At Bouwen, the vast majority of our clients are UK companies operating in the US through subsidiaries. In this arrangement, it is very common for the UK parent to provide services to the US subsidiary (or its customers), and vice-versa.
The IRS has over 200 pages of regulations designed to ensure that these transactions are conducted at arms-length – that is, as though they would be conducted between two unrelated entities. For services, the regulations identify six methods for determining arms-length pricing. Here they are in a nutshell:
Services cost method. For certain services, the IRS permits related parties to charge at actual cost, with no markup. Treas. Reg. § 1.482-9(b). Only “specified covered services” or “low margin covered services” qualify. Specified covered services include administrative services such as payroll, accounting and auditing, treasury activities, IT services, and others. Low margin covered services are transactions for which there would be very little markup (i.e., under 7%) if offered by an unrelated party. These are services which the IRS considers do not “contribute significantly to key competitive advantages, core capabilities, or fundamental risks of success or failure” for the business and therefore can be charged without markup.
Comparable uncontrolled services price method. Under this method, the service provider charges what it would charge in a comparable transaction with an unrelated party. Treas. Reg. § 1.482-9(c). The trick, of course, is determining comparability. To the extent there are differences between the transaction with the affiliate and the comparable transaction, adjustments to the pricing must be made. Potential differences might include: the quality of the services; the contractual terms; the intangible property (if any) used in rendering the services; the geographic market in which the services are rendered or received; the risks borne; the duration or quantitative measure of services rendered; and the nature of any collateral transactions or ongoing business relationship between the parties. Often, of course, the entity isn’t providing the same or comparable service to an unrelated party, rendering this method unavailable.
Gross services margin method. This method potentially applies if (a) a subsidiary performs services in connection with a contract between the parent and a third-party or some other affiliate and a third-party or, (b) the subsidiary contracts to provide services to a third-party but the services are performed by the parent or some other affiliate. Treas. Reg. § 1.482-9(d). Here, the amount to be charged (or retained) by the subsidiary is calculated by determining an appropriate gross profit margin for the subsidiary, based on transactions with unrelated parties involving comparable services. If possible, for example, you might look to the profit margin enjoyed by unrelated parties when dealing with the parent. As with the prior method, price adjustments should be made to account for any material differences between the transactions under review.
Cost of services plus method. This method usually applies when an entity provides the same or similar services to both related and unrelated parties. Treas. Reg. § 1.482-9(e). Under this method, the price is determined by adding an appropriate profit margin to the entity’s costs (including labor and materials) of providing the services. The profit margin (or “appropriate gross service profit markup”), in turn, is ideally determined by looking at the margin that the entity enjoys in providing these services to unrelated parties. Where this is not possible, the profit margin is determined by looking at the profit margin enjoyed by unrelated providers providing comparable services. If there are material differences in the services under analysis, then the markup should be adjusted.
Comparable profits method. Under this method, the arms-length price is determined by reference to the profit margins that other service providers enjoy when they engage in similar business activities under similar circumstances with unrelated service recipients. Treas. Reg. §1.482-9(f); see also § 1.482-5. In applying this method, you must first determine the relevant profit level indicator (e.g., Rate of return on capital employed? Ratio of operating profit to sales? Ratio of gross profit to operating expenses?). Then you must determine the profit levels that other service providers enjoy with respect to the “most narrowly identifiable business activity” that corresponds to the related party transaction at issue. Usually, this is done via third-party databases. Finally, a markup is applied to the costs which is sufficient to produce a profit level which falls within an acceptable range of the benchmark profit level.
Profit split method. Under the most common version of this method, you first calculate the combined operating profit (or loss) of the two entities, looking only at the “most narrowly identifiable business activity” at issue between the related parties for which data is available. You then look at how unrelated entities with similar transactions and activities split their combined operating profits (or losses) and apply this split to the related entities, adjusting the relative value of each entity’s contribution to the profit by comparing the functions performed, risks assumed, and resources employed by each to those in the comparison group. Treas. Reg. § 1.482-9(g); see also § 1.482-6. The goal is to simulate the division of profit (or loss) that would result in an arrangement between unrelated entities that perform functions similar to the related entities. The trick, of course, is to find available data in which unrelated parties engage in similar activities and split their profits.
Lest you think the IRS is inflexible, the IRS does allow the use of other “unspecified methods,” provided you can establish that the method chosen is the most reliable measure of an arm’s length result. It’s fair to assume, however, that any attempt to craft your own method is likely to face heightened IRS scrutiny.