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 pre-existing intangibles.
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 assets.
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 questionable positions:
- 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 entire business.
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.
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 rate.
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 US.
The IRS argued two reasons for its cancellation of the APAs:
- Misrepresentations, mistakes as to a material fact, and failures to state a material fact during the APA negotiations; and
- 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 APA.
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 assumption.
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 § 965(b)(3).
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 Neumann|
Fenwick & West