Amazon wins transfer-pricing case

By James A. Beavers, J.D., LL.M., CPA, CGMA

The Tax Court held that the IRS's determination, using a discounted-cash-flow (DCF) method, of the value of a cost-sharing arrangement (CSA) buy-in payment for Amazon.com's transfer to its Luxembourg subsidiary of the right to use certain preexisting intangible assets in Europe was arbitrary, capricious, and unreasonable. It further held that the IRS abused its discretion in determining that 100% of the costs accumulated in one of Amazon's cost centers were intangible development costs (IDCs) that should be included in calculating a cost-sharing payment.

Background

In 2004, online retail titan Amazon decided to create a centralized headquarters for its operations in Europe. After considering several locations, Amazon chose Luxembourg and created a subsidiary entity, Amazon Europe Holding Technologies SCS (AEHT), there to serve as the headquarters and holding company for all of Amazon's European businesses.

In 2005 Amazon entered into a CSA with AEHT that it intended to be a qualified cost-sharing arrangement (QCSA) under Regs. Sec. 1.482-7(a)(1). This arrangement required AEHT to make an upfront "buy-in payment" to compensate Amazon for the value of the intangible assets that were to be transferred to AEHT. In a series of transactions in 2005 and 2006, Amazon transferred to AEHT three groups of intangible assets: (1) the software and other technology required to operate Amazon's European websites, fulfillment centers, and related business activities (website technology); (2) marketing intangibles, including trademarks, tradenames, and domain names relevant to the European business (marketing intangibles); and (3) customer lists and other information relating to Amazon's European clientele (customer information). In addition to the buy-in payment, the agreement required AEHT to make annual cost-sharing payments to compensate Amazon for ongoing IDCs, to the extent those IDCs benefited AEHT.

To determine the amount of the buy-in payment, Amazon applied the comparable-uncontrolled-transaction (CUT) method to value the three types of intangible assets transferred. The CUT method calculates an arm's-length charge for a controlled transaction by reference to the amount charged in a comparable uncontrolled transaction. In applying the CUT method, Amazon valued each group of assets separately and assumed that the assets in each group had a limited useful life. Using the CUT method, Amazon determined a buy-in payment amount of $254.5 million.

In determining the ongoing cost-sharing payments, Amazon used a multi-step allocation system to allocate costs from its various cost centers to IDCs. Because its cost accounting system during 2005-2006 did not specifically segregate IDCs or research and development (R&D) expenses from other operating costs, Amazon developed a formula and applied it to allocate to IDCs a portion of the costs accumulated in various cost centers under its method of accounting. Amazon tracked expenses in six high-level cost centers: (1) cost of sales, (2) fulfillment, (3) marketing, (4) technology and content (T&C), (5) general and administrative, and (6) other.

On examination, the IRS concluded that the buy-in payment had not been determined at arm's length and, under Sec. 482, made transfer-pricing adjustments reallocating income from AEHT to Amazon. In the IRS's view, the transferred intangible property had an indeterminate useful life, and it had to be valued not as three distinct groups of assets but as integrated components of an operating business. Therefore, the IRS applied a DCF methodology to the expected cash flows from the European business and determined a buy-in payment of $3.6 billion, which it later reduced to $3.468 billion.

The IRS also found fault with Amazon's allocation of costs to IDCs in the calculation of its annual cost-sharing payments. Amazon had allocated about half of its T&C costs to IDCs, but the IRS claimed that it should have allocated 100% of those costs to IDCs. This had the result of increasing the cost-sharing payments from AEHT by $23 million in 2005 and $110 million in 2006.

Amazon challenged the IRS's determination in Tax Court.

The Tax Court's decision

The Tax Court, following its decision in Veritas Software Corp., 133 T.C. 297 (2009), held that the IRS's determination with respect to the buy-in payment was arbitrary, capricious, and unreasonable, and that the CUT method Amazon used, with certain adjustments, was the best method to determine the buy-in payment. It further held that the IRS had abused its discretion in determining that 100% of the T&C costs were IDCs, and that Amazon's cost-allocation method, with certain adjustments, was reasonable.

The IRS's calculation of the buy-in payment

The Tax Court, which had previously rejected the IRS's use of the DCF method under similar facts in Veritas, found that the IRS's determination of the buy-in payment using the DCF method was arbitrary, capricious, and unreasonable for the same reasons it had in that case. First, it found that the IRS had improperly assumed that the preexisting intangible assets transferred by Amazon had a perpetual life and had calculated the buy-in payment by valuing into perpetuity the cash flows supposedly attributable to the preexisting intangibles. Second, the IRS had erred in effectively treating the transfer of the preexisting intangibles as economically equivalent to the sale of an entire business.

Useful life of the intangibles: As it had in Veritas, the Tax Court found that under Regs. Sec. 1.482-7(g)(2), a CSA buy-in payment is only required for preexisting intangible property and not for subsequently developed intangibles, which are paid for by future cost-sharing payments for IDCs required by the CSA. While the IRS argued that the intangibles Amazon transferred to AEHT had an indefinite useful life, the Tax Court determined, after considering the evidence, including opinions and analysis of Amazon technology experts and software engineers, that the intangibles had only a seven-year life. Thus, the preexisting website technology transferred by Amazon in 2005 would have had little value left by 2011. However, under the IRS's DCF method, the court stated that "approximately 58% of . . . [the] proposed buy-in payment, or roughly $2 billion, [was] attributable to cash flows beginning in 2012 and continuing in perpetuity." Consequently, the court concluded a large part of the buy-in payment was not for the preexisting intangibles, but was for technology that Amazon developed subsequent to the transfer of the intangibles, which the court noted the company was paying for through the annual cost-sharing payments it was required to make under the CSA.

Equivalent to a sale: The IRS had not calculated the buy-in payment by valuing the specific intangibles transferred; rather, it had valued the preexisting intangibles by determining an enterprise value for Amazon's entire European business and subtracting the value of the business's tangible assets from the enterprise value. The Tax Court disagreed with this treatment of the transfer of the preexisting intangibles as the equivalent of a sale of the entire enterprise because this necessarily caused certain assets that Amazon did not transfer under the CSA to be included in calculating the buy-in payment.

According to the Tax Court, the definition of intangibles that applied for purposes of the cost-sharing regulations in 2005 and 2006 included five categories of assets that had substantial values independent of the services of any individual. It found that an enterprise valuation of a business includes many items, including workforce in place, going concern value, goodwill, and certain other items that do not meet the definition of intangibles for purposes of the cost-sharing regulations. Thus, the court concluded, as it had in Veritas, that because there was no explicit authority in the cost-sharing regulations for the IRS's inclusion of items such as workforce in place, goodwill, or going concern value in the calculations of the buy-in payment, the IRS could not use an enterprise valuation to calculate a buy-in payment.

Aggregation principle: The IRS argued that the aggregation principle, as expressed in the regulations in existence in 2006, supported the use of a business enterprise valuation. The regulations in effect at that time provided that the combined effect of multiple transactions may be considered "if such transactions, taken as a whole, are so interrelated that consideration of multiple transactions is the most reliable means of determining the arm's length consideration for the controlled transactions" (Regs. Sec. 1.482-1(f)(2)(i)(A)).

The Tax Court rejected this argument, finding, for at least two reasons, the type of "aggregation" proposed by the IRS was not a reasonable or the most reliable means of determining an arm's-length buy-in payment. First, the IRS's business-enterprise approach improperly aggregated preexisting intangibles and subsequently developed intangibles. Second, its business-enterprise approach improperly aggregated compensable "intangibles" (such as software programs and trademarks) and residual business assets (such as workforce in place) that are not "pre-existing intangible property" under the cost-sharing regulations in effect during 2005-2006.

Realistic alternatives: The IRS also defended its approach under the "realistic alternatives" principle. Regs. Sec. 1.482-1(f)(2)(ii)(A) authorizes the IRS to "consider the alternatives available to the taxpayer in determining whether the terms of the controlled transaction would be acceptable to an uncontrolled taxpayer faced with the same alternatives and operating under comparable circumstances." The IRS contended that Amazon had the realistic alternative of continued ownership of all the intangibles in the United States and that Amazon would have preferred this alternative if it was dealing with an unrelated party. The IRS further asserted that its analysis captured the value of this alternative by estimating the future cash flows of Amazon's entire European business.

The Tax Court stated it found the IRS's argument "unpersuasive for many reasons," but discussed only two. It first explained that it disagreed with the argument because, under it, the parties to a CSA would have to determine the buy-in payment as if they continued to operate the business as they previously had. The Tax Court found that this would make the cost-sharing election meaningless because the regulations provide that a qualified cost-sharing agreement is acceptable if it meets all the requirements of the cost-sharing regulations.

Second, Regs. Sec. 1.482-1(f)(2)(ii)(A) provides that the IRS will evaluate the results of a transaction based on its actual structure unless it lacks economic substance. Thus, as the Tax Court had held in Veritas and in Claymont Investments, Inc., T.C. Memo. 2005-254, the IRS is prohibited from restructuring the transaction as if the taxpayer had adopted an alternative if the taxpayer's actual transaction has economic substance. Accordingly, because the IRS did not contend that the transaction as structured by Amazon lacked economic substance, it could not restructure it under the realistic-alternative principle. As the Tax Court stated, "[t]he regulations in effect during 2005—2006 unambiguously entitled Amazon US to enter into a QCSA; it cannot be deprived of this entitlement on the theory that it had the alternative of doing something else."

The CUT method

Once again citing its opinion in Veritas, the Tax Court held that that the CUT method was the best method for calculating a buy-in payment under a CSA. Anticipating this possibility, the IRS had employed its own experts to determine the value of the buy-in payment using the CUT method, applied separately to the three types of intangible assets.

The IRS and Amazon generally agreed on which transactions to use to derive the comparable uncontrolled transactions to use in the analysis. However, the IRS's application of the CUT method otherwise varied significantly from Amazon's (in particular, by assuming an indefinite life for both the website technology and the marketing intangibles as it had in its application of the DCF method), and the IRS arrived at a much higher value for each type of intangibles.

After considering the testimony of the various experts offered by Amazon and the IRS, the Tax Court found that overall it agreed with how Amazon had applied the CUT method, including the company's use of a limited useful life for the intangible assets. However, on many specific details, it did not agree with the company's calculations, so based on its analysis of the evidence presented by Amazon and the IRS, it determined its own formula for how the buy-in payment should be calculated under the CUT method.

Intangible development costs

With regard to the T&C costs that Amazon included in IDCs, the Tax Court had previously ruled that to refute the IRS's claim that its T&C costs were not all IDCs, Amazon was required to show that the costs in that category contained a nontrivial amount of mixed costs (costs that contributed to the intangible development area and other areas or business activities). The IRS argued that Amazon was required to do this on a cost-by-cost basis, but the court found that this was not necessary, noting that the IRS audit team had not required this level of detail to prove that costs in other categories were not included in IDCs.

After reviewing the documentary evidence and expert testimony presented to it, the Tax Court determined that Amazon had established that it had captured substantial non-IDCs in the T&C cost center, and therefore it held that the IRS had abused its discretion in determining that 100% of the costs Amazon accumulated in the T&C cost centers were IDCs. The court further held that, with certain adjustments, Amazon's method of allocating the T&C costs was a reasonable basis for determining the portion of the costs that were IDCs.

Reflections

While the decision is a huge win for Amazon, which faced a multimillion-dollar tax bill if the IRS had prevailed, the decision's impact on other taxpayers is limited by the IRS's issuance of revised final cost-sharing regulations in 2011, which for the most part follow the approach for CSAs provided in temporary cost-sharing regulations the IRS issued in 2009. The final regulations, which generally apply to CSAs entered into in 2009 and later years, replaced the buy-in payment at issue in Amazon's case with the concept of a "platform contribution transaction."

Amazon.com, Inc., 148 T.C. No. 8 (2017)

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