IRS’s Calculation of Buy-in Payment Held Unreasonable

The Tax Court held that the IRS’s calculation of the amount of a buy-in payment for the transfer of intangible assets from a U.S. company to a newly created foreign subsidiary was arbitrary, capricious, and unreasonable.

Background

VERITAS-US (V-US) is a Delaware corporation with its principal place of business in Cupertino, California. During the years at issue (1999, 2000, and 2001), the company was the parent of a group of affiliated subsidiaries. V-US develops, manufactures, markets, and sells advanced storage management software products. Because of constantly changing software technology, V-US’s software had a relatively short life cycle, and the company generally assumed a four-year useful life for each version of its software. As it released each successive version of a software title, the company was already developing the next version. The company developed each new version of an existing software product by altering the code of the previous version in order to add desired new features to the software and improve its existing features.

Prior to 1999, V-US had a limited sales presence in Europe, the Middle East, and Africa (EMEA) and the Asian Pacific countries and Japan (APJ). In 1999, recognizing the opportunity to increase its foreign sales, V-US decided to set up a foreign subsidiary that would direct its sales efforts in EMEA and APJ. After evaluating various factors, V-US decided to headquarter its EMEA and APJ operations in Ireland and set up an Irish holding company, VERITAS-Ireland (V-Ireland) to hold several new or existing subsidiary companies that were created to serve specific geographical regions.

In November 1999, V-US assigned to V-Ireland all of V-US’s existing sales agreements with its European-based sales subsidiaries. Also effective on that date, the two companies entered into a cost-sharing arrangement for research and development costs (the CSA) and a technology license agreement (the TLA). Pursuant to the CSA, the companies agreed to pool their respective resources and R&D efforts related to software products and software manufacturing processes. They also agreed to share the costs and risks of such R&D going forward. Under the TLA, V-US granted V-Ireland the right to use certain “covered intangibles” as well as the right to use V-US’s trademarks, trade names, and service marks in EMEA and APJ.

In exchange for the rights granted by the TLA, V-Ireland agreed to pay V-US royalties. In 1999, V-Ireland paid V-US $6.3 million and agreed to prepay the remaining consideration relating to the preexisting intangibles in 2000. In 2000, V-Ireland made a $166 million lump-sum payment to V-US (the buy-in payment), and in 2002 V-Ireland and V-US adjusted the payment to $118 million.

Through its own initiative, V-Ireland quickly became a thriving sales operation and greatly increased sales of VERITAS products in EMEA and APJ. By 2004, the sales revenues of V-Ireland were five times higher than the sales of V-US in EMEA and APJ prior to the creation of V-Ireland. V-Ireland also took over production of products for the regions it served, greatly increasing the chain of supply efficiency for those regions.

On its timely filed 2000 income tax return, V-US reported a buy-in payment of $166 million from V-Ireland for the transfer and/or license of preexisting intangible property in connection with the CSA and the TLA. The company changed the amount of the buy-in payment to $118 million on an amended return filed in December 2002. On examination of V-US’s returns for 2000 and 2001, the IRS found that V-US’s cost-sharing allocations on its returns did not clearly reflect the company’s income. According to the IRS, the buy-in payment should have been $2.5 billion. Based on this amount, the IRS issued notices of deficiency of $704 million for 2000 and $54 million for 2001, plus penalties of over $300 million. V-US sought a redetermination of the deficiencies and penalties in the Tax Court, claiming that the IRS’s determination was arbitrary, capricious, and unreasonable.

Cost-Sharing Arrangements Under Sec. 482

The IRS made its calculation of the buy-in payment per Sec. 482, which authorizes the IRS to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among controlled entities if it determines that such distribution, apportionment, or allocation is necessary to prevent evasion of taxes or to clearly reflect the income of the entities. In determining the true taxable income, “the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer” (Regs. Sec. 1.482-1(b)(1)). Congress enacted Sec. 482 to prevent tax evasion and ensure that taxpayers clearly reflect income related to transactions between controlled entities.

Sec. 482 provides that in the case of any transfer of intangible property, the income with respect to the transfer shall be commensurate with the income attributable to the intangible. In a qualified cost-sharing arrangement, controlled participants share the cost of developing one or more items of intangible property (Regs. Sec. 1.482-7(a)(1)). When a controlled participant makes preexisting intangible property available to a qualified cost-sharing arrangement, that participant is deemed to have transferred interests in the property to the other participant, and the other participant must make a buy-in payment as consideration for the transferred intangibles. The buy-in payment, which the transferee participant can make in the form of a lump-sum payment, installment payments, or royalties, is the arm’s-length charge for the use of the transferred intangibles (Regs. Sec. 1.482-7(g)).

Regs. Sec. 1.482-7(g)(2) provides that the arm’s-length amount charged in a controlled transfer of intangible property must be determined under one of four methods:

• The comparable uncontrolled transaction (CUT) method;
• The comparable profits method;
• The profit split method; or
• Unspecified methods described in Regs. Sec. 1.482-7(g)(2)(d).

If the recipient of the intangibles fails to make an arm’s-length buy-in payment, the IRS is authorized to make appropriate allocations to reflect an arm’s-length payment for the transferred intangibles. The IRS’s authority to make Sec. 482 allocations is limited to situations where it is necessary to make each participant’s share of costs equal to its share of reasonably anticipated benefits or situations where it is necessary to ensure an arm’s-length buy-in payment for transferred preexisting intangibles.

Tax Court Proceedings

In its answer to V-US’s Tax Court petition, the IRS notified the court that it no longer intended to rely on the expert report used in preparing the notices of deficiency. A short time later it informed the court that it intended to use the forgone profits method to determine the deficiency and that the amount of the deficiency would be less than the amount in the notice of deficiency. Subsequently, the parties stipulated to the amount of the values of the cost-sharing payments under the CSA.

The IRS then submitted a report to the Tax Court prepared by its expert containing the details of the calculation of its revised amount for the buy-in payment. The expert, employing a discounted cashflow analysis, concluded that the requisite lump-sum buy-in payment was $1.675 billion and calculated, as an alternative, a 22.2% perpetual annual royalty. He characterized the CSA as “akin” to a sale or geographic spin-off and employed the income method to determine the requisite buy-in payment. The expert defined the buy-in payment as “the present value of royalty obligations expected to be paid under arm’s length royalty terms applicable to the rights conferred on a go-forward basis.” He used an aggregate valuation approach and did not separately value each asset included in the total. In calculating the buy-in payment, the expert assumed that the company’s preexisting intangibles had a perpetual useful life.

The Court’s Decision

The Tax Court held that the IRS’s calculation of the buy-in payment was arbitrary, capricious, and unreasonable and that V-US’s CUT method, with some adjustments, was the best method to determine the requisite buy-in payment. In a harshly worded opinion, the Tax Court found numerous flaws in the IRS’s calculation of the buy-in payment and stated that the testimony of the IRS’s expert “was unsupported, unreliable, and thoroughly unconvincing.”

The Tax Court addressed both the IRS’s original determination of the buy-in payment amount in the notice of deficiency and the revised determination adopted by the IRS during the case. In testimony, the IRS’s expert had admitted that the beta factor that the IRS used in both the original determination and the revised determination was incorrect (the beta factor measures the tendency of a security’s price to respond to market swings). According to the court, the IRS could not convincingly contend that either of the determinations was correct when a critical factor in the calculation of the deficiency amounts was incorrect.

The Tax Court also detailed additional problems with the revised deficiency determination (which, unlike the deficiency determination from the notice of deficiency, the IRS attempted to defend at trial). It first noted that the IRS’s treatment of the preexisting intangibles as a single sale was improper. Under Regs. Sec. 1.482-1(f)(2)(i)(A), the IRS can use this approach only if it produces the most reliable result. Because this approach required treating the short-lived intangibles that V-US actually transferred as having a perpetual life, the Tax Court found that aggregating the assets and treating their transfer as a sale could not have produced the most reliable result. The Tax Court further found that in calculating the buy-in payment amount, the IRS expert had included items that were not transferred, had little or no value, or were developed subsequent to the transfer and that the expert had used the wrong useful life for the assets, the wrong discount rate, and an unrealistic growth rate.

Having rejected the IRS’s claimed amount for the buy-in payment, the Tax Court then examined the calculation of the amount V-US reported on its return. The company calculated the amount using the CUT method with contracts the company had with a number of original (computer) equipment manufacturers (OEMs) for bundled and unbundled software products as comparables. The IRS argued that either the contracts used were not comparable to the assets licensed under the CSA or the OEMs involved were not comparable to V-Ireland.

The Tax Court found that, judged under the comparability factors provided in Regs. Secs. 1.482-1(d) and 1.482-4(c), the OEM contracts for bundled software were not comparable for these purposes but that the OEM contracts for unbundled software were sufficiently comparable. Thus, it held that V-US’s CUT method, taking only the OEM contracts for unbundled software into account, was the correct method to calculate the payment. However, the Tax Court also required several other specific changes to be made in the calculations, including a change in the discount rate and the royalty degradation rate used.

Reflections

The Tax Court handed the IRS a well-deserved defeat in this opinion. Despite the considerable amount at stake, the IRS abandoned the original position it took in the notice of deficiency without any explanation and then took another untenable position at trial based on a poorly prepared expert report. While the adjusted CUT method endorsed by the Tax Court will result in a larger value for the buy-in payment than the amount the taxpayer claimed, the IRS deserves little credit for obtaining this result.

VERITAS Software Corp., 133 T.C. No. 14 (2009)