The Tax Court decision in Amazon.com Inc. v.
Commissioner, 148 T.C. No. 8 (2017), is another transfer
pricing taxpayer victory. Judge Lauber rejected the Internal
Revenue Service's (IRS) attempt to re-litigate the same cost
sharing transfer pricing issues the IRS lost on in Veritas
Software Corp. v. Commissioner, 133 T.C. 297 (2009).
The IRS claimed that Amazon undervalued the buy-in
intangibles contributed to Amazon's Luxembourg subsidiary by
more than $3 billion when Amazon entered into a cost sharing
arrangement (CSA) with the Luxembourg subsidiary.
As part of its CSA, Amazon US transferred the following
three groups of intangible assets:
- Software and other technology required to
operate the European websites, fulfilment centres, and
related business activities;
- Marketing intangibles, including
trademarks, tradenames, and domain names relevant to the
European business; and
- Customer lists and other information
relating to the European clientele.
The IRS claimed that the transferred property had an
indeterminate useful life, and that it had to be valued, not as
three distinct groups of assets, but as integrated components
of an operating business and taking into account all projected
cash flows of the European business in perpetuity to value the
The Tax Court stated that by definition, compensation for
subsequently developed intangible property is not covered by
the buy-in payment. Rather, it is covered by future cost
sharing payments, whereby each participant pays its rateable
share of ongoing intangible development costs (IDCs). The Tax
Court held that the foreign subsidiary, by making cost sharing
payments, became a genuine co-owner of the subsequently
developed intangibles that the IDCs financed.
The Tax Court stated that the useful life of the trademarks,
brand names, and other marketing intangibles in
Veritas was determined to be seven years. It is
unreasonable, the Tax Court concluded, to determine the buy-in
payment by assuming that a third party, acting at arm's length,
would pay royalties in perpetuity for the use of short-lived
The Tax Court noted the essential similarity between the
IRS's discounted cash flow (DCF) methodology employed in
Veritas and the DCF methodology employed in
Amazon. In both cases, the IRS adopted the following
- The pre-existing intangibles transferred
were determined to have a perpetual useful life;
- The buy-in payment was calculated by
valuing into perpetuity the cash flows supposedly
attributable to these pre-existing intangibles; and
- The transfer of pre-existing intangibles
was treated as economically equivalent to the sale of an
The Tax Court held that an enterprise valuation of a
business includes many items of value that are not intangibles.
These include the workforce in place, going-concern value,
goodwill, and what trial witnesses described as growth options
and corporate resources or opportunities. The Tax Court stated
these items cannot be bought and sold independently; they are
an inseparable component of an enterprise's residual business
value. These items often do not have substantial value
independent of the services of any individual and do not derive
their value from their intellectual content or other intangible
properties. Thus, the Tax Court stated that as concluded in
Veritas, there was no explicit authorisation in the
cost sharing regulations for the inclusion of workforce in
place, goodwill, or going-concern value in determining the
buy-in payment for pre-existing intangibles.
The Tax Court rejected the service's aggregation argument in
Amazon, as it did in Veritas. The Tax Court
stated the type of aggregation proposed by the IRS did not
yield a reasonable means, much less the most reliable means, of
determining an arm's-length buy-in payment for at least two
reasons. First, it improperly aggregated pre-existing
intangibles (which are subject to the buy-in payment) and
subsequently developed intangibles (which are not). Second, it
improperly aggregated compensable intangibles (such as software
programs and trademarks) and residual business assets (such as
workforce in place and growth options) that did not constitute
pre-existing intangible property under the cost sharing
regulations in effect during the relevant period.
The Tax Court also found unpersuasive the IRS contention
that Amazon US had a realistic alternative available to it,
namely, continued ownership of all the intangibles in the US.
First, the court stated that the argument proved too much.
Whenever related parties enter into a CSA, they presumably have
the realistic alternative of not entering into a CSA. This
would make the cost sharing election, which the regulations
explicitly make available to taxpayers, altogether meaningless.
Second, as noted in Veritas, the regulation
enunciating the realistic alternatives principle also states
that the IRS "will evaluate the results of a transaction as
actually structured by the taxpayer unless its structure lacks
economic substance" (Treas. Reg. § 1.482-1(f)(2)(ii)(A)).
Thus, even where a realistic alternative exists, the
commissioner will not restructure the transaction as if the
alternative had been adopted by the taxpayer, so long as the
taxpayer's actual structure has economic substance.
clearly established that Amazon's website technology did not
have a perpetual or indefinite useful life. The court concluded
that Amazon's website technology, ignoring the tail, had on
average a useful life of seven years.
The Tax Court held that because the going-forward value of
the marketing intangibles would increasingly be attributable to
marketing investments by the foreign subsidiary, an unrelated
party in its position would not agree to pay royalties forever.
A trademark is, at any specific moment, the product of
investments of the past. Future investments can replace those
made in the past, and therefore the value of a trademark built
by investments of the past will diminish. The Tax Court cited
Nestle Holdings, Inc. v. Commissioner, T.C. Memo.
1995-441, 70 T.C.M. (CCH) 682, 696 ("Trademarks lose
substantial value without adequate investment, management,
marketing, advertising, and sales organisation."), rev'd in
part and remanded on other grounds, 152 F.3d 83 (2d Cir. 1998).
If consumers were dissatisfied with their shopping experience,
Amazon's marketing intangibles would rapidly decline in value.
The Tax Court found that the marketing intangibles had a useful
life of 20 years.
The Tax Court also found unpersuasive the IRS contention
that Amazon US was the true equitable owner of any marketing
intangibles legally owned by the European subsidiaries. Because
of differing cultural preferences, retail traditions, and
national regulations, the details of these operations often
varied from country to country. Local teams were thus integral
to Amazon's success in Europe. The Tax Court held that the
European subsidiaries were not mere agents of Amazon US.
IRS appeals Medtronic
The IRS filed a brief with the Eighth Circuit regarding its
appeal of the Tax Court's decision in Medtronic v.
Commissioner on July 21 2017. It is surprising that the
IRS has decided to appeal such a factually intensive case.
The IRS contends that the Tax Court erred as a matter of law
in adopting Medtronic's transfer pricing method. The IRS
asserts that the Tax Court's transfer pricing analysis is wrong
as a matter of law because it treated Medtronic's agreement
with Pacesetter (an unrelated party) as a comparable price for
Medtronic's intercompany licenses without first applying the
requirements for evaluating whether the Pacesetter agreement
qualifies as a comparable uncontrolled transaction (CUT). The
IRS argues that the Pacesetter agreement does not qualify as a
CUT under the regulations for a number of reasons, including
that it was a litigation settlement. The IRS asserts that since
there is no CUT, a profit-based approach (the comparable
profits method) must be used.
Alternatively, the IRS argues the case should be remanded to
the Tax Court to correct adjustments to the Pacesetter royalty
The government would seem to have an uphill battle in
pursuing this appeal. It will have to establish that the Tax
Court made a "clear error" regarding its findings of fact. This
is a hard standard to satisfy. The IRS brief articulates the
IRS's disagreement with the Tax Court's opinion, but it doesn't
seem to establish clear error.
Eaton's Tax Court victory
The Tax Court ruled that the IRS abused its discretion by
cancelling two advance pricing agreements (APAs) that Eaton and
the IRS entered into to establish a transfer pricing
methodology for covered transactions between Eaton and its
subsidiaries (Eaton Corp. v. Commissioner, T.C. Memo
2017-147). In an earlier 2013 summary judgment decision, the
Tax Court initially ruled for the IRS and rejected Eaton's
argument that the APAs were enforceable contracts (Eaton
Corp. v. Commissioner, 140 T.C. No. 18 (2013)).
The IRS had cancelled the APAs retroactively, claiming that
Eaton did not comply in good faith with the terms and
conditions of the two APAs and failed to satisfy the APA annual
reporting requirements. The IRS then issued a deficiency notice
to Eaton based on an alternative transfer pricing methodology.
The two APAs involved the sale of products from manufacturing
operations in Puerto Rico and the Dominican Republic to the
The IRS argued two reasons for its cancellation of the
- Misrepresentations, mistakes as to a material fact, and
failures to state a material fact during the APA
- Implementation and compliance issues.
The IRS argued that any misrepresentation or misstatement is
sufficient on its own to show that the cancellation of the APAs
was not an abuse of discretion. Tax Court Judge Kathleen
Kerrigan disagreed with this IRS argument. Only a mistake as to
a material fact or a failure to state a material fact is a
ground for cancellation based on Rev. Proc. 96-53, sec.
11.06(1) and Rev. Proc. 2004-40, sec. 10.06(1). Eaton argued it
did not omit or misrepresent any material facts in connection
with its request for, or negotiation of, the APAs.
The Tax Court held that the cancellation of an APA is a rare
occurrence and should be done only when there are valid reasons
that are consistent with the revenue procedures. A
misrepresentation must be false or misleading, usually with the
intent to deceive, and relate to the terms of the APA. The Tax
Court stated that a different viewpoint is not the same as a
misrepresentation and is not grounds for terminating an
The Tax Court looked at nine areas of APA negotiations to
determine whether it was an abuse of discretion to cancel the
APAs, including extensive factual evidence on the profit split,
tested party, and business losses. The Tax Court concluded that
none of the nine areas addressed during the APA negotiations
was a ground for cancellation. The Tax Court stated that Eaton
provided evidence that it answered all questions asked and
turned over all requested material, and the evidence was not
contradicted by the IRS. The Tax Court stated that the
negotiation process for these APAs was long and thorough and
either party could have walked away at any time.
The Tax Court held that based on all the evidence presented,
no additional material facts, mistakes of material facts, or
misrepresentations existed that would have resulted in a
significantly different APA or no APA at all. The IRS had
enough material to decide not to agree to the APAs or to reject
Eaton's proposed transfer pricing method and suggest another
APA at the time the APAs were negotiated. The Tax Court
concluded that it was an abuse of discretion for the IRS to
cancel the APAs.
The IRS argued that Eaton's transfer price calculations
contained seven errors, three of which resulted in a tax
benefit. The Tax Court held that even though Eaton's errors
were numerous when they are considered in the aggregate, it was
not enough to conclude that the aggregate of the errors
resulted in a mistake as to a material fact, a lack of good
faith or compliance, or failure to meet a critical
The Tax Court also rejected the IRS's alternative §
367(d) argument to increase Eaton's taxable income by more than
$230 million. The Tax Court stated that the gist of the IRS's
§ 367(d) argument is that the foreign operations could not
possibly be as profitable unless intangibles were transferred
to them. The Tax Court rejected this argument, stating that the
IRS did not specifically identify any intangible or explain the
exact value of any intangibles that should be covered by §
367(d). The Tax Court ruled similarly on this same IRS §
367(d) argument in a number of cases, including
Medtronic and Amazon.
Tax Court reverses course in Analog Devices
Reversing course from its earlier decision in BMC
Software Inc. v. Commissioner, 141 T.C. 224 (2013) (BMC
I), the Tax Court held in Analog Devices, Inc. v.
Commissioner, 147 T.C. No. 15 (2016), that a closing
agreement entered into pursuant to Rev. Proc. 99-32, 1991-2
C.B. 296, does not result in retroactive indebtedness for
purposes of § 965(b)(3). A Rev. Proc. 99-32 closing
agreement is often used by taxpayers to remit payment to the US
of the transfer pricing adjustment amount without having such
remittance taxed a second time as a dividend distribution.
The Tax Court's decision in Analog Devices is
important because it eliminates the uncertainty that was
created by the Tax Court's earlier decision in BMC I
regarding the proper treatment of accounts receivables/payables
under a Rev. Proc. 99-32 closing agreement.
Analog Devices, Inc. (ADI) repatriated cash dividends from
one of its foreign subsidiaries, a controlled foreign
corporation (the CFC), and claimed an 85% dividends received
deduction (DRD) for the 2005 tax year under § 965. ADI
reported no related party indebtedness during its testing
period under § 965(b)(3), which would have limited the
amount of DRD benefit available under § 965.
Separate from the dividend distribution, the IRS determined
as part of an ongoing audit that an intercompany royalty
payable by the CFC to ADI should be increased for the 2001-2005
tax years. ADI ultimately agreed to the proposed adjustment,
and in 2009, ADI and the IRS executed a closing agreement under
Rev. Proc. 99-32 for the CFC to remit payment of the additional
royalty amounts to the US in accordance with the § 482
adjustment. The closing agreement established accounts
receivable on ADI's books pursuant to the revenue procedure and
deemed the receivables to have been created as of the last day
of the taxable year to which they relate. The purpose for the
retroactive date mechanism is to allow the calculation of an
interest charge on the payment of the § 482 adjustment
amounts. However, the IRS subsequently determined that the
accounts receivable established under the Rev. Proc. 99-32
closing agreement should be treated as creating retroactive
indebtedness for other federal tax purposes (citing the
agreement's boilerplate language, "for all Federal income tax
purposes"), and specifically § 965, resulting in an
increase in related party indebtedness under §
Contrary to the Tax Court's holding in BMC I, the
Tax Court in Analog Devices held that the parties did
not reach an agreement in the closing agreement regarding the
treatment of the accounts receivable for purposes of §
965, and that the accounts receivable did not constitute
related party indebtedness arising during ADI's testing period
for purposes of § 965. Thus, the Rev. Proc. 99-32 accounts
receivable did not increase the CFC's related party
indebtedness during the testing period.
The Tax Court's decision in Analog Devices follows
the Fifth Circuit's reversal of BMC I at 780 F.3d 669
(5th Cir. 2015) (BMC II). Although the Tax Court noted that
BMC II was not binding in Analog Devices
(where an appeal would lie to the First Circuit), the Tax Court
stated that given the Fifth Circuit's reversal and the parties'
arguments, the instant case required the court to revisit its
analysis in BMC I. On balance, the Tax Court concluded
that the importance of reaching the right result in Analog
Devices outweighed the importance of following the Tax
Court's prior precedent. The decision in favour of ADI was
reviewed by the full panel of Tax Court judges, with the judges
voting 13-4 to reverse BMC I.
The Tax Court's decision has important ramifications for
taxpayers who enter into Rev. Proc. 99-32 closing agreements
following a § 482 transfer pricing adjustment. Following
the Tax Court's decision in BMC I, significant
questions arose as to whether a taxpayer's decision to enter
into a Rev. Proc. 99-32 closing agreement and the required
establishment of accounts receivable or payable with a deemed
retroactive effective date could be treated as actual
indebtedness for other federal tax purposes, such as the
investment in US property rules under § 956, or the
allocation of interest expense under § 861. With the Tax
Court's decision in Analog Devices, however, taxpayers
should be comforted that general boilerplate language contained
in Rev. Proc. 99-32 agreements should not be interpreted as
creating unspecified tax consequences.
||Andrew J Kim and Larissa B
Fenwick & West