IRS Issues Final Regulations on Intermountain Six-Year Statute of Limitations Issue

As we have previously discussed, the IRS sought to buttress its reliance on the six-year statute of limitations in Son-of-BOSS cases by issuing temporary regulations that interpret the term “omission” of gross income in Code sections 6229 and 6501 to include understatements of gross income attributable to overstatements of basis.  Because that interpretation strains the language of the statute and flies in the face of the Supreme Court’s decision in Colony, Inc. v. Commissioner, 357 U.S. 28, 32-33 (1958), the government has argued for application of Chevron deference to the temporary regulations.  The Tax Court has rejected that argument, and it is now pending in several courts of appeals.  Last week, the IRS issued final regulations that supplant the temporary regulations.  The final regulations have the same effective date as the temporary regulations (Sept. 14, 2009), and they are essentially the same, although they do clarify what the Tax Court majority in Intermountain found to be an ambiguity — making clear that the regulations are intended to apply to all cases for which the six-year statute of limitations remained open on the effective date.

The government is now submitting the final regulations as supplemental authority to the appellate courts considering the Intermountain issue.  (This is an example of the government’s supplemental submission, taken from the Fifth Circuit cases, with the final regulations attached.)  In the government’s view, the issuance of the final regulations strenghtens the argument for Chevron deference.  Taxpayers have objected that such deference was not owed to the temporary regulations because, among other reasons, they were temporary and issued without notice-and-comment.  Indeed, more than a quarter of the pages of argument in the government’s opening brief in Intermountain (here) were devoted to arguing that the temporary regulations were valid and entitled to deference notwithstanding the absence of notice-and-comment.  The final regulations arguably eliminate those objections, since the final regulations provided notice and opportunity for comment (even if the comments were disregarded).  Notice-and-comment aside, however, the government’s deference argument still faces the formidable obstacle of the contrary Supreme Court decision in Colony.

Briefing Underway in Intermountain

We recently surveyed the nationwide litigation addressing the government’s efforts to apply a six-year statute of limitations to Son-of-BOSS cases, including its efforts to have the courts defer to a late-issued temporary regulation.  The government has now filed its opening brief in the D.C. Circuit in Intermountain, the case in which the Tax Court addressed the issue.  Of note, the brief contains an extensive argument for applying Chevron deference to the temporary regulation, rather than “the differing standards of pre-Chevron jurisprudence” (an apparent reference to National Muffler Dealers, though the brief declines to acknowledge that case by name), and notwithstanding the lack of opportunity for notice and comment.  As we have discussed before here and here, the Supreme Court may shed some light in the next few months on the extent to which Chevron deference applies to Treasury regulations.

The taxpayer’s response brief is due January 5, 2011.

Intermountain – US opening brief

The Curious Non-Appeal of Veritas

Veritas Software Corp. v. Commissioner, 133 T.C. No. 14 (2009) was the first cost sharing buy-in case to go to trial.  The question before the court was the value to place on the transfer by Veritas to its Irish subsidiary of the right to use technical and marketing intangibles related to software development.  Veritas argued that the valuation should be based on an adjusted comparable uncontrolled transaction (CUT) analysis (involving licenses of the same or similar property).  The IRS argued that it should be based on an aggregate discounted cash flow (DCF) analysis that valued the hypothetical transfer of a portion of Veritas’ business to the Irish sub; i.e., an “akin to a sale” theory.

The Tax Court held for the taxpayer in substantial part.  Finding that the IRS’s “akin to a sale theory was akin to a surrender,” it rejected the IRS position that the “synergies” supposedly effectuated by considering as an aggregate various finite-lived intangibles (many of which were not even transferred) caused the whole to live forever.  This is Gunnery Sergeant Hartman’s valuation method:

Marines die, that’s what we’re here for.  But the Marine Corps lives forever.  And that means you live forever.  Full Metal Jacket (1987).

Rejecting this method, the Court dismantled the IRS’s DCF valuation which, through the application of unrealistic useful lives, growth rates, and discount rates, purported to value the transfer of assets as if it was valuing the sale of a business enterprise.

The Tax Court is correct.  The Gunny’s method doesn’t work in IP valuation and, although it sounds good, it doesn’t really work with respect to the Marine Corps either.  The whole doesn’t become everlasting simply because of the very important, historic sacrifices made by its earlier parts.  Current and future success depends on the valor (or value) of the current parts as much as, and often more than, that of the former.  Showing an understanding of this principle, the Tax Court found that a significant contributor to the anticipated future success of the Irish business was old-fashioned hard work by Veritas Ireland and its foreign affiliates.  Accordingly, the Court held that the taxpayer’s CUT method, with certain adjustments, properly reflected the value of the transferred intangibles based on their expected useful lives.

In the ordinary course, one would expect the IRS to appeal a decision where it believed the factual and legal conclusions were fundamentally erroneous.  However, like the schoolyard bully who gets beat up by the first nerdy kid he picks on, the IRS has kept its tactics but changed its victim.  The IRS declined to appeal Veritas, while setting out its plan to take someone else’s lunch money in an Action on Decision that refuses to acquiesce in the Tax Court decision and indicates that it will challenge future transactions under the same aggregate value method rejected in Veritas.  The AOD states that the IRS is not appealing Veritas because the Tax Court’s decision allegedly turns on erroneous factual findings that would be difficult to overturn on appeal.

This attempt by the IRS to use an AOD to continue to harass taxpayers should fail.  The Tax Court’s opinion did not conclude that the useful life of the pre-existing IP could never survive later technology developments.  And it did not exclude the possibility of future product value flowing from that original IP.  Rather, it rejected the view that synergies allow the IRS to turn a specific asset valuation into a global business valuation and, while they are at it, include in that valuation non-compensable goodwill and going-concern value.  The “head-start” IP provides is indeed valuable, but it is properly valued as part of a specific asset and not in some “synergistic” stew of assets, goodwill, going concern value and business opportunity.  (While we are at it, Hospital Corp. of America v. Commissioner, 81 T.C. 520 (1983)) did not bless the valuation of a business opportunity; it held that while proprietary systems, methods and processes are compensable, the mere business opportunity to engage in R&D is not.)  IP does give competitive advantages that do not necessarily disappear in next generation product developments.  However, one cannot treat an IP transfer as the segmentation and transfer of an entire living, breathing business. This ignores the transaction that happened but, more importantly, the real and substantial risks assumed by the parties in developing the future IP, risks that drive the real value of those future products, products that are but one part of the value of that continuing business.  Contra Litigating Treas. Reg. § 1.482-7T.

The AOD acknowledges that “[t]he facts found by the Court materially differed from the determinations made by the Service” but does not accept the consequences.  The Tax Court disagreed with the IRS’s view of “the facts” because those “facts” were entirely inconsistent with the business realities of IP transfers.  If it does not believe its position merits an appeal, the IRS should accept its loss.  Instead, it is pushing around other taxpayers by foisting the same untenable “factual” story on them.  As former British Prime Minister Benjamin Disraeli once said, “courage is fire and bullying is smoke.”  The Veritas AOD is nothing but smoke.

Conversation with Bob Kirschenbaum Regarding Great Debate

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.