December 4, 2010
We previously mentioned the IFA “Great Debate,” held on the campus of Stanford University on October 27, 2010, where the debaters squared off on the debatable utility of the Temporary Cost Sharing Regulations Income Method in valuing intangible transfers for transfer pricing purposes. As forecast, the debate was extremely well-attended (notwithstanding the conflicting start of the first game of the World Series just up the road in San Francisco). Bob Kirschenbaum and Clark Chandler drew the “pro” (i.e., you should never use the Income Method) while Jim O’Brien and Keith Reams drew the “con.” After the debate, Bob and I kicked around his presentation, how things went, and how he feels about the issue generally. The discussion seemed interesting enough to formalize and post.
Did you enjoy arguing the “pro” position? Would you have preferred to have the “con” position?
We were prepared for either and I think Clark and I did a good job advocating. However, I actually would have preferred the “con” position. It is more interesting analytically because you get to drill down on how the Code and Regulations might be read to permit an income method analysis that would fairly measure the value of the IP actually transferred.
With most taxpayers fighting the income method at Exam, wasn’t the “pro” position easier?
It is easier in the sense that the argument can be made very simply. That is true. The argument goes like this: The existing cost sharing regulatory construct already enabled the evaluation of rights to the anticipated income stream without essentially disregarding the transaction as actually structured by the parties. The “con” position, on the other hand, requires a more nuanced understanding of transfer pricing principles, what they are trying to achieve, and how one might go about constructing a set of variable inputs that could be used to indirectly derive the value of the IP transferred.
Personally, do you think the income method has a place in transfer pricing practice?
I think it does. However, Clark made a very persuasive argument that the Income Method as constituted in the Temporary Regs, while not to be discarded out of hand, becomes much more tenuous: (i) if the Regulations are read as mandating a counterfactual perpetual useful life of transferred IP (see Veritas v. Commissioner), and (ii) when coupled with the Periodic Trigger look-back provisions of the Temporary Regulations. If fairly applied, and in the right circumstances, the Income Method can be a powerful convergence tool for valuing IP. We have proven that in our dealings with Exam on cases where the IRS seeks to require CIP-compliant outcomes. Obviously, it will never be as good as a valid CUT, but it can be useful and does have a place in the practice.
What does the Tax Court’s recent decision in Veritas tell us about the viability of the Income Method?
At the end of the day, probably not much. Veritas was a gross overreach by the IRS; ultimately, the decision is just Bausch & Lomb revisited. Taxing a neutral transfer of business opportunity is not going to fly, nor is the imposition of a perpetual life for IP that produces premium profits for some limited number of years. That dog just will not hunt against a sophisticated and well-advised taxpayer. But it certainly doesn’t mean that the Income Method, properly applied, is never useful.
What do you see as the biggest errors the IRS makes in applying the Income Method?
(1) The perpetual useful life edict, and (2) the implicit presumption of unlimited sustention of competitive advantage. Technology progresses and, the fact is, legacy technology often doesn’t persist for multiple generations. You could not find too many people in Silicon Valley—where I do a fair amount of my work—who would take the other side of that proposition. Even where technology does persist for an extended period, the IRS at times contends that fundamentally new products, developed at great risk under Cost Sharing, owe their genesis entirely to foundational IP. You cannot assume large growth rates decades out and try to allocate all of that value to the original IP. At some point the competitive advantage associated with the pre-existing IP will dissipate. This is very basic finance theory. There are certainly other concerns but these are the most glaring weaknesses in the application of the Income Method.