Daily Tax Update - August 1, 2006

THE DAILY TAX UPDATE WILL BE PUBLISHED ON A PERIODIC BASIS UNTIL CONGRESS RETURNS FROM ITS AUGUST RECESS ON SEPTEMBER 6TH.

TREASURY AND IRS ISSUE PROPOSED AND TEMPORARY REGULATION ON THE TAX TREATMENT OF SERVICES UNDER THE TRANSFER PRICING RULES:
Today, the Treasury Department and the IRS issued proposed and temporary regulations on the tax treatment of services transactions, including services transactions related to intangible property, under the related party transfer pricing rules. The regulations update the existing rules regarding related party services transactions (which have not been revised since their issuance in 1968) to reflect an increasingly global economy, as well as the significance of cross-border services.

Key Highlights of the Proposed and Temporary Regulations:

  • The regulations will be effective in Temporary form for taxable years beginning after December 31, 2006
  • The regulations eliminate the "simplified cost based method" of the 2003 proposed regulations and replace it with a safe harbor. In general, the safe harbor provides that no mark-up is required (although the Commissioner may re-determine or re-allocate the costs themselves) if the services are either described in a revenue ruling (a version of which was also issued today) or have an arm's length return of 7% or less. These are referred to as "specified covered services" and "low margin covered services" respectively. To qualify for the safe harbor, the taxpayer must also reasonably conclude in its business judgment that the services do not contribute significantly to key competitive advantages, core capabilities, or fundamental chances of success or failure in one or more trades or businesses of the renderer, the recipient, or both. The regulations distinctly tilt towards deference to the taxpayer's business judgment on this last condition.
  • The rules provide explicit guidance on shared services arrangements (similar to cost sharing arrangements for services).
  • The IRS and Treasury significantly modified the profit split method as proposed in the 2003 regulations. Although the other methods as proposed then are substantially retained in these regulations, these new regulations contain numerous modifications to points made by commentators.
  • The new regulations address numerous other points, including the definition of "total services costs" (which includes stock based compensation); the definition of the "controlled services transactions" covered by the rules; the interaction of the services rules with the transfer pricing rules governing other types of transactions, including intangibles transfers and financial transactions including financial guarantees; and the treatment of third party costs included in the costs of services provided to related parties.
  • The new regulations also address the 2003 proposed regulations dealing with the transfer of intangibles, most importantly largely adopting the approach of the proposed regulations in the area relating to identification of the owner of the intangibles for tax purposes (using a "legal owner" approach).
  • Treasury International Tax Counsel Hal Hicks said, "The proposed and temporary regulations respond appropriately to comments that the proposed regulations would not have achieved their intended purpose of simplifying transfer pricing for low-margin services. The new guidance takes low-margin services off the table and makes administration of the rules more productive for both taxpayers and the IRS. The regulations are issued in proposed and temporary form with a delayed effective date in order to allow taxpayers sufficient time to implement any necessary internal procedural changes and to provide further comments before finalization. Along with the proposed cost sharing regulations issued last year and forthcoming re-proposed global dealing regulations, the proposed and temporary services regulations modernize our transfer pricing rules to keep them current with changing business practices."
  • For additional information, contact Philip R. West - pwest@steptoe.com or Stan Smilack - ssmilack@steptoe.com
  • The regulations can be accessed here: 26 CFR Parts 1 and 31, REG-146893-02, and Announcement 2006-50.

STEPTOE LAWYERS WEIGH IN ON FOREIGN TAX CREDIT ARBITRAGE TRANSACTIONS:
The attached letter was submitted yesterday to Treasury and the IRS regarding the issue of leveraged investments involving foreign tax credit arbitrage. The issue is one of significant concern to a large number of financial institutions and other taxpayers, raising issues of both tax policy and tax procedure.

  • The letter can be accessed here.

INTERNAL REVENUE SERVICE - CIRCULAR 230 DISCLOSURE:
As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.

STEPTOE & JOHNSON LLP - TAX PRACTICE
Steptoe & Johnson LLP has one of the largest and most diverse law firm tax practices in the country. The practice covers the entire spectrum of federal taxation, including representation of businesses before the Congress, Treasury and the national office of the IRS; transactional planning for domestic and multinational corporations; complex audit and controversy work for corporations and other business interests contesting IRS adjustments; litigation before the Tax Court, Court of Federal Claims, district courts, courts of appeals and the Supreme Court. The firm's tax practice also encompasses all aspects of employee benefits (ERISA), executive compensation, tax-exempt organizations and charitable giving.  Steptoe has an extensive state and local tax practice, representing an array of business clients on complex sales and use tax, corporate income tax and property tax matters, both advising those clients and handling audits, administrative appeals, and litigation for them.  Read  more information on Steptoe's tax practice