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US transfer pricing litigation update

26 March 2015

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David Forst and Larissa Neumann of Fenwick & West provide an overview of the recent developments in US transfer pricing litigation

In the US the IRS has been aggressively litigating transfer pricing cases and is likely to continue to aggressively pursue transfer pricing issues, especially cost sharing buy-in payments.

Former IRS chief economist, Bill Morgan, said the IRS is trying to take more, and better, cost sharing cases to court. According to Morgan, the IRS views transfer pricing litigation as preferable to a lengthy and difficult effort to revise the cost sharing regulations.


Microsoft is an example of a recent cost sharing buy-in payment transfer pricing dispute and the company could be facing a multi-billion-dollar adjustment.

The Microsoft transfer pricing adjustment made headlines when Microsoft sued to enforce a Freedom of Information Act (FOIA) request against the IRS for its use of an outside law firm, Quinn Emanuel Urquhart & Sullivan.

Quinn Emanuel will receive a fee of $2.2 million from the IRS. The use of an outside law firm demonstrates the IRS's willingness to more vigorously litigate transfer pricing, even in the face of a number of significant past losses.

Since the IRS is spending such a large amount of money on the Quinn Emanuel fees, the stakes for the IRS are high. Spending more than two million dollars in outside fees is a significant cost for the IRS, especially if it loses. In addition, calling in an outside law firm demonstrates that the IRS is not confident in the ability of its own attorneys.

The IRS's engagement of Quinn Emanuel has been met with skepticism and Microsoft may claim that the engagement is inappropriate. Quinn Emanuel will work collaboratively with the IRS, reviewing key documents (including reports, position papers, IDR responses, etcetera, prepared by, or on behalf of, the taxpayer or the IRS).

New, temporary, regulations, which allow private contractors to participate in the summons process, were issued a month after the contract with Quinn Emanuel was signed. However, the new temporary regulations apply retroactively "to summons interviews conducted on or after June 18 2014," and would therefore cover the Microsoft summons.

The IRS and Quinn Emanuel will have more time to audit Microsoft, since the IRS initiated court proceedings to enforce a designated summons, which automatically suspends the statute of limitations.

The limitations period will remain open as long as Microsoft has not fully complied with any district court order resulting from the designated summons enforcement proceedings.

The IRS also filed a summons enforcement action in a Seattle federal district court seeking additional information about Microsoft's examination.

The IRS requested:

  • value proposition analyses;
  • annual revenue and expense budgets and targets;
  • return on R&D spending information;
  • marketing investment and sales spending;
  • brand and image tracking;
  • strategic plans and market research;
  • performance evaluations and milestone goals for Microsoft executives and sales personnel;
  • and a breakdown of all Microsoft employees worldwide for each of the fiscal years from 2001 through 2006.

Microsoft objected to the demand for certain documents, including performance evaluations, strategic plans, and related external and internal communications. Microsoft characterised those demands as impermissibly overbroad and overly burdensome. Microsoft also asserts that the production would be approximately 4,025 annual performance evaluations. Microsoft instead committed to produce the annual performance evaluations for senior vice presidents or higher in each business group.

The IRS also filed 12 additional petitions enforcing related summonses. Eight of the related summonses demand testimony from current and former Microsoft executives, including former CEO, Steven Ballmer. Two are summonses issued to EY and KPMG.

Microsoft claims that it has been responsive throughout the audit, producing approximately 1.2 million pages of documents and making over 50 employees available for interviews, in response to 220 information document requests from the IRS.

The IRS appears to be developing an argument to adjust the buy-in price Microsoft used for transferring intangibles to two offshore affiliates under two different cost-sharing arrangements (CSA).

The CSA in APAC, effective April 3 2004, was entered into with an affiliated Bermuda corporation, Microsoft Asia Island Ltd. (MAIL). Under that CSA, Microsoft transferred to MAIL various rights to both technology and non-technology intangibles used in its APAC retail business. Microsoft took the position that it owned only a fraction of the non-technology intangibles used in its APAC retail business. The CSA for Americas, effective July 1 2005, transferred to the offshore affiliate only technology intangibles, such as software code. The Americas CSA was entered into with a Puerto Rican entity, Microsoft Operations Puerto Rico LLC (MOPR).

The IRS summons seek details on how Microsoft internally valued the intangibles it transferred to the offshore affiliates. The government is looking for information on Microsoft's valuation techniques and procedures.

Amazon, Inc. v. Commissioner, T.C. Dkt. 31197-12, involves a cost sharing agreement with income adjustments of over $2 billion for the two years in issue.

Amazon involves the same "perpetual useful life" issue that was litigated in Veritas v. Commissioner, 133 T.C. 297 (2009). The IRS lost in Veritas. It is difficult for the IRS to argue for a perpetual life for technology intangibles. Technology is constantly evolving and is usually seen as becoming obsolete quickly. The Amazon trial took place in November of 2014 and was closed to the public.

The IRS valued the preexisting technology and marketing intangibles buy-in at more than 20 times the amount paid by Amazon's Luxembourg subsidiary to Amazon. A study performed for the IRS by Horst Frisch found that the intangibles contributed had a value of $3.6 billion using a discounted cash flow with an 18% discount rate and a perpetual life.

The judge stated that he rejected an assumption of a 5% increase in the intangible development costs (IDCs) a year. He said that a higher projected IDC, perhaps as high as projected revenues, is the right number. The larger the IDC that is required the smaller the initial buy-in value should be, which is good for Amazon.

The judge also said that ongoing investments would be needed to keep the "technology up to snuff." These statements by the judge would seem to undermine the IRS's perpetual life argument and diminish the IRS's chance of success in this case.

Zimmer Holdings

In Zimmer Holdings, Inc. v. Commissioner, T.C. No. 19073-14, the IRS presented three different alternative positions in its Notice of Deficiency.

First, section 482 applies and Zimmer's income should be increased by just over $100 million for each of two years.

Second, in the alternative if the first argument is not successful, the IRS asserts that Zimmer's income should be increased by amounts over $100 million (more than under the section 482 adjustments) based on transfers of intangible property to its Dutch subsidiary under section 367(d).

In the third and final alternative if the first two arguments are not successful, the IRS asserts that Zimmer's taxable income should be increased by nearly $1 billion under section 367(a) based on the value of a licensing agreement, workforce-in-place and goodwill, allegedly transferred to a Dutch subsidiary.


Medtronic v. Commissioner, T.C. Dkt. 6944-11, involves sections 482 and 367(d). The company is challenging income adjustments for tax years 2005 and 2006.

The IRS is asserting a $1.35 billion transfer pricing adjustment related to the value of the intangibles and the resulting royalties owed by Medtronic's Puerto Rican entity to Medtronic.

In the alternative, the IRS claims that if the royalty payments are found to be at arm's-length, then there was a transfer of intangible property under section 367(d). Medtronic maintains that no such transfer occurred because the intangibles always remained with the US parent.

Also at issue is a $793 million dividends-received deduction under section 965. The parties have agreed to hold that issue until the primary transfer pricing issue is resolved.

Medtronic had an expert witness testify that because Medtronic makes medical devices, quality is a matter of life and death, therefore, the manufacturing process it critical and justifies the higher return that the Puerto Rican entity receives.

IRS training slides

The IRS made public a number of international training slides developed by LB&I's international practice networks.

The "Section 482 Fundamentals" slide states that the IRS examiner should consider the "functions performed, assets employed, and risks assumed". They refer to the recent transfer pricing roadmap. The slides state that the arm's-length range can be determined "either on a full range or an interquartile range", depending on the application of certain criteria. The slides also recommend interviews of key personnel.

Transfer pricing audit roadmap

In 2014 the IRS issued the transfer pricing audit roadmap, which is intended to be a guide to international examiners in developing a transfer pricing case.

According to the roadmap, the key in transfer pricing cases is to put together a compelling story of what drives the taxpayer's financial success, based on a thorough analysis of functions, assets, and risks, and an accurate understanding of the relevant financial information. The roadmap states that fact-development is the "bread and butter" of exam teams – it is what they are trained for and good at. An effective story explains the taxpayer's value chain, competitive position in its industry, and financial results, in a clear and compelling fashion.

The roadmap emphasises that even a strong position may not be sustained on review if it is not presented clearly and persuasively. A notice of proposed adjustment (NOPA) should have logical structure, and should weave the facts and applicable legal and economic principles together in a story-line that resonates with the reader. All the relevant facts – good and bad – should be addressed. The conclusion should come across as "inevitable".

This sort of presentation lends credibility to the proposed adjustment, and increases the odds of early resolution or sustention on review.

The roadmap lists a number of items that Exam should review in developing a transfer pricing case, including:

  1. Form 5471 – Information Return of US Person with Respect to Certain Foreign Corporations;?
  2. Form 5472 – Information Return of a 25% Foreign-Owned US Corporation or a Foreign Corporation Engaged in a US Trade or Business;
  3. Form 8833 – Treaty-Based Return Position Disclosure;?
  4. Form 8858 – Information Return of US Persons with Respect to Foreign Disregarded Entities;?
  5. Form 8865 – Return of US Persons with Respect to Certain Foreign Partnerships;?
  6. Form 926 – Return by a U.S. Transferor of Property to a Foreign Corporation;
  7. Uncertain Tax Positions (UTP) Disclosures; and?
  8. Schedule M-3 analysis

In addition, the roadmap states that, because transfer pricing studies are generally based on book financial information, it is helpful to become familiar with qualitative and quantitative information found in publicly available documents, such as SEC Form 10-Ks.

Other detailed information particularly useful for a transfer pricing review includes:

  • research and development activity and location;
  • descriptions of patents,
  • trademarks and other IP;
  • geographic and organisational structure;
  • segmented operational and profitability level; and
  • section 6662 documentation.

Exam is instructed to hold a transfer pricing orientation with the taxpayer to include discussions of:

  • the taxpayer's background and the history of intercompany transactions;
  • all intercompany transactions in the year(s) under exam;
  • the taxpayer's rationale for entering into the transactions;
  • the taxpayer's value chain(s) associated with the intangible, services and/or tangible goods;
  • whether the intercompany transaction is associated with the transfer of an income stream, or contribution to the value, of any intangible; the functions performed, assets employed, and risks assumed by each controlled party of the respective intercompany transaction;
  • how the preparer of the transfer pricing study gained knowledge of each controlled party's functions performed, assets employed and risks assumed; and
  • request supporting documents (interview notes, minutes).
David Forst

David Forst

Practice group leader
Fenwick & West
Tel: +1 650 335 7254
Fax: +1 650 938 5200

David Forst is the practice group leader of the tax group of Fenwick & West. He is included in Euromoney's Guide to the World's Leading Tax Advisers. He is also included in Law and Business Research's International Who's Who of Corporate Tax Lawyers (for the last six years). David was named one of the top tax advisers in the western US by International Tax Review, is listed in Chambers USA America's Leading Lawyers for Business (2011-2014), and has been named a Northern California Super Lawyer in Tax by San Francisco Magazine.

David's practice focuses on international corporate and partnership taxation. He is a lecturer at Stanford Law School on international taxation. He is an editor of and regular contributor to the Journal of Taxation, where his publications have included articles on international joint ventures, international tax aspects of M&A, the dual consolidated loss regulations, and foreign currency issues. He is a regular contributor to the Journal of Passthrough Entities, where he writes a column on international issues. David is a frequent chair and speaker at tax conferences, including the NYU Tax Institute, the Tax Executives Institute, and the International Fiscal Association.

David graduated with an AB, cum laude, Phi Beta Kappa, from Princeton University's Woodrow Wilson School of Public and International Affairs, and received his JD, with distinction, from Stanford Law School.

Larissa Neumann

Larissa Neumann

Tax attorney
Fenwick & West
Tel: +1 650 335 7253

Larissa Neumann focuses her practice on US tax planning, tax controversy, and tax litigation for corporations, with an emphasis on international transactions. She has broad experience advising US companies and foreign-based clients on the taxation of cross-border operations, acquisitions, dispositions, restructurings and transfer pricing issues. She has successfully represented clients in federal tax controversies at all levels and has substantial experience managing complex tax controversies. She represents clients from a diverse set of industries and geographic areas. Her clients range in size from high technology start-ups to large Fortune 500 companies.

In 2014, Euromoney selected Larissa for inclusion in the "Americas Women in Business Law Awards" shortlist for Best in Tax Dispute Resolution. Larissa appears as a rising star in Euromoney's "World's Leading Tax Advisers."

Larissa received her J.D. from the University of California, Berkeley, School of Law in 2005. She received her M.A. in public health from Yale University in 2002 and her B.S. in molecular cell biology from University of California, Berkeley, in 2000.

Larissa frequently speaks on US corporate and international tax issues at conferences for professional tax groups, including Tax Executives Institute, International Fiscal Association, Pacific Rim Tax Institute, Bloomberg BNA, and the American Bar Association. She is a member of the ABA Section of Taxation and the International Fiscal Association.

Larissa has published several articles, including recently:

  • US Tax Developments, International Tax Review 2013
  • US International Tax Developments, The Euromoney Corporate Tax Handbook 2012
  • Character and Source of Income from Internet Business Activities, The Contemporary Tax Journal (July 2011)

Fenwick & West has one of the World's Top Tax Planning and Tax Transactional Practices, according to International Tax Review (2014), and is first tier in tax, according to World Tax 2014. International Tax Review gave Fenwick & West its San Francisco Tax Firm of the Year Award a total of five times and its US Tax Litigation Firm of the Year Award a total of three times.

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