Contents - AL-Tax
Contents - AL-Tax Contents - AL-Tax
26 3 Overview and Critique of Existing Transfer Pricing Methods3. An established or new company may be entering a new market and seek to simplifyand streamline the market penetration process by utilizing a well-knownbrand.Individual franchisors generally offer standardized contracts to all comers, andtheir terms are publicly available. As with trademarks, one franchise is generallysubstitutable for another within categories. Franchisees have minimal bargainingpower, because of the enormous discrepancy in size between national franchisorsand individual franchisees. Lastly, prospective franchisees generally research variousfranchising opportunities extensively before entering into a franchise agreement.As such, they are knowledgeable about the alternatives available to them.3.3.4 Summary and Practical ImplicationsIn sum, when an affiliated company operates in a truly competitive market, the exactCUP method, applied to tangible property or services, is based on well-acceptedeconomic principles. By the same token, when the controlled group at issue operatesin markets with differentiated products or services, or the markets are otherwiseimperfectly competitive, the exact CUP method does not have the same economicvalidity (and generally would not be applied in any event).The rarity of competitive product markets limits the usefulness of the CUPmethod, as it is framed in the U.S. regulations and construed in the field. However,product pricing in imperfectly competitive markets (or “inexact CUPs”) canoften yield quite useful information, even when the effects of differences in productattributes cannot be precisely quantified. Unfortunately, the U.S. regulations do notprovide for the use of such information to any significant degree.Conversely, in circumstances where the provision of services is predicated onownership of unique intangible assets, comparisons of services fees across firmsare unlikely to be reliable or helpful. Moreover, the comparable uncontrolled transactionsmethod often does not have a solid economic foundation, even where thetransactions being compared involve the same licensor, the same rights and identicalintangible property. (For the reasons enumerated above, the license of trademarksand franchise arrangements are often exceptions to this general rule.)3.4 Services Cost MethodFor U.S. tax purposes, an arm’s length services fee must be levied when one memberof a group of controlled entities performs marketing, managerial, administrative,technical or other services that (a) jointly benefit the group members as a whole, or(b) benefit one or more individual group members. Charges for services that benefitmore than one member should reflect “the relative benefits intended from the services,based on the facts known at the time the services were rendered,” and must
3.4 Services Cost Method 27be levied whether or not the potential benefits are realized. 17 The OECD Guidelinesprovide that cross-charges for services rendered to affiliates are justified when therecipient derives economic or commercial value from such services. Duplicative orstewardship services rarely confer economic or commercial benefits on the recipient(s),and hence, do not generally warrant intra-group services fees. 18The U.S. Treasury Department issued Temporary Regulations governing intragroupservices on July 31, 2006. These transfer pricing regulations provide thatarm’s length services fees should be determined (under specified circumstances) byapplication of one of the following methods: The services cost method; the comparableuncontrolled services price method; the gross services margin method; thecost of services plus method; the comparable profits method; the profit split method;and, unspecified methods. All these methods, with the exception of the services costmethod, apply to transactions in tangible and/or intangible property as well, areapplied in an analogous manner and are addressed elsewhere in this Chapter. (TheOECD Guidelines on services are far less detailed, and generally favor the CUP andcost plus methods. 19 ) In this segment, we review the services cost method.3.4.1 Description of Services Cost MethodThe services cost method, or SCM, sanctions a cost-based charge for certain types ofservices (“covered services”) rendered to affiliated companies. 20 Covered servicesmay either be generic support services that are common across many industries, 21or other types of “low margin services” (defined as services for which the mediancomparable arm’s length markup on total services costs is less than or equal to7.0%). Where these covered services do not contribute significantly to key competitiveadvantages, core capabilities or the fundamental chances of success or failure in17 See Treas. Reg. 1.482-2(b)(2)(i).18 “Pure” shareholder activities performed by a parent or regional holding company benefit theseentities in their capacity as owners, and do not justify charges to recipient group members.19 The CUP method can be used “where there is a comparable service provided between independententerprises in the recipient’s market, or by the associated enterprise providing the service to anindependent enterprise in comparable circumstances.” (See Chapter 7, “Special Considerations ForIntra-Group Services,” para. 7.31.) Where the CUP method cannot be applied, the cost plus method“would likely be appropriate,” assuming the requisite standard of comparability is satisfied.20 The Temporary Regulations were originally intended to apply to taxable years beginning afterDecember 31, 2006. However, Notice 2007-5, released on December 21, 2006, postponed theeffective date of the SCM for 1 year (with the exception of the Business Judgment Rule underTemp. Treas. Reg. 1-482-9T(b)(2)).21 These services were provisionally identified by the Commissioner in a concurrently issued proposedrevenue procedure, and subsequently expanded in Rev. Proc. 2007-13, released on December21, 2006.
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26 3 Overview and Critique of Existing Transfer Pricing Methods3. An established or new company may be entering a new market and seek to simplifyand streamline the market penetration process by utilizing a well-knownbrand.Individual franchisors generally offer standardized contracts to all comers, andtheir terms are publicly available. As with trademarks, one franchise is generallysubstitutable for another within categories. Franchisees have minimal bargainingpower, because of the enormous discrepancy in size between national franchisorsand individual franchisees. Lastly, prospective franchisees generally research variousfranchising opportunities extensively before entering into a franchise agreement.As such, they are knowledgeable about the alternatives available to them.3.3.4 Summary and Practical ImplicationsIn sum, when an affiliated company operates in a truly competitive market, the exactCUP method, applied to tangible property or services, is based on well-acceptedeconomic principles. By the same token, when the controlled group at issue operatesin markets with differentiated products or services, or the markets are otherwiseimperfectly competitive, the exact CUP method does not have the same economicvalidity (and generally would not be applied in any event).The rarity of competitive product markets limits the usefulness of the CUPmethod, as it is framed in the U.S. regulations and construed in the field. However,product pricing in imperfectly competitive markets (or “inexact CUPs”) canoften yield quite useful information, even when the effects of differences in productattributes cannot be precisely quantified. Unfortunately, the U.S. regulations do notprovide for the use of such information to any significant degree.Conversely, in circumstances where the provision of services is predicated onownership of unique intangible assets, comparisons of services fees across firmsare unlikely to be reliable or helpful. Moreover, the comparable uncontrolled transactionsmethod often does not have a solid economic foundation, even where thetransactions being compared involve the same licensor, the same rights and identicalintangible property. (For the reasons enumerated above, the license of trademarksand franchise arrangements are often exceptions to this general rule.)3.4 Services Cost MethodFor U.S. tax purposes, an arm’s length services fee must be levied when one memberof a group of controlled entities performs marketing, managerial, administrative,technical or other services that (a) jointly benefit the group members as a whole, or(b) benefit one or more individual group members. Charges for services that benefitmore than one member should reflect “the relative benefits intended from the services,based on the facts known at the time the services were rendered,” and must
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