by Julie Martin
Amazon.com Inc on March 23 won a US Tax Court case, fending off IRS transfer pricing adjustments relating to a cost-sharing agreement (CSA) buy-in payment. The transfer pricing adjustments would have increased the online retailer’s taxable income by more than $1.5 billion in 2005 and 2006.
Following Veritas Software Corp. v. Commissioner, 133 T.C. 297, the Court concluded that the IRS erred when it used the discounted cash flow (DCF) method to recalculate a buy-in payment for Amazon’s transfer, under the CSA, of preexisting intangibles to a Luxembourg subsidiary, Amazon Europe Holding Technologies SCS.
The case concerns a 2005 CSA pursuant to which Amazon.com, Inc., and its domestic subsidiaries transferred to the Luxembourg subsidiary intangible assets required to operate Amazon’s European website business. The transfers were subject to 1995 cost sharing regulations that have since been replaced.
Under to the agreement, Amazon US transferred three groups of intangible assets: software and other technology needed to operate Amazon’s European websites, fulfillment centers, and related activities; marketing intangibles, such as trademarks, tradenames, and domain names; and customer lists and other information relating to Amazon’s European customers.
The Luxembourg subsidiary made buy-in payments to Amazon of $254.5 million over seven years in exchange for the use of the intangibles. The subsidiary was also required to make annual cost sharing payments to compensate Amazon for ongoing intangible development costs.
To determine the buy-in amount, Amazon valued each group of transferred assets separately using the comparable uncontrolled transaction (CUT) method. Amazon assumed that each group of assets had a seven-year useful life.
The IRS determined that the buy-in payment was not arm’s length, concluding it should be $3.6 billion rather than $254.5 million, but later reducing that amount to $3.5 billion. The IRS applied a DCF methodology to the expected cash flows from the European business to arrive at its valuation.
The IRS also disputed Amazon’s ongoing cost sharing payments, increasing those required payments to $23 million and $109.9 million in 2005 and 2006, respectively.
Due mostly to the recalculated payments, IRS determined deficiencies for 2005 and 2006 of $8.4 million and $225.7 million, respectively. The IRS also increased the amount of Amazon’s net operating loss carryover deduction used by just over $1 billion in 2005 and by $304.8 million in 2006, according to Amazon’s Tax Court petition.
Siding with Amazon, the Tax Court rejected the IRS’s recalculation of the buy-in payment, concluding it was arbitrary, capricious, and unreasonable. The CUT method, used by Amazon, was the best method to calculate the CSA buy-in payment, the Court said.
The Court said that the DCF methodology used by the IRS was similar to the transfer pricing methodology used in the Veritas case, which has been rejected by the Court.
By assuming a perpetual useful life, the IRS ‘s method failed to restrict the valuation to “preexisting intangible property,” within the meaning of the cost sharing regulations in effect at the time, the Court said.
Also, the IRS’s DCF methodology improperly included in the buy-in payment the value of “subsequently developed intangibles,” as was the case in Veritas.
Further, the method aggregates compensable “intangibles” and residual business assets, such as workforce in place and growth options, that are not “preexisting intangible property” under the cost sharing regulations in effect during 2005-2006, the Court said.
With respect to the ongoing cost sharing payments under the CSA, the Court concluded that the IRS abused its discretion in determining that 100% of certain costs constitute intangible development costs (IDCs).
Amazon’s cost-allocation method, with certain adjustments, supplies a reasonable basis for allocating costs to IDCs, the Court said.
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Expert Commentary:
Ednaldo Silva, Ph.D., Founder & Director of RoyaltyStat: The IRS is not showing competence litigating large transfer pricing cases. As Goethe is reputed to have said, the first (strategic) error may be a tragedy; but subsequent errors are farce. Repeated losses suggest that the IRS needs to rethink its development of large transfer pricing cases and work with experts who can challenge audit and counsel’s hyperbolic thinking.
Julie Martin
Julie Martin is the founder of MNE Tax. She edits the publication and regularly contributes articles on new developments in cross-border business taxation.
Julie has worked as a tax journalist and editor for more than 13 years. Prior to that, she worked as an in-house tax attorney in New York. She also holds an LLM in taxation from New York University School of Law.
Julie can be reached at [email protected].
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