IRS Tax: Tax Court rejects IRS's cost sharing buy-in valuation analysis
Taxpayers won an unequivocal victory in Veritas Software Corp. v. Commissioner, 133 T.C. No. 14 (filed December 10, 2021), in which the U.S. Tax Court held that the IRS's $1.675 billion income adjustment of the cost sharing buy-in payment received by Veritas Software Corp. (the Taxpayer) from its Irish affiliate was arbitrary, capricious, and unreasonable. The court further held that the Taxpayer's comparable uncontrolled transactions (CUT) method, with adjustments determined by the court, was the best method to calculate the buy-in payment.
The Tax Court's opinion, based on the 1996 cost sharing regulations, focused heavily on the IRS's litigation missteps, the lack of credibility of the IRS's experts, and the strength of the Taxpayer's factual evidence. But the Tax Court also clearly rejected many of the arguments the IRS has been asserting since the release of the Coordinated Issues Paper on Cost Sharing Arrangements Buy-in Adjustments on September 27, 2021 (the Coordinated Issues Paper); thus, the case will likely impact the resolution of billions of dollars of proposed IRS adjustments related to cost sharing buy-in payments.Facts
In November 1999, Veritas-US and Veritas-Ireland entered into the following intercompany agreements: (1) assignment of certain European sales agreements, (2) Agreement for Sharing Research and Development Costs (the RDA), and a Technology License Agreement (the TLA). During 1999 and 2000, Veritas-Ireland paid Veritas-US approximately $172 million for the rights transferred pursuant to the TLA. In 2002, the parties agreed to reduce this amount to $118 million. In March 2006, the IRS issued a notice of deficiency based on a buy-in valuation of $2.5 billion that employed the forgone profits method, the market capitalization method, and an analysis of the Taxpayer's arm's length acquisitions. During pretrial proceedings, the IRS abandoned the original analysis and submitted a new analysis that reduced the amount of the buy-in by $825 million to $1.675 billion. The new analysis valued in the aggregate all the alleged intangibles and other property transferred to Veritas-Ireland, and was based on a discounted cash flow or "income method" using a perpetual life. The new analysis was based on Veritas-Ireland's actual results through 2006 and projections using an assumed growth rate after that date.Tax Court opinion
The Tax Court, based on well settled law, held that the IRS position is presumptively correct unless it is arbitrary, capricious, and unreasonable.The IRS original position was arbitrary, capricious and unreasonable -
The Tax Court found the IRS original position failed to meet this standard because the IRS, without any explanation, conceded $825 million of the buy-in amount set forth in its original analysis and failed to offer even a token defense of its original position.The Court's criticisms of the IRS revised position -
The IRS's revised position appears to be consistent with its position as stated in the Coordinated Issues Paper. The Tax Court either rejected most of the IRS's arguments contained in the Coordinated Issues Paper or found that the analysis of the IRS expert did not support those positions in the present case. - Allocation included intangibles created by cost sharing payments -
The Tax Court held that Treas. Regs. § 1.482-7(g)(2) only requires taxpayers to make a buy-in payment for preexisting intangibles. No payment is required for intangible property that is subsequently developed as a result of a cost sharing arrangement. The court determined and the IRS agreed that the IRS discounted cash flow or income method, which used a perpetual useful life for preexisting intangibles, was flawed because it took into account items of income other than from preexisting intangibles. The court held that the IRS valuation was in violation of its own regulations that limited the buy-in payment to preexisting intangibles. - The IRS's "akin" to a sale of the business theory is specious -
The Coordinated Issues Paper suggests that the income method, which is a form of discounted cash flow analysis typically used in business valuations or purchase price allocations, may be the best method for determining buy-in payments. One of the IRS's principal reasons for using the income method is that it values all the transferred rights in the aggregate, which the IRS says may be more reliable because it takes into account the synergistic value of the transferred intangibles. The IRS valuation approach is "akin" to a sale. The IRS expert's report in support of its revised analysis appears to be based on a similar analysis.
The IRS position was doomed when its own expert stated at trial that he did not have an opinion as to whether his methodology captured the synergistic value of the transferred intangibles. In disagreeing with the IRS's theory that valuing the transferred intangibles and other property in the aggregate was more reliable, the Tax Court concluded the opposite, because the IRS's approach valued short-term intangibles as though they had a perpetual life, and took into account subsequently developed intangibles rather than preexisting intangibles as required by the regulations. As a result, the court rejected the IRS's income method and aggregation approach on the basis that it did not produce the most reliable result. In a footnote, the court also noted that the "akin to a sale" theory may violate Reg. §1.482-1(f)(2)(ii)(A), which provides that the IRS will evaluate the results of a transaction as actually structured by the taxpayer, unless its structure lacks economic substance. The court noted that the TLA, which had economic substance, was structured as a license of preexisting intangibles, not a sale of a business.The IRS's allocation took into account items not transferred or of insignificant value -
The IRS claimed that Veritas-US transferred its customer base, customer lists, distribution channels, and access to its marketing and R&D teams. The court found that such items were either not transferred or had insignificant value. - Distribution channels, customer base, and customer lists -
The court concluded, based on the evidence presented by the Taxpayer, that these items were not well developed outside the United States at the time of transfer and, therefore, such assets were weak and had little value. - Access R&D and Marketing teams -
The IRS's expert testified that his buy-in analysis did not consider the access to the R&D or marketing teams. In addition, the IRS expert conceded that if he assumed that the agreement relating to the sharing of R&D expenses was arm's length, a fact that the parties stipulated, then access to the R&D team would have zero value. Based on the IRS expert's testimony, the court concluded that there was no evidence that access to the R&D and marketing teams were transferred or had value.
In a footnote that likely will have implications in other cases, the court went on to state that even if evidence of the value of the R&D and marketing teams existed, they would not be taken into account in calculating the buy-in because they do not have "substantial value independent of the services of any individual" and, therefore, are not covered by the definition of intangible property described in Sec. 936(h)(3)(B) or Regs. §1.482-4(b). The court went on to note without comment that in December 2008, the IRS issued temporary cost sharing regulations that reference "assembled workforce," and that the Obama Administration recently proposed to amend the statute to include "workforce in place" in the section 482 definition of an intangible.Employed the wrong useful life, discount rate, and growth rate -
With respect to useful life, the court rejected the IRS's assumption that the preexisting intangibles had an infinite useful life. The IRS's expert acknowledged that "if you had 1999 products that you left untouched, that technology would age and eventually become obsolete," and that the preexisting product intangibles would "wither on the vine" within two to four years without ongoing R&D. The court also noted that the Taxpayer provided evidence that the useful life of the preexisting intangibles was four years, and that even with substantial ongoing R&D the products had finite life cycles.
The court found other errors in the IRS's expert's computation of the discount rate, including the determination of the Beta, the equity risk premium, and the risk-free return.
Finally, the court concluded that the IRS expert applied unrealistic growth rates into perpetuity. The court noted that the growth rates used by the IRS expert exceeded Veritas-Ireland's actual growth rate between 2004 and 2006, and that the expert could not support the growth rates that were used.The Court accepts the taxpayer's CUT method with adjustments - - Valuation of technology -
The Coordinated Issues Paper takes the position that uncontrolled licenses of makeand-sell rights generally are not comparable to the rights transferred in a cost sharing buy-in, because those transactions usually do not provide the right to further develop the intangibles. The Tax Court clearly rejected that position. In the view of the court, the focus of the buy-in payment is on preexisting intangibles, not subsequently developed intangibles.
To determine the appropriate starting royalty rate for the buy-in payment, the Taxpayer used the CUT method. The Taxpayer's CUT analysis was based on internal comparable agreements between Veritas and third parties involving bundled products, in which the Veritas software was incorporated into another company's product, and unbundled products in which the software was sold separately.
After reviewing the comparability criteria described in the regulations, the court concluded that the bundled license agreements were not comparable because Veritas gained credibility and improved brand identity when its products were sold bundled with another company's products. The court concluded that the CUTs involving unbundled products were sufficiently comparable to the controlled transaction, and that the CUT method is the best method to determine the requisite buy-in payment.
The court calculated a starting royalty rate of 32 percent of sales by calculating the mean royalty rate from 90 licenses involving unbundled products. The court determined that the preexisting intangibles had a useful life of four years based on the testimony of Veritas's and the IRS's experts. Based on the evidence, the court noted that unrelated parties that license static technology that is neither subject to updates nor rights to new versions agree to a ramp down of the royalty over the life of the agreements. Based on the comparable agreements, the court then reduced the royalty rates starting in year 2 at a rate of 33 percent per year (i.e., 32 percent in year 1; 21 percent in year 2; 14 percent in year 3; and 10 percent in year 4). The court declined to base its ramp down on the Veritas analysis of changes in the lines of code. - Valuation of trademark -
The Tax Court determined that Veritas's product and other trademarks and trade names were well known, respected, and valuable even though they were not extensively registered outside the United States. The IRS did not submit an expert report valuing the trademarks and trade names. It is unclear from the opinion exactly how Veritas's expert estimated the 0.5 percent to 1.0 percent range of royalties and the maximum life of seven years. Although the court did not find the Taxpayer's expert convincing with respect to the trademark valuation, lacking other evidence, the court applied the expert's upper-end valuation of $9.6 million. - Valuation of sales agreements -
The court noted that it did not have sufficient evidence to determine the value of the sales agreements transferred to Veritas-Ireland and ordered the parties to address this issue in their judgment calculations pursuant to the court's decision. Based on the court's statement of facts, it is unlikely that substantial value will be attributed to these agreements. - Determination of discount rate -
Veritas based its discount rate analysis on the traditional capital asset pricing model (CAPM). Veritas used its own Beta in the computation because the industry Beta was dominated by Microsoft, "a stronger and more established business than Veritas-US," and the historic risk premium. Veritas did not increase the discount rate by industry average tax rate or its specific tax rate. Based on Veritas's analysis, the court agreed that 20.47 percent was a reasonable estimate of an appropriate discount rate.Implications of Tax Court's decision
IRS appeal is likely -
The Tax Court's decision rejected the major IRS positions contained in the Coordinated Issues Paper on Cost Sharing Arrangements Buy-in Adjustments. The IRS has proposed billions of dollars in adjustments based on those theories. Therefore, the IRS is very likely to appeal the Tax Court decision to the Ninth Circuit Court of Appeals. Given the fact that additional procedures are required in the Tax Court before the decision becomes final, however, and the time required to generally file and hear an appeal in the Ninth Circuit, it is unlikely that a final decision on this case will be rendered in less than three years.Pending adjustments under 1996 regulations -
The IRS National Office of Appeals was expected to issue the longawaited and much delayed appeals settlement guidelines with respect to cost sharing buy-in payments. The guidelines were supposed to provide guidance to appeals officers regarding the settlement of cost sharing buy-in payments. As a result of the Tax Court's decision, we would expect that those guidelines will be further delayed, perhaps indefinitely.
There is only one other case pending in the Tax Court in which the taxpayer is challenging the IRS position on buy-in payments, Medtronic, Inc. That case has not been scheduled for trial. In light of the Tax Court's decision in Veritas, it is unclear whether the case will move forward, await the Ninth Circuit's decision in Veritas, or be settled. Assuming Medtronic, Inc. does not go to trial, the chance of another case being decided in the next few years is remote, given the time it takes to file a case and reach a court decision.
Since it will likely be several years before the Ninth Circuit issues its opinion or another court issues an opinion on cost sharing buy-in payments, the IRS must address the Tax Court's decision in Veritas when examining cost sharing buy-in payments computed under the 1996 regulations. Therefore, as a practical matter, in many cases the large adjustments made by IRS field economists based on the income method using an infinite life are not likely to be sustained in full.
There are many factual aspects of Veritas that taxpayers seeking the best settlement position may need to prove. For example, in Veritas, the taxpayer presented evidence on both useful life and the royalty ramp down, crucial factors in determining the value of the technology intangibles. In addition, the court reviewed each of the intangibles transferred to Veritas-Ireland and the value assigned to each of those intangibles. In some cases, taxpayers may have to examine whether their buy-in approach took those intangibles into account and whether they have adequate support for the valuation of those intangibles. The court also examined the underlying factual support for the Taxpayer's CUT method in Veritas, and made certain adjustments to the Taxpayer's CUTs. Taxpayers should be prepared to factually support the assumptions they make in their valuation analyses, whether the method used is the CUT, the residual profits method, or any other method.
Although the court did not accept the IRS's income method, the Taxpayer in Veritas was still required to support the appropriateness of its method. In Appeals, taxpayers can expect any settlement to be very fact-specific, and the stronger their factual support, the more likely a satisfactory resolution will be reached.Impact of Tax Court's decision on temporary regulations -
The Treasury Department issued temporary cost sharing regulations on January 5, 2009. The Tax Court's decision has no direct bearing on those regulations. However, some of the court's determinations could have an impact on the interpretation of those regulations. For example, the court's determination that a valuation using the income method based on a perpetual life took into account items of income other than preexisting intangibles may be equally applicable in determining the life of transferred Prior and Contemporaneous Transactions (PCTs) under the temporary regulations. In addition, the court's determination that valuing the intangibles in the aggregate was not reliable may be equally applicable to the aggregation rules in the temporary regulations.5 Finally, the court's conclusion that access to the U.S. based R&D and Marketing teams may not have any value independent of the services of any individual may limit the value of those items under the temporary regulations.
In the Ninth Circuit's recent decision in Xilinx, Inc. v. Commissioner, 567 F.3d 482 (9th Cir. 2009) the court permitted the IRS and Treasury to promulgate regulations defining the arm's length standard differently from its plain meaning. Xilinx has requested the Ninth Circuit to rehear the case because the court's decision appears to be inconsistent with the testimony in that case that arm's length parties do not share stock option expense. If the Ninth Circuit were to require that the regulations be consistent with the arm's length standard, the Tax Court's decision could have added implications under the temporary regulations.Proposed legislation -
The President's Fiscal Year 2010 Budget Proposals contain a proposal that would "clarify" that (i) work force in place, goodwill, and going concern value are intangibles for purposes of sections 482 and 367(d), and (ii) that when multiple intangible properties are transferred, the commissioner may value them on an aggregate basis when doing so achieves a more reliable result.
The Joint Committee on Taxation, in its commentary on the Administration's transfer pricing proposal, described other proposals Congress could consider in the transfer pricing area that would go beyond the President's proposals.6 It is possible that the Tax Court's decision could be seen by some in Congress and/or the Treasury Department as evidence that the current transfer pricing rules are in need of revision.