On March 23, 2017, the Tax Court ruled against the IRS in its lengthy transfer pricing dispute with Amazon.com, Inc. (“Amazon U.S.”) over Amazon’s transfer pricing policies relating to intangible assets provided by Amazon U.S. to its European subsidiary in 2005 and 2006 that were required to operate Amazon’s European website business.[i] In redetermining the IRS’s reallocation of income from Amazon’s European subsidiary to Amazon U.S., the Tax Court held that the IRS abused its discretion and acted arbitrarily and capriciously in its original determinations against Amazon.
Transfer Pricing Adjustments. Under Section 482 of the Internal Revenue Code, the IRS has broad authority to allocate gross income and deductions among commonly controlled entities if necessary “to prevent evasion of taxes or clearly to reflect the income.”[ii] The purpose of Section 482 is to prevent artificial shifting of income between controlled entities in order to ensure that the amount of income reported by each entity for U.S. tax purposes is consistent with the economics of the transactions between the related entities, which is especially relevant where income is shifted from the U.S. to a jurisdiction with a lower tax rate.[iii]
The IRS has broad powers under Section 482. While the general rule in Tax Court cases is that the taxpayer has the burden of proving by a preponderance of the evidence that the taxpayer’s return was correct, in Section 482 cases, the IRS’s determinations will be upheld unless the taxpayer is able to show that that IRS’s determination was arbitrary, capricious, or unreasonable.[iv] Note that while the taxpayer’s burden of proving the IRS’s determination to be arbitrary, capricious, or unreasonable is unique to Section 482 adjustments, the arbitrary, capricious, or unreasonable standard is also used for determining when the IRS loses its presumption of correctness for its adjustments in a Notice of Deficiency, allowing the taxpayer to shift the burden of proof to the IRS.[v]
Amazon’s Transfer Pricing Policies. In examining Amazon’s transfer pricing policies, the IRS determined that amounts Amazon’s European subsidiary paid for the intangible assets it received in 2005 and 2006 from Amazon U.S. for use in its business in Europe in 2005 and 2006 were not at arm’s length.[vi] The arrangement between Amazon’s European subsidiary and Amazon U.S required Amazon’s European subsidiary to make a “buy-in” payment for the preexisting intangibles it received from Amazon U.S. in a series of transactions in 2005 and 2006, as well as a cost sharing arrangement to split the costs of Amazon’s ongoing intangible development costs. The effect of the cost sharing arrangement was to essentially make Amazon’s European subsidiary a co-owner of the subsequently developed intangibles. Amazon originally reported a buy-in payment from Amazon’s European subsidiary of $254.5 million, to be paid over 7 years.
The IRS Acted Arbitrarily and Capriciously. The IRS determined that the buy-in payment should have instead been $3.6 billion, which it subsequently reduced to $3.468 billion. Rather than using a method allowed in the regulations under Section 482 for specifically valuing each of the intangible assets transferred to Amazon’s European subsidiary, the IRS valued the intangible assets using a discounted cash flow analysis, as though Amazon U.S. had transferred an entire operating business to its European subsidiary. Finding that Amazon’s European subsidiary was already an operating company when it received the intangibles, the Tax Court held the IRS abused its discretion in using this method, because it erroneously included in its determination of the arm’s length buy-in payment the value of the European subsidiary’s existing ongoing business (e.g., its existing goodwill) and also the value of subsequently created intangibles, which were separately compensated for using the cost sharing arrangement. The IRS’s approach in the Amazon case was the same as the method it had used in the case Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009), where the Tax Court had held that method to be arbitrary and capricious.[vii] The Tax Court further held that the IRS abused its discretion in its determination of its adjustments to Amazon’s determination of amounts its European subsidiary owed pursuant to the cost sharing arrangement for subsequently created intangibles, based on its determination that 100% of Amazon’s “Technology and Content” costs are subject to the cost sharing agreement, whereas Amazon’s position was that only 50% were allocable to the ongoing intangible development costs.[viii]
The Tax Court Finds Amazon’s Methods Reasonable. Once finding that the IRS acted arbitrarily and capriciously, the Tax Court evaluated the taxpayer’s arguments in support of the amounts charged and found that the taxpayer’s “comparable uncontrolled transaction” (CUT) method is the best method for calculating the requisite buy-in payment and the taxpayer’s system of allocating costs for the cost sharing arrangement was a reasonable basis for allocating costs, though the Tax Court made certain adjustments to the taxpayer’s application of the methods.
LACEY STRACHAN – For more information please contact Lacey Strachan at Strachan@taxlitigator.com. Ms. Strachan is a senior tax attorney at Hochman, Salkin, Rettig, Toscher & Perez, P.C. and represents clients throughout the United States and elsewhere in complex civil tax litigation and criminal tax prosecutions (jury and non-jury). She represents U.S. taxpayers in litigation before both federal and state courts, including the federal district courts, the U.S. Tax Court, the U.S. Court of Federal Claims, and the Ninth Circuit Court of Appeals. Ms. Strachan has experience in a wide range of complex tax cases, including cases involving technical valuation issues. She routinely represents and advises U.S. taxpayers in foreign and domestic voluntary disclosures, sensitive issue civil tax examinations where substantial civil penalty issues or possible assertions of fraudulent conduct may arise, and in defending criminal tax fraud investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.
[i] Amazon.com, Inc. v. Comm’r, 148 T.C. No. 8, Docket No. 31197-12, 2017 (Mar. 23, 2017).
[ii] IRC § 482.
[iii] Treas. Reg. § 1.482-1(a)(1).
[iv] Amazon.com, Inc., 148 T.C. No. 8 at p. 174.
[v] See, e.g., Sealy Power Ltd. v. Comm’r, 46 F.3d 381, 386 (5th Cir. 1995) (“Several courts have recognized, however, that they need not give effect to the presumption of correctness and may instead shift the burden from the taxpayer to the Commissioner when the notice of deficiency is determined to be arbitrary or excessive.”).
[vi] Treas. Reg. § 1.482—7(g)(2).
[vii] Amazon.com, Inc., 148 T.C. No. 8 at pp. 73-88.
[viii] Id. at 174-177.