After U.K.-based GlaxoSmithKline (GSK) developed Zantac, an ulcer medication, in the early 1980s, it contracted an American subsidiary to market the drug in the U.S. GSK paid very little for those marketing services–which helped transform Zantac into one of the most profitable drugs in U.S. history.

The company, though, attributed the majority of the profits from the drug to its U.K.-based R&D entity, effectively removing billions of dollars of taxable revenue from the U.S.

That caught the attention of the IRS. The agency believed that the drug's success had nothing to do with R&D because it wasn't the first drug of its kind to market. Instead, it attributed the success to the marketing–which it viewed as a premium service. It eventually sent two tax bills to the U.S. subsidiary requesting billions of dollars in unpaid taxes for profits earned on Zantac. GSK refused to pay the bill, arguing that the marketing was a back-office service–a service that isn't integral to the success or failure of a business. Therefore, GSK argues, the profits from Zantac were rightfully attributed to the European business unit.

GSK isn't the only company that is fighting the IRS over the issue of what is or isn't a back-office service. U.S. tax regulations don't clearly define what back-office services are, nor do they provide a clear method for companies to price those services. In August the IRS, along with the Treasury Department, took the first step to resolve this long-standing problem when it proposed new temporary regulations that clearly define what back-office services are for tax purposes and how to price them.

“In essence, the IRS is saying to multinationals, 'We don't want to burden you or our examiners with audits of a bunch of services that don't really involve a huge amount of income,” says Robert Greene, a member at Caplin & Drysdale in Washington, D.C.

Back-Office Burden

The definition of back-office services has long been vague. The current rules, which haven't changed for nearly 50 years, defined back-office services as non-integral to a business. However, what's non-integral is subjective.

“There are two types of services,” says David Canale, a practice leader in Ernst & Young's transfer pricing group. “Those that supply the 'show-how,' or non-integral services, and those that supply the 'know-how,' or integral services. Multinationals were really grappling with the gray area between them.”

This confusion often created huge financial liabilities. Companies would label a service as back office, while the IRS labeled the same service as premium. The IRS then would demand additional taxes to compensate for the difference in revenue, sometimes charging millions of dollars.

Other times, a company would purposefully exploit the tax provision, providing premium services but classifying them as back office. This is what the IRS is accusing GSK of doing.

“The agency thought companies were transferring valuable intangibles through these low-margin services at cost or cost plus a small markup, leading to an underpayment of services,” says Deloris Wright, managing principal at the Analysis Group, a financial and economic consultancy. “They have been wanting to close this loophole for a number of years.”

The new rules solve this problem. The regulations create a category of services called “specified covered services.” Multinationals can classify any of these 48 services–which include preparing payroll forms, making payments to vendors and performing data entry–as back-office services without fear of future tax penalties.

“The good news is that in-house counsel can now safely classify certain services as back office,” says Holly McClellan, a partner at Baker & McKenzie in Chicago.

Taxing Issues

In addition to the confusion about what constitutes a back-office service, the IRS and multinationals also disagree over how to price those services. The IRS had allowed companies to charge at cost under the “cost safe harbor rule.” However, because some companies exploited the safe harbor, the IRS drafted new rules in 2003.

Those rules laid out a method for calculating the cost of back-office services called the services cost base method (SCBM). This method required companies to conduct comparability studies to determine an appropriate markup on a low-margin service–an expensive and burdensome undertaking. Many companies objected to the SCBM and the IRS never enforced it. In August the IRS officially scrapped the SCBM and instituted a simplified system for pricing back-office services.

“The SCBM called for quantitative judgments that businesspeople are not qualified to make by themselves,” the Treasury Department said in a press release. “It is in the interest of sound tax administration to minimize the compliance burdens applicable to such services.”

To accomplish that, the IRS proposed a new pricing method known as the services cost method (SCM). The SCM strikes a balance between the easily exploited safe harbor and the overly complex SCBM.

“What they've done effectively with these new regulations is to say, 'Let's stop chasing the penny and let's let companies just charge at cost,” Wright says.

The SCM provides two avenues for companies to price services at cost. The first parallels the safe harbor rule–allowing multinationals to charge for specified covered services at cost. The second method allows multinationals to price low-margin services not included in the specified covered services at cost plus a small markup. That rule applies to any service that does not “contribute significantly to the company's fundamental risks of success or failure.”

Looking Ahead

Although the IRS has finally created clear guidelines for defining and pricing back-office services, other areas of the transfer pricing rules remain ambiguous.

One such area is location savings. This is when a company establishes a manufacturing facility in another country that has low labor costs and tax incentives. The IRS taxes manufacturing facilities on a cost plus basis. The total amount taxed includes labor, equipment and the facility along with a markup comparable to what a third party would pay. By constructing a facility in an area with a lower cost base, a company can save millions of dollars in taxes.

“The question with location savings is who gets the benefit for tax purposes,” Green says. “Those issues are unclear right now, and when you are talking about doing business in China and India, this is going to be a huge issue.”

Still, most experts support the rule changes as an good first step toward clarifying transfer-pricing.

“The new regulations will reduce compliance burdens for multinational companies,” McClellan says.