Earlier this year, the U.S. Tax Court issued its decision in Amazon.com, Inc. v. Commissioner.1 The case involved various issues, with the largest dollar issue arising because of the ‘‘buy-in’’ payment that Amazon’s Luxembourg affiliate made to Amazon US when the two entities entered into a cost sharing agreement (CSA) in 2005. Amazon had computed a buy-in payment of $254.5 million. The Internal Revenue Service, upon audit, determined that the buy-in payment should be more than 10 times larger, at$3.468 billion.2
As will be discussed in more detail below, I believe that the economic experts retained by the taxpayer and the IRS reached very different conclusions as to the value of the buy-in payment because they were asked to value different things. The taxpayer’s experts were asked to value the speciﬁc intangible property deﬁned in the §482³ regulations (the ‘‘§936(h) intangibles’’) while the IRS’s experts were asked to value either the cash ﬂows associated with the transfer of the overall business or the cash ﬂows that would have resulted under a different business arrangement in which Amazon US continued to fund the development of intangibles. The latter included proﬁts that are commonly associated with attributes such as business opportunities, goodwill, and going concern; the former did not.
The Tax Court concluded that the legal standard adopted by the taxpayer’s experts was the correct one, and consequently found that the IRS adjustment was arbitrary, capricious, and unreasonable. In doing this, the court explicitly reaffirmed the key legal conclusions that were laid out in an earlier landmark decision, Veritas Software Corp. v. Commissioner.4
However, the Tax Court also said its decision was based on the regulations that were in effect during the years at issue, 2005–2006. The §482 regulations have changed substantially since then. Therefore, a key question looking forward is the extent to which those changes have made it more likely that the Tax Court in the future will adopt the approach followed by the IRS.
In this article, I will explore how the following economic issues may be affected by the regulatory changes that have occurred since 2005–2006:
- The deﬁnition of intangibles;
- The life of intangibles;
- Geographic or other forms of exclusivity; and
- The application of the concept of ‘‘reasonable alternatives.’’
To state the obvious, this is largely a speculative exercise, and as an economist I am focused on the economic considerations that may affect future legal decisions. I am making no predictions as to the legal conclusions that may be reached by the Tax Court in future cases.
SUMMARY OF FACTS
From its founding until 2005, Amazon US developed and owned almost all of Amazon’s key intangibles. In 2005, Amazon US and Amazon Luxembourg (‘‘AEHT’’) entered into a CSA.5 Upon the formation of the CSA, Amazon Luxembourg paid Amazon US $254.5 million to acquire the rights to the pre-existing intangibles owned by Amazon US with respect to the rest-of-the-world (ROW) territories out-side of the United States.6 Amazon US and Amazon Luxembourg also agreed to share in the cost of ongoing intangible development expenses based on their relative shares of expected future beneﬁts.
Amazon used a residual proﬁt split analysis to compute a buy-in payment of $254.5 million to be paid over seven years, which was the estimated useful life of the speciﬁc pre-existing intangibles (website technology, marketing intangibles, and customer information) transferred to Amazon Luxembourg with the formation of the CSA. The IRS, following its audit, co-cluded that the buy-in payment should be determined using an aggregated approach rather than as three distinct groups of assets, and that it should reﬂect the present value of the forgone residual proﬁts of Amazon’s ROW business based on an indeterminate (or in effect an inﬁnite) life. Given this, the IRS calculated a buy-in payment of $3.6 billion, later reduced to$3.468 billion.
At trial, the primary IRS position was a discounted cash ﬂow (DCF) analysis in which Dr. Frisch, one of the economic experts retained by the IRS, computed the value of the buy-in payment by (a) projecting the net cash ﬂows that would be given up by Amazon US,(b) determining an appropriate discount rate, and (c) computing the present value of those cash ﬂow into perpetuity. As noted above, this led to a value of$3.468 billion.
The other economic experts retained by both the taxpayer and the IRS computed the value of the three speciﬁc intangibles that were transferred using comparable uncontrolled transaction (CUT) analyses. What I found particularly striking in reading the Tax Court decision is that the respective experts substantially relied upon the same or similar data and the same or similar comparables, and adopted (from a 50,000-foot level) broadly consistent assumptions with respect to royalty rates and discount rates — yet reached vastly different conclusions as to the buy-in payment. To quote the Tax Court decision:7
“Respondent’s and petitioner’s experts agree that the CUT method may reliably be used to value separately the website technology, the marketing intangibles, and the customer information, though they disagree mightily about the outcomes that this method should produce.”
The most important reason for the dramatically different values obtained by the respective experts was that the taxpayer’s assumed a speciﬁc life for the intangibles that they valued while the IRS’s assumed an indeterminate/inﬁnite life.For example, Dr. Higinbotham (an economic expert retained by the IRS) and Dr. Wills (an economic expert retained by the taxpayer) both used royalty rates obtained from various M.com agreements to compute the buy-in payment that would be expected for website technology. There were differences in their interpretation of the agreements: Dr. Higinbotham derived a royalty rate of 4% from the agreements while Dr. Wills derived a range of royalty rates that extended from 1.4% to 2.4% — but these differences, while material, in no way explain the gulf between Dr. Higinbotham’s $3.3 billion8 and Dr. Wills’s upper-end buy-in payment of $182 million. As a quick way of approximating the difference implied by the royalty rates alone, had Dr. Wills used a royalty rate of 4%, his buy-in computation would have increased to just$303 million9 — still only about one-tenth of that computed by Dr. Higinbotham.
The key reason for the vast difference in the buy-in payments computed by Dr. Frisch, Dr. Higinbotham, and Dr. Wills is that they were asked to value very different things. Speciﬁcally:
- Dr. Frisch, in using a discounted cash ﬂow (DCF) based on Amazon’s overall cash ﬂows, was asked to determine the value of the business that was supported by Amazon’s intangibles (and presumably any other economic assets/attributes) at the time of transfer, including business opportunities/goodwill and going concern, which valued all intangibles in aggregate and could be expected to have a perpetual life;
- Dr. Wills was asked to determine the value of speciﬁcally deﬁned preexisting technology as it existed at the time of the transfer, and whose value (whether measured in terms of its use or of its value as a market barrier) could be expected to erode over time; and
- Dr. Higinbotham was asked to determine the value of Amazon’s technology assuming a perpetual life. While the Tax Court did not describe the reasons that Dr. Higinbotham used to support his assumption that Amazon’s website technology had a perpetual life, this assumption appears to imply that Amazon US would continue to make the investments needed to sustain the value of the licensed technology.
At some level, therefore, the central issue in Amazon came down to whether the buy-in payments needed to reﬂect (a) the value of speciﬁcally deﬁned intangibles with a limited life or (b) the value of intangibles — whether valued in aggregate or separately— in perpetuity. The taxpayer asked its experts to determine the life of speciﬁcally deﬁned intangibles over the period in which the intangible attributes in existence at the time of the transfer would have generated a positive payment from a third party. The IRS asked its experts to value the cash ﬂows that the intangibles in existence would generate in perpetuity, presumably assuming the continued refreshment of the intangibles. Not surprisingly, the different questions gave rise to different answers.
TAX COURT DECISION
The Tax Court determined that the buy-in payment was for the ‘‘pre-existing’’ value of the intangibles that were explicitly enumerated in the §482 regulations, and that these intangibles had a limited life ranging from approximately seven years for website technology to 20 years for marketing intangibles. Having reached this conclusion regarding the legal requirements of what had to be paid for, the court rejected the DCF method used by Dr. Frisch because it incorporated at least three items of value over and above the intangibles that had to be paid for. These three items of value were:10
- The value of future enhancements in next-generation website technology. While this technology performed the same function as the website technology that was transferred, it was substantially modiﬁed and enhanced over time, and Amazon Luxembourg paid for these enhancements through its cost sharing payments.
- The value of new intangibles (including the Kindle, Amazon Prime, the Fire smartphone, Fire TV, digital music/video offerings, cloud computing and storage, and the EFN, which implemented standardized and improved fulﬁllment operations across Europe) that were not in existence at the time of the transfer, and which therefore were not derived from the website technology that was transferred under the buy-in.
- The value of Amazon’s residual business intangibles — workforce in place, going concern, future business opportunities — differed from the speciﬁcally deﬁned intangibles in that they cannot be transferred separately from the business and often do not have ‘‘substantial value independent of the services of any individual.’’
The Tax Court also rejected the IRS’s argument that the U.S. taxpayer had the ‘‘reasonable alternative’’ of not entering the cost sharing agreement and that, therefore, the buyin payment should reﬂect the present value of the proﬁts it would have earned, had it retained ownership of the intangible property contributed to the CSA. The court rejected this argument on two grounds:
- ‘It proves too much’’: As any taxpayer entering into a CSA has the option of not doing so, requiring the same economic outcome under a CSA as would exist absent the CSA would, in effect, make the regulation meaningless; and
- The IRS needs to respect the business arrangements established by the taxpayer provided they have substance, which also implies the need to respect the economic consequences of these business arrangements.
Having rejected the DCF method, the Tax Court then determined the value of each of the three speciﬁc intangibles (website technology, marketing intangibles, and customer information) contributed to the CSA. The key attributes of the court’s decisions regarding the present value of these three discrete intangibles are that they are:
- all based on CUT data, with the CUT data for both technology and customer information taken from agreements that Amazon reached with third parties and the CUT data for marketing intangibles taken from agreements that were located from a search of public sources and which did not involve
- ; and
- fact-speciﬁc with respect to how they were used, what adjustments were made, and the life of the intangibles.
or example, in the case of technology, the Tax Court started with the royalty rates contained in the licensing agreements relied upon by both parties’ experts, and then allowed the royalty rate to ratchet down over a 7-year life. The court also concluded that the pre-existing intangibles contributed to the CSA had a ‘‘research value’’ that was not limited to the continued use of source code that existed at the time that the CSA was formed, but which reﬂected the value of intangible property made available ‘‘for purposes of research in the intangible development area.’’11 The court concluded that this research value could be derived from the royalty rate in place at the end of the 7-year life of the intangibles over a life that was approximately half that of the underlying technology.12
CHANGES IN REGULATORY STANDARDS
The Amazon decision was based on the regulations in effect during the years at issue — 2005 and 2006— and the Tax Court speciﬁcally noted that regulations issued after that time were not relevant, stating:13
‘‘In 2011 the Secretary ﬁnalized new cost sharing regulations that replaced the 1995 regulations involved in this case. T.D. 9568, 2012-12 I.R.B. 499. Issued in temporary form in 2009 and effective (as relevant here) in January 2009, these new regulations replaced the buy-in payment with the concept of a ‘‘platform contribution transaction’’
(PCT). 74 Fed. Reg. 341–342 (Jan. 5, 2009). The preamble to the temporary regulations noted objections from commenters that the PCT ‘‘included elements such as workforce, goodwill or going concern value, or business opportunity, which in the commentators’ view either do not constitute intangibles, or are not being transferred, and so, in the commentators’ view, are not compensable.’’ 74 Fed. Reg. 342. The Treasury Department replied by stating that the new regulations ‘‘do not limit platform contributions that must be compensated***tothe transfer of intangibles deﬁned in section 936(h)(3)(B).’’ Id. As we noted in Veritas, 133 T.C. at 315–316, 329–330, the 2009 regulations did not apply in that case, and they have no application to this case either.’’
Therefore, any evaluation of the implications of the Tax Court’s decision in the Amazon case is complicated by the fact that the regulations have changed, and legal conclusions reached under the regulations that are currently in place may be different from those reached in Amazon.
One set of changes in U.S. transfer pricing regulations came with the ﬁnalization of the cost sharing regulations in 2011. Some of the key changes include:
- The introduction of the need to pay for a ‘‘platform contribution transaction’’ (‘‘PCT’’), which includes all ‘‘resources, capabilities, or rights’’ used to develop future intangibles, rather than a requirement to pay a buy-in based on the value of the transferred pre-existing intangibles. The deﬁnition of what needs to be paid for as part of the PCT — all resources, capabilities, or rights — is clearly intended to capture value over and above that which is included in the §936(h) intangibles.
- Substantial limitations on the structure of the cost sharing transaction that have the effect, when taken together, of making the transfer look like the transfer of an ongoing business. These changes require that each cost sharing partner have exclusive and perpetual rights to a given territory or ﬁeld of use for the intangibles covered by the CSA; and the agreement must in effect cover all intangibles needed to operate the business at issue.14 Collectively, these restrictions can arguably be interpreted as making each CSA participant something more akin to a business owner than simply the licensee of a set of intangibles.
- The introduction of the income method, which is explicitly based on the difference in the present value of cash ﬂows under cost sharing and under the ‘‘reasonable alternative’’ of not cost sharing but rather entering a licensing transaction in which the licensor funds ongoing intangible development. Under the income method, the value of the PCT is computed as the difference between the income that would have been earned under the business terms that existed prior to the formation of the CSA (e.g., with the transferor bearing the costs and risks of intangible development activities) and under the business terms that existed after the formation of the CSA (e.g., with the transferee bearing the costs and risks of intangible development activities). The computation of the value of a PCT under the income method is therefore explicitly based on the concept that the transferor has the ‘‘reasonable alternative’’ of not entering the CSA.
It is worth noting that these changes apply explicitly only to cost sharing arrangements and, therefore, there is — at least in my mind — a considerable amount of uncertainty as to their impact on a traditional Reg. §1.482-4 transfer of intangibles. While there is a cross-reference that appears to allow the IRS to at least assert that the Reg. §1.482-7 methods apply to Reg. §1.482-4 transactions as well, it is not clear that this is substantially different than the requirement to use the ‘‘most reliable’’ method even if it is an unspeciﬁed method. Moreover, the requirement that the payment needs to cover all ‘‘resources, capabilities, or rights’’ and the restrictions on the structure of the transaction appear to be speciﬁc to the cost sharing transactions.
However, the temporary §482 regulations issued in conjunction with the proposed §367 regulations in September 201515 appear to bring concepts, that were ﬁrst incorporated into the cost sharing regulations, into the §482 regulations generally. The ﬁrst of these is the requirement that arm’s-length compensation be consistent with and account for all ‘‘value’’ provided in a transaction between controlled parties:16
‘‘…. All value provided between controlled taxpayers in a controlled transaction requires an arm’s length amount of compensation determined under the best method rule of §1.482-1(c). Such amount must be consistent with, and must account for all of, the value provided between the parties in the transaction, without regard to the form or character of the transaction. For this purpose, it is necessary to consider the entire arrangement between the parties, as determined by the contractual terms, whether written or imputed in accordance with the economic substance of the arrangement, in light of the actual conduct of the parties….’’
The language above appears to introduce two key concepts, namely that: (a) the compensation must reﬂect ‘‘all value’’ — a broad and relatively vague term; and (b) the amount of such value is independent of the form or character of the transaction.
Second, the temporary regulations emphasize that an aggregate analysis of transactions may be more reliable than looking at each transaction on a standalone basis, stating that:17 (a) the consideration of the combined effect of two or more transactions may need to be considered in aggregate to capture possible synergies among the transactions and (b) transactions may be aggregated even when they do not involve related products or services. The general theme behind this change is that there are often cases in which the aggregate value of a group of transactions may be greater than the simple sum of their individual values due to synergies, and that in such cases the larger value should be used. The temporary regulations further state that a coordinated/aggregated analysis should be applied when value needs to be determined under different sections of the regulations.18
Finally, in Example 11, the temporary regulations state that, under the realistic alternatives principle, the form of the transaction should not affect the amount that is paid, and while the IRS would ‘‘respect’’ a license that has substance, it may determine the value assigned to the license under a different structure ‘‘. . . because P could have directly exploited the manufacturing process and manufactured product X itself, this realistic alternative may be taken into account under §1.482-4(d) in determining the arm’s length consideration for the controlled transaction.’’19
THE KEY QUESTION: WHAT NEEDS TO BE PAID FOR
The IRS has had a long-standing concern that U.S. taxpayers have been able to transfer proﬁts from U.S. entities to offshore entities ‘‘for less than full consideration,’’ particularly under cost sharing. The key reason for this concern is that taxpayers have determined the value of buy-in payments based on the intangibles deﬁned under §936(h), which generally have a limited life, while entering business arrangements that have had the effect of transferring proﬁts earned in perpetuity. As will be discussed below, the net cash ﬂows expected from a business enterprise are often greater than the expected value of the net cash ﬂows generated by the speciﬁc (intangible and other) assets owned by the business enterprise.
In both Veritas and Amazon, the Tax Court determined that a buy-in payment made on entering a CSA needs to reﬂect the arm’s-length value of pre-existing intangibles. The §936(h) intangibles include:
- patents, inventions, formulae, processes, designs, patterns, or know-how;
- copyrights and literary, musical, or artistic compositions;
- trademarks, trade names, or brand names;
- franchises, licenses, or contracts;
- methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists, or technical data; and
- other similar items, or an item which derives its value not from its physical attributes but from its intellectual content or other intangible properties.
The present value of such intangibles, however, is generally less than the present value of the business that is using these intangibles, even after adjusting for the value of tangible and ﬁnancial assets. This difference is illustrated in Figure 1 below, where the downward sloping line showing cash ﬂows ‘‘From Pre-Existing Intangibles’’ shows proﬁts from intangibles declining over time and eventually reaching zero, while the line showing cash ﬂows ‘‘From Business’’ is a steadily upward sloping line.
At a high level, Amazon’s economic experts were asked to determine the present value of cash ﬂows related to the downward sloping line, while the IRS’s were asked to determine the present value of cash ﬂows associated with the upward sloping line. If the deﬁnition of intangibles is limited to the speciﬁc preexisting intangible property listed in the regulations, then (with the possible exception of legal rights that are granted into perpetuity such as trademarks) intangibles — and perhaps especially technology intangibles — logically tend to have a limited life. DOS may have launched Microsoft on its way, but it is hard to argue that DOS plays a major role in the technology used in either the current Microsoft operating system or in other varied products offered by Microsoft (the office suite, its investment in the cloud, Internet browsing, the X-BOX). Given this, the value of such speciﬁcally deﬁned intangible property can be expected to fall over time.
However, most businesses are expected to grow in terms of both revenues and proﬁts. Therefore, if the payment needed is deﬁned in terms of the cash ﬂows that can be expected from the business supported by pre-existing intangibles rather than the intangibles per se, the expected cash ﬂows logically reﬂect the expected investment ﬂexibility of the business. While the technology underlying ﬂoppy disks has relatively little overlap with CD technology and virtually none with a memory stick, being in the storage business may make it likely that a company will invest in new storage technologies and will be in a better position to market such storage technology products than someone else. A business enterprise based on storage technology may also logically expand into other related business, such as the storage and sale of data libraries, that are not outgrowths of the pre-existing technology per se but are plausible extensions of its core business.
Neither deﬁnition is right or wrong per se. Indeed, ﬁnancial statement valuations employ both deﬁnitions— the ﬁrst to determine the value of speciﬁcally identiﬁable intangible property that can be transferred separately from the business, and the second as the starting point for determining the goodwill and going concern value of a business. However, these two measures address two different things, and therefore a buy-in payment based on the present value of §936(h) intangibles will generally be lower than the value of ‘‘all’’ intangibles based on the DCF of the overall business.
The IRS’s concern is that the transfer of all or essentially all of the §936(h) intangibles owned by a business (at least with respect to a speciﬁc geography or ﬁeld of use) in substance also implies the transfer of the entire business, and all of the proﬁts/net cash ﬂows associated with the business. Thus, limiting the value of a buy-in payment to just the value of the §936(h) intangibles allows taxpayers to transfer the potentially much greater value of the entire enterprise (at least as it relates to the speciﬁc geography or ﬁeld of use at issue). In effect, the total value of the business enterprise is transferred for a payment that reﬂects just a portion of that value.
In both Veritas and Amazon, the IRS argued that:(a) the transfers of §936(h) intangibles made as part of the establishment of the respective CSAs were ‘‘akin to the transfer of a business’’; (b) the pre-existing §936(h) intangibles provided the foundation for future intangible development; (c) the intangibles needed to be valued in aggregate; and (d) the value of the buy-in payment should be based on the reasonable alternative of not entering into a CSA. These arguments were all designed to link the value of the cash ﬂows generated by the business enterprise to the transfer of the §936(h) intangibles contributed to the CSA.
In both cases, the Tax Court decided that the only intangible transfers that created taxable income were the §936(h) intangibles, regardless of whether the overall business proﬁts were in fact shifted from a U.S. legal entity to an offshore entity as a result of the transfer of these §936(h) intangibles. Therefore, even if the value of business opportunities, goodwill, and going concern, etc., were shifted from a U.S. legal entity to an offshore entity, they were not compensable and this was not a taxable event. The regulatory changes that have taken place since 2005–2006 are clearly designed to put in place legal requirements that favor the higher deﬁnition of value.
POTENTIAL IMPLICATIONS OF THE CHANGES IN THE §482 REGULATIONS
Many of the changes in the §482 regulations that have been brieﬂy discussed above support various arguments that the IRS lost in the Tax Court’s Amazon decision. This obviously raises the possibility that under the regulations in place currently the Tax Court would reach a different conclusion from what it did under the regulations that were in place in 2005–2006.
However, the changes to the §482 regulations do not address explicitly what I view as the central issue in the Amazon case: Does goodwill and going concern need to be paid for as part of a PCT in a newly formed CSA or in other transfers of intangibles? While this in theory could have been done by simply changing the deﬁnition of intangibles, outside of cost sharing the regulatory changes have left the deﬁnition of intangibles largely intact (at least in the §482 regulations), and have instead attempted to bring in goodwill and going concern value indirectly through a combination of changes that limit the business arrangements that are allowed under cost sharing, pushing for an increased focus on aggregation, and the invocation of the concept of realistic alternatives.
THE SHIFT TO RESOURCES, CAPABILITIES, OR RIGHTS
The ﬁnal CSA regulations issued in 2011 change the deﬁnition of what needs to be paid for under a CSA from the §936(h) intangibles in existence at the time a CSA is formed to a PCT, which covers all resources, capabilities, or rights. The 2011 cost sharing regulations deﬁne a PCT as follows:20
‘‘A platform contribution is any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to the intangible development activity (whether prior to or during the course of the CSA) that is reasonably anticipated to contribute to developing cost shared intangibles. The determination of whether a resource, capability, or right is reasonably anticipated to contribute to developing cost shared intangibles is ongoing and based on the best available information. Therefore, a resource, capability, or right reasonably determined not to be a platform contribution as of an earlier point in time, may be reasonably determined to be a platform contribution at a later point in time. The PCT obligation regarding a resource or capability or right once determined to be a platform contribution does not terminate merely because it may later be determined that such resource or capability or right has not contributed, and no longer is reasonably anticipated to contribute, to developing cost shared intangibles.’’
The shift in the requirement that a taxpayer entering a CSA needs to make a PCT payment that covers all ‘‘resources, capabilities, or rights’’ rather than one that simply covers speciﬁcally deﬁned pre-existing §936(h) intangibles is clearly intended to broaden the deﬁnition of what needs to be paid for. At a very basic level, the pre-existing intangibles used in the development of future intangibles21 are presumably included within the deﬁnition of ‘‘resources, capabilities, or rights,’’ and therefore the payment for the latter must be equal to or greater than the payment for the former. As a speciﬁc example, the IRS views the R&D workforce, which was not part of pre-existing §936(h) intangibles under the prior regulations, as one component of resources, capabilities, or rights.
A key question, however, is whether the Tax Court will interpret the deﬁnition of ‘‘resources, capabilities, or rights’’ only as something that the taxpayer must have at the time it enters a CSA, or whether it also includes resources, capabilities, or rights developed/obtained after entering the CSA. While the deﬁnition of the PCT states that resources, capabilities, or rights developed, maintained, or acquired during the course of the CSA have to be considered, it seems a stretch to say that the initial PCT payment must cover things that are not in some way linked to resources, capabilities, or rights that exist at the time of the initial PCT.(Indeed, additional PCT payments are explicitly required when new resources, capabilities, or rights —perhaps obtained through acquisition — are brought into a CSA.)
Addressing this question requires not just a reading of the regulatory language, but also some understanding of the speciﬁc factors that are leading to the gap between the value of pre-existing intangibles (shown on the downward-sloping line of Figure 1) and the value of the business enterprise (the upward-sloping line of Figure 1). The proﬁts in this area are attributed to a wide range of factors including business opportunities, synergy values, goodwill, and going concern.
The IRS, in making its changes to the deﬁnition of what needs to be paid for, has generally taken the position that, whatever the deﬁned area is called, the proﬁts in this gap are generally related to the non-ﬁnancial attributes of the ﬁrm at the time of the initial PCT, and are therefore derived from the pre-existing intangibles/resources, capabilities, or rights of the ﬁrm. Thus, even though a thumb drive is not a ﬂoppy disk, it is a memory storage device, and therefore there is a linkage between the ﬂoppy disk and the thumb drive. Or, to put it in a more economic framework, the transferor’s intangibles/resources, capabilities, or rights are such that investments in next-generation technology will provide economic proﬁts— proﬁts greater than those that would be expected by an investor lacking these pre-existing capabilities.
However, it is not clear that this is always the case. Take the case of a car company (‘‘CarCo’’) that has been selling gasoline-powered cars for decades. CarCo presumably has either developed, bought, or otherwise obtained access to the full range of technology and know-how needed to manufacture and sell cars. Moreover, CarCo almost certainly has the resources and capabilities to design subsequent generations of cars.
Now suppose that CarCo realizes that battery-powered electric vehicles are likely to become a signiﬁcant part of its product offerings at some point in the future. CarCo has no expertise whatsoever in the battery technology that will be needed to make such vehicles. This lack of expertise, however, is unlikely to have an impact on the long-term projected growth rates or proﬁt margins that drive the upward-sloping line in Figure 1 for CarCo. The company, and investors in the company, will assume that CarCo will take the necessary steps to either develop or buy the battery technology that it needs to remake itself into a viable producer of electric- as well as gasoline-powered cars. CarCo does not have any current capabilities with respect to the battery technology that it will need to make and sell battery-powered cars, nor did it have any such capabilities when it entered into its CSA. However, the sales and proﬁts that it implicitly expects to earn from such battery-powered cars are built into its forecasts and expected present value of future proﬁts. If it has a 5% market share now, investors will almost certainly assume that it will ﬁnd some way of reinventing itself and maintaining its 5% market share into the indeﬁnite future.
Given the above:
- Is battery technology a ‘‘right, resource, or capability’’ of CarCo at the time it entered into its CSA?
- Is CarCo’s automotive technology a ‘‘platform’’ for developing the battery technology needed to manufacture and sell electric cars?
- Depending upon the answers to these questions, should the initial PCT have incorporated all of the cash ﬂows that CarCo expected as a business en-terprise?
- Would the economic answer to these questions change if CarCo establishes an offshore affiliate that is dedicated to the development of battery technology but is not provided access to CarCo’s automotive technology through a CSA or license?
In short, while the shift in the deﬁnition from §936(h) intangibles to all resources, rights, and capabilities is likely to broaden the deﬁnition of what has to be paid for, it does not directly address the issue of whether the payment has to be linked to an attribute that exists at the time of the formation of the CSA or whether it also includes unrelated attributes that are obtained/developed at some future point in time.
PRE-EXISTING RESOURCES, CAPABILITIES, OR RIGHTS – AND LIFE
The basic question raised in the discussion above is whether a payment for intangibles/resources, capabilities, or rights that exist as of a speciﬁc date should include the value of intangibles/resources, capabilities, or rights that do not then exist but are developed later, based on intangible development costs incurred. In this regard, there are three broad ways of looking at this question, which I will refer to as a legal deﬁnition of life, an economic deﬁnition of life, and an ongoing business enterprise deﬁnition of life. These three different concepts can be summarized as follows:22
- ‘‘Legal’’: For an intangible transferred as of Date X, the life of the ‘‘pre-existing’’ intangible is the period over which it contributes to value (including its value in developing next-generation intangibles) but excludes the value associated with intangible-generating investments made by the transferee after Date X. Under this deﬁnition, the value of the battery technology discussed above is not included in the value that needs to be paid for, as it is not something that was owned by the transferor at the time of the transfer. As a general matter, this answer would not seem to depend upon whether we are talking about paying for pre-existing intangibles or pre-existing resources, capabilities, or rights, although it is certainly possible to imagine situations in which a developed ‘‘capability’’ has not crystalized into a speciﬁc intangible. This appears to be the deﬁnition of life upon which the Tax Court relied in its Veritas and Amazon decisions.
- ‘‘Economic’’: For an intangible transferred as of Date X, the life of the intangible includes the above plus the excess returns/economic proﬁts that are expected — at the time of transfer — on investments in intangibles made after Date X. Under this deﬁnition, the value of the battery technology discussed above may potentially be included in the value that needs to be paid for, if the expected return on the investment in battery technology made by the cost-shared business is greater than that which would have been expected from a standalone investment. Thus, if an investment of $500 in battery technology generated a net return (after repaying the initial $500 investment) of $1,000 when made in the cost-shared business but would have generated a net return of just $300 if it had been made by a standalone business, the investment in battery technology would presumably have contributed $700 in incremental value. There is some attribute of the initial transfer that allows the investment in battery technology to be more proﬁtable than it would have been otherwise, and this value is included in the payment that is made for pre-existing intangibles/resources, capabilities, or rights. It is worth noting that this deﬁnition does not appear to have been presented to, or evaluated by, the Tax Court in either Veritas or Amazon.
- ‘‘Ongoing Business’’: Under this perspective, the transfer of pre-existing intangibles/resources, capabilities, or rights is, in effect, a transfer of a business. Therefore, the value of the pre-existing intangibles is the same as the value of the business, and the most straightforward way of determining the value of the business is to compute the present value of its cash ﬂows, and to then determine the value of intangibles by deducting the present value of routine proﬁts. As the life of a business is indeﬁnite/perpetual, the cash ﬂows that are used under this approach are also perpetual. It is worth noting that this deﬁnition would not appear to be applicable to the transfer of a single speciﬁc intangible that was only one of many factors that the transferee needed to operate its business.
As noted above, the Tax Court’s decisions appear to be based on the ﬁrst of the three deﬁnitions of what needs to be paid for. The court explicitly rejected the third deﬁnition: that the transfer was akin to the sale of a business and should be valued appropriately. It did not ask the question of whether Amazon’s investments in, for example, the development of the Kindle, were more proﬁtable than those that would have been realized by a standalone investor, which is a necessary question under the second deﬁnition.
REQUIREMENT FOR GEOGRAPHIC OR FIELD OF USE EXCLUSIVITY
One of the requirements introduced in the 2011 changes to the cost sharing regulations is that ‘‘Each controlled participant must receive a non-overlapping divisional interest in the cost-shared intangibles without further obligation to compensate another controlled participant for such interest.’’23 This in essence requires that each participant to a CSA must have exclusive rights to a clearly deﬁned share of the taxpayer’s business, and is most commonly implemented through geographic exclusivity. Moreover, each participant must have all rights needed to develop the intangibles required to conduct business within this exclusive territory/ﬁeld of use, and the transfer is in perpetuity.
The requirement for territorial or other divisional exclusivity can perhaps be viewed as a requirement that a CSA must be set up in such a way that the original owner of the business is in effect transferring a share of the business (e.g., the exclusive rights to the non-U.S. market) to a newly formed CSA participant, and that this therefore necessarily reﬂects the transfer or sale of a business. This presumably strengthens the IRS argument that a PCT payment should be computed on the basis that the overall business has been transferred, and therefore should be based on a valuation method that reﬂects this (e.g., the present value of all future residual proﬁts). As will be discussed below, the aggregation rules may arguably contribute to this position.
This argument is obviously strongest in cases where the U.S. taxpayer entering the CSA is an established U.S. business with no operations outside the United States. In this case, the non-U.S. participant’s only contribution is a ﬁnancial one, and this ﬁnancial contribution allows it to enter the business in question. The issue is more clouded, however, if the U.S. taxpayer already has established business operations outside of the United States. Under such circumstances, it is more difficult to determine whether the goodwill and going concern component of the business is associated with intangibles only, or whether it includes values that are related to the ‘‘non-intangible’’ elements of the business, such as local customer networks and other local business interests.
In this regard, in its discussion of why Dr. Frisch’s DCF analysis was not appropriate, the Tax Court noted that: ‘‘. . . AEHT was not an empty cash box. The European Subsidiaries, of which AEHT became the parent, had been in business for approximately six years. They had a skilled workforce; they owned tangible and intangible assets; and they had goodwill and going-concern value….’’24
One of the key questions looking forward, therefore, is whether the requirement for divisional exclusivity is sufficient to lead the Tax Court to treat a transfer to a new CSA as the transfer of a business —and the associated goodwill and going concern value related to that business — and whether this will depend upon whether the taxpayer does or does not have an established business in the other territories (or in the speciﬁc ﬁeld of use) at issue.
Finally, the requirement for divisional exclusivity in perpetuity is an attribute of the cost sharing regulations, and not of the §482 regulations in general. Tax-payers presumably can still structure transfers outside of the cost sharing regulations in a way that would not be viewed as a perpetual transfer of an exclusive interest in a business.
Another change in regulatory requirements is the IRS’s push to have intangibles valued in aggregate, rather than as discrete and separate. The temporary regulations state:25
‘‘(B) Aggregation. The combined effect of two or more separate transactions (whether before, during, or after the year under review), including for purposes of an analysis under multiple provisions of the Code or regulations,26 may be considered if the transactions, taken as a whole, are so interrelated that an aggregate analysis of the transactions provides the most reliable measure of an arm’s length result determined under the best method rule of §1.482-1(c). Whether two or more transactions are evaluated separately or in the aggregate depends on the extent to which the transactions are economically interrelated and on the relative reliability of the measure of an arm’s length result provided by an aggregate analysis of the transactions as compared to a separate analysis of each transaction. For example, consideration of the combined effect of two or more transactions may be appropriate to determine whether the overall compensation in the transactions is consistent with the value provided, including any synergies among items and services provided.’’
The temporary regulations also specify that if the value of a speciﬁc component of an aggregated bundle needs to be determined separately (e.g., because one transaction is with country A while another is with County B), the ‘‘more reliable’’ aggregate value should be allocated among the different transactions.
If this requirement is interpreted as requiring that ‘‘property’’ intangibles such as those listed in §936(h) have to be aggregated with goodwill and going concern intangibles (e.g., because the 482 intangibles at issue have to be aggregated with a transfer under §367 that includes goodwill and going concern), this would obviously push the valuation answer to one that includes the overall value of the business that is being transferred rather than one that is limited to the value of individual intangibles. However, this would seem to imply that the IRS has already established the principle that goodwill and going concern need to be paid for and, therefore, the value of goodwill and going concern will ultimately be captured regardless of whether the analysis is done on an aggregated basis.
The more interesting question is whether the aggregation rules, absent an explicit requirement to include goodwill and going concern intangibles, are likely to increase the amount paid for intangibles. The most obvious potential impact of requiring intangibles to be valued in aggregate — and the issue that the IRS points to in the temporary regulations — is that of synergies. Given synergies (or dis-synergies) the value of a combined bundle of property may be greater than (or less than) the value of the individual components of the bundle. Thus, even if the value of a trademark is clearly 5% of sales while the value of the technology needed to produce the product being sold under the trademark is also 5% of sales, the value of a license that conveys both trademark and technology rights may be greater than (or less than) the 10%derived by simply adding the two separate royalty rates. And if they are used in the same business, the temporary regulations appear to require that they be valued in aggregate.
As a matter of ﬁrst impression, the three intangibles transferred to the CSA in Amazon (technology, marketing, and customer relationships) appear to qualify for aggregate valuation under the standard set forth in the temporary regulations, as they were all used in the same business and each contributed to the success of that business. Thus, on their face, the regulatory changes that have occurred since 2005–2006 appear to strengthen the IRS position that the transfer of the three intangibles should be treated in aggregate.
However, the rationale that the IRS has advanced for aggregation — that it may be more accurate to determine the value of the bundle that is transferred than to add up the individual components of the bundle ‘‘. . .if the transactions, taken as a whole, are so interrelated that an aggregate analysis of the transactions provides the most reliable measure of an arm’s length result determined under the best method rule. . .’’ does not appear to address the Tax Court’s primary reason for rejecting the aggregated approach used by Dr. Frisch. In rejecting the use of the aggregated DCF approach, the court stated:27
‘‘First, Dr. Frisch’s business-enterprise approach improperly aggregates pre-existing intangibles (which are subject to the buy-in payment) and subsequently developed intangibles (which are not). Second, his business-enterprise approach improperly aggregates compensable ‘‘intangibles’’ (such as software programs and trademarks) and residual business assets (such as workforce in place and growth options) that do not constitute ‘‘pre-existing intangible property’’ under the cost sharing regulations in effect during 2005-2006 ….’’
In short, Dr. Frisch’s aggregate approach was rejected because it included factors that the Tax Court concluded did not have to be paid for: subsequently developed intangibles and residual business assets. The court does not appear to have had to address the issue that the regulations use to support the need to aggregation — i.e., whether there were synergies among the various transferred intangibles that made an aggregate analysis more reliable than an intangible-speciﬁc analysis.
It is, however, possible that aggregation rules may have indirect effects. As an obvious point, aggregation almost certainly favors proﬁt-based methods, in that it is generally easier to ﬁnd comparable transactions for speciﬁc intangibles than for groups of intangibles. Thus, the aggregation rules have the potential for making it more difficult for the Tax Court to apply transactional methods in the future.
There also may be an alternative way of using the aggregation requirements as support for adopting an enterprise valuation approach. Under this alternative view, there may be some threshold in which the transfer of ‘‘all’’ intangibles or ‘‘all’’ resources, capabilities, or rights is a de facto transfer of the entire business. This issue may be especially important in the case of newly established CSAs, as the 2011 cost sharing regulations require geographic or other exclusivity into perpetuity. The transfer of all intangibles and other property needed to operate a business, when combined with a requirement that the transaction be structured in a way that provides the transferee with perpetual and exclusive rights to a deﬁned geography or ﬁeld of interest, may look like the transfer of the business as a whole.
As a ﬁnal observation, the aggregation rules implicitly assume that all intangibles/resources, capabilities, or rights are owned by the same legal entity. However, this is often not the case — especially when the deﬁnition is expanded to include resources, capabilities, or rights rather than just intangibles. As discussed above, the Tax Court noted in Amazon that the cost sharing partner in the Netherlands had a pre-existing business and was not a simple cash-box. As long as some resources, capabilities, or rights are owned off-shore, it is more difficult to start from the value of the overall bundle and then derive the value of just those intangibles/resources, capabilities, or rights owned by a speciﬁc legal entity.
APPLICATION OF REASONABLE ALTERNATIVES
Historically, the Tax Court has given little if any weight to the concept of reasonable alternatives. In Bausch & Lomb, for example, the court ruled that Bausch & Lomb’s U.S. affiliate was free to pay a price of $7.50 per lens even though it could produce that same lens for approximately $2.00.28 In Amazon,as has been discussed above, the court rejected the IRS’s argument that the U.S. taxpayer had the reasonable alternative of not entering into the CSA on the grounds that (a) requiring the same economic outcome under a CSA as would exist absent the CSA would, in effect, make the cost sharing regulations meaningless and (b) the IRS needs to respect the business arrangements established by the taxpayer provided they have substance, which also implies the need to respect the economic consequences of these business arrangements. The court went on to state:29
‘‘. . . as we noted in Veritas . . . the regulation enunciating the ‘realistic alternatives’ principle also states that the IRS ‘will evaluate the results of a transaction as actually structured by the taxpayer unless its structure lacks economic substance….’Thus, even where a realistic alternative exists, the Commissioner ‘will not restructure the transaction as if the alternative had been adopted by the taxpayer,’ so long as the taxpayer’s actual structure has economic substance….
The transaction actually structured by Amazon US was a cost sharing arrangement, and respondent does not contend that this structure lacked economic substance. The 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 regulatory changes that have been made since 2005–2006 largely reﬂect the IRS arguments that were rejected by the Tax Court. The 2011 cost sharing regulations, for example, introduced a new method —the income method — that is explicitly based on the concept of reasonable alternatives, in that it computes the PCT as the difference between the present value of proﬁts under cost sharing and under the ‘‘reasonable alternative’’ of not cost sharing. More recently, the temporary regulations issued in 2015 explicitly endorse the concept of reasonable alternatives as a way of requiring taxpayers to pay ‘‘full value’’ for any transfers. The preamble to the temporary regulations states: ‘‘Thus, although a taxpayer may choose among different transactional forms — for example, a long-term license, research and development services, a cost sharing arrangement, or a transfer subject to section 367 — speciﬁed and unspeciﬁed methods applicable to each form will provide consistent arm’s length results for economically equivalent transactions.’’
With these changes, the current §482 regulations appear to contain two different principles, with the potential for conﬂicting interpretations on how they interact, as follows:
- Taxpayers have the right to set up the business arrangements that best meet their needs. The IRS is required to respect the business arrangements adopted by the taxpayer if they are appropriately documented, have economic substance, and are followed. Business arrangements have economic consequences — a license is not the same as a sale — and therefore economic outcomes will vary depending upon the speciﬁc business arrangements that the taxpayer has put into place.
- At arm’s length, two unrelated parties would evaluate the various alternatives that are available to them, and will reject any alternatives that produce worse economic results than another viable alternative. If one business alternative produces expected net residual proﬁts of $100, and another produces net residual proﬁts of $40, the second will be selected if and only if the taxpayer in question receives an additional payment of $60 so that the two alternatives produce economically equivalent results.
The key question going forward, therefore, is whether the regulatory changes that have occurred since 2005–2006 will lead to the development of a ‘‘reasonable alternatives’’ measure that weakens the deference given in the past to the business arrangements established by the taxpayer. The following three questions may come into play in any evaluation of this issue:
- Is the IRS’s application of the concept of reasonable alternatives simply a way of shifting the value attributable to a non-taxable transfer of goodwill and going concern to a taxable transfer of intangible property?
- Can the requirement that different business arrangements have equivalent economic outcomes be reconciled with the fact that economic out-comes vary, depending upon the details of the business arrangement?
- How are realistic alternatives defined, and is there an obvious best realistic alternative?
Is the IRS application of the concept of reasonable alternatives simply a way of shifting the value attributable to a non-taxable transfer of goodwill and going concern to a taxable transfer of intangible property?
In Amazon, the Tax Court distinguished between compensable intangibles (e.g., the pre-existing §936(h) intangibles) and non-compensable items, including both (a) intangibles developed after the CSA went into effect and (b) residual business assets such as goodwill and going concern, workforce in place, business opportunities. If the Tax Court continues to take the position that the overall value of a business enterprise includes some non-compensable assets (e.g., that there are at least some elements of goodwill and going concern value that can be transferred without triggering a taxable event), will it accept an IRS application of the reasonable alternatives argument that has the practical effect of shifting ‘‘value’’ from a category that is non-taxable to one that is taxable?
Taking Amazon’s initial buy-in payment of $254 million as an accurate measure of the present value of the income for the pre-existing intangibles that were transferred to Amazon Netherlands, and the IRS’s DCF value of $3.468 billion as an accurate measure of the present value of the residual proﬁts that Amazon US gave up by entering into the CSA, the taxpayer shifted $3.214 billion in proﬁts from Amazon US (where it would be taxed by the United States) to Amazon Netherlands (where U.S. taxes were deferred indeﬁnitely). The essence of the IRS’s reasonable alternatives argument is that no reasonable economic actor would agree to ‘‘sell’’ $3.468 billion in the present value of cash ﬂows for a payment of just $254 million.
However, the question is not this black and white. For simplicity, I will call the $3.468 billion ﬁgure, the total value of ‘‘all’’ intangibles; the $254 million buy-in payment, the value of §936(h) intangibles; and the difference of $3.214 billion, the value of ‘‘residual’’ intangibles. The Tax Court concluded that while the transfer of §936(h) intangibles from Amazon US to Amazon Netherlands was compensable, thus generating a taxable event, the transfer of residual intangibles was not compensable and, therefore, did not lead to a taxable event. Thus, even if the shift in compensable property allowed, or even necessarily led to, a corresponding shift in non-compensable income, the taxable value of the transfer was limited to the value of compensable intangibles only.30
Given the distinction between compensable and non-compensable income, the core IRS argument around reasonable alternatives is that if the transfer of § 936(h) intangibles also leads to the transfer of residual intangibles, the taxpayer (at arm’s length) will insist on receiving a price for the compensable
§ 936(h) intangibles that includes the value of every-thing that is transferred, including residual intangibles. However, my (non-legal) reading of the Tax Court decision is that even if the transfer of the compensable §936(h) intangibles led to the transfer of non-compensable residual value as well, this did not change the character of the intangible income that was transferred and, therefore, did not shift value from the category of nontaxable residual intangibles to taxable
§ 936(h) intangibles. The transfer of the value of the residual intangibles, even if real, was not taxable.
In short, the way in which the IRS used the reasonable alternatives argument in Amazon and the way it is using the argument in both the 2011 cost sharing regulations and the temporary regulations is quite different from the issue in raised in Bausch & Lomb or in the use of reasonable alternatives as a way of incorporating opportunity cost into a §482 valuation. Under the Tax Court’s logic in Amazon, the cost sharing partner ultimately received one set of beneﬁts/future income — pre-existing §936(h) intangibles —that created a taxable payment and another set of beneﬁts/future income — the present value of cash ﬂows linked to future R&D, goodwill and going concern, business opportunities — that was not compensable and did not generate taxable income.
In this regard, Amazon, as a parent company, clearly received the economic beneﬁts of both the compensable portion of the transfer (in the form of taxable income) and the non-compensable portion to the transfer (in the form of its equity interests in the offshore enterprise).31 Looking at the transfer from this perspective suggests that Amazon US did in fact receive/retain the full value of Amazon’s offshore business; however, only a portion of this value was taxable. The question of whether the taxable portion of transfer should or should not have included goodwill and going concern value thus becomes a question of what is compensable, and not what are the taxpayer’s reasonable alternatives.
Can the requirement that different business arrangements have equivalent economic outcomes be reconciled with the fact that economic outcomes vary, depending upon the details of the business arrangement?
The question of whether tax authorities need to respect the business arrangements established by taxpayers has been a highly controversial topic. From the taxpayer’s perspective, transfer prices and the associated proﬁt outcomes are highly dependent upon the business arrangements governing the transaction at issue: who is at risk if the price of raw materials increases; are prices set on a spot basis or ﬁxed for several years; the speciﬁc property transferred, and if the transfer is for an intangible, which party is responsible for funding any ongoing investments needed to maintain the value of that intangible; what are each party’s rights to terminate the business arrangement, and will a payment be needed in the event of termination? Allowing tax authorities to second guess the business arrangements put in place by taxpayers, particularly based on ex post information developed during a tax audit, allows tax authorities to make adjustments based on transfer prices that are inconsistent with those that would result at arm’s length under the business arrangements of the taxpayer.
Tax authorities, on the other hand, are concerned that taxpayers can develop business arrangements that ‘‘artiﬁcially’’ limit taxable income in their jurisdiction. Therefore they often believe that it is important to look beyond a speciﬁc business arrangement in determining whether transfer pricing outcomes are arm’s-length. As discussed above, the IRS has long been concerned that taxpayers, by transferring a bundle of §936(h) intangibles and paying just for the value of those intangibles over a speciﬁc life, have also transferred proﬁts related to goodwill and going concern intangibles as well.
The IRS approach to addressing this issue, as set forth in the temporary regulations, has been to state that it will respect the business structure established by the taxpayer but will base its analysis of the value of what has been transferred by starting with the ‘‘realistic alternative’’ that the taxpayer did not have to transfer the intangible property/resources, capabilities, or rights in question. This principle can be illustrated using changes to office rental agreements as an example. Assume that renter A has a 5-year rental agreement. In year 3, renter A decides to negotiate an extension of that rental agreement to cover a 10-year term starting at the beginning of year 4. Given that the other party (the landlord) has the right not to change the agreement, the rental terms for years 4 and 5 will have an impact on the ﬁnal terms of the new agreement. Therefore, the rent paid under the renegotiated agreement may be higher or lower than the rent paid under an agreement that was negotiated de novo. However, the speciﬁc terms of the new rental agreement still matter, and the rents paid can be expected to vary depending upon the details of whether the landlord or renter is expected to pay utilities, the termination clauses in the agreement, and other obligations of the renter and landlord.
The current regulations recognize that the terms of speciﬁc business arrangements have to be taken into account in the application of the realistic alternatives principle, particularly with respect to risk. The 2011 cost sharing regulations, for example, explicitly discuss the need to adjust for risk when comparing different reasonable alternatives, noting that the discount rate used to compute the present value of cash ﬂows may be higher under the cost sharing alternative than under the licensing alternative due to the greater risk the transferee bears in the former alternative with respect to investments in the development of intangibles. Moreover, experience has shown that the differences in the present value of future cash ﬂows due to the use of different discount rates for the licensing and cost sharing alternatives can be substantial, especially for businesses with high expected growth rates in the ﬁrst few years following the formation of the CSA.
However, risk is not the only way in which business arrangements affect value in the transfer of intangible property. To cite a trivial example, the amount paid in a buy-in depends upon the scope of the territorial rights that are conveyed — the value of a transfer of the right to use the Amazon intangibles that is limited to Europe alone is presumably less than the value of a transfer of the rights to use such intangibles in all countries outside the United States. Once again, the §482 regulations clearly take into account such changes in the scope of the geographic rights conveyed.
The key question, however, is whether the IRS can use the reasonable alternatives analysis to limit the options that are available to the taxpayer in structuring its business arrangements. The IRS has clearly incorporated such limitations into the cost sharing regulations by, for example, requiring perpetual and exclusive rights rather than allowing for an agreement for more limited rights. By imposing such limitations, the IRS appears to be trying to prevent taxpayers from adopting arrangements in which the transfer of §936(h) intangibles that have only limited value will allow for a much larger transfer of expected non-compensable future proﬁts for the more limited value of the §936(h) intangibles per se. Moreover, as discussed above, these limitations may strengthen the IRS argument that the transfer of rights under a CSA is akin to the transfer of a business.
The temporary regulations at least suggest that the IRS may try to impose limitations on the types of transfers that are made outside of a CSA as well —the IRS has indicated that certain intangibles may be so closely related that an aggregated analysis is needed. Under such circumstances, the determination of the price for any single component of a bundle of rights needs to start from the value of the overall bundle rather than the standalone value of the speciﬁc intangible in question. This raises questions going forward of whether the IRS can argue that the value of two marketing intangibles — say trademarks and customer relations — are so interrelated that they need to be valued in aggregate.
In summary, while the temporary regulations explicitly state that the option of not entering a transaction needs to be taken into account in determining the price that should be paid for a transfer of intangibles (or other transfers as well), the IRS continues to acknowledge that the speciﬁc terms of business arrangements matter. When viewed in this light, I am not sure that this is a new requirement — it is no different from the observation that when a rental agreement is renegotiated, the existing agreement needs to be considered before it has expired. The real question is whether the changes in the regulations that have occurred since 2005–2006 limit the taxpayer’s options with respect to scope of the new business arrangements in a way that will change the computation of the value of compensable transfers.
How are realistic alternatives deﬁned, and is there an obvious best realistic alternative?
In both its Amazon arguments and the regulatory changes that have taken place since 2005–2006, the IRS takes the position that the ‘‘reasonable alternative’’ to the transfer at issue is to not enter into the transaction, which it interprets as a continuation of the status quo for an indeﬁnite period (e.g., perpetuity). This implies that any change can be evaluated against the status quo, and by implication any such change that leads to a reduction in proﬁts needs to be paid for. Moreover, the approach discussed generally envisions only two alternatives: to transfer all intangibles/resources, capabilities and rights to an offshore entity, or to retain all such rights in the legal entity that currently owns them.
There are at least two issues with this simpliﬁed analysis. The ﬁrst and most obvious issue is that the simple reasonable alternative examples presented in the temporary regulations implicitly assume that the transferee is a cash box, in that they ignore the resources, capabilities, or rights of the transferee. However, most large companies have established international operations, and the attributes of these international operations have to be considered.
Second, taxpayers generally have a wide range of different options that they can consider in setting up a new business arrangement. Using the facts as presented by the Tax Court in Amazon to illustrate the point, Amazon presumably could have set up Amazon Netherlands with the speciﬁc limited objective of developing the Kindle market in Europe. To the extent needed, Amazon US presumably would have licensed any website technology needed to develop the Kindle32 market to Amazon Netherlands. Amazon Netherlands presumably would then make the investments needed to develop the Kindle market in Europe.
The IRS has an obligation to respect the fact that Amazon Netherlands (not Amazon US) is making the investments needed to develop the European market for the Kindle and, further, to respect the fact that the Kindle market was not (based on the description provided by the Tax Court) in existence at the time the CSA was established. The key question, given this, is whether the IRS can determine the buy-in that Amazon Netherlands has to pay Amazon US for website technology used in the development of the Kindle based the ‘‘reasonable alternative’’ that Amazon US (rather the Amazon Netherlands) ‘‘could’’ have made the investments needed to develop the market for the Kindle in Europe while still respecting the business arrangements established by the taxpayer.
The above example about changing a rental agreement in the middle of the lease term may provide some guidance on this question. In the rental example, the pricing and other terms of the original lease affect the terms of the new lease because the original lease sets forth the rights and obligations of the renter and landlord in years 4 and 5, and that the economic value of the changes in these terms in years 4 and 5 needs to be reﬂected in the new rental terms. However, if the original rental agreement contained a provision that allowed the renter to break the agreement with a day’s notice, then the leverage that the original agreement provided to the landlord disappears, and the renter can negotiate an agreement on de novo terms if that is in his/her interest. The original lease (e.g., the status quo) matters only if it gives the landlord leverage in the new negotiations.
In the case of the Kindle technology example discussed above, the key question therefore is the extent to which Amazon Netherlands’s ability to launch a successful Kindle business in Europe depends upon the website technology owned by Amazon US. The argument that the IRS could determine the price for the license of website technology for use in the Kindle based on the assumption that Amazon US had the reasonable alternative of investing in the Kindle technology in the US may make sense if the development of the market for the Kindle in Europe is wholly/highly dependent upon the licensed website technology. Given such a dependence, Amazon US presumably could prevent Amazon Netherlands from developing the market for the Kindle, and arguably could develop the European market on its own.
However, the logic breaks down if the development of the Kindle market in Europe does not depend upon the licensed website technology, either because the Kindle market is simply different — it requires the ability to buy or manufacture a hardware product and maintain a library of e-books, but not necessarily to maintain a diverse range of online retail products — or if that technology conceptually could have been obtained from another source. Under these circumstances, Amazon Netherlands would have the ‘‘reasonable alternative’’ of not paying Amazon US and developing the Kindle market on its own. Once this is acknowledged as a possibility, the analysis shifts to the question of which future products made and sold by Amazon Netherlands were dependent upon the website technology contained in the initial license. Nor does the aggregation argument help, as it may be difficult for the IRS to argue that the Kindle and website attributes are so intertwined that they cannot be evaluated separately absent a technological or other link between the two products.
SUMMARY OBSERVATIONS ON REASONABLE ALTERNATIVES
The Tax Court’s decision regarding reasonable alternatives in the Amazon case was based on bright lines: The taxpayer has the right to set up speciﬁc business arrangements; if those business arrangements have substance the IRS needs to respect them; the evaluation of whether transfer prices are arm’s-length therefore needs to respect the business arrangements put in place by the taxpayer and does not have to take into account other options that might have been available.
The IRS argument is that, given two alternatives, a party operating at arm’s length will always choose the more lucrative alternative, or will insist on a pricing adjustment to the alternative option to make it as ﬁnancially attractive. Given the option of not entering into a transaction, the taxpayer should expect to receive compensation under the new business arrangement equivalent to that under the status quo. How-ever, this simple formulation of a reasonable alternatives analysis may pull in payments for non-compensable transfers of income. Moreover, the §482 regulations, even with the regulatory changes that have occurred since 2005–2006, acknowledge that the IRS will respect the business arrangements that the taxpayer has adopted, and the speciﬁc details of the business arrangements as having to be taken into consideration in computing ‘‘equivalent’’ compensation.
The IRS has had a long-standing concern that tax-payers have been shifting intangible ownership — and the proﬁts associated with the ownership of intangibles — offshore for ‘‘less than full consideration.’’ The key source of the IRS’s concern is that while tax-payers are only receiving a payment for ‘‘pre-existing’’ §936(h) intangible property, the substantive effect of this transfer is to shift the overall proﬁts of the business enterprise as a whole, including residual proﬁts that are commonly associated with goodwill and going concern. The IRS has developed a series of legal and economic arguments that are intended to re-quire a payment for the residual proﬁts associated with the transfer of the business as well as the speciﬁcally deﬁned intangible property.
The IRS has litigated this issue twice — in Veritas and Amazon — and in both cases the Tax Court has concluded that while taxpayers must pay for the speciﬁcally deﬁned pre-existing §936(h) intangibles, they do not have to pay for either (a) intangibles that were developed after the outbound transfer and which were therefore funded by the offshore cost sharing entity, or (b) ‘‘residual intangibles’’ such as business opportunities/goodwill and going concern that cannot be transferred separately from the business itself. In doing this, the Tax Court has explicitly rejected the various arguments that the IRS has advanced around the life of intangibles, aggregation, treating the trans-fer as akin to the sale of a business enterprise, and the concept of reasonable alternatives.
The §482 regulations, however, have changed since 2005–2006, and many of the concepts that the IRS advanced to support its position in Veritas and Amazon have now been incorporated into the §482 regulations, either in the cost sharing regulations that were ﬁnalized in 2011 or in the temporary regulations that went into effect in 2015. It will be interesting to see, going forward, whether these regulatory changes will lead the Tax Court to:
- conclude that some transfers are, in fact, akin to the sale of a business and therefore require a payment based on the value of the business, presumably less ‘‘routine’’ business value;
- redeﬁne what needs to be paid for (e.g., all re-sources, capabilities, or rights) without necessarily capturing the entire value of the business enterprise;
- adopt valuation approaches (such as the economic rather than legal deﬁnition of life or the explicit consideration of synergies in an aggregate analysis) that lead to higher intangible valuations, even given a deﬁnition of intangibles that is relatively consistent with that which existed in 2005–2006; and/or
- reduce its historic bright-line respect for the business arrangements established by the taxpayer in order to take into account the regulatory observation that the amount paid for intangibles/resources, capabilities, or rights should be equivalent, regardless of the speciﬁc business arrangements that have been put in place.
While all of these are possibilities, experience suggests that it is difficult to predict how the Tax Court will react to regulatory changes. For example, there was an expectation that the changes in the 1994 regulations would make it more difficult to use the CUP method as they removed the priority of methods. Despite this change, the Tax Court has continued to rely heavily upon CUP/CUT analyses, and relied on CUT analyses in its decisions in both Veritas and Amazon.