Economic Issues Arising from the Tax Court Decision in the Amazon Transfer Pricing Case

Transcription

1 Tax Management International Journal TM Reproduced with permission from Tax Management International Journal, 46 TM International Journal 655, 11/10/17. Copyright 2017 by The Bureau of National Affairs, Inc. ( ) Economic Issues Arising from the Tax Court Decision in the Amazon Transfer Pricing Case By Clark Chandler * OVERVIEW Earlier this year, the U.S. Tax Court issued its decision in Amazon.com, Inc. v. Commissioner. 1 The case involved various issues, with the largest dollar issue arising because of the buy-in payment that Amazon s Luxembourg affiliate made to Amazon US when the two entities entered into a cost sharing agreement (CSA) in Amazon had computed a buy-in payment of $254.5 million. The Internal Revenue Service, upon audit, determined that the buy-in payment should be more than 10 times larger, at $3.468 billion. 2 As will be discussed in more detail below, I believe that the economic experts retained by the taxpayer and the IRS reached very different conclusions as to * Clark Chandler is a partner with Economics Partners LLC in Washington, D.C. The opinions expressed in this article are the author s alone, and do not represent the views of Economic Partners T.C. No. 8 (Mar. 23, 2017) (hereinafter, Amazon ). 2 Amazon, valued at about $467.4 billion, successfully challenged the IRS s income adjustment of $2.2 billion and resultant tax bill of $234 million. Amazon was due to get a $7 million refund after calculations filed to the Tax Court on June 29, 2017, showed it had an overpayment of $9.55 million for 2005 and a tax bill of $2.54 million for On September 29, the IRS notified the Tax Court that it would appeal the Amazon decision. Other of the court s considerations included issues around the definition of the intangible development costs that had to be cost shared and the approach used to compute the allocation of benefits. This article, however, focuses only on the buy-in payment. the value of the buy-in payment because they were asked to value different things. The taxpayer s experts were asked to value the specific intangible property defined in the regulations (the 936(h) intangibles ) while the IRS s experts were asked to value either the cash flows associated with the transfer of the overall business or the cash flows that would have resulted under a different business arrangement in which Amazon US continued to fund the development of intangibles. The latter included profits that are commonly associated with attributes such as business opportunities, goodwill, and going concern; the former did not. The Tax Court concluded that the legal standard adopted by the taxpayer s experts was the correct one, and consequently found that the IRS adjustment was arbitrary, capricious, and unreasonable. In doing this, the court explicitly reaffirmed the key legal conclusions that were laid out in an earlier landmark decision, Veritas Software Corp. v. Commissioner. 4 However, the Tax Court also said its decision was based on the regulations that were in effect during the years at issue, The 482 regulations have changed substantially since then. Therefore, a key question looking forward is the extent to which those changes have made it more likely that the Tax Court in the future will adopt the approach followed by the IRS. In this article, I will explore how the following economic issues may be affected by the regulatory changes that have occurred since : 1) The definition of intangibles; 2) The life of intangibles; 3) Aggregation; 4) Geographic or other forms of exclusivity; and 5) The application of the concept of reasonable alternatives. 3 All section references are to the U.S. Internal Revenue Code, as amended, or the Treasury regulations thereunder, unless otherwise indicated T.C. No. 297 (2009), nonacq., I.R.B. (2010) (hereinafter, Veritas ) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 1

2 To state the obvious, this is largely a speculative exercise, and as an economist I am focused on the economic considerations that may affect future legal decisions. I am making no predictions as to the legal conclusions that may be reached by the Tax Court in future cases. SUMMARY OF FACTS From its founding until 2005, Amazon US developed and owned almost all of Amazon s key intangibles. In 2005, Amazon US and Amazon Luxembourg ( AEHT ) entered into a CSA. 5 Upon the formation of the CSA, Amazon Luxembourg paid Amazon US $254.5 million to acquire the rights to the pre-existing intangibles owned by Amazon US with respect to the rest-of-the-world (ROW) territories outside of the United States. 6 Amazon US and Amazon Luxembourg also agreed to share in the cost of ongoing intangible development expenses based on their relative shares of expected future benefits. Amazon used a residual profit split analysis to compute a buy-in payment of $254.5 million to be paid over seven years, which was the estimated useful life of the specific pre-existing intangibles (website technology, marketing intangibles, and customer information) transferred to Amazon Luxembourg with the formation of the CSA. The IRS, following its audit, concluded that the buy-in payment should be determined using an aggregated approach rather than as three distinct groups of assets, and that it should reflect the present value of the forgone residual profits of Amazon s ROW business based on an indeterminate (or in effect an infinite) life. Given this, the IRS calculated a buy-in payment of $3.6 billion, later reduced to $3.468 billion. At trial, the primary IRS position was a discounted cash flow (DCF) analysis in which Dr. Frisch, one of the economic experts retained by the IRS, computed the value of the buy-in payment by (a) projecting the net cash flows that would be given up by Amazon US, (b) determining an appropriate discount rate, and (c) computing the present value of those cash flow into perpetuity. As noted above, this led to a value of $3.468 billion. CUT ANALYSES The other economic experts retained by both the taxpayer and the IRS computed the value of the three 5 This discussion is based upon the statement of facts contained in the Tax Court decision in Amazon. 6 There were apparently a series of transactions during 2005 through 2006 in which Amazon US transferred to Amazon Luxembourg three groups of intangible assets: (1) the software and other technology required to operate Amazon s European websites, fulfillment centers, and related business activities; (2) marketing intangibles, including trademarks, tradenames, and domain names relevant to the European business; and (3) customer lists and other information relating to Amazon s European clientele. Amazon at 6. specific intangibles that were transferred using comparable uncontrolled transaction (CUT) analyses. What I found particularly striking in reading the Tax Court decision is that the respective experts substantially relied upon the same or similar data and the same or similar comparables, and adopted (from a 50,000-foot level) broadly consistent assumptions with respect to royalty rates and discount rates yet reached vastly different conclusions as to the buy-in payment. To quote the Tax Court decision: 7 Respondent s and petitioner s experts agree that the CUT method may reliably be used to value separately the website technology, the marketing intangibles, and the customer information, though they disagree mightily about the outcomes that this method should produce. The most important reason for the dramatically different values obtained by the respective experts was that the taxpayer s assumed a specific life for the intangibles that they valued while the IRS s assumed an indeterminate/infinite life. For example, Dr. Higinbotham (an economic expert retained by the IRS) and Dr. Wills (an economic expert retained by the taxpayer) both used royalty rates obtained from various M.com agreements to compute the buy-in payment that would be expected for website technology. There were differences in their interpretation of the agreements: Dr. Higinbotham derived a royalty rate of 4% from the agreements while Dr. Wills derived a range of royalty rates that extended from 1.4% to 2.4% but these differences, while material, in no way explain the gulf between Dr. Higinbotham s $3.3 billion 8 and Dr. Wills s upper-end buy-in payment of $182 million. As a quick way of approximating the difference implied by the royalty rates alone, had Dr. Wills used a royalty rate of 4%, his buy-in computation would have increased to just $303 million 9 still only about one-tenth of that computed by Dr. Higinbotham. The key reason for the vast difference in the buy-in payments computed by Dr. Frisch, Dr. Higinbotham, and Dr. Wills is that they were asked to value very different things. Specifically: Dr. Frisch, in using a discounted cash flow (DCF) based on Amazon s overall cash flows, was asked to determine the value of the business that was supported by Amazon s intangibles (and presum- 7 Amazon at It is interesting to note that the technology value computed by Dr. Higinbotham is close to the value of all residual profits as computed by Dr. Frisch, even though Dr. Frisch used a completely different methodology that was intended to capture the value of all intangibles. 9 Calculated as: $182 million / Some of the difference was due to differences in the discount rates used by Dr. Higinbotham and Dr. Wills Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.

3 ably any other economic assets/attributes) at the time of transfer, including business opportunities/ goodwill and going concern, which valued all intangibles in aggregate and could be expected to have a perpetual life; Dr. Wills was asked to determine the value of specifically defined pre-existing technology as it existed at the time of the transfer, and whose value (whether measured in terms of its use or of its value as a market barrier) could be expected to erode over time; and Dr. Higinbotham was asked to determine the value of Amazon s technology assuming a perpetual life. While the Tax Court did not describe the reasons that Dr. Higinbotham used to support his assumption that Amazon s website technology had a perpetual life, this assumption appears to imply that Amazon US would continue to make the investments needed to sustain the value of the licensed technology. At some level, therefore, the central issue in Amazon came down to whether the buy-in payments needed to reflect (a) the value of specifically defined intangibles with a limited life or (b) the value of intangibles whether valued in aggregate or separately in perpetuity. The taxpayer asked its experts to determine the life of specifically defined intangibles over the period in which the intangible attributes in existence at the time of the transfer would have generated a positive payment from a third party. The IRS asked its experts to value the cash flows that the intangibles in existence would generate in perpetuity, presumably assuming the continued refreshment of the intangibles. Not surprisingly, the different questions gave rise to different answers. 10 Amazon at The first two of these categories represented intangibles that were developed based on R&D carried out after the CSA was established; the third reflects factors such as workforce in place, goodwill and going concern, and growth options that are not intangible property that can be transferred separately from the business. First, Dr. Frisch s business-enterprise TAX COURT DECISION The Tax Court determined that the buy-in payment was for the pre-existing value of the intangibles that were explicitly enumerated in the 482 regulations, and that these intangibles had a limited life ranging from approximately seven years for website technology to 20 years for marketing intangibles. Having reached this conclusion regarding the legal requirements of what had to be paid for, the court rejected the DCF method used by Dr. Frisch because it incorporated at least three items of value over and above the intangibles that had to be paid for. These three items of value were: 10 1) The value of future enhancements in nextgeneration website technology. While this technology performed the same function as the website technology that was transferred, it was substantially modified and enhanced over time, and Amazon Luxembourg paid for these enhancements through its cost sharing payments. 2) The value of new intangibles (including the Kindle, Amazon Prime, the Fire smartphone, Fire TV, digital music/video offerings, cloud computing and storage, and the EFN, which implemented standardized and improved fulfillment operations across Europe) that were not in existence at the time of the transfer, and which therefore were not derived from the website technology that was transferred under the buy-in. 3) The value of Amazon s residual business intangibles workforce in place, going concern, future business opportunities differed from the specifically defined intangibles in that they cannot be transferred separately from the business and often do not have substantial value independent of the services of any individual. The Tax Court also rejected the IRS s argument that the U.S. taxpayer had the reasonable alternative of not entering the cost sharing agreement and that, therefore, the buy-in payment should reflect the present value of the profits it would have earned, had it retained ownership of the intangible property contributed to the CSA. The court rejected this argument on two grounds: 1) It proves too much : As any taxpayer entering into a CSA has the option of not doing so, requiring the same economic outcome under a CSA as would exist absent the CSA would, in effect, make the regulation meaningless; and 2) The IRS needs to respect the business arrangements established by the taxpayer provided they have substance, which also implies the need to respect the economic consequences of these business arrangements. Having rejected the DCF method, the Tax Court then determined the value of each of the three specific intangibles (website technology, marketing intangibles, and customer information) contributed to the CSA. The key attributes of the court s decisions re- approach improperly aggregates pre-existing intangibles (which are subject to the buy-in payment) and subsequently developed intangibles (which are not). Second, his business-enterprise approach improperly aggregates compensable intangibles (such as software programs and trademarks) and residual business assets (such as workforce in place and growth options) that do not constitute pre-existing intangible property under the cost sharing regulations in effect during See Veritas, 133 T.C. at ; see also Guidant LLC v. Commissioner, 146 T.C. 60, (2016). Amazon at Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 3

4 garding the present value of these three discrete intangibles are that they are: 1) all based on CUT data, with the CUT data for both technology and customer information taken from agreements that Amazon reached with third parties and the CUT data for marketing intangibles taken from agreements that were located from a search of public sources and which did not involve Amazon; and 2) fact-specific with respect to how they were used, what adjustments were made, and the life of the intangibles. For example, in the case of technology, the Tax Court started with the royalty rates contained in the licensing agreements relied upon by both parties experts, and then allowed the royalty rate to ratchet down over a seven-year life. The court also concluded that the pre-existing intangibles contributed to the CSA had a research value that was not limited to the continued use of source code that existed at the time that the CSA was formed, but which reflected the value of intangible property made available for purposes of research in the intangible development area. 11 The court concluded that this research value could be derived from the royalty rate in place at the end of the seven-year life of the intangibles over a life that was approximately half that of the underlying technology. 12 CHANGES IN REGULATORY STANDARDS The Amazon decision was based on the regulations in effect during the years at issue 2005 and 2006 and the Tax Court specifically noted that regulations issued after that time were not relevant, stating: 13 In 2011 the Secretary finalized new cost sharing regulations that replaced the 1995 regulations involved in this case. T.D. 9568, I.R.B Issued in temporary form in 2009 and effective (as relevant here) in January 2009, these new regulations replaced the buy-in payment with the concept of a platform contribution transaction (PCT). 74 Fed. Reg (Jan. 5, 2009). The preamble to the temporary regulations noted objections from commenters that the PCT included elements such as workforce, 11 Amazon at This conclusion was based on the Tax Court s analysis of the specific attributes of Amazon s website technology, and a different fact pattern may have led the court to reach different quantitative results. 13 Amazon at 82. goodwill or going concern value, or business opportunity, which in the commentators view either do not constitute intangibles, or are not being transferred, and so, in the commentators view, are not compensable. 74 Fed. Reg The Treasury Department replied by stating that the new regulations do not limit platform contributions that must be compensated ***to the transfer of intangibles defined in section 936(h)(3)(B). Id. As we noted in Veritas, 133 T.C. at , , the 2009 regulations did not apply in that case, and they have no application to this case either. Therefore, any evaluation of the implications of the Tax Court s decision in the Amazon case is complicated by the fact that the regulations have changed, and legal conclusions reached under the regulations that are currently in place may be different from those reached in Amazon. One set of changes in U.S. transfer pricing regulations came with the finalization of the cost sharing regulations in Some of the key changes include: The introduction of the need to pay for a platform contribution transaction ( PCT ), which includes all resources, capabilities, or rights used to develop future intangibles, rather than a requirement to pay a buy-in based on the value of the transferred pre-existing intangibles. The definition of what needs to be paid for as part of the PCT all resources, capabilities, or rights is clearly intended to capture value over and above that which is included in the 936(h) intangibles. Substantial limitations on the structure of the cost sharing transaction that have the effect, when taken together, of making the transfer look like the transfer of an ongoing business. These changes require that each cost sharing partner have exclusive and perpetual rights to a given territory or field of use for the intangibles covered by the CSA; and the agreement must in effect cover all intangibles needed to operate the business at issue. 14 Collectively, these restrictions can arguably be interpreted as making each CSA participant something more akin to a business owner than simply the licensee of a set of intangibles. The introduction of the income method, which is explicitly based on the difference in the present value of cash flows under cost sharing and under the reasonable alternative of not cost sharing 14 This is at least my view on the intent of the various requirements imposed by the 2011 cost sharing regulations; once again, I am not a lawyer and am offering no conclusions about how these detailed requirements will be interpreted in practice Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.

5 but rather entering a licensing transaction in which the licensor funds ongoing intangible development. Under the income method, the value of the PCT is computed as the difference between the income that would have been earned under the business terms that existed prior to the formation of the CSA (e.g., with the transferor bearing the costs and risks of intangible development activities) and under the business terms that existed after the formation of the CSA (e.g., with the transferee bearing the costs and risks of intangible development activities). The computation of the value of a PCT under the income method is therefore explicitly based on the concept that the transferor has the reasonable alternative of not entering the CSA. It is worth noting that these changes apply explicitly only to cost sharing arrangements and, therefore, there is at least in my mind a considerable amount of uncertainty as to their impact on a traditional Reg transfer of intangibles. While there is a cross-reference that appears to allow the IRS to at least assert that the Reg methods apply to Reg transactions as well, it is not clear that this is substantially different than the requirement to use the most reliable method even if it is an unspecified method. Moreover, the requirement that the payment needs to cover all resources, capabilities, or rights and the restrictions on the structure of the transaction appear to be specific to the cost sharing transactions. However, the temporary 482 regulations issued in conjunction with the proposed 367 regulations in September appear to bring concepts, that were first incorporated into the cost sharing regulations, into the 482 regulations generally. The first of these is the requirement that arm s-length compensation be consistent with and account for all value provided in a transaction between controlled parties: The 367 regulations were then issued in final form in December The final 367 regulations effectively require taxpayers to include foreign goodwill and going concern value in transfers that were made under 367 by eliminating the prior 367(d) exception for foreign goodwill and going concern and call for a close coordination of transfers made under 367 and under Reg T(i)(A)....All value provided between controlled taxpayers in a controlled transaction requires an arm s length amount of compensation determined under the best method rule of (c). Such amount must be consistent with, and must account for all of, the value provided between the parties in the transaction, without regard to the form or character of the transaction. For this purpose, it is necessary to consider the entire arrangement between the parties, as determined by the contractual terms, whether written or imputed in accordance with the economic substance of the arrangement, in light of the actual conduct of the parties... The language above appears to introduce two key concepts, namely that: (a) the compensation must reflect all value a broad and relatively vague term; and (b) the amount of such value is independent of the form or character of the transaction. Second, the temporary regulations emphasize that an aggregate analysis of transactions may be more reliable than looking at each transaction on a standalone basis, stating that: 17 (a) the consideration of the combined effect of two or more transactions may need to be considered in aggregate to capture possible synergies among the transactions and (b) transactions may be aggregated even when they do not involve related products or services. The general theme behind this change is that there are often cases in which the aggregate value of a group of transactions may be greater than the simple sum of their individual values due to synergies, and that in such cases the larger value should be used. The temporary regulations further state that a coordinated/aggregated analysis should be applied when value needs to be determined under different sections of the regulations. 18 Finally, in Example 11, the temporary regulations state that, under the realistic alternatives principle, the form of the transaction should not affect the amount that is paid, and while the IRS would respect a license that has substance, it may determine the value assigned to the license under a different structure... because P could have directly exploited the manufacturing process and manufactured product X itself, this realistic alternative may be taken into account under (d) in determining the arm s length consideration for the controlled transaction. 19 THE KEY QUESTION: WHAT NEEDS TO BE PAID FOR The IRS has had a long-standing concern that U.S. taxpayers have been able to transfer profits from U.S. entities to offshore entities for less than full consideration, particularly under cost sharing. The key reason for this concern is that taxpayers have determined the value of buy-in payments based on the intangibles defined under 936(h), which generally have a limited life, while entering business arrangements that have had the effect of transferring profits earned in perpetuity. As will be discussed below, the net cash flows expected from a business enterprise are often greater than the expected value of the net cash flows generated by the specific (intangible and other) assets owned by the business enterprise. 17 Reg T(i)(B). 18 Reg T(i)(C). 19 Reg T(ii)(B) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 5

6 In both Veritas and Amazon, the Tax Court determined that a buy-in payment made on entering a CSA needs to reflect the arm s-length value of pre-existing intangibles. The 936(h) intangibles include: 1) patents, inventions, formulae, processes, designs, patterns, or know-how; 2) copyrights and literary, musical, or artistic compositions; 3) trademarks, trade names, or brand names; 4) franchises, licenses, or contracts; 5) methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data; and 6) other similar items, or an item which derives its value not from its physical attributes but from its intellectual content or other intangible properties. The present value of such intangibles, however, is generally less than the present value of the business that is using these intangibles, even after adjusting for the value of tangible and financial assets. This difference is illustrated in Figure 1 below, where the downward sloping line showing cash flows From Pre- Existing Intangibles shows profits from intangibles declining over time and eventually reaching zero, while the line showing cash flows From Business is a steadily upward sloping line. Profits Figure 1 Cash Flow Projections Years From business From pre-existing intangibles At a high level, Amazon s economic experts were asked to determine the present value of cash flows related to the downward sloping line, while the IRS s were asked to determine the present value of cash flows associated with the upward sloping line. If the definition of intangibles is limited to the specific preexisting intangible property listed in the regulations, then (with the possible exception of legal rights that are granted into perpetuity such as trademarks) intangibles and perhaps especially technology intangibles logically tend to have a limited life. DOS may have launched Microsoft on its way, but it is hard to argue that DOS plays a major role in the technology used in either the current Microsoft operating system or in other varied products offered by Microsoft (the office suite, its investment in the cloud, Internet browsing, the X-BOX). Given this, the value of such specifically defined intangible property can be expected to fall over time. However, most businesses are expected to grow in terms of both revenues and profits. Therefore, if the payment needed is defined in terms of the cash flows that can be expected from the business supported by pre-existing intangibles rather than the intangibles per se, the expected cash flows logically reflect the expected investment flexibility of the business. While the technology underlying floppy disks has relatively little overlap with CD technology and virtually none with a memory stick, being in the storage business may make it likely that a company will invest in new storage technologies and will be in a better position to market such storage technology products than someone else. A business enterprise based on storage technology may also logically expand into other related business, such as the storage and sale of data libraries, that are not outgrowths of the pre-existing technology per se but are plausible extensions of its core business. Neither definition is right or wrong per se. Indeed, financial statement valuations employ both definitions the first to determine the value of specifically identifiable intangible property that can be transferred separately from the business, and the second as the starting point for determining the goodwill and going concern value of a business. However, these two measures address two different things, and therefore a buy-in payment based on the present value of 936(h) intangibles will generally be lower than the value of all intangibles based on the DCF of the overall business. The IRS s concern is that the transfer of all or essentially all of the 936(h) intangibles owned by a business (at least with respect to a specific geography or field of use) in substance also implies the transfer of the entire business, and all of the profits/net cash flows associated with the business. Thus, limiting the value of a buy-in payment to just the value of the 936(h) intangibles allows taxpayers to transfer the potentially much greater value of the entire enterprise (at least as it relates to the specific geography or field of use at issue). In effect, the total value of the business enterprise is transferred for a payment that reflects just a portion of that value. In both Veritas and Amazon, the IRS argued that: (a) the transfers of 936(h) intangibles made as part of the establishment of the respective CSAs were akin to the transfer of a business ; (b) the preexisting 936(h) intangibles provided the foundation for future intangible development; (c) the intangibles needed to be valued in aggregate; and (d) the value of the buy-in payment should be based on the reasonable alternative of not entering into a CSA. These arguments were all designed to link the value of the cash flows generated by the business enterprise to the Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.

7 transfer of the 936(h) intangibles contributed to the CSA. In both cases, the Tax Court decided that the only intangible transfers that created taxable income were the 936(h) intangibles, regardless of whether the overall business profits were in fact shifted from a U.S. legal entity to an offshore entity as a result of the transfer of these 936(h) intangibles. Therefore, even if the value of business opportunities, goodwill, and going concern, etc., were shifted from a U.S. legal entity to an offshore entity, they were not compensable and this was not a taxable event. The regulatory changes that have taken place since are clearly designed to put in place legal requirements that favor the higher definition of value. POTENTIAL IMPLICATIONS OF THE CHANGES IN THE 482 REGULATIONS Many of the changes in the 482 regulations that have been briefly discussed above support various arguments that the IRS lost in the Tax Court s Amazon decision. This obviously raises the possibility that under the regulations in place currently the Tax Court would reach a different conclusion from what it did under the regulations that were in place in However, the changes to the 482 regulations do not address explicitly what I view as the central issue in the Amazon case: Does goodwill and going concern need to be paid for as part of a PCT in a newly formed CSA or in other transfers of intangibles? While this in theory could have been done by simply changing the definition of intangibles, outside of cost sharing the regulatory changes have left the definition of intangibles largely intact (at least in the 482 regulations), and have instead attempted to bring in goodwill and going concern value indirectly through a combination of changes that limit the business arrangements that are allowed under cost sharing, pushing for an increased focus on aggregation, and the invocation of the concept of realistic alternatives. THE SHIFT TO RESOURCES, CAPABILITIES, OR RIGHTS The final CSA regulations issued in 2011 change the definition of what needs to be paid for under a CSA from the 936(h) intangibles in existence at the time a CSA is formed to a PCT, which covers all resources, capabilities, or rights. The 2011 cost sharing regulations define a PCT as follows: 20 A platform contribution is any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to the intangible development activity (whether prior to or during the course of the CSA) that is reasonably anticipated to 20 Reg (c)(1). contribute to developing cost shared intangibles. The determination of whether a resource, capability, or right is reasonably anticipated to contribute to developing cost shared intangibles is ongoing and based on the best available information. Therefore, a resource, capability, or right reasonably determined not to be a platform contribution as of an earlier point in time, may be reasonably determined to be a platform contribution at a later point in time. The PCT obligation regarding a resource or capability or right once determined to be a platform contribution does not terminate merely because it may later be determined that such resource or capability or right has not contributed, and no longer is reasonably anticipated to contribute, to developing cost shared intangibles. The shift in the requirement that a taxpayer entering a CSA needs to make a PCT payment that covers all resources, capabilities, or rights rather than one that simply covers specifically defined pre-existing 936(h) intangibles is clearly intended to broaden the definition of what needs to be paid for. At a very basic level, the pre-existing intangibles used in the development of future intangibles 21 are presumably included within the definition of resources, capabilities, or rights, and therefore the payment for the latter must be equal to or greater than the payment for the former. As a specific example, the IRS views the R&D workforce, which was not part of pre-existing 936(h) intangibles under the prior regulations, as one component of resources, capabilities, or rights. A key question, however, is whether the Tax Court will interpret the definition of resources, capabilities, or rights only as something that the taxpayer must have at the time it enters a CSA, or whether it also includes resources, capabilities, or rights developed/ obtained after entering the CSA. While the definition of the PCT states that resources, capabilities, or rights developed, maintained, or acquired during the course of the CSA have to be considered, it seems a stretch to say that the initial PCT payment must cover things that are not in some way linked to resources, capabilities, or rights that exist at the time of the initial PCT. (Indeed, additional PCT payments are explicitly required when new resources, capabilities, or rights perhaps obtained through acquisition are brought into a CSA.) Addressing this question requires not just a reading of the regulatory language, but also some understand- 21 The cost sharing regulations distinguish between makesell rights, which are used to manufacture and sell products, and platform rights, which are used in the development of intangibles. Intangible make-sell rights are not included as part of the PCT, but still need to be paid for when transferred from one legal entity to another Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 7

8 ing of the specific factors that are leading to the gap between the value of pre-existing intangibles (shown on the downward-sloping line of Figure 1) and the value of the business enterprise (the upward-sloping line of Figure 1). The profits in this area are attributed to a wide range of factors including business opportunities, synergy values, goodwill, and going concern. The IRS, in making its changes to the definition of what needs to be paid for, has generally taken the position that, whatever the defined area is called, the profits in this gap are generally related to the nonfinancial attributes of the firm at the time of the initial PCT, and are therefore derived from the pre-existing intangibles/resources, capabilities, or rights of the firm. Thus, even though a thumb drive is not a floppy disk, it is a memory storage device, and therefore there is a linkage between the floppy disk and the thumb drive. Or, to put it in a more economic framework, the transferor s intangibles/resources, capabilities, or rights are such that investments in nextgeneration technology will provide economic profits profits greater than those that would be expected by an investor lacking these pre-existing capabilities. However, it is not clear that this is always the case. Take the case of a car company ( CarCo ) that has been selling gasoline-powered cars for decades. CarCo presumably has either developed, bought, or otherwise obtained access to the full range of technology and know-how needed to manufacture and sell cars. Moreover, CarCo almost certainly has the resources and capabilities to design subsequent generations of cars. Now suppose that CarCo realizes that batterypowered electric vehicles are likely to become a significant part of its product offerings at some point in the future. CarCo has no expertise whatsoever in the battery technology that will be needed to make such vehicles. This lack of expertise, however, is unlikely to have an impact on the long-term projected growth rates or profit margins that drive the upward-sloping line in Figure 1 for CarCo. The company, and investors in the company, will assume that CarCo will take the necessary steps to either develop or buy the battery technology that it needs to remake itself into a viable producer of electric- as well as gasoline-powered cars. CarCo does not have any current capabilities with respect to the battery technology that it will need to make and sell battery-powered cars, nor did it have any such capabilities when it entered into its CSA. However, the sales and profits that it implicitly expects to earn from such battery-powered cars are built into its forecasts and expected present value of future profits. If it has a 5% market share now, investors will almost certainly assume that it will find some way of reinventing itself and maintaining its 5% market share into the indefinite future. Given the above: Is battery technology a right, resource, or capability of CarCo at the time it entered into its CSA? Is CarCo s automotive technology a platform for developing the battery technology needed to manufacture and sell electric cars? Depending upon the answers to these questions, should the initial PCT have incorporated all of the cash flows that CarCo expected as a business enterprise? Would the economic answer to these questions change if CarCo establishes an offshore affiliate that is dedicated to the development of battery technology but is not provided access to CarCo s automotive technology through a CSA or license? In short, while the shift in the definition from 936(h) intangibles to all resources, rights, and capabilities is likely to broaden the definition of what has to be paid for, it does not directly address the issue of whether the payment has to be linked to an attribute that exists at the time of the formation of the CSA or whether it also includes unrelated attributes that are obtained/developed at some future point in time. PRE-EXISTING RESOURCES, CAPABILITIES, OR RIGHTS AND LIFE The basic question raised in the discussion above is whether a payment for intangibles/resources, capabilities, or rights that exist as of a specific date should include the value of intangibles/resources, capabilities, or rights that do not then exist but are developed later, based on intangible development costs incurred. In this regard, there are three broad ways of looking at this question, which I will refer to as a legal definition of life, an economic definition of life, and an ongoing business enterprise definition of life. These three different concepts can be summarized as follows: 22 1) Legal : For an intangible transferred as of Date X, the life of the pre-existing intangible is the period over which it contributes to value (including its value in developing next-generation intangibles) but excludes the value associated with intangible-generating investments made by the transferee after Date X. Under this definition, the value of the battery technology discussed above is not included in the value that needs to be paid for, as it is not something that was owned by the transferor at the time of the transfer. As a general matter, this answer would not seem to depend upon whether we are talking about paying for preexisting intangibles or pre-existing resources, capabilities, or rights, although it is certainly possible to imagine situations in which a developed capability has not crystalized into a specific intangible. This appears to be the definition of life 22 There are a wide range of specific definitions that could be (and often have been) employed, that differ from the abbreviated definitions provided here. I am using these simply as a framework for discussing issues Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.

9 upon which the Tax Court relied in its Veritas and Amazon decisions. 2) Economic : For an intangible transferred as of Date X, the life of the intangible includes the above plus the excess returns/economic profits that are expected at the time of transfer on investments in intangibles made after Date X. Under this definition, the value of the battery technology discussed above may potentially be included in the value that needs to be paid for, if the expected return on the investment in battery technology made by the cost-shared business is greater than that which would have been expected from a standalone investment. Thus, if an investment of $500 in battery technology generated a net return (after repaying the initial $500 investment) of $1,000 when made in the cost-shared business but would have generated a net return of just $300 if it had been made by a standalone business, the investment in battery technology would presumably have contributed $700 in incremental value. There is some attribute of the initial transfer that allows the investment in battery technology to be more profitable than it would have been otherwise, and this value is included in the payment that is made for preexisting intangibles/resources, capabilities, or rights. It is worth noting that this definition does not appear to have been presented to, or evaluated by, the Tax Court in either Veritas or Amazon. 3) Ongoing Business : Under this perspective, the transfer of pre-existing intangibles/resources, capabilities, or rights is, in effect, a transfer of a business. Therefore, the value of the pre-existing intangibles is the same as the value of the business, and the most straightforward way of determining the value of the business is to compute the present value of its cash flows, and to then determine the value of intangibles by deducting the present value of routine profits. As the life of a business is indefinite/perpetual, the cash flows that are used under this approach are also perpetual. It is worth noting that this definition would not appear to be applicable to the transfer of a single specific intangible that was only one of many factors that the transferee needed to operate its business. As noted above, the Tax Court s decisions appear to be based on the first of the three definitions of what needs to be paid for. The court explicitly rejected the third definition: that the transfer was akin to the sale of a business and should be valued appropriately. It did not ask the question of whether Amazon s investments in, for example, the development of the Kindle, were more profitable than those that would have been realized by a standalone investor, which is a necessary question under the second definition. REQUIREMENT FOR GEOGRAPHIC OR FIELD OF USE EXCLUSIVITY One of the requirements introduced in the 2011 changes to the cost sharing regulations is that Each controlled participant must receive a non-overlapping divisional interest in the cost-shared intangibles without further obligation to compensate another controlled participant for such interest. 23 This in essence requires that each participant to a CSA must have exclusive rights to a clearly defined share of the taxpayer s business, and is most commonly implemented through geographic exclusivity. Moreover, each participant must have all rights needed to develop the intangibles required to conduct business within this exclusive territory/field of use, and the transfer is in perpetuity. The requirement for territorial or other divisional exclusivity can perhaps be viewed as a requirement that a CSA must be set up in such a way that the original owner of the business is in effect transferring a share of the business (e.g., the exclusive rights to the non-u.s. market) to a newly formed CSA participant, and that this therefore necessarily reflects the transfer or sale of a business. This presumably strengthens the IRS argument that a PCT payment should be computed on the basis that the overall business has been transferred, and therefore should be based on a valuation method that reflects this (e.g., the present value of all future residual profits). As will be discussed below, the aggregation rules may arguably contribute to this position. This argument is obviously strongest in cases where the U.S. taxpayer entering the CSA is an established U.S. business with no operations outside the United States. In this case, the non-u.s. participant s only contribution is a financial one, and this financial contribution allows it to enter the business in question. The issue is more clouded, however, if the U.S. taxpayer already has established business operations outside of the United States. Under such circumstances, it is more difficult to determine whether the goodwill and going concern component of the business is associated with intangibles only, or whether it includes values that are related to the nonintangible elements of the business, such as local customer networks and other local business interests. In this regard, in its discussion of why Dr. Frisch s DCF analysis was not appropriate, the Tax Court noted that:... AEHT was not an empty cash box. The European Subsidiaries, of which AEHT became the parent, had been in business for approximately six years. They had a skilled workforce; they owned tan- 23 Reg (b)(1)(v)(iii) Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc. 9

10 gible and intangible assets; and they had goodwill and going-concern value One of the key questions looking forward, therefore, is whether the requirement for divisional exclusivity is sufficient to lead the Tax Court to treat a transfer to a new CSA as the transfer of a business and the associated goodwill and going concern value related to that business and whether this will depend upon whether the taxpayer does or does not have an established business in the other territories (or in the specific field of use) at issue. Finally, the requirement for divisional exclusivity in perpetuity is an attribute of the cost sharing regulations, and not of the 482 regulations in general. Taxpayers presumably can still structure transfers outside of the cost sharing regulations in a way that would not be viewed as a perpetual transfer of an exclusive interest in a business. AGGREGATION Another change in regulatory requirements is the IRS s push to have intangibles valued in aggregate, rather than as discrete and separate. The temporary regulations state: 25 (B) Aggregation. The combined effect of two or more separate transactions (whether before, during, or after the year under review), including for purposes of an analysis under multiple provisions of the Code or regulations, 26 may be considered if the transactions, taken as a whole, are so interrelated that an aggregate analysis of the transactions provides the most reliable measure of an arm s length result determined under the best method rule of (c). Whether two or more transactions are evaluated separately or in the aggregate depends on the extent to which the transactions are economically interrelated and on the relative reliability of the measure of an arm s length result provided by an aggregate analysis of the transactions as compared to a separate analysis of each transaction. For example, consideration of the combined effect of two or more transactions may be appropriate to determine whether the overall compensation in the transactions is consistent with the value provided, including any synergies among items and services provided. 24 Amazon at Reg T, Allocation of Income and Deductions Among Taxpayers (Temporary). 26 One of the objectives of the temporary regulations apparently was to prevent some property from being transferred under a different code section (particularly 367) in a way that would not trigger a payment but would lead to a reduction in the value of transfers under 482. I am not addressing this issue in this article. The temporary regulations also specify that if the value of a specific component of an aggregated bundle needs to be determined separately (e.g., because one transaction is with country A while another is with County B), the more reliable aggregate value should be allocated among the different transactions. If this requirement is interpreted as requiring that property intangibles such as those listed in 936(h) have to be aggregated with goodwill and going concern intangibles (e.g., because the 482 intangibles at issue have to be aggregated with a transfer under 367 that includes goodwill and going concern), this would obviously push the valuation answer to one that includes the overall value of the business that is being transferred rather than one that is limited to the value of individual intangibles. However, this would seem to imply that the IRS has already established the principle that goodwill and going concern need to be paid for and, therefore, the value of goodwill and going concern will ultimately be captured regardless of whether the analysis is done on an aggregated basis. The more interesting question is whether the aggregation rules, absent an explicit requirement to include goodwill and going concern intangibles, are likely to increase the amount paid for intangibles. The most obvious potential impact of requiring intangibles to be valued in aggregate and the issue that the IRS points to in the temporary regulations is that of synergies. Given synergies (or dis-synergies) the value of a combined bundle of property may be greater than (or less than) the value of the individual components of the bundle. Thus, even if the value of a trademark is clearly 5% of sales while the value of the technology needed to produce the product being sold under the trademark is also 5% of sales, the value of a license that conveys both trademark and technology rights may be greater than (or less than) the 10% derived by simply adding the two separate royalty rates. And if they are used in the same business, the temporary regulations appear to require that they be valued in aggregate. As a matter of first impression, the three intangibles transferred to the CSA in Amazon (technology, marketing, and customer relationships) appear to qualify for aggregate valuation under the standard set forth in the temporary regulations, as they were all used in the same business and each contributed to the success of that business. Thus, on their face, the regulatory changes that have occurred since appear to strengthen the IRS position that the transfer of the three intangibles should be treated in aggregate. However, the rationale that the IRS has advanced for aggregation that it may be more accurate to determine the value of the bundle that is transferred than to add up the individual components of the bundle...if the transactions, taken as a whole, are so interrelated that an aggregate analysis of the transactions provides the most reliable measure of an arm s length result determined under the best method rule... does not appear to address the Tax Court s primary reason for rejecting the aggregated approach used by Dr Tax Management Inc., a subsidiary of The Bureau of National Affairs, Inc.