US Tax Court holds IRS was arbitrary, capricious and unreasonable in determining Amazon subsidiary s buy-in payment

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1 28 March 2017 International Tax Alert News from Transfer Pricing US Tax Court holds IRS was arbitrary, capricious and unreasonable in determining Amazon subsidiary s buy-in payment EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Executive summary In a T.C. opinion 1 of over 200 pages released on 23 March 2017, Amazon.com, Inc. & Subsidiaries v. Commissioner, the Tax Court held that the Internal Revenue Service s (IRS s) determination of the cost sharing buy-in payment relating to intangibles transferred from the parent corporation, Amazon.com, Inc. (Amazon US), to its Luxembourg subsidiary (Amazon Lux), was arbitrary, capricious, and unreasonable, and that Amazon US s comparable uncontrolled transaction (CUT) method was the best method to calculate the requisite buy-in payment. The IRS asserted the buy-in payment did not meet the arm s-length standard for a variety of reasons, including that the transferred property had an indeterminate useful life. The Tax Court also held that the IRS abused its discretion in determining that 100% of the costs captured in Amazon US s technology-and-content cost center constituted intangible development costs (IDCs), and that Amazon US s cost-allocation method for these costs was reasonable. Detailed discussion Background In 2005, Amazon US entered into a cost sharing arrangement with Amazon Lux, granting Amazon Lux the right to use certain pre-existing intangible property (IP) in Europe to operate a website business. Under the terms of the

2 2 International Tax Alert News from Transfer Pricing agreement, Amazon Lux had to make an upfront buyin payment for the pre-existing intangible property and then annual payments to fund ongoing IDCs. In filing its tax return, Amazon US used an unspecified income-based method to determine that Amazon Lux was required to make a US$ million buy-in payment over seven years. Upon audit, the IRS determined that Amazon US s method was inappropriate and applied the discounted cash flow (DCF) method. Under the DCF method, the IRS determined that the buy-in-payment should be $3.4 billion. The IRS further asserted that 100% of technology and content costs constituted IDCs for cost-sharing purposes. Amazon US disagreed and petitioned the Tax Court, arguing that the IRS s determination was contrary to Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009), a case in which the Tax Court rejected a method similar to the DCF method for determining buy-in payments. Detailed analysis Veritas In its opinion, the Tax Court noted that the IRS invited the Tax Court to interpret legal statements in the Veritas opinion as constituting dicta, or to outright overrule such legal statements. The Tax Court did neither, and in fact directly applied the principles of the Veritas opinion to this case. Pre-existing intangibles At the outset of the opinion, the Tax Court held that the IRS s expert improperly included subsequently developed intangibles in his valuation of the buy-in payment, rather than restricting his valuation to pre-existing intangible property. The Tax Court emphasized that those subsequently developed intangibles would have been funded by Amazon Lux s future cost-sharing payments, and therefore Amazon Lux should not have to pay for them as part of the buy-in payment. The Tax Court explained that under the cost sharing regulations in effect during , [t]he regulations make clear that the buy-in payment represents compensation solely for the use of pre-existing intangibles and reiterated its position in the Veritas opinion that [b]y definition, compensation for subsequently developed intangible property is not covered by the buy-in payment. The Tax Court s opinion explains that pre-existing intangibles were those intangibles owned by Amazon US and made available to Amazon Lux at the time of the buy-in transaction. The Tax Court also found that in addition to the value of the pre-existing intangibles, Amazon Lux was required to compensate Amazon US for the research value present in the pre-existing IP at the time of the transfer and required adjustments to account for said value. Workforce in place, goodwill and going concern The Tax Court also held that the DCF method improperly included the entire enterprise value rather than just the specific intangibles transferred. The Tax Court noted that the buy-in payment is made for intangibles as defined in Internal Revenue Code 3 Section 936(h)(3)(B), and held that items such as workforce in place, going concern value, goodwill, growth options, corporate resources and corporate opportunities are not included in the definition of intangibles in Section 936(h)(3)(B). Accordingly, the Tax Court held that these items were not compensable and should not have been included in computing the buy-in payment for pre-existing intangibles. Aggregation of transactions As in Veritas, the IRS relied on the aggregation of transactions to justify the use of the DCF method to value, in perpetuity, the intangible property transferred by Amazon US to Amazon Lux. The Tax Court, as in Veritas, rejected aggregation for the following reasons: (a) the transactions were structured as licenses and not as a sale of an entire business and therefore should not be viewed as akin to a sale ; (b) workforce in place, goodwill, going concern, growth options, corporate resources, and opportunities are not Section 936(h)(3)(B) intangibles and are therefore non-compensable under the regulations in effect at the time and should not be included with assets such as technology, trademarks and customer information, which are clearly Section 936(h)(3)(B) intangibles and are compensable; (c) the different transferred intangibles have different lives and decay rates and aggregation reduces the reliability of the method by blending these different lives and decay rates; and (d) aggregation of intangibles risks inclusion of subsequently developed intangibles in the valuation. Realistic Alternatives The Tax Court also rejected the IRS argument that in determining the value of the buy-in payment the Court should consider Amazon US s realistic alternative of continued ownership of the intangibles in the United States. The Tax Court concluded that requiring the parties to determine the buy-in payment as if the parties had not elected cost sharing, but had continued to operate the business as they had done previously would have made the

3 International Tax Alert News from Transfer Pricing 3 cost-sharing election altogether meaningless. In addition, the Tax Court indicated that the transaction as actually structured by Amazon US was a cost-sharing arrangement, and the IRS does not contend that the structure lacked economic substance. The Tax Court went on to note that the regulations in effect at the time of the transaction unambiguously entitled Amazon US to enter into a [costsharing arrangement] and that it cannot be deprived of this entitlement on the theory that it had the alternative of doing something else. Life of pre-existing intangibles The Tax Court noted that if Amazon Lux was only required to compensate Amazon US for pre-existing intangibles, it was critical to determine the useful life of these intangibles. Consistent with Veritas, the Tax Court determined that: (a) the IRS s assumption of an indefinite life for the pre-existing intangibles was inconsistent with the statutory definition of intangibles under Section 936(h)(3)(B) and Treas. Reg. Section (b) as well as the cost sharing regulations in effect at the time; (b) the IRS should have employed a decay curve because pre-existing intangibles are replaced by newly developed ones; and (c) it was appropriate to consider a tail to capture the research value of the pre-existing intangibles. The Tax Court also noted that although the IRS argued that the intangibles had an indefinite useful life, the IRS expert admitted at trial that the practical effect of assuming an indefinite useful life in this case was the same as assuming a perpetual useful life. CUT method is preferred over other methods The transfer pricing regulations require the application of the best method for the determination of the arm s length price. While the IRS argued that the DCF constituted the best method, the Tax Court (as in Veritas and many previous cases) determined that the CUT method constituted the best method to determine the arm s length price for the buy-in payment. The Court concluded that while Amazon US s CUT method constituted the best method, it was necessary to adjust the CUTs to reach an appropriate arm s length price. Implications The Tax Court decision provides taxpayers with very important lessons, discussed below. Importance of useful life of intangibles Useful life was one of the key elements of the Veritas and Amazon decisions, and taxpayers should focus on determining and supporting with factual evidence the useful life of the transferred intangible. Input from persons familiar with the business is particularly important. Amazon US presented at least four engineers to support its determination of the useful life of the website technology. A taxpayer s analysis of useful life should be based on the particular facts and circumstances of the intangible in question, and the IRS s default assertion that most intangibles have perpetual lives does not meet this standard. For example, in Amazon, based on the facts entered into the record, the Tax Court rejected the IRS s determination of indefinite/perpetual useful lives and found that the website technology had a 7-year useful life (with decay plus an additional tail), the trademarks and marketing intangibles had a 20-year useful life (with decay), and the customer information had a 10-year useful life. The Tax Court has repeatedly preferred CUTs The Tax Court has repeatedly preferred CUTs, even if those CUTs represent imperfect comparable transactions. Although the use of corroborative methods is an excellent way of reinforcing the reliability of a primary method (as emphasized by the US transfer pricing regulations and the Organisation for Economic Co-operation and Development Transfer Pricing Guidelines), CUTs, when available, often represent the best method of determining the arm s length price and internal CUTs can be particularly persuasive because of they reflect the taxpayer s actual factual circumstances. Court appears to put some limits on re-characterizing a transaction and the application of realistic alternatives Another important lesson from the Amazon opinion is the importance, when entering into a cost sharing arrangement, of rigorously following the cost sharing requirements. The Tax Court indicated in Amazon that since the taxpayer had followed the cost sharing requirements and the transactions had economic substance, the IRS was barred from re-characterizing the transaction. Perhaps even more importantly, the Tax Court also appeared to indicate that the taxpayers compliance with the cost sharing requirements limited the application of the realistic alternative principle.

4 4 International Tax Alert News from Transfer Pricing The Tax Court included language that indicated that the application of the realistic alternatives principle in connection with the cost-sharing regulations in effect at the time of the transaction could be viewed as an improper recharacterization of a transaction. Income method While the CUT method still is the preferred method for the US Tax Court, the IRS has been pushing for the adoption of income based methods through its issuance of the temporary cost-sharing regulations in 2009 and then final cost-sharing regulations in Although this case deals with the pre-2009 regulations, some of these concepts are similar to those in the current regulations. Issues such as useful life and the presence of CUTs would appear to be applicable issues under the current rules. Moreover, as this case demonstrates, the facts are key to the results and appear to be persuasive over predetermined prescriptive regulatory approaches. Endnotes 1. A T.C. Opinion is published by the Tax Court and has precedential value as contrasted with a T.C. Memo, which is not published by the Tax Court (but is often published by reporting services) and does not have precedential value. 2. Currency references in this Alert are to US$. 3. All Section references are to the Internal Revenue Code of 1986, and the regulations promulgated thereunder.

5 International Tax Alert News from Transfer Pricing 5 For additional information with respect to this alert, please contact the following: Ernst & Young LLP, US Transfer Pricing Controversy Services David Canale, Washington DC david.canale@ey.com Anne Welsh, Seattle anne.welsh@ey.com Thomas Vidano, Washington DC thomas.vidano@ey.com Dan Karen, Atlanta dan.karen@ey.com Carlos Mallo, Washington DC carlos.mallo@ey.com

6 6 International Tax Alert News from Transfer Pricing Ernst & Young LLP, International Tax Services US Transfer Pricing Controversy Services David Arnold David Canale Paul Chmiel Ken Christman kenneth.christmanjr.com David Farhat Hiro Furuya Peter Griffin Fred Johnson Ameet Kapoor Dan Karen Carlos Mallo Dick McAlonan Tom Ralph Craig Sharon Tom Vidano Miller Williams Transfer Pricing leaders Ernst & Young LLP, Minneapolis Peter Griffin Ernst & Young LLP (Canada), Ottawa Tom Tsiopoulos Mancera, S.C., Mexico City Enrique Gonzalez Ernst & Young Ltda., Bogota Andres Parra Kost Forer Gabbay & Kasierer, Tel Aviv Lior Harary-Nitzan Ernst & Young LLP, US Area Leaders Larry Eyinla, Atlanta Colleen Warner, Chicago Lonnie Brist, Houston Tracee Fultz, New York Barbara Mace, New York (Financial Services) Anne Welsh, Seattle David Canale, Washington, DC (National Tax) Dick McAlonan, Washington, DC (National Tax)

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