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
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Executive summary
In a T.C. opinion1 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
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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$2254.5 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 2005 – 2006, “[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 Code3 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
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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 1.482-4(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.
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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.
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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 2011. 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.
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