y’s profitability and the efficiency of its operations, and not solely to protect Company X’s investment in Company Y or to facilitate Company X’s compliance with Country B’s corporate laws, or to both, these activities do not constitute shareholder activities. Example 13.Shareholder activities. Company X establishes detailed personnel policies for its sub- sidiaries, including Company Y. Company X also re- views and approves the performance appraisals of Company Y’s executives, monitors levels of com- pensation paid to all Company Y personnel, and is involved in hiring and firing decisions regarding the senior executives of Company Y. Because this per- sonnel-related activity by Company X involves day- to-day management of Company Y, this activity does not relate solely to Company X’s role as an investor of capital or a shareholder of Company Y, and there- fore does not constitute a shareholder activity. Example 14.Shareholder activities. Each year, Company X conducts a two-day retreat for its senior executives. The purpose of the retreat is to refine the long-term business strategy of Company X and its subsidiaries, including Company Y, and to pro- duce a confidential strategy statement. The strategy statement identifies several potential growth initia- tives for Company X and its subsidiaries and lists general means of increasing the profitability of the company as a whole. The strategy statement is made available without charge to Company Y and the other subsidiaries of Company X. Company Y indepen- dently evaluates whether to implement some, all, or none of the initiatives contained in the strategy state- ment. Because the preparation of the strategy state- ment does not relate solely to Company X’s role as an investor of capital or a shareholder of Company Y, the expense of preparing the document is not a share- holder expense. Example 15.Passive association/benefit. Com- pany X is the parent corporation of a large controlled group that has been in operation in the informa- tion-technology sector for ten years. Company Y is a small corporation that was recently acquired by the Company X controlled group from local Coun- try B owners. Several months after the acquisition of Company Y, Company Y obtained a contract to redesign and assemble the information-technology networks and systems of a large financial institution in Country B. The project was significantly larger and more complex than any other project undertaken to date by Company Y. Company Y did not use Company X’s marketing intangibles to solicit the contract, and Company X had no involvement in the solicitation, negotiation, or anticipated execution of the contract. For purposes of this section, Com- pany Y is not considered to obtain a benefit from Company X or any other member of the controlled group because the ability of Company Y to obtain the contract, or to obtain the contract on more favor- able terms than would have been possible prior to its acquisition by the Company X controlled group, was due to Company Y’s status as a member of the Company X controlled group and not to any specific activity by Company X or any other member of the controlled group. Example 16.Passive association/benefit.The facts are the same as inExample 15,exceptthatCom- pany X executes a performance guarantee with re- spect to the contract, agreeing to assist in the project if Company Y fails to meet certain mileposts. This performance guarantee allowed Company Y to obtain the contract on materially more favorable terms than otherwise would have been possible. Company Y is considered to obtain a benefit from Company X’s ex- ecution of the performance guarantee. Example 17.Passive association/benefit.The facts are the same as inExample 15,exceptthatCom- pany X began the process of negotiating the contract with the financial institution in Country B before ac- quiring Company Y. Once Company Y was acquired by Company X, the contract with the financial insti- tutionwasenteredintobyCompanyY.CompanyY is considered to obtain a benefit from Company X’s negotiation of the contract. Example 18.Passive association/benefit.The facts are the same as inExample 15,exceptthatCom- pany X sent a letter to the financial institution in Country B, which represented that Company X had a certain percentage ownership in Company Y and that Company X would maintain that same percent- age ownership interest in Company Y until the con- tract was completed. This letter allowed Company Y to obtain the contract on more favorable terms than otherwise would have been possible. Since this letter from Company X to the financial institution simply affirmed Company Y’s status as a member of the con- trolled group and represented that this status would be maintained until the contract was completed, Com- pany Y is not considered to obtain a benefit from Company X’s furnishing of the letter. Example 19.Passive association/benefit.(i)Sis a company that supplies plastic containers to compa- nies in various industries. S establishes the prices for its containers through a price list that offers customers discounts based solely on the volume of containers purchased. (ii) Company X is the parent corporation of a large controlled group in the information technology sec- tor. Company Y is a wholly-owned subsidiary of Company X located in Country B. Company X and Company Y both purchase plastic containers from unrelated supplier S. In year 1, Company X purchases 1 million units and Company Y purchases 100,000 units. S, basing its prices on purchases by the entire group, completes the order for 1.1 million units at a price of $0.95 per unit, and separately bills and ships the orders to each company. Companies X and Y un- dertake no bargaining with supplier S with respect to the price charged, and purchase no other products from supplier S. (iii) R1 and its wholly-owned subsidiary R2 are a controlled group of taxpayers (unrelated to Company X or Company Y) each of which carries out functions comparable to those of Companies X and Y and un- dertakes purchases of plastic containers from supplier S, identical to those purchased from S by Company X and Company Y, respectively. S, basing its prices on purchases by the entire group, charges R1 and R2 $0.95 per unit for the 1.1 million units ordered. R1 and R2 undertake no bargaining with supplier S with respect to the price charged, and purchase no other products from supplier S. (iv) U is an uncontrolled taxpayer that carries out comparable functions and undertakes purchases of plastic containers from supplier S identical to Com- pany Y. U is not a member of a controlled group, un- dertakes no bargaining with supplier S with respect to the price charged, and purchases no other products from supplier S. U purchases 100,000 plastic contain- ers from S at the price of $1.00 per unit. (v) Company X charges Company Y a fee of $5,000, or $0.05 per unit of plastic containers purchased by Company Y, reflecting the fact that Company Y receives the volume discount from sup- plier S. (vi) In evaluating the fee charged by Company X to Company Y, the Commissioner considers whether the transactions between R1, R2, and S or the trans- actions between U and S provide a more reliable measure of the transactions between Company X, Company Y and S. The Commissioner determines that Company Y’s status as a member of a controlled group should be taken into account for purposes of evaluating comparability of the transactions, and concludes that the transactions between R1, R2, and S are more reliably comparable to the transac- tions between Company X, Company Y, and S. The comparable charge for the purchase was $0.95 per unit. Therefore, obtaining the plastic containers at a favorable rate (and the resulting $5,000 savings) is entirely due to Company Y’s status as a member of the Company X controlled group and not to any specific activity by Company X or any other member of the controlled group. Consequently, Company Y is not considered to obtain a benefit from Company X or any other member of the controlled group. Example 20.Disaggregation of transactions.(i) X, a domestic corporation, is a pharmaceutical com- pany that develops and manufactures ethical phar- maceutical products. Y, aCountry B corporation, is a distribution and marketing company that also per- forms clinical trials for X in Country B. Because Y does not possess the capability to conduct the trials, it contracts with a third party to undertake the trials at a cost of $100. Y also incurs $25 in expenses related to the third-party contract (for example, in hiring and working with the third party). (ii) Based on a detailed functional analysis, the Commissioner determines that Y performed func- tions beyond merely facilitating the clinical trials for X, such as audit controls of the third party performing those trials. In determining the arm’s length price, 2006–34 I.R.B.306August 21, 2006 the Commissioner may consider a number of alter- natives. For example, for purposes of determining the arm’s length price, the Commissioner may deter- mine that the intercompany service is most reliably analyzed on a disaggregated basis as two separate transactions: in this case, the contract between Y and the third party could constitute an internal CUSP with a price of $100. Y would be further entitled to an arm’s length remuneration for its facilitating services. If the most reliable method is one that provides a markup on Y’s costs, then “total services cost” in this context would be $25. Alternatively, the Commissioner may determine that the intercompany service is most reliably analyzed as a single transac- tion, based on comparableuncontrolled transactions involving the facilitation of similar clinical trial ser- vices performed by third parties. If the most reliable method is one that provides a markup on all of Y’s costs, and the base of the markup determined by the comparable companies includes the third-party clinical trial costs, then such a markup would be applied to Y’s total services cost of $125. Example 21.Disaggregation of transactions.(i) X performs a number of administrative functions for its subsidiaries, including Y, a distributor of widgets in Country B. These services include those relating to working capital (inventory and accounts receiv- able/payable) management. To facilitate provision of these services, X purchases an ERP system specifi- cally dedicated to optimizing working capital man- agement. The system, which entails significant third- party costs and which includes substantial intellectual property relating to its software, costs $1000. (ii) Based on a detailed functional analysis, the Commissioner determines that in providing adminis- trative services for Y, X performed functions beyond merely operating the ERP system itself, since X was effectively using the ERP as an input to the adminis- trative services it was providingtoY.Indetermining arm’s length price for the services, the Commissioner may consider a number of alternatives. For example, if the most reliable uncontrolled data is derived from companies that use similar ERP systems purchased from third parties to perform similar administrative functions for uncontrolled parties, the Commissioner may determine that a CPM is the best method for measuring the functions performed by X, and, in ad- dition, that a markup on total services costs, based on the markup from the comparable companies, is the most reliable PLI. In this case, total services cost, and the basis for the markup, would include appro- priate reflection of the ERP costs of $1000. Alter- natively, X’s functions may be most reliably mea- sured based on comparable uncontrolled companies that perform similar administrative functions using their customers’ own ERP systems. Under these cir- cumstances, the total services cost would equal X’s costs of providing the administrative services exclud- ing the ERP cost of $1000. (m)Coordination with transfer pricing rules for other transactions—(1)Services transactions that include other types of transactions. A transaction structured as a controlled servicestransaction may in- clude other elements for which a sepa- rate category or categories of methods are provided, such as a loan or advance, a rental, or a transfer of tangible or intan- gible property. See §§1.482–1(b)(2) and 1.482–2(a), (c), and (d). Whether such an integrated transaction is evaluated as a controlled services transaction under this section or whether one or more elements should be evaluated separately under other sections of the section 482 regulations de- pends on which approach will provide the most reliable measure of an arm’s length result. Ordinarily, an integrated transac- tion of this type may be evaluated under this section and its separate elements need not be evaluated separately, provided that each component of the transaction may be adequately accounted for in evaluating the comparability of the controlled transaction to the uncontrolled comparables and, ac- cordingly, in determining the arm’s length result in the controlled transaction. See §1.482–1(d)(3). (2)Services transactions that effect a transfer of intangible property.Atrans- action structured as a controlled services transaction may in certain cases include an element that constitutes the transfer of in- tangible property or may result in a trans- fer, in whole or in part, of intangible prop- erty. Notwithstanding paragraph (m)(1) of this section, if such element relating to in- tangible property is material to the evalu- ation, the arm’s length result for the ele- ment of the transaction that involves intan- gible property must be corroborated or de- termined by an analysis under §1.482–4. (3)Services subject to a qualified cost sharing arrangement. Services provided by a controlled participant under a quali- fied cost sharing arrangement are subject to §1.482–7. (4)Other types of transactions that include controlled services transactions. A transaction structured other than as a controlled services transaction may in- clude one or more elements for which separate pricing methods are provided in this section. Whether such an integrated transaction is evaluated under another section of the section 482 regulations or whether one or more elements should be evaluated separately under this section de- pends on which approach will provide the most reliable measure of an arm’s length result. Ordinarily, a single method may beappliedtosuchanintegratedtransac- tion, and the separate services component of the transaction need not be separately analyzed under this section, provided that the controlled services may be adequately accounted for in evaluating the compara- bility of the controlled transaction to the uncontrolled comparables and, accord- ingly, in determining the arm’s length results in the controlled transaction. See §1.482–1(d)(3). (5)Examples. The following examples illustrate paragraphs (m)(1) through (4) of this section: Example 1. (i) U.S. parent corporation Company X enters into an agreement to maintain equipment of Company Y, a foreign subsidiary. The mainte- nance of the equipment requires the use of spare parts. The cost of the spare parts necessary to maintain the equipment amounts to approximately 25 percent of the total costs of maintaining the equipment. Com- pany Y pays a fee that includes a charge for labor and parts. (ii) Whether this integrated transaction is evalu- ated as a controlled services transaction or is evalu- ated as a controlled servicestransaction and the trans- fer of tangible property depends on which approach will provide the most reliable measure of an arm’s length result. If it is not possible to find comparable uncontrolled services transactions that involve simi- lar services and tangible property transfers as the con- trolled transaction between Company X and Com- pany Y, it will be necessary to determine the arm’s length charge for the controlled services, and then to evaluate separately the arm’s length charge for the tangible property transfers under §1.482–1 and §§1.482–3 through 1.482–6. Alternatively, it may be possible to apply the comparable profits method of §1.482–5, to evaluate the arm’s length profit of Com- pany X or Company Y from the integrated controlled transaction. The comparable profits method may pro- vide the most reliable measure of an arm’s length re- sult if uncontrolled parties are identified that perform similar, combined functions of maintaining and pro- viding spare parts for similar equipment. Example 2. (i) U.S. parent corporation Company X sells industrial equipment to its foreign subsidiary, Company Y. In connection with this sale, Company X renders to Company Y services that consist of demonstrating the use of the equipment and assisting in the effective start-up of the equipment. Company X structures the integrated transaction as a sale of tangible property and determines the transfer price under the comparable uncontrolled price method of §1.482–3(b). (ii) Whether this integrated transaction is evalu- ated as a transfer of tangible property or is evaluated as a controlled services transaction and a transfer of tangible property depends on which approach will provide the most reliable measure of an arm’s length result. In this case, the controlled services may be similar to services rendered in the transactions used to determine the comparable uncontrolled price, or they may appropriately be considered a difference between the controlled transaction and comparable transactions with a definite and reasonably ascertain- able effect on price for which appropriate adjustments can be made. See §1.482–1(d)(3)(ii)(A)(6). In either case, application of the comparable uncontrolled price method to evaluate the integrated transaction may provide a reliable measure of an arm’s length August 21, 20063072006–34 I.R.B. result, and application of a separate transfer pricing method for the controlled services element of the transaction is not necessary. Example 3. (i)ThefactsarethesameasinEx- ample 2except that, after assisting Company Y in start-up, Company X also renders ongoing services, including instruction and supervision regarding Com- pany Y’s ongoing use of the equipment. Company X structures the entire transaction, including the incre- mental ongoing services, as a sale of tangible prop- erty, and determines the transfer price under the com- parable uncontrolled price method of §1.482–3(b). (ii) Whether this integrated transaction is evalu- ated as a transfer of tangible property or is evalu- ated as a controlled services transaction and a trans- fer of tangible property depends on which approach will provide the most reliable measure of an arm’s length result. It may not be possible to identify com- parable uncontrolled transactions in which a seller of merchandise renders services similar to the ongoing services rendered by Company X to Company Y. In such a case, the incremental services in connection with ongoing use of the equipment could not be taken into account as a comparability factor because they are not similar to the services rendered in connection with sales of similar tangible property. Accordingly, it may be necessary to evaluate separately the transfer price for such services under this section in order to produce the most reliable measure of an arm’s length result. Alternatively, it may be possible to apply the comparable profits method of §1.482–5 to evaluate the arm’s length profit of Company X or Company Y from the integrated controlled transaction. The com- parable profits method may provide the most reliable measure of an arm’s length result if uncontrolled par- ties are identified that perform the combined func- tions of selling equipment and rendering ongoing af- ter-sale services associated with such equipment. In that case, it would not be necessary to separately eval- uate the transfer price for the controlled services un- der this section. Example 4. (i) Company X, a U.S. corporation, and Company Y, a foreign corporation, are members of a controlled group. Both companies perform re- search and development activities relating to inte- grated circuits. In addition, Company Y manufac- tures integrated circuits. In years 1 through 3, Com- pany X engages in substantial research and develop- ment activities, gains significant know-how regard- ing the development of a particular high-temperature resistant integrated circuit, and memorializes that re- search in a written report. In years 1 through 3, Com- pany X generates overall net operating losses as a re- sult of the expenditures associated with this research and development effort. At the beginning of year 4, Company X enters into a technical assistance agree- ment with Company Y. As part of this agreement, the researchers from Company X responsible for this project meet with the researchers from Company Y and provide them with a copy of the written report. Three months later, the researchers from Company Y apply for a patent for a high-temperature resis- tant integrated circuit based in large part upon the know-how obtained from theresearchers from Com- pany X. (ii) The controlled services transaction between Company X and Company Y includes an element that constitutes the transfer of intangible property (such as, know-how). Because theelement relating to the intangible property is material to the arm’s length evaluation, the arm’s length result for that element must be corroborated or determined by an analysis under §1.482–4. (n)Effective date—(1)In general.This section is generally applicable for taxable years beginning after December 31, 2006. In addition, a person may elect to apply the provisions of this section, §1.482–9T, to earlier taxable years. See paragraph (n)(2) of this section. (2)Election to apply regulations to ear- lier taxable years—(i)Scope of election. A taxpayer may elect to apply §§1.482–1T, 1.482–2T, 1.482–4T, 1.482–6T, 1.482–8T, and 9T, 1.861–8T, §1.6038A–3T, §1.6662–6T and §31.3121(s)–1T of this chapter to any taxable year beginning after September 10, 2003. Such elec- tion requires that all of the provisions of this section, §§1.482–1T, 1.482–2T, 1.482–4T, 1.482–6T, 1.482–8T, and 1.482–9T, as well as the related provisions, §§1.861–8T, 1.6038A–3T, 1.6662–6T and 31.3121(s)–1T of this chapter be applied to such taxable year and all subsequent taxable years (earlier taxable years) of the taxpayer making the election. (ii)Effect of election.Anelectiontoap- ply the regulations to earlier taxable years has no effect on the limitations on assess- ment and collection or on the limitations on credit or refund (see Chapter 66 of the Internal Revenue Code). (iii)Time and manner of making elec- tion. An election to apply the regula- tions to earlier taxable years must be made by attaching a statement to the taxpayer’s timely filed U.S. tax return (including ex- tensions) for its first taxable year after De- cember 31, 2006. (iv)Revocation of election. An election to apply the regulations to earlier taxable years may not be revoked without the con- sent of the Commissioner. (3)In general. The applicability of §1.482–9T expires on or before July 31, 2009. Par. 15. Section 1.861–8 is amended as follows: 1. Paragraph (a)(5)(ii) is redesignated as paragraph (a)(5)(iii). 2. A new paragraph (a)(5)(ii) is added. 3. Paragraph (e)(4) is revised. 4. Paragraph (f)(4)(i) is revised. 5. Paragraph (g),Example 17,Example 18,andExample 30are revised. The addition and revisions read as fol- lows: §1.861–8 Computation of taxable income from sources within the United States and from other sources and activities. (a) * * * (5) * * * (ii) [Reserved]. For further guidance, see §1.861–8T(a)(5)(ii). ***** (e) * * * (4) [Reserved]. For further guidance, see §1.861–8T(e)(4). (f) * * * (4) * * * (i) [Reserved]. For further guidance, see §1.861–8T(f)(4)(i). ***** (g) * * * Example 17. [Reserved]. For further guidance, see §1.861–8T(g),Example 17. Example 18. [Reserved]. For further guidance, see §1.861–8T(g),Example 18. ***** Example 30. [Reserved]. For further guidance, see §1.861–8T(g),Example 30. ***** Par. 16. Section 1.861–8T is amended as follows: 1. Paragraphs (a)(3) and (a)(4) are removed and reserved and paragraph (a)(5)(ii) is revised. 2. Paragraph (b)(3) is revised. 3. Paragraph (e)(4) is added. 4. Paragraph (f)(4)(i) is revised. 5. Paragraph (g),Example 17,Example 18,andExample 30are added. 6. Paragraph (h) is revised. The addition and revisions read as fol- lows: §1.861–8T Computation of taxable income from sources within the United States and from other sources and activities (temporary). (a) * * * (5) * * * (ii) Paragraph (e)(4), the last sentence of paragraph (f)(4)(i), and paragraph (g), Example 17,Example 18,andExample 30 of this section are generally applicable for taxable years beginning after Decem- ber 31, 2006. In addition, a person may elect to apply the provisions of paragraph (e)(4) of this section to earlier years. Such 2006–34 I.R.B.308August 21, 2006 election shall be made in accordance with the rules set forth in §1.482–9T(n)(2). (b) * * * (3)Supportive functions. Deductions which are supportive in nature (such as overhead, general and administrative, and supervisory expenses) may relate to other deductions which can more readily be al- located to gross income. In such instance, such supportive deductions may be allo- cated and apportioned along with the de- ductions to which they relate. On the other hand, it would be equally accept- able to attribute supportive deductions on some reasonable basis directly to activi- ties or property which generate, have gen- erated or could reasonably be expected to generate gross income. This would ordi- narily be accomplished by allocating the supportive expenses to all gross income or to another broad class of gross income and apportioning the expenses in accor- dance with paragraph (c)(1) of this section. For this purpose, reasonable departmental overhead rates may be utilized. For ex- amples of the application of the principles of this paragraph (b)(3) to expenses other than expenses attributable to stewardship activities, seeExamples 19through21of paragraph (g) of this section. See para- graph (e)(4)(ii) of this section for the allo- cation and apportionment of deductions at- tributable to stewardship expenses. How- ever, supportive deductions that are de- scribed in §1.861–14T(e)(3) shall be allo- cated and apportioned in accordance with the rules of §1.861–14T and shall not be al- located and apportioned by reference only to the gross income of a single member of an affiliated group of corporations as de- fined in §1.861–14T(d). ***** (e) * * * (4)Stewardship and controlled ser- vices—(i)Expenses attributable to con- trolled services. If a corporation performs a controlled services transaction (as de- fined in §1.482–9T(l)(3)), which includes any activity by one member of a group of controlled taxpayers that results in a benefit to a related corporation, and the rendering corporation charges the related corporation for suchservices, section 482 and these regulations provide for an allo- cation where the charge is not consistent with an arm’s length result as determined. The deductions for expenses of the cor- poration attributable to the controlled services transaction are considered defi- nitely related to the amounts so charged and are to be allocated to such amounts. (ii)Stewardship expenses attribut- able to dividends received.Stewardship expenses, which result from “oversee- ing” functions undertaken for a corpo- ration’s own benefit as an investor in a related corporation, shall be consid- ered definitely related and allocable to dividends received, or to be received, from the related corporation. For pur- poses of this section, stewardship ex- penses of a corporation are those expenses resulting from “duplicative activities” (as defined in §1.482–9T(l)(3)(iii)) or “shareholder activities” (as defined in §1.482–9T(l)(3)(iv))ofthecorporation with respect to the related corporation. Thus, for example, stewardship expenses include expenses of an activity the sole effect of which is either to protect the corporation’s capital investment in the related corporation or to facilitate com- pliance by the corporation with reporting, legal, or regulatory requirements appli- cable specifically to the corporation, or both. If a corporation has a foreign or international department which exercises overseeing functions with respect to re- lated foreign corporations and, in addition, the department performs other functions that generate other foreign-source income (such as fees for services rendered outside of the United States for the benefit of for- eign related corporations, foreign-source royalties, and gross income of foreign branches), some part of the deductions with respect to that department are con- sidered definitely related to the other foreign-source income. In some instances, the operations of a foreign or international department will also generate United States source income (such as fees for ser- vices performed in the United States). Per- missible methods of apportionment with respect to stewardship expenses include comparisons of time spent by employees weighted to take into account differences in compensation, orcomparisons of each related corporation’s gross receipts, gross income, or unit sales volume, assuming that stewardship activities are not sub- stantially disproportionate to such factors. See paragraph (f)(5) of this section for the type of verification that may be required in this respect. See §1.482–9T(l)(5) for examples that illustrate the principles of §1.482–9T(l)(3). SeeExample 17and Example 18of paragraph (g) of this sec- tion for the allocation and apportionment of stewardship expenses. See paragraph (b)(3) of this section for the allocation and apportionment of deductions attributable to supportive functions other than stew- ardship expenses, such as expenses in the nature of day-to-day management, and paragraph (e)(5) of this section generally for the allocation and apportionment of deductions attributable to legal and ac- counting fees and expenses. (f) * * * (4)Adjustments made under other pro- visions of the Code—(i)In general.Ifan adjustment which affects the taxpayer is made under section 482 or any other pro- vision of the Code, it may be necessary to recomputed the allocations and appor- tionments required by this section in or- der to reflect changes resulting from the adjustment. The recomputation made by the Commissioner shall be made using the same method of allocation and apportion- ment as was originally used by the tax- payer, provided such method as originally used conformed with paragraph (a)(5) of this section and, in light of the adjustment, such method does not result in a mate- rial distortion. In addition to adjustments which would be made aside from this sec- tion, adjustments to the taxpayer’s income and deductions which would not otherwise be made may be required before applying this section in order toprevent a distortion in determining taxable income from a par- ticular source of activity. For example, if an item included as a part of the cost of goods sold has been improperly attributed to specific sales, and, as a result, gross in- come under one of the operative sections referred to in paragraph (f)(1) of this sec- tion is improperly determined, it may be necessary for the Commissioner to make an adjustment to the cost of goods sold, consistent with the principles of this sec- tion, before applying this section. Sim- ilarly, if a domestic corporation transfers the stock in its foreign subsidiaries to a do- mestic subsidiary and the parent corpora- tion continues to incur expenses in con- nection with protecting its capital invest- ment in the foreign subsidiaries (see para- graph (e)(4) of this section), it may be nec- essary for the Commissioner to make an al- location under section 482 with respect to August 21, 20063092006–34 I.R.B. such expenses before making allocations and apportionments required by this sec- tion, even though the section 482 alloca- tion might not otherwise be made. (g) * * * Example 17.Stewardship Expenses (Consoli- dation). (i) (A) Facts. X, a domestic corporation, wholly owns M, N, and O, also domestic corpora- tions. X, M, N, and O file a consolidated income tax return. All the income of X and O is from sources within the United States, all of M’s income is gen- eral limitation income from sources within South America, and all of N’s income is general limitation income from sources within Africa. X receives no dividends from M, N, or O. During the taxable year, the consolidated group of corporations earned consolidated gross income of $550,000 and incurred total deductions of $370,000 as follows: Gross incomeDeductions Corporations: X ................................... $100,000$50,000 M ................................... 250,000 100,000 N ................................... 150,000 200,000 O ................................... 50,000 20,000 Total.............................. 550,000 370,000 (B) Of the $50,000 of deductions incurred by X, $15,000 relates to X’s ownership of M; $10,000 relates to X’s ownership of N; $5,000 relates to X’s ownership of O; and the sole effect of the entire $30,000 of deductions is to protect X’s capital in- vestment in M, N, and O. X properly categorizes the $30,000 of deductions as stewardship expenses. The remainder of X’s deductions ($20,000) relates to production of United States source income from its plant in the United States. (ii) (A)Allocation. X’s deductions of $50,000 are definitely related and thus allocable to the types of gross income to which they give rise, namely $25,000 wholly to general limitation income from sources out- side the United States ($15,000 for stewardship of M and $10,000 for stewardship of N) and the remain- der ($25,000) wholly to gross income from sources within the United States. Expenses incurred by M and N are entirely related and thus wholly allocable to general limitation income earned from sources with- out the United States, and expenses incurred by O are entirely related and thus wholly allocable to income earned within the United States. Hence, no appor- tionmentofexpensesofX,M,N,orOisnecessary. For purposes of applying the foreign tax credit limita- tion, the statutory grouping is general limitation gross income from sources without the United States and the residual grouping is gross income from sources within the United States. As a result of the allocation of deductions, the X consolidated group has taxable income from sources without the United States in the amount of $75,000, computed as follows: Foreign source general limitation gross income ($250,000fromM+$150,000fromN) ............................................$400,000 Less: Deductions allocable to foreign source general limitation gross income ($25,000 from X, $100,000fromM,and$200,000fromN)...........................................325,000 Totalforeign-sourcetaxableincome ............................................ 75,000 (B) Thus, in the combined computation of the general limitation, the numerator of the limiting frac- tion (taxable income fromsources outside the United States) is $75,000. Example 18.Stewardship and Supportive Ex- penses.(i)(A)Facts. X, a domestic corporation, manufactures and sells pharmaceuticals in the United States. X’s domestic subsidiary S, and X’s foreign subsidiaries T, U, and V perform similar functions in the United States and foreign countries T, U, and V, respectively. Each corporation derives substantial net income during the taxable year that is general limitation income described in section 904(d)(1). X’s gross income for the taxable year consists of: Domesticsalesincome ............................... $32,000,000 Dividends from S (before dividendsreceived deduction) . . . . .3,000,000 DividendsfromT ...................................2,000,000 DividendsfromU ...................................1,000,000 DividendsfromV ...................................0 Royalties from T and U . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1,000,000 FeesfromUforservicesperformedbyX.................1,000,000 Totalgrossincome................................ 40,000,000 (B) In addition, X incurs expenses of its supervi- sion department of $1,500,000. (C) X’s supervision department (the Depart- ment) is responsible for the supervision of its four subsidiaries and for rendering certain services to the subsidiaries, and this Department provides all the supportive functions necessary for X’s foreign activities. The Department performs three principal types of activities. The first type consists of ser- vices for the direct benefit of U for which a fee is paid by U to X. The cost of the services for U is $900,000 (which results in a total charge to U of $1,000,000). The second type consists of activities described in §1.482–9(l)(3)(iii) that are in the nature of shareholder oversight that duplicate functions performed by the subsidiaries’ own employees and that do not provide an additional benefit to the sub- sidiaries. For example, a team of auditors from X’s accounting department periodically audits the subsidiaries’ books and prepares internal reports for use by X’s management. Similarly, X’s treasurer periodically reviews for the board of directors of X the subsidiaries’ financial policies. These activities do not provide an additional benefit to the related corporations. The cost of the duplicative services and related supportive expenses is $540,000. The third type of activity consists of providing services which are ancillary to the license agreements which X maintains with subsidiaries T and U. The cost of the ancillary services is $60,000. (ii)Allocation. The Department’s outlay of $900,000 for services rendered for the benefit of U is allocated to the $1,000,000 in fees paid by U. The remaining $600,000 in the Department’s deductions are definitely related to the types of gross income to which they give rise, namely dividends from sub- 2006–34 I.R.B.310August 21, 2006 sidiaries S, T, U, and V and royalties from T and U. However, $60,000 of the $600,000 in deductions are found to be attributable to the ancillary services and are definitely related (and therefore allocable) solely to royalties received from T and U, while the remaining $540,000 in deductions are definitely re- lated (and therefore allocable) to dividends received from all the subsidiaries. (iii) (A)Apportionment. For purposes of applying the foreign tax credit limitation, the statutory group- ing is general limitation gross income from sources outside the United States and the residual grouping is gross income from sources within the United States. X’s deduction of $540,000 for the Department’s ex- penses and related supportive expenses which are al- locable to dividends received from the subsidiaries must be apportioned between the statutory and resid- ual groupings before the foreign tax credit limita- tion may be applied. In determining an appropriate method for apportioning the $540,000, a basis other than X’s gross income must be used since the divi- dend payment policies of the subsidiaries bear no re- lationship either to the activities of the Department or to the amount of income earned by each subsidiary. This is evidenced by the fact that V paid no divi- dends during the year, whereas S, T, and U paid div- idends of $1 million or more each. In the absence of facts that would indicate a material distortion re- sulting from the use of such method, the stewardship expenses ($540,000) may be apportioned on the basis of the gross receipts of each subsidiary. (B) The gross receipts of the subsidiaries were as follows: S.................................... $4,000,000 T....................................3,000,000 U.................................... 500,000 V.................................... 1,500,000 Total..............................9,000,000 (C) Thus, the expenses of the Department are ap- portio ned for purposes of the foreign tax credit limi- tation as follows: Apportionment of stewardship expenses to the statutory grouping of gross income: $540,000 x [($3,000,000 + $500,000 + $1,500,000)/$9,000,000] . . . . . . . . . . . . . $300,000 Apportionment of supervisory expenses to the residual grouping of grossincome:$540,000x[$4,000,000/9,000,000]....................................240,000 Total:Apportionedstewardshipexpense......................................... $540,000 ***** Exa mple 30.Income Taxes.(i)(A)Facts.Asin Example 17of this paragraph, X is a domestic corpo- ration that wholly owns M, N, and O, also domestic cor porations. X, M, N, and O file a consolidated in- come tax return. All the income of X and O is from sources within the United States, all of M’s income is ge neral limitation income from sources within South America, and all of N’s income is general limita- tion income from sources within Africa. X receives no dividends from M, N, or O. During the taxable year, the consolidated group of corporations earned consolidated gross income of $550,000 and incurred t otal deductions of $370,000. X has gross income of $100,000 and deductions of $50,000, without re- gard to its deduction for state income tax. Of the $ 50,000 of deductions incurred by X, $15,000 re- lates to X’s ownership of M; $10,000 relates to X’s ownership of N; $5,000 relates to X’s ownership of O; and the entire $30,000 constitutes stewardship ex- penses. The remainder of X’s $20,000 of deductions (which is assumed not to include state income tax) relates to production of U. S. source income from its plant in the United States. M has gross income of $250,000 and deductions of $100,000, which yield foreign-source general limitation taxable income of $150,000. N has gross income of $150,000 and de- ductions of $200,000, which yield a foreign-source general limitation loss of $50,000. O has gross in- come of $50,000 and deductions of $20,000, which yield U.S. source taxable income of $30,000. (B) UnlikeExample 17of this paragraph (g), however, X also has a deduction of $1,800 for state A income taxes. X’s state A taxable income is computed by first making adjustments to the Federal taxable income of X to derive apportionable taxable income for state A tax purposes. An analysis of sta te A law indicates that state A law also includes in its definition of the taxable business income of X which is apportionable to X’s state A activities, th e taxable income of M, N, and O, which is related to X’s business. As inExample 25, the amount of apportionable taxable income attributable to business ac tivities conducted in state A is determined by mul- tiplying apportionable taxable income by a fraction (the “state apportionment fraction”) that compares t he relative amounts of payroll, property, and sales within state A with worldwide payroll, property, and sales. Assuming that X’s apportionable taxable i ncome equals $180,000, $100,000 of which is from sources without the United States, and $80,000 is from sources within the United States, and that the state apportionment fraction is equal to 10 percent, X has state A taxable income of $18,000. The state A income tax of $1,800 is then derived by applying the state A income tax rate of 10 percent to the $18,000 of state A taxable income. (ii)Allocation and apportionment. Assume that underExample 29, it is determined that X’s deduction for state A income tax is definitely related to a class of gross income consisting of income from sources both within and without the United States, and that the state A tax is apportioned $1,000 to sources with- out the United States, and $800 to sources within the United States. UnderExample 17, without regard to the deduction for X’s state A income tax, X has a separate loss of ($25,000) from sources without the United States. After taking into account the deduc- tion for state A income tax, X’s separate loss from sources without the United States is increased by the $1,000 state A tax apportioned to sources without the United States, and equals a loss of ($26,000), for pur- poses of computing the numerator of the consolidated gen eral limitation foreign tax credit limitation. (h) Effective dates—(1)In general.In gen eral, the rules of this section, as well as the rules of §§1.861–9T, 1.861–10T, 1. 861–11T, 1.861–12T, and 1.861–14T ap ply for taxable years beginning after De cember 31, 1986, except for para- gr aphs (a)(5)(ii), (b)(3), (e)(4), (f)(4)(i), a nd paragraph (g)Example 17,Exam- p le 18,andExample 30of this section, w hich are generally applicable for tax- a ble years beginning after December 31, 2 006. Also, see §1.861–8(e)(12)(iv) and § 1.861–14(e)(6) for rules concerning the allocation and apportionment of deduc- tions for charitable contributions. In the case of corporate taxpayers, transition rules set forth in §1.861–13T provide for the gradual phase-in of certain provisions of this and the foregoing sections. How- ever, the following rules are effective for taxable years commencing after December 31, 1988: (i) Section 1.861–9T(b)(2) (concerning the treatment of certain foreign currency). (ii) Section 1.861–9T(d)(2) (concern- ing the treatment of interest incurred by nonresident aliens). August 21, 20063112006–34 I.R.B. (iii) Section 1.861–10T(b)(3)(ii) (pro- viding an operating costs test for purposes of the nonrecourse indebtedness excep- tion). (iv) Section 1.861–10T(b)(6) (concern- ing excess collaterilzation of nonrecourse borrowings). (2) In addition, §1.861–10T(e) (con- cerning the treatment of related controlled foreign corporation indebtedness) is appli- cable for taxable years commencing after December 31, 1987. For rules for taxable years beginning before January 1, 1987, and for later years to the extent permitted by §1.861–13T, see §1.861–8 (revised as of April 1, 1986). (3)Expiration date. The applicability of the paragraphs (a)(5)(ii), (b)(3), (e)(4), (f)(4)(i), and paragraph (g)Example 17, Example 18,andExample 30of this sec- tion, expires on or before July 31, 2009. Par. 17. Section 1.6038A–3(a)(3) is amended by revising paragraph (a)(3),Ex- ample 4to read: §1.6038A–3 Record maintenance. (a) * * * (3) * * * Example 4. [Reserved]. For further guidance, see §1.6038A–3T,Example 4. ***** Par. 18. Section 1.6038A–3T is added to read as follows: §1.6038A–3T Record maintenance (temporary). (a)(1) through (3)Examples 1through 3[Reserved]. For further guidance, see §1.6038A–3(a)(1) through (3)Examples 1 through3. Example 4. S, a U.S. reporting corporation, pro- vides computer consulting services for its foreign par- ent, X. Based on the application of section 482 and the regulations, it is determined that the cost of ser- vices plus method, as described in §1.482–9T(e), will provide the most reliable measure of an arm’s length result, based on the facts and circumstances of the controlled transaction between S and X. S is required to maintain records to permit verification upon audit of the comparable transactional costs (as described in §1.482–9T(e)(2)(iii)) used to calculate the arm’s length price. Based on the facts and circumstances, if it is determined that X’s records are relevant to deter- mine the correct U.S. tax treatment of the controlled transaction between S andX, the record maintenance requirements under section 6038A(a) and this section will be applicable to the records of X. (b)(1) through (h) [Reserved]. For further guidance, see §1.6038A–3T(b)(1) through (h). (i)Effective date—(1)In general.This provision is generallyapplicable for tax- able years beginning after December 31, 2006. (2)Election to apply regulation to ear- lier taxable years. A person may elect to apply the provisions of this section to ear- lier taxable years in accordance with the rules set forth in §1.482–9T(n)(2). (3)Expiration date. The applicability of this section expires on or before July 31, 2009. Par. 19. Section 1.6662–6 is amended as follows: 1.Paragraphs (d)(2)(ii)(A) through (d)(2)(ii)(G) are redesig- nated as paragraphs (d)(2)(ii)(A)(1) through (d)(2)(ii)(A)(7) and paragraph (d)(2)(ii) introductory text as paragraph (d)(2)(ii)(A), respectively. 2. A new paragraph (d)(2)(ii)(B) is added. 3. Paragraphs (d)(2)(iii)(B)(4) and (d)(2)(iii)(B)(6) are revised. 4. Paragraph (g) is revised. The additions and revisions read as fol- lows: §1.6662–6 Transactions between persons described in section 482 and net section 482 transfer price adjustments. ***** (d) * * * (2) * * * (ii) * * * (B) [Reserved]. For further guidance, see §1.6662–6T(d)(2)(ii)(B). ***** (iii) * * * (B)*** (4) [Reserved]. For further guidance, see §1.6662–6T(d)(2)(iii)(B)(4). ***** (6) [Reserved]. For further guidance, see §1.6662–6T(d)(2)(iii)(B)(6). ***** (g) [Reserved]. For further guidance, see §1.6662–6T(g). Par. 20. Section 1.6662–6T is added to read as follows: §1.6662–6T Transactions between parties described in section 482 and net section 482 transfer price adjustments (temporary). (a) through (d)(2)(ii)(A) [Reserved]. For further guidance, see §1.6662–6(a) through (d)(2)(ii)(A). (d)(2)(ii)(B)Services cost method.A taxpayer’s selection of the services cost method for certain services, described in §1.482–9T(b), and its application of that method to a controlled services transaction will be considered reasonable for purposes of the specified method requirement only if the taxpayer reasonably allocated and apportioned costs in accordance with §1.482–9T(k), reasonably concluded that the controlled services transaction meets the conditions of §1.482–9T(b)(3), and reasonably concluded that the controlled services transaction is not described in §1.482–9T(b)(2). Whether the taxpayer’s conclusion was reasonable must be de- termined from all the facts and circum- stances. The factors relevant to this de- termination include those described in paragraph (d)(2)(ii)(A) of this section, to the extent applicable. (d)(2)(iii)(A) through (d)(2)(iii)(B)(3) [Reserved].For further guidance, see §1.6662–6(d)(2)(iii)(A) through (d)(2)(iii)(B)(3). (d)(2)(iii)(B)(4) A description of the method selected and an explanation of why that method was selected, including an evaluation of whether the regulatory conditions and requirements for applica- tion of that method, if any, were met; (d)(2)(iii)(B)(5) [Reserved].For further guidance, see §1.6662–6(d) (2)(iii)(B)(5). (d)(2)(iii)(B)(6) A description of the controlled transactions (including the terms of sale) and any internal data used to analyze those transactions. For exam- ple, if a profit split method is applied, the documentation must include a schedule providing the total income, costs, and assets (with adjustments for different ac- counting practices and currencies) for each controlled taxpayer participating in the relevant businessactivity and detailing the allocations of such items to that activ- ity. Similarly, if a cost-based method (such as the cost plus method, the services cost method for certain services, or a compara- ble profits method witha cost-based profit level indicator) is applied, the documen- tation must include a description of the 2006–34 I.R.B.312August 21, 2006 manner in which relevant costs are deter- mined and are allocated and apportioned to the relevant controlled transaction; (d)(2)(iii)(B)(7) through (f) [Re- served]. For further guidance, see §1.6662–6(d)(2)(iii)(B)(7) through (f). (g)Effective date—(1) This section is generally effective February 9, 1996. However, taxpayers may elect to apply this section to all open taxable years be- ginning after December 31, 1993. (2)(i) The provisions of paragraphs (d)(2)(ii)(B), (d)(2)(iii)(B)(4)and (d)(2)(iii)(B)(6) of this section are ap- plicable for taxable years beginning after December 31, 2006. (ii)Electiontoapplyregulationtoear- lier taxable years. A person may elect to apply the provisions of this section to ear- lier taxable years in accordance with the rules set forth in §1.482–9T(n)(2) of this chapter. (iii)Expiration date. The applicability of §1.6662–6T expires on or before July 31, 2009. PART 31—EMPLOYMENT TAXES AND COLLECTION OF INCOME TAX AT THE SOURCE Par. 21. T he authority citation for part 31 contin ues to read as follows: Authorit y: 26 U.S.C. 7805 * * * Par. 22. Se ction 31.3121(s)–1 is amended b y revising paragraphs (c)(2)(iii) and (d) to read as follows: §31.3121(s)–1 Concurrent employment by related corporations with common paymaster. ***** (c) * * * (2) * * * (iii) [Reserved]. For further guidance, see §31.3121(s)–1T(c)(2)(iii). (d) [Reserved]. For further guidance, see §31.3121(s)–1T(d). ***** Par. 23 . Section 31.3121(s)–1T is added t o read as follows: §31.3121(s)–1T Concurrent employment by related corporations with common paymaster (temporary). (a) through (c)(2)(ii) [Reserved]. For further guidance, see §31.3121(s)–1(a) through (c)(2)(ii). (c)(2)(iii)Group-wide allocation rules. Under the group-wide method of allo- cation, the district director may allocate the taxes imposed by sections 3102 and 3111 in an appropriate manner to a related corporation that remunerates an employee through a common paymaster if the com- mon paymaster fails to remit the taxes to the Internal Revenue Service. Allocation in an appropriate manner varies according to the circumstances. It may be based on sales, property, corporate payroll, or any other basis that reflects the distribution of the services performed by the employee, or a combination of the foregoing bases. To the extent practicable, the Commissioner may use the principles of §1.482–2(b) of this chapter in making the allocations with respect to wages paid after Decem- ber 31, 1978, and on or before December 31, 2006. To the extent practicable, the Commissioner may use the principles of §1.482–9T of this chapter in making the allocations with respect to wages paid af- ter December 31, 2006. (d)Effective date—(1)In general. This section is applicable with respect to wages paid after December 31, 1978. [§31.3121(s)–1]. The fourth sentence of paragraph (c)(2)(iii) of this section is ap- plicable with respect to wages paid after December 31, 1978, and on or before December 31, 2006. The fifth sentence of paragraph (c)(2)(iii) of this section is applicable with respect to wages paid after December 31, 2006. (2)Election to apply regulation to ear- lier taxable years. A person may elect to apply the fifth sentence of paragraph (c)(2)(iii) of this section to earlier taxable years in accordance with the rules set forth in §1.482–9T(n)(2). (3)Expiration date. The applicability of §31.3121(s)–1T expires on or before July 31, 2009. Mark E. Matthews, Deputy Commissioner for Services and Enforcement. Approved July 11, 2006. Eric Solomon, Acting Deputy Assistant Secretary of the Treasury. (Filed by the Office of the Federal Register on July 31, 2006, 4:40 p.m., and published in the issue of the Federal Register for August 4, 2006, 71 F.R. 44465) Section 6103.—Confi- dentiality and Disclosure of Returns and Return Information 26 CFR 301.6103(j)(1)–1: Disclosures of return in- formation reflected on returns to officers and employ- ees of the Department of Commerce for certain sta- tistical purposes and related activities. T.D. 9267 DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 301 Disclosure of Return Information to the Bureau of Economic Analysis AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Te mporary regulations. SUMMARY: This document contains temporary regulations regarding addi- tional items of return information disclos- able to the Bureau of Economic Analysis (Bureau) of the Department of Commerce. The text of these temporary regulations serves as the text of the proposed reg- ulations (REG–148864–03) set forth in the notice of proposed rulemaking on this subject in this issue of the Bulletin. DATES:Effective Date:These temporary regulations are effective July 6, 2006. Applicability Date:For dates of appli- cability, see §301.6103(j)(1)–1T(f). FOR FURTHER INFORMATION CONTACT: Joel D. McMahan, (202) 622–4580 (not a toll-free number). SUPPLEMENTARY INFORMATION: Background Under section 6103(j)(1)(B) of the In- ternal Revenue Code (Code), upon written request from the Secretary of Commerce, the Secretary of the Treasury shall furnish to the Bureau return information that is prescribed by Treasury regulations for the purpose of, but only to the extent neces- sary in, structuring of national economic accounts and conducting related statis- tical activities authorized by law. This August 21, 20063132006–34 I.R.B. document adopts temporary regulations that authorize the IRS to disclose the ad- ditional items of return information that have been requested by the Department of Commerce for purposes related to measur- ing economic change in the U.S. national economic accounts. Temporary regulations in this issue of the Bulletin amend the Procedure and Administration Regulations (26 CFR part 301) under Code section 6103(j)(1)(B). The temporary regulations contain rules relating to the disclosure of return infor- mation reflected on returns to officers and employees of the Department of Com- merce for structuring national economic accounts and conducting related statistical activities authorized by law. Explanation of Provisions By letter dated December 18, 2003, the Department of Commerce requested that additional items of return information be disclosed to the Bureau for purposes re- lated to measuring economic change in the U.S. national economic accounts. Specif- ically, the Department of Commerce re- quested access to return information, ob- tained from all corporate returns, not just those processed by the IRS’s Statistics of Income Division for its corporate sample file. Under this temporary regulation, the IRS will disclose to the Bureau’s officers and employees designated items of return information from returns filed by all cor- porations. Special Analyses It has been determined that these tem- porary regulations are not a significant reg- ulatory action as defined in Executive Or- der 12866. Therefore, a regulatory assess- ment is not required. It also has been de- termined that section 553(b) of the Admin- istrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations. For applicability of the Regulatory Flexibility Act (5 U.S.C. chapter 6), please refer to the cross-referenced notice of proposed rule- making published elsewhere in this issue of the Bulletin. Pursuant to section 7805(f) of the Code, these temporary regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Admin- istration for comment on their impact on small business. Draft Information The principal author of these temporary regulations is Joel D. McMahan, Office of the Associate ChiefCounsel (Procedure & Administration), Disclosure and Privacy Law Division. ***** Amendments to the Regulations Accordingly, 26 CFR part 301 is amended as follows: PART 301—PROCEDURE AND ADMINISTRATION Paragraph 1. The authority citation for part 301 is amended by adding an entry in numerical order to read, in part, as follows: Authority: 26 U.S.C. 7805 * * * Section 301.6103(j)(1)–1T also issued under 26 U.S.C. 6103(j)(1), * * * Par. 2. Section 301.6103(j)(1)–1 is amended by revising paragraphs (c) intro- ductory text to read as follows: §301.6103(j)(1)–1 Disclosures of return information reflected on returns to officers and employees of the Department of Commerce for certain statistical purposes and related activities. ***** (c) * * * (1) [Reserved]. For further guidance, see §301.6103(j)(1)–1T(c). ***** Par. 3. Section 301.6103(j)(1)–1T is revised to read as follows: §301.6103(j)(1)–1T Disclosures of return information reflected on returns to officers and employees of the Department of Commerce for certain statistical purposes and related activities (temporary). (a) and (b) [Reserved]. For further guidance, see §301.6103(j)(1)–1(a) and (b). (c)Disclosure of return information re- flected on returns of corporations to offi- cers and employees of the Bureau of Eco- nomic Analysis. (1) The Internal Revenue Service will disclose to officers and employees of the Bureau of Economic Analysis for purposes of, but only to the extent necessary in, con- ducting and preparing statistical analyses, as authorized by law, all return information from the Statistics of Income sample, in- cluding edited information and regardless of format or medium, of designated classes or categories of corporations with respect to the tax imposed by chapter 1 of the In- ternal Revenue Code. (2) [Removed and Reserved.] (3) The Internal Revenue Service will disclose the following return information reflected on returns filed by corporations to officers and employees of the Bureau of Economic Analysis: (i) From the business master files of the Internal Revenue Service— (A) Taxpayer identity information (as defined in section 6103(b)(6) of the Inter- nal Revenue Code) with respect to corpo- rate taxpayers; (B) Business or industry activity codes; (C) Filing requirement code; and (D) Physical location. (ii) From Form SS–4 filed by an entity identifying itself on the form as a corpora- tion or a private services corporation— (A) Taxpayer identity information (as defined in section 6103(b)(6), including le- gal, trade, and business name); (B) Physical location; (C) State or Country of incorporation; (D) Entity Type (Corporate only); (E) Estimated highest number of em- ployees expected in the next 12 months; (F) Principal activity of the business; (G) Principal line of merchandise; (H) Posting cycle date relative to filing; and (I) Document code. (iii) From an employment tax return filed by a corporation— (A) Taxpayer identity information (as defined in section 6103(b)(6)); (B) Total compensation reported; (C) Taxable wages paid for purposes of Chapter 21 to each employee; (D) Master file tax account code (MFT); (E) Total number of individuals em- ployed in the taxable period covered by the return; (F) Posting cycle date relative to filing; (G) Accounting period covered; and (H) Document code. (iv) From returns of corporate taxpayer, including Forms 1120, 851, and other busi- ness returns, schedules and forms that the Internal Revenue Service may issue— 2006–34 I.R.B.314August 21, 2006 (A) Taxpayer identity information (as defined in section 6103(b)(6)), including that of parent corporation, affiliate or sub- sidiary, and shareholder; (B) Gross sales and receipts; (C) Returns and allowances; (D) Cost of labor, salaries, and wages; (E) Total assets; (F) Posting cycle date relative to filing; (G) Accounting period covered; (H) Master file tax account code (MFT); (I) Document code; and (J) Principal industrial activity code. (d) [Reserved]. For further guidance, see §301.6103(j)(1)–1(d). (e) [Reserved]. For further guidance, see §301.6103(j)(1)–1(e). (f) Effective date. This section is appli- cable to disclosures to the Bureau of Eco- nomic Analysis on or after July 6, 2006. Mark E. Matthews, Deputy Commissioner for Services and Enforcement. Approved June 5, 2006. Eric Solomon, Acting Deputy Assistant Secretary oftheTreasury(TaxPolicy). (Filed by the Office of the Federal Register on July 5, 2006, 8:45 a.m., and published in the issue of the Federal Register for July 6, 2006, 71 F.R. 38262) August 21, 20063152006–34 I.R.B. Part III. Administrative, Procedural, and Miscellaneous Modification of Notice 2006–53 Notice 2006–71 On February 22, 2006, the Service is- sued Notice 2006–26, 2006–11 I.R.B. 622, providing guidance regarding the credit for nonbusiness energy property under section 25C of the Internal Revenue Code. In par- ticular, section 4 of Notice 2006–26 pro- vided rules and procedures relating to Eli- gible Building Envelope Components. On June 2, the Service issued Notice 2006–53, 2006–26 I.R.B. 1180, which amended section 4.04 of Notice 2006–26 to clarify that exterior siding does not qualify as an Eligible Building Envelope Component. Notice 2006–53 applied to siding purchased after June 26, 2006, and to certificationsthat a manufacturer provided after that date to purchasers of siding. This notice modifies Notice 2006–53 by revising its effective date. In general, Notice 2006–53 remains effective with re- spect to siding purchased and certifica- tions provided after June 26, 2006. In addition, in the case of siding installed before December 1, 2006, taxpayers, in- cluding manufacturers, distributors, con- tractors, and homeowners, may rely on the provisions of section 4.04 of Notice 2006–26, as in effect before the issuance of Notice 2006–53, in providing certifica- tions and claiming credits. DRAFTING INFORMATION The principal author of this notice is Jennifer Bernardini of the Office of Associate Chief Counsel (Passthroughs & Special Industries). For further in- formation regarding this notice, contact Jennifer Bernardini at (202) 622–3120 (not a toll-free call). 2006–34 I.R.B.316August 21, 2006 Part IV. Items of General Interest Notice of Proposed Rulemaking by Cross-Reference to Temporary Regulations, Notice of Proposed Rulemaking, and Notice of Public Hearing Treatment of Services Under Section 482; Allocation of Income and Deductions From Intangibles; and Apportionment of Stewardship Expense REG–146893–02; REG–115037–00; REG–138603–03 AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Notice of proposed rulemaking by cross-reference to temporary regula- tions, notice of proposed rulemaking, and notice of public hearing. SUMMARY: In a separate part to this issue of the Bulletin, the IRS is issuing temporary regulations (T.D. 9278) relat- ing to the treatment of controlled services transactions under section 482. These temporary regulations also provide guid- ance regarding the allocation of income from intangibles, in particular with respect to contribution by a controlled party to the value of an intangible owned by another controlled party as it relates to controlled services transactions and modify the reg- ulations under section 861 concerning stewardship expenses to be consistent with the changes made to the regulations under section 482. The text of those reg- ulations also serves as the text of these proposed regulations. These proposed regulations also contain a coordination rule with global dealing operations. The Treasury Department and the IRS are presently working on new global dealing regulations and intend that when final regulations are issued, those regulations, not §1.482–9T, will govern the evaluation of the activities performed by a global dealing operation within the scope of those regulations. Pending finalization of the global dealing regulations, taxpayers may rely on the proposed global dealing regulations, not the temporary services regulations, to govern financial transac- tions entered into in connection with a global dealing operation as defined in proposed §1.482–8. Therefore, proposed regulations under §1.482–9(m)(5) clarify that a controlled services transaction does not include a financial transaction entered into in connection with a global dealing operation. These proposed regulations potentially affect controlled taxpayers within the meaning of section 482. This document also provides notice of a public hearing on these proposed regulations. DATES:Written or electronic comments must be received by November 2, 2006. ADDRESSES:Send submissions to: CC:PA:LPD:PR(REG–146893–02, REG–115037–00, and REG–138603–03), Internal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be sent elec- tronically, via the IRS internet site at www.irs.gov/regsor via Federal eRule- making Portal atwww.regulations.gov (IRS REG–146893–02, REG–115037–00, and REG–138603–03). FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Thomas A. Vidano, (202) 435–5265, or Carol B. Tan, (202) 435–5265 for matters relating to section 482, or David Bergkuist (202) 622–3850 for matters relating to stewardship ex- penses; concerning submission of com- ments, the hearing, and/or, to be placed on the building access list to attend the hearing, Kelly Banks, (202) 622–0392 (not toll-free numbers). SUPPLEMENTARY INFORMATION: Background and Explanation of Provisions Temporary regulations in this issue of the Bulletin amend the Income Tax Reg- ulations (26 CFR parts 1 and 31) relating to section 482. The temporary regulations set forth guidance on the treatment of con- trolled services transactions, the allocation from intangibles under section 482, and stewardship expenses under section 861. The text of those regulations also serves as the text of these proposed regulations. The preamble to the temporary regulations ex- plains the temporary regulations and these proposed regulations. These proposed reg- ulations potentially affect controlled tax- payers within the meaning of section 482. Special Analyses It has been determined that this notice of proposed rulemaking is not a signifi- cant regulatory action as defined in Exec- utive Order 12866. Therefore, a regula- tory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regu- lations, and because the regulation does not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code (Code), this regulation has been submitted to the Chief Counsel for Advocacy of the Small Business Admin- istration for comment on their impact on small business. Comments and Public Hearing Before these proposed regulations are adopted as final regulations, consideration will be given to any written comments (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and Treasury Department specifically request comments on the clarity of the proposed rule and how it may be made easier to understand. All comments will be available for public in- spection and copying. A public hearing will be scheduled if requested in writing by any person that timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for the public hearing will be published in theFederal Register. Drafting Information The principal authors of these reg- ulations are Thomas A. Vidano and August 21, 20063172006–34 I.R.B. Carol B. Tan, Office of Associate Chief Counsel (International). ***** Proposed Amendments to the Regulations Accordingly, 26 CFR parts 1 and 31 are proposed to be amended as follows: PART 1—INCOME TAXES Paragraph 1. The authority citation for part 1 is amended by adding an entry in numerical order to read in part as follows: Authority: 26 U.S.C. 7805 * * * Section 1.482–9 also issued under 26 U.S.C. 482. * * * Par. 2. Section 1.482–0 is amended as follows: 1. The section heading is revised. 2. The entries for §1.482–2(b) are re- vised. 3. The entries for §1.482–4(f)(3), (f)(4) and (f)(5) are revised and new entries for §1.482–4(f)(6) are added. 4. New entries for §§1.482–6T(c)(3) (i)(B)(1) and (2) and 1.482–9T are added. The revisions and additions read as fol- lows: §1.482–0 Outline of regulations under section 482. ***** [The text of the proposed amendment to §1.482–0 is the same as the text of §1.482–0T published elsewhere in this is- sue of the Bulletin]. Par. 3. Section 1.482–1 is amended as follows: 1.Paragraphs (a)(1), (b)(2)(i), (d)(3)(ii)(C) Example 3, (d)(3)(v), (f)(2)(ii)(A), (f)(2)(iii)(B), (g)(4)(i), (g)(4)(iii) and paragraph (i) are revised. 2. Paragraphs (d)(3)(ii)(C), Example 4, Example 5, and Example 6, and (j)(6) are added. The additions and revisions read as fol- lows: §1.482–1 Allocation of income and deductions among taxpayers. (a)(1) [The text of the proposed amend- ment to §1.482–1(a)(1) is the same as the text of §1.482–1T(a)(1) published else- where in this issue of the Bulletin]. ***** (b)***(1)*** (b)(2)(i) [The text of the proposed amendment to §1.482–1(b)(2)(i) is the same as the text of §1.482–1T(b)(2)(i) published elsewhere in this issue of the Bulletin]. ***** (d) * * * (3) * * * (ii) * * * (C)*** Example 3. [The text of the proposed amendment to §1.482–1(d)(3)(ii)(C), Example 3is the same as the text of §1.482–1T(d)(3)(ii)(C)Example 3pub- lished elsewhere in this issue of the Bul- letin]. Example 4. [The text of the proposed amendment to §1.482–1(d)(3)(ii)(C) Example 4is the same as the text of §1.482–1T(d)(3)(ii)(C)Example 4pub- lished elsewhere in this issue of the Bul- letin]. Example 5. [The text of the proposed amendment to §1.482–1(d)(3)(ii)(C) Example 5is the same as the text of §1.482–1T(d)(3)(ii)(C)Example 5pub- lished elsewhere in this issue of the Bul- letin]. Example 6. [The text of the proposed amendment to §1.482–1(d)(3)(ii)(C) Example 6is the same as the text of §1.482–1T(d)(3)(ii)(C)Example 6pub- lished elsewhere in this issue of the Bul- letin]. (v)Property or services.[The text of the proposed amendment to §1.482–1(d)(3)(v) is the same as the text of §1.482–1T(d)(3)(v) published elsewhere in this issue of the Bulletin]. ***** (f) * * * (2) * * * (ii)(A) [The text of the proposed amendment to §1.482–1(f)(2)(ii)(A) is the same as the text of §1.482–1T(f)(2)(ii)(A) published elsewhere in this issue of the Bulletin]. (iii) * * * (B) [The text of the proposed amend- ment to §1.482–1(f)(3)(iii)(B) is the same as the text of §1.482–1T(f)(3)(iii)(B) pub- lished elsewhere in this issue of the Bul- letin]. ***** (g) * * * (4) * * * (i) * * * [The text of the pro- posed amendment to §1.482–1(g)(4)(i) is the same as the text of §1.482–1T(g)(4)(i) published elsewhere in this issue of the Bulletin]. (iii) * * * Example 1. [The text of the pro- posed amendment to §1.482–1(g)(4)(iii) Example 1is the same as the text of §1.482–1T(g)(4)(iii)Example 1published elsewhere in this issue of the Bulletin]. ***** (i) [The text of the proposed amend- ment to §1.482–1(i) is the same as the text of §1.482–1T(i) published elsewhere in this issue of the Bulletin]. ***** (j) [The text of the proposed amend- ment to §1.482–1(j)(6) is the same as the text of §1.482–1T(j)(6) published else- where in this issue of the Bulletin]. Par. 4. Section 1.482–2 is amended as follows: 1. Paragraph (b) is revised. 2. Paragraph (e) is added. The revision and addition reads as fol- lows: §1.482–2 Determination of taxable income in specific situations. ***** (b) [The text of the proposed amend- ment to §1.482–2(b) is the same as the text of §1.482–2T(b) published elsewhere in this issue of the Bulletin]. ***** (e) [The text of the proposed amend- ment to §1.482–2(e) is the same as the text of §1.482–2T(e)(1) and (2) published else- where in this issue of the Bulletin]. Par. 5. Section 1.482–4 is amended as follows: 1. Paragraph (f)(3) is revised. 2. Paragraphs (f)(4) and (f)(5) are re- designated as paragraphs (f)(5) and (f)(6), respectively. 3. New paragraphs (f)(4) and (f)(7) are added. The revision and addition read as fol- lows: §1.482–4 Methods to determine taxable income in connection with a transfer of intangible property. ***** (f) * * * 2006–34 I.R.B.318August 21, 2006 (3) [The text of the proposed amend- ment to §1.482–4(f)(3) is the same as the text of §1.482–4T(f)(3) published else- where in this issue of the Bulletin]. ***** (4) [The text of the proposed amend- ment to §1.482–4(f)(4) is the same as the text of §1.482–4T(f)(4) published else- where in this issue of the Bulletin]. ***** (7) [The text of the proposed amend- ment to §1.482–4(f)(7) is the same as the text of §1.482–4T(f)(7)(i) and (ii) published elsewhere in this issue of the Bulletin]. ***** Par. 6. Section 1.482–6 is amended by revising paragraphs (c)(2)(ii)(B)(1), (c)(2)(ii)(D), (c)(3)(i)(A), (c)(3)(i)(B), and (c)(3)(ii)(D), and adding paragraph (d) to read as follows: §1.482–6 Profit split method. ***** (c) * * * (2) * * * (ii) * * * (B)***(1)***[Thetext of the proposed amendment to §1.482–6(c)(2)(ii)(B)(1) is the same as the text of §1.482–6T(c)(2)(ii)(B)(1) published elsewhere in this issue of the Bulletin]. ***** (D) [The text of the proposed amend- ment to §1.482–6(c)(2)(ii)(D) is the same as the text of §1.482–6T(c)(2)(ii)(D) pub- lished elsewhere in this issue of the Bul- letin]. ***** (3) * * * (i)***(A)[Thetextoftheproposed amendment to §1.482–6(c)(3)(i)(A) is the same as the text of §1.482–6T(c)(3)(i)(A) published elsewhere in this issue of the Bulletin]. (B) [The text of the proposed amend- ment to §1.482–6(c)(3)(i)(B) is the same as the text of §1.482–6T(c)(3)(i)(B) pub- lished elsewhere in this issue of the Bul- letin]. ***** (ii) * * * (D) [The text of the proposed amend- ment to §1.482–6(c)(3)(ii)(D) is the same as the text of §1.482–6T(c)(3)(ii)(D) pub- lished elsewhere in this issue of the Bul- letin]. ***** (d) [The text of the proposed amend- ment to §1.482–6(d) is the same as the text of §1.482–6T(d)(1) and (2) published else- whereinthisissueoftheBulletin]. Par. 7. Section 1.482–8 is amended by adding Examples 10 through 12 to read as follows: §1.482–8 Examples of the best method rule. ***** (b)***Example 10.Cost of ser- vices plus method preferred to other meth- ods. [The text of the proposed amendment to §1.482–8(a)Example 10is the same as the text of §1.482–8T(a)Example 10pub- lished elsewhere in this issue of the Bul- letin]. Example 11.CPM for services pre- ferred to other methods.[Thetextof the proposed amendment to §1.482–8(a) Example 11is the same as the text of §1.482–8T(a)Example 11published else- whereinthisissueoftheBulletin]. Example 12.Residual profit split pre- ferred to other methods.[Thetextof the proposed amendment to §1.482–8(a) Example 12is the same as the text of §1.482–8T(a)Example 12published else- whereinthisissueoftheBulletin]. Par. 8. A new §1.482–9 is added to read as follows: §1.482–9 Methods to determine taxable income in connection with a controlled services transaction. (a) through (m)(5) [The text of the pro- posed §1.482–9(a) through (m)(5) is the same as the text of §1.482–9T(a) through (m)(5) published elsewhere in this issue of the Bulletin]. (m)(6)Global dealing operations.A controlled services transaction does not in- clude a financial transaction entered into in connection with a global dealing oper- ation as defined in the current proposed §1.482–8. (n) [The text of the proposed §1.482–9(n) is the same as the text of §1.482–9T(n)(1) and (n)(2) published elsewhere in this issue of the Bulletin]. Par. 9. Section 1.861–8 is amended by revising paragraphs (a)(5), the fifth and sixth sentences in paragraph (b)(3), (e)(4), (f)(4)(i), (g)Examples 17,18,and30,and the first sentence in paragraph (h) intro- ductory text to read as follows: §1.861–8 Computation of taxable income from sources within the United States and from other sources and activities. (a) * * * (5) [The text of the proposed amend- ment to §1.861–8(a)(5) is the same as the text of §1.861–8T(a)(5) published else- whereinthisissueoftheBulletin]. (b) * * * (3) * * * [The text of the proposed amendment to §1.861–8(b)(3) is the same as the text in §1.861–8T(b)(3) published elsewhere in this issue of the Bulletin]. *** ***** (e) * * * (4) [The text of the proposed amend- ment to §1.861–8(e)(4) is the same as the text of §1.861–8T(e)(4) published else- whereinthisissueoftheBulletin]. (f) * * * (4)***(i)[Thetextoftheproposed amendment to §1.861–8(f)(4)(i) is the same as the text of §1.861–8T(f)(4)(i) published elsewhere in this issue of the Bulletin]. (g) * * * Example 17. [The text of the proposed amendment to §1.861–8(g)Example 17is the same as the text of §1.861–8T(g)Ex- ample 17, published elsewhere in this is- sue of the Bulletin]. Example 18. [The text of the proposed amendment to §1.861–8(g)Example 18is the same as the text of §1.861–8T(g)Ex- ample 18, published elsewhere in this is- sue of the Bulletin]. ***** Example 30. [The text of the proposed amendment to §1.861–8(g)Example 30is the same as the text of §1.861–8T(g)Ex- ample 30, published elsewhere in this is- sue of the Bulletin]. (h) [The text of the proposed amend- ment to §1.861–8(h) is the same as the text of §1.861–8T(h) published elsewhere in this issue of the Bulletin]. * * * ***** August 21, 20063192006–34 I.R.B. Par. 10. Section 1.6038A–3(a)(3) is amended by revising paragraph (a)(3)Ex- ample 4and (i) to read: §1.6038A–3 Record maintenance. (a) * * * (3) * * * Example 4. [The text of the proposed amendment to §1.6038A–3,Example 4is the same as the text of §1.6038A–3T,Ex- ample 4published elsewhere in this issue of the Bulletin]. ***** (i) [The text of the proposed amend- ment to §1.6038A–3(i) is the same as the text of §1.6038A–3T(i)(1) and (2) pub- lished elsewhere in this issue of the Bul- letin]. Par. 11. Section 1.6662–6 is amended by revising paragraphs (d)(2)(ii)(B), (d)(2)(iii)(B)(4), (d)(2)(iii)(B)(6) and (g) to read as follows: §1.6662–6 Transactions between persons described in section 482 and net section 482 transfer price adjustments. ***** (d) * * * (2) * * * (ii) * * * (B) [The text of the proposed amend- ment to §1.6662–6(d)(2)(ii)(B) is the same as the text of §1.6662–6T(d)(2)(ii)(B) pub- lished elsewhere in this issue of the Bul- letin]. ***** (iii) * * * (B)***(4)[Thetextof theproposedamendmentto §1.6662–6(d)(2)(iii)(B)(4) is the same as the text of §1.6662–6T(d)(2)(iii)(B)(4) published elsewhere in this issue of the Bulletin]. ***** (6) [The text of the proposed amend- ment to §1.6662–6(d)(2)(iii)(B)(6) is the same as the text of §1.6662–6T(d)(2)(iii)(B)(6) published elsewhere in this issue of the Bulletin]. ***** (g) [The text of the proposed amend- ment to §1.6662–6(g) is the same as the text of §1.6662–6T(g)(1) and (2) published elsewhere in this issue of the Bulletin]. PART 3—EMPLOYMENT TAXES AND COLLECTION OF INCOME TAX AT THE SOURCE Par. 12. The authority citation for part 31 continues to read as follows: Authority: 26 U.S.C. 7805 * * * Par. 13. Section 31.3121(s)–1 is amended by revising paragraphs (c)(2)(iii) and (d) to read as follows: §31.3121(s)–1 Concurrent employment by related corporations with common paymaster. ***** (c) * * * (2) * * * (iii) [The text of the proposed amendment to §31.3121(s)–1(c)(2)(iii) is the same as the text of §31.3121(s)–1T(c)(2)(iii)published elsewhere in this issue of the Bulletin]. ***** (d) [The text of the proposed amend- ment to §31.3121(s)–1(d) is the same as the text of §31.3121(s)–1T(d)(1) and (2) published elsewhere in this issue of the Bulletin]. ***** Mark E. Matthews, Deputy Commissioner for Services and Enforcement. (Filed by the Office of the Federal Register on July 31, 2006, 4:40 p.m., and published in the issue of the Federal Register for August 4, 2006, 71 F.R. 44247) Notice of Proposed Rulemaking by Cross-Reference to Temporary Regulations Disclosure of Return Information to the Bureau of Economic Analysis REG–148864–03 AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Notice of proposed rulemaking by cross-reference to temporary regula- tions. SUMMARY: In this issue of the Bulletin, the IRS is issuing temporary regulations (T.D. 9267) regarding additional items of return information disclosable to the Bu- reau of Economic Analysis (Bureau) of the Department of Commerce for purposes re- lated to measuring economic change in the U.S. national economic accounts. These temporary regulations provide guidance to IRS personnel responsible for disclosing the information. The text of these tempo- rary regulations published in this issue of the Bulletin serves as the text of the pro- posed regulations. DATES: Written and electronic comments and requests for a public hearing must be received by October 4, 2006. ADDRESSES: Send submissions to: CC:PA:LPD:PR(REG–148864–03), room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Sta- tion, Washington, DC 20044. Sub- missions may be hand-delivered be- tween the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG–148864–03), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW, Wash- ington, DC, or sent electronically, via the IRS Internet site atwww.irs.gov/regs, or via the Federal eRulemaking Por- tal atwww.regulations.gov(IRS and REG–148864–03). FOR FURTHER INFORMATION CONTACT: Concerning submission of comments, Richard A. Hurst at Richard.A.Hurst@irscounsel.treas.gov and (202) 622–7180; concerning the tem- porary regulations, Joel D. McMahan at (202) 622–4580 (not toll-free numbers). SUPPLEMENTARY INFORMATION: Background Under section 6103(j)(1), upon written request from the Secretary of Commerce, the Secretary of the Treasury must fur- nish to the Bureau return information that is prescribed by Treasury regulations for purposes related to measuring economic change in the U.S. national economic ac- counts. Section 301.6103(j)(1)–1(c) of the regulations provides an itemized descrip- tion of the return information authorized to be disclosed for this purpose. Periodically, 2006–34 I.R.B.320August 21, 2006 the disclosure regulations are amended to reflect the changing needs of the Bureau for data for its statutorily authorized statis- tical activities. This document contains proposed reg- ulations authorizing IRS personnel to dis- close additional items of return informa- tion that have been requested by the Sec- retary of Commerce. Temporary regulations in this issue of the Bulletin amend the Procedure and Administration Regulations (26 CFR Part 301) relating to Internal Revenue Code (Code) section 6103(j). The temporary regulations contain rules relating to the disclosure of return information reflected on returns to officers and employees of the Department of Commerce for structuring censuses and national economic accounts and conducting related statistical activities authorized by law. The text of the temporary regulations also serves as the text of these proposed regulations. The preamble to the tempo- rary regulations explains the proposed reg- ulations. Special Analyses It has been determined that this notice of proposed rulemaking is not a signifi- cant regulatory action as defined in Exec- utive Order 12866. Therefore, a regula- tory assessment is not required. It also has been determined thatsection 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these reg- ulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, these proposed regulations will be submit- ted to the Chief Counsel for Advocacy of the Small BusinessAdministration for comment on their impact on small busi- ness. Comments and Requests for a Public Hearing Before these proposed regulations are adopted as final regulations, consideration will be given to any electronic and writ- ten comments (a signed original and eight (8) copies) that are submitted timely to the IRS. The IRS and Treasury Department specifically request comments on the clar- ity of the proposed regulations and how they can be made easier to understand. All comments will be available for public in- spection and copying. A public hearing may be scheduled if requested in writing by a person who timely submits comments. If a public hearing is scheduled, notice of the date, time, and place for the hearing will be published in theFederal Register. Drafting Information The principal author of these regula- tions is Joel D. McMahan, Office of the Associate Chief Counsel (Procedure & Administration), Disclosure and Privacy Law Division. ***** Proposed Amendments to the Regulations Accordingly, 26 CFR part 301 is pro- posed to be amended as follows: PART 301—PROCEDURE AND ADMINISTRATION Paragraph 1. The authority ci tation for part 301 is amended in part, by adding an entry in numerical order to re ad as follows: Authority: 26 U.S.C. 7805 * * * Section 301.6103(j)(1)–1 al so issued under 26 U.S.C. 6103(j)(1); * ** Par. 2. In §301.6103(j)(1)–1 para- graphs (c) and (f) are revise d to read as fol- lows: §301.6103(j)(1)–1 Disclosure of return information to officers and employees of the Department of Commerce for certain statistical purposes and related activities. ***** (c)[Thetextofthisproposed paragraph is the same as the text of §301.6103(j)(1)–1T(c) published else- whereinthisissueoftheBulletin]. ***** (f) [The text of this proposed para- graph is the same as the text of §301.6103(j)(1)–1T(f) published else- whereinthisissueoftheBulletin]. Mark E. Matthews, Deputy Commissioner for Services and Enforcement. (Filed by the Office of the Federal Register on July 5, 2006, 8:45 a.m., and published in the issue of the Federal Register for July 6, 2006, 71 F.R. 38323) Announcement That Identifies Specified Covered Services Eligible for Services Cost Method Under Section 482 Regulations Announcement 2006–50 BACKGROUND In 2003, the Treasury Department is- sued proposed section 482 regulations that set forth a simplified cost based method (SCBM). Prop. § 1.482–9(f). That method was intended to preserve the salutary as- pects of the cost safe harbor in current § 1.482–2(b) while at the same time elimi- nating problematic features of those rules. In light of public comments, however, the Treasury Department has issued temporary and proposed regulations, concurrently with this announcement, that eliminate the SCBM and replace it with the services cost method (SCM). According to these temporary and proposed regulations, two categories of covered services, “specified covered services” and “low margin cov- ered services,” are eligible for the SCM. This announcement relates to “specified covered services,” which are support ser- vices identified in a revenue procedure published by the IRS. Included with this announcement is the proposed revenue procedure identifying specified covered services. The Service invites comments from interested mem- bers of the public prior to publishing the revenue procedure. The temporary regula- tions have a delayed effective date for tax years beginning after December 31, 2006. It is contemplated that a final revenue procedure will be issued after taking into account comments on this announcement and that this final revenue procedure will be effective concurrent with the effective date of the temporary regulations. Comments (eight copies) should be sent to Associate Chief Counsel (Inter- national) CC:INTL:FO, Internal Revenue Service, 1111 Constitution Avenue, NW, Room 4554, Washington, DC 20224, mak- ing reference in the comments to Control Number NOT–127827–06. To ensure that August 21, 20063212006–34 I.R.B. 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 per- formed 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 Trea- sury 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 ser- vices. 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, tax- payers would potentially need to expend substantial sums to prepare comparabil- ity studies, perhaps separately for each of numerous back office services. They contended that, although taxpayers have in-depth knowledge concerning their busi- nesses and the relative value added by their back offices, the SCBM called for quan- titative judgments that business people are not qualified to make by themselves, especially in the prevailing compliance environment. As a matter of proper ac- countability, taxpayers would be required as a practical matter to devote significant compliance resources to enlist outside consultants or otherwise to develop sup- port for those judgments. In light of the extensive public com- ments concerning the SCBM, the Treasury Department and the IRS have substantially redesigned the relevant provisions. Rec- ognizing that the section 482 services reg- ulations 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 applica- ble to such services, which would typically bear low arm’s length markups. Accordingly, the temporary and pro- posed 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 cov- ered services, as defined, is arm’s length by reference to the total services costs with no markup. Where the conditions on ap- plication of the method are met, the SCM will be considered the best method for pur- poses 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 gen- erally 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 appro- priately reduced administrative burdens for low margin services. Since the Gov- ernment has made the initial determination that these specified covered services are eligible to be priced under the SCM, tax- payers may rely upon this listing and need not perform their own independent analy- sis of comparable service providers. Although specified covered services cover a wide range of support activities, the Treasury Department and the IRS rec- ognize 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 spec- ified covered services and low margin covered services must also meet the re- quirements 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 iden- tified in § 1.482–9T(b)(3)(ii) (excluded transactions). As explained above, this announcement contains an initial listing of specified cov- ered services. The Treasury and the IRS solicit public input both on whether the list of services sufficiently covers the full range of back office services typical within multinational groups, as well as on the de- scriptions provided for these covered ser- vices. It is contemplated that a final rev- enue procedure, reflecting revisions based on comments received, will be issued to coincide with the effective date of the tem- porary and proposed regulations for tax- able years beginning after December 31, 2006. DRAFTING INFORMATION The principal author of this announce- ment is Thomas A. Vidano of the Office of Associate Chief Counsel (International). For further information regarding this an- nouncement, contact Thomas A. Vidano at (202) 435–5265 (not a toll-free call). Proposed Revenue Procedure [26 CFR 1.482–9T]: Methods to determine taxable income in connection with a con- trolled services transaction. (Also: ) Rev. Proc. [2006–XX] SECTION 1. PURPOSE This revenue procedure identifies spec- ified covered services within the meaning of Section 1.482–9T(b)(4)(i). The activi- ties identified in this revenue procedure are support services common among taxpay- ers in a variety of industry sectors, and gen- erally do not involve a significant arm’s length markup on total services costs. Ser- vices identified in this revenue procedure must meet the other conditions set forth in Section 1.482–9T(b) to be evaluated under the services cost method. SECTION 2. BACKGROUND The section 482 regulations provide pricing methods for transactions between controlled parties, including transactions involving services. The existing regula- tions 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-in- tegral” services to be priced at cost. In 2003, the Treasury Department and IRS issued proposed regulations that set forth 2006–34 I.R.B.322August 21, 2006 a simplified cost based method (SCBM) intended to preserve some benefits of the current § 1.482–2(b) cost safe harbor. A number of commentators noted that SCBM called for quantitative judgments that business people are not qualified to make by themselves. As a practical mat- ter, taxpayers would be required to devote significant compliance resources to enlist outside consultants or otherwise to de- velop support for those judgments. In 2006, the Treasury Department and the IRS issued temporary regulations that eliminated the SCBM and replaced it with the services cost method (SCM), as set forth in § 1.482–9T(b). The Treasury De- partment and IRS recognized that because the section 482 services regulations poten- tially 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 burden of such services, which would typically bear low arm’s length markups. The SCM evaluates whether the price for covered services, as defined, is arm’s length by reference to the total ser- vices costs with no markup. Section 1.482–9T(b)(4) provides for two cate- gories of covered services eligible for the SCM. The first category consists of speci- fied covered services that will be identified in this revenue procedure. These specified covered services are so identified because they constitute support services of a type common across industry sectors that gen- erally 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 rev- enue procedure have a median comparable arm’s length markup on total services costs of less than or equal to 7 percent. SECTION 3. SCOPE The following categories of services are eligible for treatment under section 1.482–9T(b)(4)(i): Payroll: 1. Compiling and posting employee time and other informationneeded to calculate periodic compensation to employees. Computing employees’ time worked, production, and commissions. Computing and posting wages and deductions to appropriate accounting records. Preparing paychecks,travel reimbursement and expense reimbursement. 2. Preparing payroll tax forms (such as the preparation of Forms 940, 941 and W–2 in order to comply with U.S. requirements or similar requirements under another country’s laws). Premiums for Unemployment, Disability and Workers Compensation: 3. Processing employees’ unemployment insurance premiums, disability premiums and workers compensation premiums. Accounts Receivable: 4. Compiling, analyzing and recording current credit data and other financial information regarding individuals or firms (including preparing reports with this information for use in decisionmaking). 5. Compiling and recording billing, accounting and other numerical data for billing purposes. Preparing billing invoices for services rendered or for delivery or shipment of goods. 6. Locating and notifying customers of delinquent accounts by mail (either electronic or otherwise) or telephone to solicit payment. Receiving payment from customers and posting payment to customer’s account. If customer fails to respond, preparing statements to credit department, initiating repossession proceedings or service disconnection.Keeping records of collection activities and status of accounts. Accounts Payable: 7. Compiling information and records to draw up purchase orders for procurement of materials and services. 8. Making payment to vendors and posting payment to status of accounts. General Administrative: 9. Performing clerical and administrative functions such as drafting correspondence, scheduling appointments, and organizing and maintaining paper and electronic files. 10. Performing data entry through use of a keyboard or scanningdevice, including verifying data and preparing materials for printing. 11. Using a word processor/computer or typewriter to generate (without substantial modification) letters, reports, forms, or other material from another person’s rough draft, corrected copy, or voice recording. 12. Performing duties relating to office management systemsand procedures, such as answering telephones, bookkeeping, typing, word processing, office machine operation, and filing. 13. Operating any of the following office machines: photocopying, scanning and facsimile machines. August 21, 20063232006–34 I.R.B. Public Relations: 14. Preparation and distribution of internal and external corporate communications. Meeting Coordination: 15. Coordinating activities of staff and convention personnel to make arrangements for group meetings and conventions. Accounting and Auditing: 16. Gathering and reviewing information in accounting records for use in preparing financial statements. 17. Computing, classifying, and recording numerical data to maintain accurate and complete financial records, performing any combination of calculating, posting, and verifying duties to obtain primary financial data for use in maintaining accounting records, checking the accuracy of figures, calculations, and postings pertaining to business transactions recorded by other workers. Tax: 18. Processing tax payments according to prescribed laws and regulations. 19. Gathering information from accountingrecords and including that informationin the preparation of income, property, sales/use, VAT, excise and other tax returns. Compliance: 20. Gathering information and preparing documentation relating to eligibility for or compliance with laws and regulations governing contracts, licenses and permits. 21. Gathering information, verifying data and preparing documentation relating to compliance with laws and regulations governing financial and securities institutions and financial and real estate transactions. Examining and verifying correctness of, or establishing authenticity of records. Budgeting: 22. Compiling data for use by cost estimators in determining cost projections and in preparing budget estimates, including verifying information for completeness, accuracy, and conformance with internal procedures and regulations. 23. Compiling data to prepare budget and accounting reports for management. Treasury Activities: 24. Establishing bank accounts and lockboxes for use by controlledparties, including overdraft facilities and lines of credit. Statistical Assistance: 25. Compiling data for use in statistical studies. Staffing, Recruiting and Related Services: 26. Providing staffing support that includes creating job announcements, determining eligibility, evaluating qualifications of candidates, conducting background checks on final candidates,verifying references, developing performance evaluation procedures and forms, and conducting exit interviews for departed employees. 27. Coordinating with temporary employment agencies, applicants, and management throughout the recruiting process. 28. Providing information to applicants regarding open positions, the application and recruiting process, and employment policies. 29. Providing administrative support that includes sourcing andprocessing resumes, arranging interview schedules for open positions, preparing offer letters, and entering new employee information into the human resource system. 30. Establishing and maintaining employee files relating to payroll, performance and other personnel issues. 31. Assisting with new employee orientations and paperwork. 32. Implementing recruiting plan and locating potential candidates by working with professional search firms, colleges, universities and professional associations. Organizing and attending job fairs and other recruitment events. 33. Developing recruiting and marketing materials and assisting in developing and maintaining content for recruiting website. 34. Analyzing recruiting data and review all jobanalysis, promotion and placement products. 35. Posting job opening advertisements in appropriate markets through publications, journals and other media. 2006–34 I.R.B.324August 21, 2006 36. Managing company-wide job postings and employee referral program. Training Services: 37. Assisting in training of personnel including assessing development and training needs, creating and conducting internal development and training programs and communicating training opportunities to personnel. 38. Arranging for management training on employment law compliance, employer liability avoidance, interviewing, hiring, terminations, promotions, performance reviews, safety, and sexual harassment. Benefit Services: 39. Implementing employee compensation and benefits including healthcare, life insurance, 401(k), pension, worker’s compensation, unemployment, dental, profit sharing, employeeincentive compensation, and employee assistance programs. 40. Providing guidance and direction to employees regarding elections for benefits,applications for benefits and receipt of benefits (including providing assistance toemployees in completing all necessary forms). 41. Arranging annual benefit enrollment meetings and employee benefit seminars. 42. Processing employee benefits inquiries and complaints, and reconciling billing issues. 43. Coordinating with hospitals, physicians, insurers, employees, and beneficiaries to facilitate proper and complete utilization of benefits for all employees. Computer Support: 44. Providing technical assistance to users of computer systems and other information technology devices. Answering questions or resolving technical problems relating to computer systems and other information technology devices in person, via telephone or from remote location. Providing assistance concerning the use of computer hardware and software, including printing, installation, word processing, electronic mail, and operating systems. Database Administration: 45. Maintaining and testing existing computer databases (including implementing security measures to safeguard computer databases), but not to include analyzing user needs or developing hardware or software solutions (such as systems integration, website design, writing computer programs, modifying general applications software, or recommending the purchase of commercially available hardware or software). Network and Computer System Administration: 46. Supporting an organization’s existing local area network(LAN),wideareanetwork(WAN),andInternetsystemora segment of a network system, regular maintenance of network hardware and software, monitoring network to ensure network availability to all system users and performing necessary maintenance to support network availability, supervising other network support and client server specialists (including implementing network security measures), but not to include analyzing user needs or developing hardware or software solutions (such as systems integration, website design, writing computer programs, modifying general applications software, or recommending commercially available software). Legal Services: 47. General legal services performed on behalf of the taxpayer byin-house legal counsel, including but not limited to, drafting and review of contracts, legal documents, and opinions, representation and advocacy before courts, administrative agencies, arbitrators, legislatures, or other bodies. Support and administrative functions associated with the above activities (legal research, secretarial, filing and document retrieval, etc.). Insurance Claims Management: 48. Coordination with third party insurers, including preparing claims for submission to such third party insurers. SECTION 4. APPLICATION The services cost method (SCM) as set forth in § 1.482–9T(b) evaluates whether the price for covered services, as defined, is arm’s length by reference to the total services costs with no markup. Two cat- egories of covered services are eligible for the SCM. The first category, spec- ified covered services, is described in § 1.482–9T(b)(i) and is limited to services that are described in this revenue proce- dure. The second category, low margin covered services, is not described in this revenue procedure. SECTION 5. EFFECTIVE DATE This revenue procedure is generally effective for taxable years beginning after December 31, 2006. Taxpayers may elect to apply retroactively the provisions of § 1.482–9T to certain taxable years. See § 1.482–9T(n)(1). In the case of a valid election, this revenue procedure would also apply to the taxable years subject to such an election. August 21, 20063252006–34 I.R.B. SECTION 6. DRAFTING INFORMATION The principal author of this revenue procedure is Thomas A. Vidano of the Office of Associate Chief Counsel (In- ternational). For further information re- garding this revenue procedure, contact Thomas A. Vidano at (202) 435–5265 (not a toll-free call). 2006–34 I.R.B.326August 21, 2006 Definition of Terms Revenue rulings and revenue procedures (hereinafter referred to as “rulings”) that have an effect on previous rulings use the following defined terms to describe the ef- fect: Amplifieddescribes a situation where no change is being made in a prior pub- lished position, but the prior position is be- ingextendedtoapplytoavariationofthe fact situation set forth therein. Thus, if an earlier ruling held that a principle ap- plied to A, and the new ruling holds that the same principle also applies to B, the earlier ruling is amplified. (Compare withmodi- fied,below). Clarifiedis used in those instances where the language in a prior ruling is be- ing made clear because the language has caused, or may cause, some confusion. It is not used where a position in a prior ruling is being changed. Distinguisheddescribes a situation where a ruling mentions a previously pub- lished ruling and points out an essential difference between them. Modifiedis used where the substance of a previously published position is being changed. Thus, if a prior ruling held that a principle applied to A but not to B, and the new ruling holds that it applies to both A and B, the prior ruling is modified because it corrects a published position. (Compare withamplifiedandclarified, above). Obsoleteddescribes a previously pub- lished ruling that is not considered deter- minative with respect to future transac- tions. This term is most commonly used in a ruling that lists previously published rul- ings that are obsoleted because of changes in laws or regulations. A ruling may also be obsoleted because the substance has been included in regulations subsequently adopted. Revokeddescribes situations where the position in the previously published ruling is not correct and the correct position is beingstatedinanewruling. Supersededdescribes a situation where the new ruling does nothing more than re- state the substance and situation of a previ- ously published ruling (or rulings). Thus, the term is used to republish under the 1986 Code and regulations the same po- sition published under the 1939 Code and regulations. The term is also used when it is desired to republish in a single rul- ing a series of situations, names, etc., that were previously published over a period of time in separate rulings. If the new rul- ing does more than restate the substance of a prior ruling, a combination of terms is used. For example,modifiedandsu- persededdescribes a situation where the substance of a previously published ruling is being changed in part and is continued without change in part and it is desired to restate the valid portion of the previously published ruling in a new ruling that is self contained. In this case, the previously pub- lished ruling is first modified and then, as modified, is superseded. Supplementedis used in situations in which a list, such as a list of the names of countries, is published in a ruling and that list is expanded by adding further names in subsequent rulings. After the original rul- ing has been supplemented several times, a new ruling may be published that includes the list in the original ruling and the ad- ditions, and supersedes all prior rulings in the series. Suspendedis used in rare situations to show that the previous published rul- ings will not be applied pending some future action such as the issuance of new or amended regulations, the outcome of cases in litigation, or the outcome of a Service study. Abbreviations The fol lowing abbreviations in current use and for merly used will appear in material publis hedintheBulletin. A—Individual. Acq.—A cquiescence. B—Individual. BE—Beneficiary. BK—Bank . B.T.A.—Board of Tax Appeals. C—Individual. C.B.—Cu mulative Bulletin. CFR—Code of Federal Regulations. CI—City. COOP—Coo perative. Ct.D.—Court Decision. CY—County. D—Decede nt. DC—Dummy Corporation. DE—Donee. Del. Order —Delegation Order. DISC—Domestic International Sales Corporation. DR—Donor. E—Estate. EE—Employee. E.O.—Executive Order. ER—Emp loyer. ERISA—Employee Retirement Income Security Act. EX—Executor. F—Fiduc iary. FC—Foreign Country. FICA—Federal Insurance Contributions Act. FISC—Fo reign International Sales Company. FPH—Foreign Personal Holding Company. F.R.—Federal Register. FUTA—Fed eral Unemployment Tax Act. FX—Foreign corporation. G.C.M.—Chief Counsel’s Memorandum. GE—Grante e. GP—General Partner. GR—Grantor. IC—Insura nce Company. I.R.B.—Internal Revenue Bulletin. LE—Lessee. LP—Limited Partner. LR—Lessor. M—Minor. Nonacq.—No nacquiescence. O—Organization. P—Parent Corporation. PHC—Persona l Holding Company. PO—Possession of the U.S. PR—Partner. PRS—Pa rtnership. PTE—Prohibited Transaction Exemption. Pub. L.—Public Law. REIT—Re al Estate Investment Trust. Rev. Proc.—Revenue Procedure. Rev. Rul.—Revenue Ruling. S—Subsi diary. S.P.R.—Statement of Procedural Rules. Stat.—Statutes at Large. T—Target Corporation. T.C.—Tax Court. T.D.—Treasury Decision. TFE—Trans feree. TFR—Transferor. T.I.R.—Technical Information Release. TP—Taxpay er. TR—Trust. TT—Trustee. U.S.C.—Uni ted States Code. X—Corporation. Y—Corporation. Z—Corporat ion. August 21, 2006i2006–34 I.R.B. Numerical Finding List 1 Bulletins 2006–27 through 2006–34 Announcements: 2006-42, 2006-27 I.R.B.48 2006-43, 2006-27 I.R.B.48 2006-44, 2006-27 I.R.B.49 2006-45, 2006-31 I.R.B.121 2006-46, 2006-28 I.R.B.76 2006-47, 2006-28 I.R.B.78 2006-48, 2006-31 I.R.B.135 2006-49, 2006-29 I.R.B.89 2006-50, 2006-34 I.R.B.321 2006-51, 2006-32 I.R.B.222 2006-52, 2006-33 I.R.B.254 2006-53, 2006-33 I.R.B.254 2006-54, 2006-33 I.R.B.254 Notices: 2006-56, 2006-28 I.R.B.58 2006-57, 2006-27 I.R.B.13 2006-58, 2006-28 I.R.B.59 2006-59, 2006-28 I.R.B.60 2006-60, 2006-29 I.R.B.82 2006-61, 2006-29 I.R.B.85 2006-62, 2006-29 I.R.B.86 2006-63, 2006-29 I.R.B.87 2006-64, 2006-29 I.R.B.88 2006-65, 2006-31 I.R.B.102 2006-66, 2006-30 I.R.B.99 2006-67, 2006-33 I.R.B.248 2006-68, 2006-31 I.R.B.105 2006-69, 2006-31 I.R.B.107 2006-70, 2006-33 I.R.B.252 2006-71, 2006-34 I.R.B.316 Proposed Regulations: REG-135866-02, 2006-27 I.R.B.34 REG-146893-02, 2006-34 I.R.B.317 REG-148864-03, 2006-34 I.R.B.320 REG-109512-05, 2006-30 I.R.B.100 REG-112994-06, 2006-27 I.R.B.47 REG-118775-06, 2006-28 I.R.B.73 REG-118897-06, 2006-31 I.R.B.120 Revenue Procedures: 2006-29, 2006-27 I.R.B.13 2006-30, 2006-31 I.R.B.110 2006-31, 2006-27 I.R.B.32 2006-32, 2006-28 I.R.B.61 2006-33, 2006-32 I.R.B.140 Revenue Rulings: 2006-35, 2006-28 I.R.B.50 2006-37, 2006-30 I.R.B.91 Revenue Rulings— Continued: 2006-38, 2006-29 I.R.B.80 2006-39, 2006-32 I.R.B.137 2006-40, 2006-32 I.R.B.136 Treasury Decisions: 9265, 2006-27 I.R.B.1 9266, 2006-28 I.R.B.52 9267, 2006-34 I.R.B.313 9268, 2006-30 I.R.B.94 9269, 2006-30 I.R.B.92 9270, 2006-33 I.R.B.237 9271, 2006-33 I.R.B.224 9274, 2006-33 I.R.B.244 9277, 2006-33 I.R.B.226 9278, 2006-34 I.R.B.256 1 A cumulative list of all revenue rulings, revenueprocedures, Treasury decisions, etc., publishedin Internal Revenue Bulletins 2006–1 through 2006–26 is in Internal Revenue Bulletin 2006–26, dated June 26, 2006. 2006–34 I.R.B.iiAugust 21, 2006 Finding List of Current Actions on Previously Published Items 1 Bulletins 2006–27 through 2006–34 Announcements: 2005-59 Updated and superseded by Ann. 2006-45, 2006-31 I.R.B.121 Notices: 2006-20 Supplemented and modified by Notice 2006-56, 2006-28 I.R.B.58 2006-53 Modified by Notice 2006-71, 2006-34 I.R.B.316 Proposed Regulations: REG-134317-05 Corrected by Ann. 2006-47, 2006-28 I.R.B.78 Revenue Procedures: 2002-9 Modified and amplified by Notice 2006-67, 2006-33 I.R.B.248 2005-41 Superseded by Rev. Proc. 2006-29, 2006-27 I.R.B.13 2005-49 Superseded by Rev. Proc. 2006-33, 2006-32 I.R.B.140 Revenue Rulings: 2003-43 Amplified by Notice 2006-69, 2006-31 I.R.B.107 Treasury Decisions: 9254 Corrected by Ann. 2006-44, 2006-27 I.R.B.49 9258 Corrected by Ann. 2006-46, 2006-28 I.R.B.76 9264 Corrected by Ann. 2006-46, 2006-28 I.R.B.76 1 A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2006–1 through 2006–26 is in Internal Revenue Bulletin 2006–26, dated June 26, 2006. August 21, 2006iii2006–34 I.R.B. INTERNAL REVENUE BULLETIN The Introduction at the beginning of this issue describes the purpose and content of this publication. The weekly Internal Revenue Bulletin is sold on a yearly subscription basis by the Superintendent of Documents. Current subscribers are notified by the Superin- tendent of Documents when their subscriptions must be renewed. CUMULATIVE BULLETINS The contents of this weekly Bulletin are consolidated semiannually into a permanent, indexed, Cumulative Bulletin. These are sold on a single copy basis andare notincluded as part of the subscription to the Internal Revenue Bulletin. Subscribers to the weekly Bulletin are notified when copies of the Cumulative Bulletin are available. Certain issues of Cumulative Bulletins are out of print and are not available. Persons desiring available Cumulative Bulletins, which are listed on the reverse, may purchase them from the Superintendent of Documents. ACCESS THE INTERNAL REVENUE BULLETIN ON THE INTERNET You may view the Internal Revenue Bulletin on the Internet at www.irs.gov. Under information for: select Businesses. Under related topics, select More Topics. Then select Internal Revenue Bulletins. INTERNAL REVENUE BULLETINS ON CD-ROM Internal Revenue Bulletins are available annually as part ofPublication 1796 (Tax Products CD-ROM). The CD-ROM can be purchased from National Technical Information Service (NTIS) on the Internet at www.irs.gov/cdorders (discount for online orders) or by calling 1-877-233-6767. The first release is available in mid-December and the final release is available in late January. HOW TO ORDER Check the publications and/or subscription(s) desired on the reverse, complete the order blank, enclose the proper remittance, detach entire page, and mail to the Superintendent of Documents, P.O. Box 371954, Pittsburgh PA, 15250–7954. Please allow two to six weeks, plus mailing time, for delivery. WE WELCOME COMMENTS ABOUT THE INTERNAL REVENUE BUL LETIN If you have c omments concerning the format or production of the Internal Revenue Bulletin or suggestions for improving it, we would be p leased to hear from you. You can e-mail us your suggestions or comments through the IRS Internet Home Page (www.irs.g ov) or write to the IRS Bulletin Unit, SE:W:CAR:MP:T:T:SP, Washington, DC 20224 Internal Revenue Service W ashington,DC20224 Official B usiness Penalty for Private Use, $300
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