TAX NEWS - DECEMber 2009

IRS Tax: In big loss for IRS, Tax Court rejects IRS reallocation under cost sharing agreement

The Tax Court on December 10 largely upheld a corporate parent's use of the comparable uncontrolled transaction (CUT) method to determine the requisite buy-in payment for an Irish subsidiary with which the corporate parent entered into a cost sharing arrangement. The court determined that some adjustments were necessary. (Veritas Software Corp. v. Commissioner, 133 T.C. No. 14 (Dec. 10, 2009).) URL: http://www.ustaxcourt.gov/InOpHistoric/Veritas.TC.WPD.pdf

Pursuant to the cost sharing arrangement to develop and manufacture storage management software products, the parent corporation granted to its subsidiary the right to use certain preexisting intangibles in Europe, the Middle East, Africa, and Asia. As consideration for the transfer of preexisting intangibles, the subsidiary made a $166 million buy-in payment to the parent, which had used the CUT method to calculate the payment. In a notice of deficiency, the IRS employed an income method and determined a requisite buy-in payment of $2.5 billion and made an income allocation to the parent of that amount. In an amendment to answer in this case, the IRS reduced the allocation from $2.5 billion to $1.675 billion. The IRS further determined that the requisite buy-in payment must take into account access to the parent's research and development team; access to the parent's marketing team; and the parent's distribution channels, customer lists, trademarks, trade names, brand names, and sales agreements.

The court concluded that the Service's determination (in the original notice and in the amendment to answer) was arbitrary, capricious, and unreasonable. First, the court found that the IRS gave little explanation for the large decrease in valuation. Further, the court found that the two IRS employees who made the original and subsequent valuations employed an incorrect – and critical – factor, applied temporary regulations that were promulgated years after the transaction, and used the wrong useful life and the wrong discount rate.

As to the taxpayer's CUT method, the court determined that adjustments were necessary for the starting royalty rate, useful life and royalty degradation rate, and valuation of trademark intangibles and sales agreements. The court agreed with the discount rate the taxpayer used to estimate its weighted average cost of capital derived under the capital asset pricing model.