Facebook’s tax dispute over the pricing of transactions with an offshore subsidiary marks the first time an important anti-profit-shifting regulatory regime has been challenged in court, and the outcome will have major consequences.
During a lengthy Tax Court trial, Facebook has vigorously contested the IRS’s valuation of intellectual property and other intangible rights contributed to a cost-sharing arrangement (CSA) with an Irish subsidiary in 2010.
Facebook argues that the IRS’s $21.15 billion valuation of the company’s contributions to the CSA was nearly $15 billion too high, and the difference reflects stark disagreements concerning the variables and assumptions used in the IRS’s valuation method.
But Facebook’s arguments also challenge the general validity of the IRS’s valuation method itself, the income method, which was one of the signature features of a regulatory scheme introduced in 2009. The method targets cases in which a U.S. participant contributes valuable self-developed intangibles and an offshore “cash box” participant simply cuts checks to fund its share of the U.S. participant’s development activities.
Plugging Old Holes
In a CSA, each participant bears the costs of developing intangibles in proportion to the future economic benefits it expects to receive in its territory. This often begins with an initial contribution of intangible property to serve as the foundation for developing future intangibles.
To illustrate, assume that a U.S. parent company with a self-developed software application contributes version 1.0 to a CSA with a foreign subsidiary. If sales of future versions of the application in the U.S. parent’s territory are expected to account for 40 percent of the global total, the parent must bear 40 percent of the development costs and the subsidiary must bear the remaining 60 percent.
To make the U.S. tax base whole for its loss of expected future income, the cost-sharing regulations require that the parent in the example charge its foreign subsidiary an amount — referred to as a “buy-in payment” by earlier versions of the regulations — that reflects the value of the initial contribution.
The reason CSAs became the IP offshoring vehicle of choice for many U.S. tech multinationals was that the pre-2009 regulations arguably allowed taxpayers to exclude from the buy-in payment the value of goodwill, going concern value, and other residual business assets. The Ninth Circuit endorsed this interpretation in Amazon
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The risk that courts would read the regulations in this way prompted Treasury and the IRS to overhaul the cost-sharing regulations, which led to the release of temporary regulations in 2009 and final regulations in 2011. The amended regulations mooted the question of what does and what doesn’t constitute an intangible by relying on entirely different terminology. They also recognized a set of valuation methods that incorporate residual business asset value and established standards for evaluating methods’ reliability.
The income method was one of these new valuation methods, and the regulations favor its use when one party makes all the unique contributions and the other is a cash box.
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The Facebook Test
According to the Ninth Circuit panel that decided Amazon, there was “no doubt” that the IRS’s position would have been correct if the 2009 temporary regulations had been in force. However, the amended cost-sharing regulations, including the provisions relevant to the income method, had not been tested in court — until now.
One of Facebook’s primary criticisms of the income method is that it deprives the foreign participant of any return for its participation in the CSA, and that this brings the regulations into conflict with other regulatory provisions and with IRC section 482.
The income method gives a cash-box cost-sharing participant a return on its investment commensurate with the risk of the intangible development activity, which in the Facebook case corresponds to a discount rate of 14 percent (as the IRS argues), 19 percent (as Facebook argues), or somewhere in between.
When Facebook complains that the income method denies a cost-sharing participant returns on its participation, it’s really claiming that a cash box deserves even more than the discount rate. However, it’s unclear why a cash box should expect to earn more than a risk-adjusted return on its cash investment.
Facebook also argues that the income method inappropriately allocates returns attributable to the parties’ future intangible development costs to the initial intangible contribution. But a cash box contributes only cash, and a risk-adjusted investment seems an appropriate reward for its contribution.
The other prong of Facebook’s attack on the income method attempts to resurrect the semantic defect that led to the IRS’s loss in Amazon by claiming that section 482 contained the same defect until it was amended in 2017. This argument is odd, considering the Amazon opinion’s observation that the IRS would have won under the 2009 regulations and its exclusive focus on a regulatory definition.
But Facebook’s claim that the vague wording of section 482 implies that Congress never intended to authorize the income method is outright bizarre. Under Chevron U.S.A. Inc. v. Natural Resources Defense Council Inc., 467 U.S. 837 (1984), an agency’s interpretation of an ambiguous statutory provision must be upheld as permissible unless it is arbitrary, capricious, or manifestly contrary to the statute. This means that the vague wording of section 482 makes it even harder for Facebook to establish the impermissibility of the income method regulations.
Regardless of whether Facebook prevails on other grounds, the Tax Court should reject these general attacks on the income method’s validity. By restricting the offshore participant’s profit to a return commensurate with the risk associated with the relevant intangible development activity, the income method prevents — or at least limits — multinationals’ ability to shift an outsize share of the returns attributable to U.S.-developed intangibles to lower-tax jurisdictions.
If the Tax Court invalidates the method, the IRS’s ability to prevent profit shifting in other cost-sharing cases will be significantly weakened.