The effect of the Veritas Software case in resolving similar disputes pending before the IRS

On November 10 2010 the IRS issued an Action on Decision (AOD) stating its position on the Veritas case. Veritas involved the valuation of the arm’s length charge (buy-in payment) for the contribution of intangible property at the commencement of a qualified cost sharing arrangement (QCSA). The Tax Court in Veritas soundly rejected arguments the IRS has been using at least since 2007 to propose adjustments in cost sharing buy-in cases. The AOD states that the IRS does not acquiesce in the Tax Court’s decision. According to the AOD, the IRS disagrees with the facts found by the Tax Court regarding the nature of the intangibles transferred by the taxpayer when cost sharing commenced. The AOD states that because of the Tax Court’s erroneous factual findings, the court was not required to reach the legal issues discussed by the court in the opinion, with which the IRS does not agree. The AOD cautions taxpayers that the IRS will not follow Veritas in future case. However, the IRS Chief of Appeals recently confirmed that IRS Appeals is taking the Veritas decision into account in negotiating settlements of cost sharing buy-in cases. Thus, there is a conflict within the IRS over the effect of the Veritas decision.

Since April 2007, IRS has classified cost sharing buy-in issues as a Tier One examination issue- the IRS’s highest priority. Subsequently, in September 2007, IRS issued a coordinated issue paper (CIP) setting forth positions to be used by examiners to develop cases involving cost sharing buy-ins. The CIP arguments were soundly rejected by the Tax Court in the Veritas case.

The CIP generally advocates that IRS agents and economists choose, as the best method to evaluate the consideration for a buy-in, the transfer pricing methods set forth in the cost sharing regulations first proposed in 2007 and later adopted in January 2009. The CIP treats the income method (foregone profits), the market capitalisation method, and the acquisition price method as the so-called best methods to evaluate the consideration for pre-2009 buy-in transactions. The CIP generally rejects a taxpayer’s use of the comparable uncontrolled transaction method (CUT) and residual profit split method (RPSM) as the best methods to value a cost sharing buy-in. CUT and RPSM were the two methods most commonly used by taxpayers to value buy-in transactions before 2009.

Shortly after the CIP was issued, the National Office of IRS Appeals asked for taxpayer comments as part of the process of developing formal settlement guidelines to be used by IRS Appeals Officers for resolving cost sharing buy-in cases. Many organisations and taxpayer representatives submitted comments that were generally critical of the legal and economic theories set forth in the CIP. Appeals has never issued formal settlement guidelines for these pre- 2009 buy-in cases. Speculation is that settlement guidelines were never issued because some officials in Appeals had serious doubts about the validity of the positions espoused in the CIP. Recently, the National Director of Appeals has confirmed that Appeals Officers are taking the Veritas decision into account in resolving pending cases where taxpayers are challenging pre- 2009 buy-in adjustments that were made by IRS Exam using the principles of the CIP.

Summary of CIP issues relevant to pre-2009 buy-in cases

There are two basic fact patterns set forth in the CIP: one for initial buy-ins and another for what is referred to as a subsequent acquisition buy-in. An initial buy-in occurs at the time that a cost sharing agreement is first put into place. There are two methods that the CIP deems to be the best methods for valuing buy-ins in the initial buy-in situation: 1) the income method (also referred to as the foregone profits method); and 2) the market capitalisation method. The CIP also describes the acquisition price method as the best method to use in a subsequent acquisition buy-in case.

The CIP dismisses all of the specified transfer pricing methods that could be used by taxpayers as being the best method for either the first or second type of buy-in situation. These methods are dismissed as being fundamentally inconsistent with the nature of buy-in intangibles or the economic circumstances assumed to be involved in a cost sharing buy-in situation.

There are a number of factual assumptions or assumed economic principles that are set forth in the CIP. The assumptions used by the CIP are:

·        A cost sharing buy-in transaction is akin to a sale of the right to earn future profits from the geographic area assigned to the foreign cost sharing party;

·        At arm’s length, the party contributing intangibles is entitled to 100% of the future economic rents to be earned from the contributed intangibles less a return for the contributions made by the receiving party: an investor return for agreeing to make cost sharing payments and a return for routine economic functions performed;

·        Buy-in intangibles are classified as a platform from which all future profits arise;

·        Buy-in intangibles are broadly defined to include workforce in place and synergies, as well as traditional intangibles that are best valued in the aggregate;

·        Buy-in intangibles are assumed to have an indefinite useful life. That is, buy-in intangibles (platform contributions) are assumed to be present in all future intangibles or products until the end of time.

The Veritas Case

  The Veritas case dealt with the core issue that is present in the IRS CIP- that is, how to apply the arm’s length standard when valuable and unique intangible property is transferred at the start of a QCSA. In part, the Veritas decision was a technical decision focused on defining pre-existing intangible property that is subject to the buy-in. However, the Veritas decision found the court taking a practical, fact-based approach to applying the arm’s length standard, in contrast to the  more theoretically based IRS approach. 

  Veritas valued the buy-in based on license transactions that Veritas had entered into with third party OEMs, such as Hewlett-Packard and Sun Microsystems, using the third party royalty rates with a declining royalty feature that eliminated the payments after four years. The declining royalty income stream was then discounted into a net present value (NPV) that, after adjustment, resulted in cash buy-in payments in 1999-2002 of $124.3 million. 

IRS subsequently examined the buy-in and proposed adjustments using the principles of the CIP. The adjustments proposed during the IRS examination ranged from $1.9 billion to $4 billion. The IRS Notice of Deficiency proposed a buy-in adjustment of $2.5 billion using the income (foregone profits) method as well analysis of the company’s market capitalisation (market cap method) and acquisitions (acquisition price method). However, after the Tax Court proceeding began, IRS amended its position to ask for an adjustment to the buy-in of $1.675 billion based on the foregone profits method and income method.

  The Tax Court had little difficulty in finding that the IRS original and revised adjustments were “arbitrary, capricious and unreasonable” and, thus, invalid. The court held that the taxpayer’s declining royalty using a slightly different subset of OEM licenses was, after a few minor adjustments, the best transfer pricing method.

The court held that the IRS income method employed the wrong legal standard in characterising the buy-in license as akin to a sale of the foreign business because the IRS income method included the value of property developed through the cost sharing arrangement, not just pre-existing intangible property as required by the regulations. The court also rejected the IRS attempt to value identified and unidentified intangibles in the aggregate through the income method, which the court said was another way of valuing intangibles developed after cost sharing, not pre-existing intangibles. Moreover, the court said that the general classes of intangibles the IRS claimed were transferred (synergies, access to R&D work force, access to marketing work force) either did not exist (synergies), had little value (marketing intangibles) or did not have value independent of the services of individuals (work force in place)- the legal standard for defining an intangible subject to the transfer pricing rules.

Moreover, the court rejected the IRS assumption that the life of the transferred intangibles was indefinite- a standard argument made by IRS in these types of cases. Finally, the court rejected the IRS objections to using OEM agreements as comparables. In short, the Tax Court rejected nearly every standard argument set forth in the cost sharing CIP.

  Although the Tax Court accepted the basic CUT method used by the taxpayer, the court used a different subset of license agreements, which the court held were more comparable to the buy-in license. The court determined that the useful life of the transferred intangibles (determined without post cost sharing improvements) was four years. The court then adjusted the beginning royalty rate down ratably over four years. Finally, the court adjusted the buy-in to take into account the value of trademarks and trade names that were transferred (slightly less than $10 million), adjusted the discount rate to compute the lump sum amount and directed the parties to agree on the value of the sales contracts that had been transferred to Veritas Ireland.

Veritas in the aftermath of the IRS AOD

An AOD is a document issued by the Office of Chief Counsel of the IRS that explains the IRS position on an adverse decision that the IRS has not appealed. In this case, IRS has not appealed Veritas and the Tax Court decision has become final. Because IRS Examination has not withdrawn the CIP, IRS Exam and the Chief Counsel lawyers will continue to follow the CIP. However, the Tax Court decision is the law on the IRS CIP position.

RS Appeals has a statutory mandate to resolve cases based on the legal and factual merits of a case. Appeals is independent from Exam and the Chief Counsel’s Office. Appeals is taking Veritas into account to settle cases. Because the Tax Court has rejected nearly every technical argument or economic assumption set forth in the CIP, taxpayers with adjustments to pre-2009 buy-ins will generally need to support the buy-in amounts using the transfer pricing tools and arguments that were used to resolve buy-in cases before the CIP was adopted. In essence, this means carefully identifying all intangibles made available for research to the QCSA participants, supporting the useful life (without further improvement) of the pre-existing intangibles and making appropriate adjustments to improve comparability between the intangibles transferred to the QCSA participants and the intangibles transferred in the uncontrolled comparable transactions.

Mike Patton (mike.patton@dlapiper.com) is a partner in the Century City (Los Angeles, CA) office of DLA Piper. The author was the editor and a contributing author of the Transfer Pricing White Paper referenced in the text of this article.