Transfer Pricing Alert
This alert reports on two significant developments in the transfer pricing area. The first is the U.S. Tax Court’s decision in Veritas Software Corp. & Subs. v. Commissioner,1 in which the court rejected an IRS adjustment in excess of $2 billion related to intangible property made available to a cost-sharing arrangement and adopted the taxpayer’s methodology (with some adjustments). The second is an announcement by IRS Commissioner Douglas Shulman of a new “Transfer Pricing Practice” within its Large and Mid-Size Business Division to strategically and systematically administer transfer pricing issues.2 Both developments have broad implications.
Veritas: A Major Victory for Taxpayers in Cost Sharing Buy-In Case
The taxpayer, a U.S. software developer/manufacturer, entered into the cost-sharing arrangement with its newly formed Irish subsidiary in 1999 and contemporaneously licensed non-U.S. rights to exploit pre-existing intangibles to the Irish subsidiary in exchange for a lump-sum payment of $118 million. The taxpayer calculated this buy-in amount based on its actual third-party royalty rates, assumptions about the useful life of the pre-existing intangible property, and foreign revenue forecasts for the intangible property over that useful life.
The IRS asserted a deficiency based on a much higher buy-in payment of $2.5 billion. The IRS relied on an expert report that used the forgone-profits, market-capitalization, and acquisition-price methodologies. The IRS engaged a second economist during the course of the litigation. That economist calculated a $1.675 billion buy-in payment based on the forgone-profits and acquisition-price methodologies. This second report was based on an assumption that the taxpayer, in transferring both pre-existing intangible property and other “attributes” such as access to the U.S. marketing and research teams and certain marketing intangibles, effectively transferred a business and not discrete intangibles. That valuation therefore included forecasted profits in perpetuity. None of the methods relied upon by the IRS were specified methods under the then-applicable regulations.
The Tax Court’s Analysis
The Tax Court addressed two key issues: (1) whether the appropriate subject of the buy-in payment was just the pre-existing intangible property or the broader set of enterprise assets and attributes identified by the IRS; and (2) the appropriate methodology for calculating the buy-in payment.
The Tax Court held, in accordance with then-applicable regulations, that the buy-in payment was consideration for only the pre-existing intangible property specified in the licensing agreement. The Court observed that the additional intangible property and attributes either were not transferred at all or were of little value under the facts because such attributes were undeveloped. The Court thus distinguished intangible property that existed at the time of the transfer from intangible property that was to be developed under the cost-sharing arrangement. The Court took particular exception to the IRS’s reliance on theories and terminology from subsequently drafted regulations (effective January 2009) in supporting its theory that a business, rather than discrete intangibles, had been transferred.3 The Court noted that the Administration’s 2010 budget proposals to “clarify” the issue by explicitly defining “intangible property” to include attributes such as assembled workforce, goodwill, and going-concern value were projected to raise significant revenue, implying that such a proposal would change the substantive law. Once this threshold issue was decided, the forecasted profits and acquisition prices that formed the basis of the IRS’s valuation were not supportable. The Court also criticized the determination of the discount rate and profit-projection period in the IRS’s valuation report.
The Tax Court accepted -- with some adjustments -- the taxpayer’s methodology, which was based on royalties charged to third parties for licenses of similar intangible property. The Court determined that “unbundled” licenses -- that is, licenses in which the taxpayer’s software would not be bundled with the licensee’s operating systems but rather offered to consumers as an option -- were sufficiently comparable to the transaction at issue; in both cases the ultimate consumers could choose which software to purchase from the licensee. The Court took the mean royalty rate from these comparable transactions to determine a starting royalty, applied a declining royalty over a four year period consistent with the taxpayer’s experience in licensing static technology to third parties, added a nominal amount for certain marketing intangibles, and used the taxpayer’s discount rate (the equity risk premium component of which was based on taxpayer-specific data).
Although the opinion does not clearly articulate the effect of the Court’s adjustments to the taxpayer’s methodology, it appears that the adjustments will result in a buy-in payment significantly closer to the taxpayer’s position than to that of the IRS. Indeed, Symantec Corp. (the successor in interest to the taxpayer) issued a press release stating its preliminary belief that its related financial reserves exceed the estimated additional tax assessment, and that it does not expect to make any additional cash tax payments to the government related to this matter.
Implications of the Decision
The Veritas decision deals a significant blow to the IRS’s efforts to curb what the tax agency perceives as abuses of the transfer pricing rules through the cost-sharing regime, particularly the offshore migration of U.S.-developed intangible property for less than arm’s-length compensation. Although it is unclear whether they will do so, the IRS may appeal to the Ninth Circuit.4 The decision is not final until computations are complete under Tax Court Rule 155, and these computations require the application of the Court’s modified methodology and the resolution of issues related to the value of sales agreements transferred in the buy-in. Thus, it may be some time before the decision is ripe for appeal. Should it stand, the significance of the Tax Court’s opinion cannot be overstated.
The decision will have a profound effect on the disposition of numerous cases currently under audit and at IRS Appeals that raise similar issues about the scope of the pre-existing intangibles transferred in the buy-in transaction and their appropriate valuation. Further, the decision could undermine the temporary cost sharing regulations issued at the end of 2008.5 While those temporary regulations provide prescriptive rules and additional methodologies consistent with the IRS’s litigating position in Veritas, the Tax Court’s decision is based on the arm’s-length standard that undergirds the U.S. transfer-pricing regime, and that standard has not changed.
In addition, the decision will have implications outside the cost-sharing arena, including in the standard licensing context or in the context of outbound transfers governed by section 367(d). Further, in analyzing the buy-in transaction as a license (rather than as a transaction unique to a cost-sharing arrangement), the Court provided significant guidance on broad principles applicable in many transfer-pricing contexts. This guidance includes, for example, an analysis of the best-method rule where both specified and unspecified methods were being proposed, an analysis of comparability factors and appropriate adjustments in the case of inexact comparables, guidance regarding the appropriate determination of a discount rate, and the use of actual profit experience following the transaction to check the reasonableness of the valuations. On this basis alone, the Tax Court’s opinion is likely the most significant case decided under the “modern” (i.e., post-1994) transfer-pricing regime.
The decision also presents a case study on framing transfer pricing issues in controversy and especially in litigation. The taxpayer focused on the precise facts at issue, including its own licenses of similar intangible property to third parties, and on drawing conclusions based on its facts. This approach resonated with the Tax Court, and the Tax Court dismissed the IRS’s efforts to fit the specific facts at issue into more generalized paradigms. The IRS’s case was hurt by what the Tax Court perceived as an evolving position throughout the proceedings. Although the Tax Court was more persuaded by the taxpayer’s technical analysis of the specific regulations in effect during the years at issue than the IRS’s more general perception of what the law ought to say, the Court’s disposition turned on the facts.
Finally, the opinion could attract the attention of policymakers within the Administration and the Congress in the context of international tax legislation. As noted above, the Administration’s 2010 Budget included an item clarifying the rules applicable to the transaction at issue and other outbound transfers of intangible property. The Joint Committee on Taxation criticized the proposal as too narrow, suggesting that serious consideration be given to strengthening the commensurate-with-income rules or eliminating the specific cost-sharing rules altogether.6 The Tax Court’s conclusion in Veritas could draw further attention to these issues.
IRS Commissioner Announces Transfer Pricing Practice within LMSB
On December 10, IRS Commissioner Douglas Shulman announced the establishment of a new “Transfer Pricing Practice” within its Large and Mid-Size Business Division (LMSB) to strategically and systematically administer transfer-pricing issues. Commissioner Shulman cited frustrations expressed by the private sector and the government with the current administration of the transfer-pricing rules, including frustration with the length of time needed to resolve transfer pricing disputes, the lack of consistency in resolving disputes, and the lack of coordination among transfer-pricing personnel within LMSB.
The new Transfer Pricing Practice is intended to address these issues by creating a centralized group of transfer-pricing experts. These experts will provide technical expertise in examinations, assist in the development of new risk-assessment techniques to better identify taxpayers and issues, and develop best practices for transfer-pricing examinations.
It is too early to predict the practical implications of the new Transfer Pricing Practice. The IRS already devotes significant examination and other resources to transfer pricing issues, and has significant expertise throughout its organization. The Transfer Pricing Practice may provide coordination, focus and stature to existing and new IRS transfer pricing personnel. It is expected that the Director of this group will report directly to the Deputy Commissioner LMSB (International), similar to the current Directors of the International Compliance, Strategy, and Policy group and the Treaty Administration and International Coordination group. It will be interesting to see how the new Transfer Pricing Group interacts with the existing groups, in particular given that much of the work of the Treaty Administration and International Coordination group involves transfer pricing and other allocation cases in the competent authority process.
Coupled with an increased IRS budget that will allow the hiring of hundreds of additional staff dedicated to international enforcement, the establishment of the new Transfer Pricing Practice signals a renewed commitment to transfer-pricing administration and enforcement. Although the Commissioner’s remarks suggest that taxpayers should expect greater efficiency, focus, and rationality in their future transfer pricing audits, that is a tall order in this fact-intensive and business-specific area. What is certain is that taxpayers will continue to see greater resources devoted to identifying and examining transfer-pricing issues.
For additional information regarding these or other transfer pricing developments, please contact any of the following members of the Miller & Chevalier tax department.
Rocco Femia, firstname.lastname@example.org, 202-626-5823
George Hani, email@example.com, 202-626-5953
Kevin Kenworthy, firstname.lastname@example.org, 202-626-5848
Kimberly Tan Majure
Megan McLaughlin Kirmil
1 133 T.C. No. 14 (Dec. 10, 2009).
2 Commissioner Shulman’s prepared remarks.
3 For a discussion of the dangers of using positions developed in a forward looking regulatory process in justifying adjustments in prior years, see Rocco V. Femia and David Blair, “Hazards Ahead: The IRS’s Coordinated Issue Paper on Cost Sharing Buy-In Payments,” 49 Tax Mgmt. Mem. (BNA) No. 10, at 195 (2008).
4 Note that the Ninth Circuit Court of Appeals recently reversed a favorable decision of the Tax Court dealing with cost sharing arrangements, Xilinx, Inc. v. Commissioner, 567 F.3d. 482 (9th Cir. 2009). The issue in Xilinx was whether the “costs” to be pooled and shared in a cost sharing arrangement included costs related to stock based compensation. The Ninth Circuit in Xilinx concluded that the regulations at issue required the inclusion of such costs notwithstanding factual evidence that taxpayers at arm’s length may not share such costs in similar arrangements. The taxpayer in Xilinx has moved for a rehearing en banc, and the government has responded in opposition to such motion. The Ninth Circuit has not yet ruled on the motions.
5 See IRS Issues Temporary Cost Sharing Regulations Effective Immediately, 1/14/09.
6 Joint Committee on Taxation, Description Of Revenue Provisions Contained In The President’s Fiscal Year 2010 Budget Proposal Part Three: Provisions Related To The Taxation Of Cross-Border Income And Investment (JCS-4-09), Sept. 14, 2009.