There are so many reasons to love the services cost method of benchmarking: it’s simple, it’s straight forward, and can even excuse you from paying the BEAT in some cases. CrossBorder Solutions Chief Product Officer Andrei Enoiu and Head of Professional Services Adam Sandford discuss the services cost method and the new BEAT tax in detail on today’s episode of ‘The Fiona Show’.
Andrei Enoiu: What are some other methods that that can be used for service transactions? Cause we know that, that there are times if you have a low value added service, you don’t necessarily need to go, you know, A to Z in terms of analyzing it. But what do those methods look like?
Adam Sandford: The most common one would be the services cost method.
Andrei Enoiu: … which is an IRS specific method.
Adam Sandford: Correct. This was introduced by the IRS in 2007. It has no specific regulations about the treatment of services and it’s intended to minimize the compliance burden of common intercompany services that weren’t low markups, like we’ve mentioned before. So it might be the accounting, the payroll, the admin services… This allows taxpayers to compare costs without comparing profit.
Andrei Enoiu: And so does the IRS allow you to use it for any type of service?
Adam Sandford: No, it can’t be applied for any type of service. There are specific services that are as listed as acceptable for this type of method. Most of those services will be considered low value added services. There’s extensive documentation listing out these services and if you fall into one of those buckets, you can consider yourself for the SCM or the services cost method. If it’s a high value added service – and you can imagine the strategic management, research and development – you will not be eligible for the SCM.
Andrei Enoiu: Yeah. So that’s, that’s actually a good point. So Fiona, I’m wondering if you can actually tell us all the different types of services that are not acceptable, or specifically excluded by the IRS for application of the SCM.
Fiona: The IRS has excluded the following services from the SCM or services cost method: manufacturing, production extraction, exploration or processing of natural resources, construction, reselling, distribution, acting as a sales or purchasing agent, acting under a commission or other similar arrangement, research development or experimentation, engineering or scientific projects, financial transactions including guarantees and insurance or reinsurance.
Andrei Enoiu: Adam, as long as the service isn’t under one of these umbrellas are categories, then it’s okay?
Adam Sandford: Not necessarily. The service can’t contribute to the success or failure and it can contribute to key competitive advantages, core capabilities, or fundamental risk, or success or failure in one or more trades or businesses of the control group, not just the render or recipient of services.
Andrei Enoiu: And so what kind of records do you have to keep to be able to apply this?
Adam Sandford: You, you have to keep great records. You have to be able to show records to apply the SCM and they have to include the intent to apply that cm. So this is more of a planning exercise. If you are potentially applicable, if your services are potentially applicable for the SCM, you should know this ahead of time and plan for it as a tax department
Andrei Enoiu: And it’s also an elective method. The IRS doesn’t force you to use the SCM.
Adam Sandford: Correct. Most of our clients end up using the cm as a benefit to them. Like you said, nobody’s offering it to them. It is available.
Andrei Enoiu: And so basically to qualify for the SCM: if the service passes the benefit test, and is a low margin service, and is not on the specifically excluded a list from the IRS, then it sounds like the tax payer can choose to apply it but doesn’t necessarily have to apply it.
Adam Sandford: Yes, that’s correct. But logic applies too, for instance, if you’re in the business of providing accounting and auditing services to an affiliate, you can qualify for the SCM. But if accounting and auditing is your business, then you have to charge out for those services with an element of profit.
Andrei Enoiu: So basically, the business judgment rule?
Adam Sandford: Correct.
Andrei Enoiu: So given that the SCM is an IRS-specific concept, is there any similar type of elective method that you can apply anywhere else outside the U.S. if you have a transaction between affiliates not in the U.S. and you want to the simplified approach – not have to worry about a markup and not have to worry about doing a comparable search – what can someone do in that case?
Adam Sandford: Well, the OECD has a simplified approach similar to the IRS’s SCM and there are services that are of low value in nature. [They’re] supportive, they don’t use unique intangible property. They don’t create significant risk or significant value. The differences are that all costs, with the exception of the past cost should be marked up by 5 percent. The OECD provides guidelines and they’re only guidelines, whereas the IRS is law in the United States. Additionally, the OECD guidelines must be adopted by a country for this to be applicable.
Andrei Enoiu: And so going back to the SCM method: We know that the main benefit is less of a compliance burden, but are there any other benefits to using the service cost method?
Adam Sandford: Yes, a big one. You can actually get around paying the tax outlined in the BEAT provision.
Andrei Enoiu: So what is the BEAT provision?
Adam Sandford: Well, it actually stands for Base Erosion and Anti-Abuse Tax and it imposes a minimum tax on certain deductible payments made by us taxpayer to related parties.
Andrei Enoiu: And this is a new IRS tax as part of the comprehensive tax reform that we saw?
Adam Sandford: That’s correct. And it’s aligned to limit the exposure paid to parent companies outside of the U.S. providing low value added services to U.S. multinationals.
Andrei Enoiu: Interesting. So let’s pause here. Let’s ask Fiona for a second. Fiona, how does a BEAT’s minimum tax rate work?
Fiona: BEAT is complicated, so stay with me. The tax rate is 5 percent for tax years starting in 2018, 10 percent for taxes starting in 2019 through 2025, and 12.5 percent for subsequent tax years on certain deductible payments made by U.S. taxpayers to related parties.
Andrei Enoiu: If I’m understanding your correctly, do you not have to pay BEAT if your transaction is tied to the service cost method?
Adam Sandford: That’s correct. There’s an exception tied to the service cost method for amounts paid or accrued by taxpayers for services.
Andrei Enoiu: So what are the conditions?
Adam Sandford: Well if services meet the requirements for eligibility for that services cost method under Section 482, all the requirements that we previously talked about, then they could meet the conditions for an exemption.
Andrei Enoiu: And then are there any types of payments that are not included in the BEAT tax and the base of erosion category?
Adam Sandford: Yeah, there’s actually several. There’s COGS or cost of goods sold. There’s a qualified derivative payments. And additionally, there are services which meet the requirements for eligibility for the services cost method under IRS’s 482. And those previous examples are not included in the base erosion payment category.
Andrei Enoiu: So it sounds like there is a big benefit to the SCM. Then, as a taxpayer who may have payments to foreign related parties or foreign parents providing these services, how do you know if you qualify?
Adam Sandford: First you need to identify if you qualify for the use of the SCM and then you need to determine if you meet the exception to BEAT.
Andrei Enoiu: And so what is that exception to be look like? Is it sounds like not all multinational companies have to pay the BEAT tax.
Adam Sandford: No, that’s correct. So first it needs to be a foreign parent providing a low value added service and we need to prove that it’s a low value added service. There’s a threshold and you must meet both conditions. The U.S. corporation must have an average annual gross receipts in excess of $500 million over the past three years, and the corporation’s deductible payments made to related parties must exceed 3 percent of the U.S. corporation’s aggregate allowable deductions in the current taxable year.
Andrei Enoiu: So what are some challenges then in terms of becoming exempt to be through the use of the SCM and being eligible for this?
Adam Sandford: Yeah, well I’d say primarily identifying those expenses can be very difficult for our clients and taxpayers in general.
Andrei Enoiu: Why would that be?
Adam Sandford: Well, many charges made to U.S. taxpayers from foreign related parties may involve a bundling of various types of expenses, only a portion of which may be SCM-eligible. A lot of times these invoices come in with a lot of the services that we mentioned earlier. It could be the R&D, it could be the accounting, it could be a nice mixture of the high and low value added services.
Andrei Enoiu: And you have to find a way to disaggregate them and figure out how much of that invoice is attributable to each one then.
Adam Sandford: Correct. So going back to what we talked about earlier, it really is a healthy for our taxpayers to treat this as a planning exercise going forward and go ahead and carve those services out now in your day-to-day operations, which makes the reporting and the compliance part of transfer pricing a lot easier on the backend.
Andrei Enoiu: Are there any other things that taxpayers should consider when determining their SCM eligibility, specifically for the purposes of BEAT?
Adam Sandford: Yes, the SCM is an effective safe harbor available to U.S. taxpayers under IRS’s 482. The SCM is almost never used for services rendered by non-U.S. parties because the OECD guidelines, not 482, include an elective safe harbor, which requires a markup of 5 percent over costs.
The BEAT applies to outbound payments of U.S. taxpayers correct…
Andrei Enoiu: The in-bound services coming, in other words …
Adam Sandford: Correct. The service transactions have relevance for the BEAT or services rendered by non-U.S. parties to their U.S. affiliates, which typically include a profit markup over total service costs.
Andrei Enoiu: So Adam, just in summary: How would you summarize the relationship and the correlation between the SCM and this new BEAT tax?
Adam Sandford: So first, for all U.S. taxpayers to be excluded from the BEAT tax: let’s say if you have a foreign related party providing low value-added services to be excluded from the BEAT tax, you’ll need to first apply for the SCM.
And these will need to be low value-added services, which we’ve talked about here previously being provided by that foreign entity. Then you can be potentially excluded from BEAT if you meet all the requirements.
Andrei Enoiu: So the relationship between the SCM and BEAT is essentially that it’s that the SCM is a good tool to avoid falling within the BEAT category.
Adam Sandford: Good and necessary. They won’t be able to apply for the BEAT if they don’t fit in. They’re not excluded from the BEAT if they don’t have the SCM.