New IRS and Treasury Department regulations on transfer pricing include a regulation that could create conflict between the IRS and multinational companies over shared service centers and other arrangements where the level of payment depends upon performance.

The IRS has long set transfer pricing rules to ensure that US multinationals do not reduce profits in the US by paying too much for services provided by overseas affiliates, or by undercharging for services those affiliates purchase. Typically, that means that different units of the same company must deal at arm’s-length with each other by charging a market rate for services — a rate that includes both the cost of the service and a profit.

The new regulation, which is particularly likely to affect multinationals in high-tech and services industries, affects so-called “contingent service agreements.” Those are contracts in which a service provider — whether an affiliate or a third party — receives payment only if certain results are achieved. For example, “If the R&D activity [of a foreign affiliate] led to some discovery or a new process, the service provider could be paid something in addition to what it would have gotten on a fee basis,” explains Rocco Femia, an attorney at Washington, D.C.-based law firm Miller & Chevalier.

Although contingent agreements are common, this is the first time the IRS has acknowledged their use. The recognition gives corporate taxpayers greater flexibility in setting up payment arrangements between business units, and the new rules provide more guidance on how the IRS will interpret those arrangements, notes Dave Canale, director of national transfer pricing at Ernst & Young. The regulations “recognize there can be a range of correct prices and as long as a taxpayer falls within that range, the IRS won’t make an adjustment,” said Canale.

However, “The real question is how taxpayers will convince the IRS the arrangements are at arm’s length,” says Tom Zollo, a principal in international corporate services at KPMG. Part of the benefit of contingent service arrangements is that they minimize cross-border payments — and changes in tax liability — unless some offsetting corporate benefit is achieved. But tax authorities are likely to take the opposite view. “The IRS will be happy to let lie any arrangement that produces a beneficial result in terms of taxable income in the U.S.,” said Zollo. “When risks materialize in a way unfavorable to the taxpayer, they will challenge that it was at arm’s length,” he projected.

The new regulations take effect January 1, 2007 — the first update since 1968 — and are intended to reflect the increased importance of services and intellectual property in the global economy. Under the 1968 rules, a broad safe harbor provision allowed one unit to charge another unit at cost for many types of transactions. The revision was prompted in 2003 by Treasury and IRS concern that companies were “getting away with charging costs and no profit element for too wide a range of services,” explains Zollo.

Initial proposals in 2003 sharply narrowed that safe harbor. The safe harbor contained in the final rules, while broader than initially proposed, is not as broad as it was under the 1968 regulations, and require many more transactions to be charged at an arm’s length price.

“Some will applaud the IRS and Treasury for loosening up the standard,” said Zollo, “and some will say they preferred the 1968 regs — that is unrealistic given the way the economy has changed over the past several years.”

For example, research and development cannot be charged at cost. In successful transactions, using an arm’s length approach toward pricing services would bring more income into the U.S. and result in a larger tax bill.

The changed regulations will result in a significant increase in U.S. tax revenues in the aggregate, predicts Zollo. The impact on individual companies depends upon the nature of their inter-company services. For instance, industrial companies may not experience a noticeable change, but companies in the high-tech sector and those that have inter-company services at their core of their business could see a material difference in taxes, he says.

However, some tax analysts worry that the IRS may have questions for companies whose business transactions are not successful enough to trigger the contingent payment. “There is a danger of Monday morning quarterbacking with contingent service arrangements,” notes Zollo. “When a U.S. party has assumed risk and loses, the IRS will be unhappy and challenge that.”

The new rules also come with a compliance burden: Companies must analyze services to see whether they are still eligible to be priced at cost, said Femia. Multinational companies must “re-evaluate all of their cross-border services, make sure that they either modify or enter into new internal contractual arrangements, make sure such arrangements are consistent with foreign law requirements, and update internal accounting systems appropriately,” he said. Doing all that by the end of the year could prove to be a tall order for some companies. “I’m afraid that for some taxpayers, four or five months may not be enough time,” said Femia.