New U.S. Transfer Pricing Regulations for I/P and Services

On August 1, 2006, the Treasury U.S. Department and Internal Revenue Service 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 were issued in temporary form with a delayed effective date for taxable years beginning after December 31, 2006. Controlled taxpayers may also elect to apply these temporary regulations to any taxable year beginning after September 10, 2003, the date of publication of the 2003 proposed regulations.

According to a press release from Treasury International Tax Counsel Hal Hicks,

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.

The changes involve Section 482 of the Income Tax Regulations (26 CFR parts 1 and 31) which places a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining the true taxable income of the controlled taxpayer. The stated purpose of Section 482 of the regulations is to ensure that taxpayers clearly reflect income attributable to controlled transactions and to prevent the avoidance of taxes with respect to such transactions.

In broad terms, the Commissioner will evaluate the results of a transaction as actually structured by the taxpayer unless its structure lacks economic substance. However, the Commissioner may consider the alternatives available to the taxpayer in determining whether the terms of the controlled transaction would be acceptable to an uncontrolled taxpayer faced with the same alternatives and operating under comparable circumstances. In such cases the Commissioner may adjust the consideration charged in the controlled transaction based on the cost or profit of an alternative as adjusted to account for material differences between the alternative and the controlled transaction, but will not restructure the transaction as if the alternative had been adopted by the taxpayer.

These changes clarify that, subject to the best method rule and satisfaction of economic substance requirements, controlled parties may adopt contractual terms that provide for marketing, research and development, or other intangible development 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.

For example, the arm’s length consideration for a contribution by one controlled taxpayer that develops or enhances the value, or may be reasonably anticipated to develop or enhance the value, of an intangible owned by another controlled taxpayer will be determined in accordance with the applicable rules under section 482. If the consideration for such a contribution is embedded within the contractual terms for a controlled transaction that involves such intangible, then ordinarily no separate allocation will be made with respect to such contribution. In such cases, the contribution must be accounted for in evaluating the comparability of the controlled transaction to uncontrolled comparables, and accordingly in determining the arm's length consideration in the controlled transaction.

More transfer pricing guidance from the IRS here.

In other taxing IP news, "Peter Zura's Two-Seventy-One Patent Blog" has pointed out that, a few weeks ago, the Select Revenue Measures Subcommittee of the House Ways & Means Committee held a hearing on "tax strategy patents." According to Zura,

So far, the PTO lists 43 issued patents, and 62 patent applications related to tax planning. The IRS claims to have reviewed many of the tax patents and applications and concluded that they were not "abusive" tax strategies that would invite further IRS scrutiny (and potentially invalidate the patent under the rarely-used "illegal" or "immoral" utility requirement). However, the IRS was very explicit in pointing out that a US patent on tax strategy does not carry with it an IRS "seal of approval."