Reflections on the Ninth Circuit’s Decision in Amazon.com

Post by
October 17, 2019

Although some time has passed (and we’ve fallen short of our hope here to get something up “soon”), we nevertheless wanted to post some thoughts on the Ninth Circuit’s unanimous affirmance of the taxpayer’s victory in the Tax Court in Amazon.com while also revisiting some of the topics that we covered here after oral argument. The panel’s opinion is brief, but it touched on several important aspects of the law under section 482.

Finding Ambiguity in the Regulatory Definition of “Intangible”

As you’ll recall, the primary dispute on appeal was whether the regulatory definition of “intangible” under Treas. Reg. § 1.482-4(b) included residual business assets like goodwill, going concern, and the amorphous notions of “growth options” and “culture of continuous innovation” that the government theorized the taxpayer made available in its cost-sharing agreement.

The taxpayer argued that the definition excluded such residual business assets because it did not expressly list them in any of the six subparagraphs of the definition. And the taxpayer argued that the 28 specified items in the regulation all “can be sold independently” from the business while the residual business assets cannot, invoking the statutory-interpretation canon of ejusdem generis to reason that the regulation therefore excludes residual business assets (which cannot be sold without a sale of the entire business).

The government argued that those residual business assets fell under the sixth subparagraph of Treas. Reg. § 1.482-4(b), which provides that “intangible” includes “other similar items” and that “an item is considered similar … if it derives its value not from its physical attributes but from its intellectual content or other intangible properties.” Since residual business assets do not derive their value from physical attributes but from other intangible properties, the government reasoned, they must be included here. And the government went on to argue that residual business assets must be compensable because otherwise, taxpayers could have transferred assets of value to a cost-sharing arrangement without compensation, which the government asserts would have violated the arm’s-length principle that undergirds section 482 and its regulations.

The panel held that although the taxpayer’s “focus on the commonality of the 28 specified items has some force,” that argument did not carry the day. The panel drew this conclusion from the plain language in the sixth subparagraph: that paragraph does not state that the commonality is that each item “can be sold independently” but rather states that each item “derives its value … from its intellectual content or other intangible properties.” The panel reasoned that the regulation therefore “leaves open the possibility of a non-listed item being included in the definition even if it doesn’t share the attribute of being separately transferable.” The panel thus echoed the concern that Judge Fletcher raised at oral argument—that while the 28 specified items share the commonality of being independently transferable, that commonality is “not the one the text [describing what constitutes a ‘similar item’ under the regulation] gives me.”

Resolving the Ambiguity by Looking to the Drafting History of the Regulation

After concluding that the regulatory definition “is susceptible to, but does not compel, an interpretation that embraces residual-business assets,” the panel looked to the overall regulatory scheme but held that to be inconclusive. The panel then turned to the drafting history of Treas. Reg. § 1.482-4(b) and found it to show that Treasury’s 1994 final regulations (which amended the sixth subparagraph of Treas. Reg. § 1.482-4(b)) both (1) exclude residual business assets from the definition of intangible and (2) provide reason to think that the definition of “intangible” includes only independently transferable assets.

The panel described how when Treasury issued temporary and proposed regulations in 1993, it asked “whether the definition of intangible property … should be expanded to include … goodwill or going concern value.” The panel concluded that since Treasury asked whether the definition should be “expanded” to include residual business assets, those assets were not included in the then-existing definition. And when Treasury issued final regulations in 1994 without expressly enumerating goodwill or going concern value in that definition, Treasury stated that its final rule “merely ‘clarified’ when an item would be deemed similar to the 28 items listed in the definition.” The panel concluded that by its own admission, Treasury would have needed to “expand” the definition to include residual business assets but instead opted to merely “clarif[y]” its definition, and therefore Treasury did not intend for the 1994 final regulations to include residual business assets.

Moreover, Treasury’s 1993 regulations limited the universe of compensable intangibles to “any commercially transferable interest.” But when it issued final regulations in 1994, Treasury dropped the “commercially transferable interest” language because “it was superfluous: if the property was not commercially transferable, then it could not have been transferred in a controlled transaction.” The panel concluded that the transfer-pricing regulations thus “contemplate a situation in which particular assets are transferred from one entity to another.” Since Treasury stated that it would have been “superfluous” to expressly state that the definition of “intangible” includes only commercially transferable assets, the panel held that the regulatory history “strongly supports Amazon’s position that Treasury limited the definition of ‘intangible’ to independently transferable assets.”

That the panel found this history dispositive comes as no surprise. We observed in our prior post that both Judge Callahan and Judge Christen recounted the regulatory history, with Judge Callahan questioning government counsel about whether Treasury ever expressed an intent to expand the definition to include residual business assets.

What Is the Rationale for Including Only Independently Transferable Assets in the Definition of Intangible?

Although the panel’s explanation for how it concluded that the definition of intangibles includes only independently transferable assets is explicit, the rationale for why Treasury would include only independently transferable assets is markedly subtler. It’s possible, however, to cobble together an explanation from other statements in the decision.

The first clue is when the panel looked to the genesis of the cost-sharing regulations, where Treasury identified “intangibles as being the product of R&D efforts.” In that sense, the panel reasoned, the “regulations seem to exclude” residual business assets, “which ‘are generated by earning income, not by incurring deductions.’” This distinction is clear enough—businesses incur expenses in undertaking R&D efforts, while goodwill and going concern value are byproducts of a well-run and successful business.

Why does this distinction matter? One answer lies in the legislative history and policy underpinnings for the statutory definition of “intangibles.” As the panel observed in a footnote, the “Senate Report states that the Committee viewed the bill as combatting the practice of transferring intangibles ‘created, developed or acquired in the United States’ to foreign entities to generate income tax free.” Which is to say that one animating concern in defining intangibles was to prevent U.S. entities from developing intangibles domestically but then transferring those intangibles to foreign affiliates whose income is not subject to U.S. tax.

And the reason why this is a concern for intangibles that result from R&D and other independently transferrable assets but not goodwill or going-concern value should be apparent: while the former involve expenditures that are deductible against U.S. income (but where the asset transfer will prevent the income from being taxed in the U.S.), the latter involve assets that exist only if the taxpayer has generated business income in the U.S. in the first place. In other words, the definition of “intangible” was initially meant to prevent taxpayers from incurring expenses to create intangibles in the U.S. and deducting those expenses against U.S. income, but then turning around and transferring those intangibles to foreign affiliates that may not owe U.S. tax on the income resulting from those intangibles.

Distinguishing the Definition of “Intangibles” from the Value of Those Intangibles

On brief and at oral argument, the government repeatedly cited deposition testimony by one of the taxpayer’s experts in which that expert admitted that parties at arm’s length would pay for residual business assets. The government tried to leverage that admission to argue that the arm’s-length standard itself means that residual business assets are compensable because “it is undisputed that a company entering into the same transaction under the same circumstances with an unrelated party would have required compensation.”

The panel addressed that argument in a footnote, holding that the government’s argument “misses the mark.” The panel explained that while the arm’s-length standard “governs the valuation of intangibles; it doesn’t answer whether an item is an intangible.” This is a decisive response to the government’s arguments; it cannot be the case that any value associated with a business falls under the definition of “intangible.”

Putting Footnote 1 in Context

One aspect of the panel’s decision that is certain to receive attention in future transfer-pricing disputes is the discussion in the first footnote. In that footnote, the panel described the 2009 changes to the cost-sharing regulations as “broadening the scope of contributions for which compensation must be made” and explained that the TCJA “amended the definition of ‘intangible property’” in section 936(h)(3)(b). The footnote then stated that “[i]f this case were governed by the 2009 regulations or by the 2017 statutory amendment, there is no doubt the Commissioner’s position would be correct.”

There are a few things worth noting about this footnote, the first of which is arguably the most important: It’s dicta. The question of whether residual assets are compensable under the 2009 cost-sharing regulations or the 2017 statutory amendment was not before the court. And since the panel says nearly nothing in the footnote about the language in those 2009 regulations or the TCJA amendment, there is no reason to think that the panel gave material consideration to whether the outcome in the case would have been different under either.

Second, given some of the panel’s other statements, it is not so clear that “there is no doubt the Commissioner’s position would be correct” for years after the 2009 changes to the regulations. Recall that the government’s case was predicated on charging a higher buy-in for the purported transfer of “growth options” and a “culture of continuous innovation” to the cost-sharing arrangement. Although the 2009 regulatory amendments changed the cost-sharing regulations and TCJA amended the statutory definition for “intangibles,” there was no change to the definition under Treas. Reg. § 1.482-4(b). That regulation provides that an item not otherwise specified is an intangible only if it “has substantial value independent of the services of any individual.” The panel itself expressed serious doubt about whether the purported intangibles in this case met that requirement, stating that “residual business assets, such as ‘growth options’ and a ‘culture of innovation,’ are amorphous, and it’s not self-evident whether such assets have ‘substantial value independent of the services of any individual.’”

Finally, the TCJA amendments would affect the result in the case only if the purported “growth options” and “culture of continuous innovation” are items of property that fall under the new statutory category of “goodwill, going concern value, or workforce in place” or constitute an item “the value or potential value of which is not attributable to … the services of any individual.” But there is reason to think that the government is itself unconvinced that “growth options” and “culture of continuous innovation” fall under that new statutory category. At oral argument, the panel asked government counsel why, if Treasury meant to expand the definition of “intangible” with its 1994 changes, Treasury didn’t just add “goodwill and going concern” to the list. In response, government counsel argued that merely adding “goodwill and going concern” to the list would not have solved anything because then taxpayers would just fight about whether particular assets fell under those additions to the list. The government cannot coherently maintain both that (1) Treasury could not have achieved the Commissioner’s desired result in this case by expanding the regulatory list to include goodwill and going concern in 1994 and (2) Congress’s addition of goodwill and going concern to the list in TCJA would change the result in this case. Even though Congress meant to change the result in cases like this, government counsel’s argument suggests an absence of faith that expanding the list succeeds in changing the result.

Whether the Commissioner’s Litigating Position Warrants Auer Deference

The government also argued that under Auer, the Tax Court should have deferred to the Commissioner’s interpretation of Treas. Reg. § 1.482-4(b) as including residual business assets. The panel rejected this argument for two reasons.

First, the panel found that pursuant to the Supreme Court’s decision in Kisor, the Commissioner’s interpretation warrants Auer deference only if the regulation is “genuinely ambiguous.” The panel states that Auer thus implicates a higher standard for ambiguity. Under that standard, a regulation is “genuinely ambiguous” for Auer purposes only if ambiguity remains once the court has exhausted the traditional tools of construction, which requires it to consider “the text, structure, history, and purpose of a regulation.” The panel concluded that the text of Treas. Reg. § 1.482-4(b), its place in the transfer-pricing regulations, and its rulemaking history “leave little room for the Commissioner’s proffered meaning.” The panel’s holding is therefore that the definition of “intangible” under Treas. Reg. § 1.482-4(b) is ambiguous but not genuinely ambiguous.

Second, the panel also rejected the government’s deference argument because the government first advanced an interpretation of Treas. Reg. § 1.482-4(b) in the litigation that had never appeared in the drafting history of the regulations or anywhere else. As we remarked earlier, reliance concerns loomed large at oral argument, and especially in Judge Callahan’s questions. The panel’s conclusion that “Amazon and other taxpayers were not given fair warning of the Commissioner’s current interpretation of the regulatory definition of an ‘intangible’” was thus foreseeable from oral argument.

Whether the Cost-Sharing Regulations Provide a Safe Harbor

As we observed in our prior post, at oral argument the government disavowed the notion that the Treasury Regulations create a safe-harbor for cost-sharing arrangements. We surmised that whether the Ninth Circuit agreed with the government on this point might be pivotal in the outcome.

While the extent to which that issue factored into the panel’s decision is not evident, the panel’s decision is entirely consistent with the notion that cost sharing operates as a safe harbor. First, the panel described cost sharing as “an alternative to licensing … under which [the parties to the cost-sharing arrangement] become co-owners of intangibles as a result of the entities’ joint R&D efforts.” If the cost-sharing arrangement qualifies, then it “provides the taxpayer the benefit of certainty because … new intangibles need not be valued as they are developed.” But the panel explained that the certainty comes at a price—the R&D payments by the foreign cost-sharing participants “serve to reduce the deductions the [domestic] taxpayer can take for the R&D costs (thereby increasing tax liability).” What the panel thus described operates like a safe harbor—taxpayers that ensure that their cost-sharing arrangements qualify and sacrifice some deductions for intangible development costs can gain certainty that their intangibles need not be re-valued. The panel’s decision will hamper any future IRS arguments that cost-sharing does not operate like a safe harbor.

Procedural Status

The government did not file a petition for rehearing in the case; the mandate issued on October 8. There is still time for the government to file a petition for certiorari; it is due November 14.

Ninth Circuit Affirms Tax Court in Amazon.com

Post by
August 16, 2019

In a unanimous opinion issued today, the Ninth Circuit affirmed the taxpayer’s victory in the Tax Court in Amazon.com. We previously covered the case and oral argument here. We will take some time to digest the opinion and post on its finer points soon. In the meantime, one key sentence in the opinion is worth noting because it appears to capture the thrust of the Ninth Circuit’s decision about the disputed scope of the relevant regulatory definition for the term “intangible”: “Although the language of the definition is ambiguous, the drafting history of the regulations shows that ‘intangible’ was understood to be limited to independently transferable assets.”

Amazon.com Ninth Circuit Opinion

Petition for Rehearing En Banc Filed in Altera

Post by
July 24, 2019

As most expected, Altera filed a petition for rehearing en banc after the reconstituted three-judge panel decided to reverse the Tax Court’s invalidation of Treasury’s cost-sharing regulations. (A link to the petition is below.) As we explained previously, those regulations have been the subject of much controversy over the last two decades, and the success that Xilinx had with its petition for rehearing several years ago made it likely that Altera would ask for rehearing.

The petition picks up on one of the themes we discussed in our most recent post here. The taxpayer takes aim at the majority’s conclusion that the “commensurate with income” language added to section 482 in 1986 is relevant in the cost-sharing context. The taxpayer argues that language was aimed at addressing a different issue from the one before the court here—“how to value transfers of existing intangible property from one related entity to another” and not “intangible property yet to be created.”

The taxpayer makes four or five (the petition combines arguments (3) and (4) below) arguments for why its petition should be granted:

(1) The decision upsets settled principles about the application of the arm’s-length standard because the majority permitted Treasury to “cast aside the settled arm’s-length standard” for “a new standard” that is “purely internal.”

(2) The decision “validates bad rulemaking” because, contrary to the majority’s account of the regulation’s history, “[n]o one involved in the rulemaking thought the IRS was interpreting ‘commensurate with income’ to justify a new standard that did not depend on empirical evidence.” And under the law in Chenery, the court must assess the “‘propriety of [the agency’s] action solely by the grounds invoked by the [agency]’ in the administrative record.”

(3) The decision is irreconcilable with the Ninth Circuit’s decision in Xilinx, which held that parties would not share in employee stock option costs at arm’s length.

(4) The decision “threatens the uniform application of the tax law” because, under the Golsen rule, the Tax Court will continue to apply its unanimous decision declaring the regulation invalid to cases arising anywhere outside the Ninth Circuit.

(5) As evidenced by the glut of amicus briefs, the treatment of employee stock options in cost-sharing arrangements is “exceptionally important.”

It is likely that additional amicus briefs will be filed in support of the rehearing petition. And given the prominence of the issue, we anticipate that the court will order the government to file a response to the petition. We will report on further developments as warranted.

Altera Petition for Rehearing En Banc July 2019

Observations on Changes in the Ninth Circuit’s Second Altera Decision

Post by
June 27, 2019

As we posted earlier here (with a link to the new decision), the Ninth Circuit issued a new decision in Altera after replacing the late Judge Reinhardt with Judge Graber on the panel. But the result was the same as the withdrawn July 2018 decision—the Ninth Circuit upheld the validity of Treasury’s cost-sharing regulation that requires taxpayers to include the cost of employee stock options under qualifying cost sharing arrangements (QCSAs). Today, we present some observations after comparing the majority and dissent in the new decision with those in the Ninth Circuit’s withdrawn decision.

In the new decision, Judge Thomas recycled much of the language and logic from his withdrawn opinion, and Judge O’Malley reused much of her original dissent. Although they are few, some changes in the two opinions are interesting and notable. Overall, the changes serve to sharpen the disagreements between the parties (and the disagreements between the majority and dissent) in ways that will focus the discussion in the likely event of a rehearing en banc petition (or possible petition for certiorari). We focus here on two aspects of the changes.

Was There a Transfer of Intangibles that Implicated the Commensurate-With-Income Language in the Second Sentence of Section 482?

The majority did not address this issue in its withdrawn opinion, so some background is in order. When Treasury proposed cost-sharing regulations that explicitly required related parties to include employee-stock-option costs in the pool of shared costs, commenters put forward evidence that unrelated parties do not share employee-stock-option costs. But Treasury did not heed those comments and ultimately determined that the arm’s-length standard would be met if the regulations required taxpayers in QCSAs to include the cost of employee stock options in the pool of shared costs, regardless of what a comparability analysis might show about whether unrelated parties share those costs. So in order to uphold the Treasury Regulations, the majority had to conclude that the arm’s-length standard under section 482 does not mandate the use of comparable transactions.

In reaching that conclusion, the majority relied on the history of section 482 and especially on the addition of the second sentence of section 482. That second sentence provides that “[i]n the case of any transfer (or license) of intangible property…, the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.” The majority held that the Congressional intent behind the addition of that language in 1986 is what made it reasonable for Treasury to conclude that it was permitted “to dispense with a comparable transaction analysis in the absence of actual comparable transactions.”

Was there a “transfer (or license) of intangible property” such that Treasury could invoke the commensurate-with-income language to justify dispensing with a comparable-transaction analysis? There was indeed a transfer of intangibles at the outset of the QCSA in this case; Altera transferred intangible property to its QCSA with its foreign subsidiary. But that initial transfer is unrelated to the disputed employee-stock-option costs. Those stock-option costs relate to subsequently developed intangibles, not to the value of the pre-existing intangibles that Altera initially contributed. Then-applicable Treasury Regulation § 1.482-7A(g)(2) required a buy-in payment only for “pre-existing intangibles.”

It is, then, wholly unclear how those employee-stock-option costs for as-yet undeveloped intangibles constitute a “transfer (or license) of intangible property” such that the commensurate-with-income language is implicated at all. The taxpayer argued—both in its initial and supplemental briefing—that by its own terms, the commensurate-with-income language is not implicated once a QCSA is in place and therefore that language is irrelevant to the dispute. The taxpayer reasoned that “no ‘transfer (or license)’ occurs when entities develop intangibles jointly” because jointly developed intangibles “are not transferred or licensed between the parties, but rather are owned upon their creation by each participant.”

The majority said little about this issue in its withdrawn opinion and did not address the taxpayer’s argument. In its new opinion, the majority addressed the argument and declared itself “unpersuaded.” It held that “[w]hen parties enter into a QCSA, they are transferring future distribution rights to intangibles, albeit intangibles that are yet to be developed.” The majority does not, however, explain how “intangibles that are yet to be developed” are “pre-existing intangible property” under Treas. Reg. § 1.482-7A(g)(2) or, perhaps more importantly, how such undeveloped future intangibles can constitute intangible assets at all under the words of the statute. Instead, the majority leaned on the language in the second sentence of section 482 providing that the commensurate-with-income standard applies to “any” transfer of intangible property, holding that “that phrasing is as broad as possible, and it cannot reasonably be read to exclude the transfers of expected intangible property.”

The dissent seized on whether there was any transfer of intangibles that implicated the commensurate-with-income language. The dissent stated that “[t]he plain text of the statute limits the application of the commensurate with income standard to only transfers or licenses of intangible property.” And it observed that there is a contradiction between the majority’s conclusion that QCSAs “constitute transfers of already existing property” and Treasury’s own characterization (in the very preamble of the disputed regulations) of QCSAs “as arrangements ‘for the development of high-profit intangibles,’” inferring that parties cannot transfer something that is not yet developed. The dissent concluded that Treasury’s failure to make “a finding that QCSAs constitute transfers of intangible property” should be, as a matter of review under the APA, fatal to Treasury’s cost-sharing regulations.

Has the Arm’s-Length Standard Historically Required a Comparable-Transaction Analysis?

The majority made several changes from its withdrawn opinion in its account of the history of the arm’s-length standard under section 482. The changes appear to be aimed at bolstering the majority’s conclusion that Treasury was justified in concluding that the arm’s-length standard does not necessitate a comparable-transaction analysis. These changes take a couple of forms.

First, the changes add justifications for the proposition that the arm’s-length standard has not always mandated a comparable-transaction analysis in all cases. The withdrawn opinion included some evidence for this historical account, recounting the Tax Court’s Seminole Flavor decision from 1945 (where the Tax Court “rejected a strict application of the arm’s length standard in favor of an inquiry into whether the allocation…was ‘fair and reasonable’”). In its new opinion, the majority added the observation that Treasury provided for an unspecified fourth method for pricing intangibles in its 1968 regulations. And the majority refined its discussion of the Ninth Circuit’s 1962 decision in Frank, still quoting the language from that opinion denying that “‘arm’s length bargaining’ is the sole criterion for applying” section 482 (as it did in the withdrawn opinion) but then adding the new assertion that the “central point” of Frank is that “the arm’s length standard based on comparable transactions was not the sole basis” for reallocating costs and income under section 482. (As the dissent pointed out, a later Ninth Circuit decision limited the holding in Frank to the complex circumstances in that case and noted that the parties in Frank had stipulated to apply a standard other than the arm’s-length standard.)

Second, the majority made changes to add a series of new and more sweeping assertions that under section 482, Treasury has always had the leeway to dispense with comparable-transaction analyses in deriving the correct arm’s-length price. For instance, as a rejoinder to the taxpayer’s argument that the arm’s-length standard requires a comparable-transaction analysis, the majority wrote that “historically the definition of the arm’s length standard has been a more fluid one” and that “courts for more than half a century have held that a comparable transaction analysis was not the exclusive methodology to be employed under the statute.” It added similarly broad historical statements elsewhere in the new opinion, all in service of concluding that Treasury acted reasonably in dispensing with a comparable-transaction analysis in its cost-sharing regulations: “[a]s demonstrated by nearly a century of interpreting § 482 and its precursor, the arm’s length standard is not necessarily confined to one methodology” (p. 33); “the arm’s length standard has historically been understood as more fluid than Altera suggests” (p. 41); and “[g]iven the long history of the application of other methods…Treasury’s understanding of its power to use methodologies other than a pure transactional comparability analysis was reasonable” (p. 49).

In one of the subtler but more interesting changes from the withdrawn opinion, the majority’s new opinion removed a single word. In its withdrawn opinion, the majority said that Treasury’s 1988 White Paper “signaled a dramatic shift in the interpretation of the arm’s length standard” by advancing the “basic arm’s length return method…that would apply only in the absence of comparable transactions….” (emphasis added). But consistent with its conclusion in the new opinion that “for most of the twentieth century the arm’s length standard explicitly permitted the use of flexible methodology,” the majority appears to have concluded that shift in the White Paper was not so “dramatic,” dropping that word altogether in its new opinion. (In this vein, the majority also removed its assertion in the withdrawn opinion that “[t]he novelty of the 1968 regulations was their focus on comparability.”)

The new dissenting opinion disputed the majority’s historical account, stating that the first sentence of section 482 “has always been viewed as requiring an arm’s length standard” and that before the 1986 amendment, the Ninth Circuit “believed that an arm’s length standard based on comparable transactions was the sole basis for allocating costs and income under the statute in all but the narrow circumstances outlined in Frank.” And the dissent observed that even with the 1986 addition of the commensurate-with-income language, “Congress left the first sentence of § 482—the sentence that undisputedly incorporates the arm’s length standard—intact,” thus requiring a comparable-transaction analysis everywhere that comparable transactions can be found. The dissent pointed out that the White Paper clarified that this was true “even in the context of transfers or licenses of intangible property,” quoting Treasury’s own statement in the White Paper that in that context the “‘intangible income must be allocated on the basis of comparable transactions if comparables exist.’”

Ninth Circuit Again Upholds Cost-Sharing Regulation in Altera

Post by
June 7, 2019

The Ninth Circuit issued a new opinion in Altera today after having withdrawn its July 2018 opinion. But today’s opinion does not change the result—by a 2-1 vote, the Ninth Circuit upheld the validity of the Treasury Regulation under section 482 that requires taxpayers to include the cost of employee stock options in the pool of costs that must be shared in qualifying cost sharing arrangements. Judge Thomas again wrote the panel’s opinion, Judge O’Malley again dissented, and Judge Graber—who was added to the panel to replace the late Judge Reinhardt—voted with Judge Thomas.

Although it borrows heavily from the withdrawn opinion (indeed, much of the language remains similar if not the same), there are some notable differences between today’s opinion and the withdrawn opinion. We will post some observations after a more careful comparison.

The taxpayer may seek a rehearing of the decision by the full Ninth Circuit (which is likely after the success that another taxpayer had in the Ninth Circuit’s rehearing of a similar issue in Xilinx). A petition for rehearing would be due July 22.

Altera Ninth Circuit Opinion June 2019

Both Parties Face Tough Questions in Amazon.com Ninth Circuit Argument

Post by
May 1, 2019

As we previewed here, the Ninth Circuit heard oral argument in Amazon.com v. Commissioner on Friday, April 12. Before giving a detailed recap of that oral argument, some background on the dispute is in order.

The Primary Issue in Dispute

Amazon.com, the U.S. parent company (Amazon US), entered into a qualified cost-sharing agreement with its Luxembourg subsidiary (AEHT) in 2005. Amazon US contributed the intangible assets required to operate its European website business to that cost-sharing agreement. Then effective Treas. Reg. § 1.482-7(g)(2) provided that AEHT owed Amazon US a buy-in payment for the “pre-existing intangibles” that Amazon US contributed. Although AEHT made a buy-in payment for that contribution of over $100 million, the IRS determined that the buy-in should have been $2.7 billion higher.

At trial, the parties submitted competing valuations of the contributed pre-existing intangibles—the taxpayer used comparable uncontrolled transactions (CUTs) to separately price the website technology, marketing intangibles, and European customer information that Amazon US contributed; the Commissioner used a discounted-cash-flow (DCF) method to determine the present value of the projected future income that AEHT would earn using the contributed intangibles. Underlying the methodological differences between the parties, however, is a fundamental dispute about the scope of the pre-existing intangibles for which AEHT owed a buy-in payment.

The taxpayer’s position was that AEHT owed a buy-in payment for only those intangibles enumerated in the definition of “intangible” in Treas. Reg. § 1.482-4(b), which definition does not expressly include so-called “residual” business assets like goodwill and going-concern value, and that the taxpayer’s CUT method accurately priced the enumerated intangibles that Amazon US contributed. The Commissioner argued that despite not explicitly naming residual business assets, any such assets are included in the definition of “intangible” in Treas. Reg. § 1.482-4(b)(6) and that only his DCF method captured the value of those residual business assets. He also argued that the bundle of compensable pre-existing intangibles that Amazon US made available in the cost-sharing arrangement included its “culture of continuous innovation” and other unspecified “growth options.”

Treas. Reg. § 1.482-4(b) provides that “[f]or purposes of section 482, an intangible is an asset that comprises any of the following items and has substantial value independent of the services of any individual—” and then lists 28 specified intangibles in the first five subparagraphs (like patents and trademarks) and concludes with a sixth subparagraph that states that the definition encompasses “[o]ther similar items.” That subparagraph goes on to say that “[f]or purposes of section 482, an item is considered similar to those listed in paragraph (b)(1) through (5) of this section if it derives its value not from its physical attributes but from its intellectual content or other intangible properties.”

The Tax Court sided with the taxpayer’s reading of Treas. Reg. § 1.482-4(b), concluding that the Commissioner’s DCF included the value of residual business assets that were not “pre-existing intangibles” under the cost-sharing regulations. The Tax Court made some material adjustments to the taxpayer’s CUTs, ultimately finding that AEHT owed a higher buy-in, albeit nowhere near the size of the Commissioner’s proposed adjustment. The government appealed the Tax Court’s decision on legal grounds, arguing that the pertinent Treasury Regulations do not foreclose the DCF method that was the basis for the Commissioner’s adjustments. The government argued in its brief that “[t]he Treasury Regulations broadly define intangibles and do not exclude residual-business assets from the scope of the buy-in requirement.” Oral argument at the Ninth Circuit was held before the three-judge panel of Judges Fletcher, Callahan, and Christen. (The video is available here.)

Plain Language of the Regulation

Government counsel started oral argument by asserting that the plain language of Treas. Reg. § 1.482-4(b) favored the government’s position because the regulatory definition of “intangible” was so broad that it must include residual business assets like “growth options” and “corporate culture.” In support, she argued that the sixth regulatory category of “other similar items” is “written so broadly to include any item that derives its value from anything other than physical attributes.”

Amazon’s counsel responded that the government’s argument proves too much. If the definition of “intangible” truly encompassed any asset that is not tangible, then it would belie the regulation’s enumeration of 28 items that count as “intangibles” under the regulatory definition. As Amazon argued in its brief, “[i]f Treasury intended to capture all intangibles, there would have been no reason to specify any particular types of intangibles, let alone list 28 of them.” Amazon’s brief went on to argue that the court should be guided by the interpretive canon of ejusdem generis. That canon requires the court to “focus ‘on the common attribute’ of the list of items that precedes the catch-all.”

This meant, however, that Amazon’s counsel had to explain what that “common attribute” is. He argued that the 28 listed items share characteristics that the residual business assets do not have—the 28 listed items are independently transferable and created by expenditures, but residual intangibles are not independent of the business and are the product of the operation’s income-producing success. As for why the list includes only items that are independently transferable, taxpayer’s counsel argued that only those assets that can be transferred independent of the entire business are susceptible to valuation while residual business assets like goodwill or so-called “growth options” were inextricable from the entire business and impossible to value with any precision.

But the panel questioned Amazon’s invocation of ejusdem generis. Judge Callahan asked why the court should apply that canon here where the regulation defines what it means to be similar (providing that “an item is considered similar to those listed in paragraph (b)(1) through (5) of this section if it derives its value not from its physical attributes but from its intellectual content or other intangible properties”). And in his only remarks of the day, Judge Fletcher called the taxpayer’s ejusdem generis argument “somewhat peculiar.” He went on to remark that he understood Amazon counsel’s explanation of what the 28 enumerated items had in common “but it’s not the one the text gives me,” going on to state that if he were “a pure textualist, you lose.” (Judge Fletcher’s remarks may not indicate how he will vote; he prefaced his remarks with the assertion that “I’m not sure that in the end that I would disagree with your position.”)

The description of “other similar items” was not the only regulatory language that drew the panel’s attention. Judge Christen questioned government counsel about how to reconcile the government’s reading of “other similar items” to include residual business assets like “corporate culture” with the regulation’s limitation that the universe of intangibles was limited to only those assets that have “substantial value independent of the services of any individual.” (That language played a role in the Tax Court’s decision; it found that residual business assets like goodwill and growth options “often do not have ‘substantial value independent of the services of any individual.’”) Amazon made the same point in its brief, arguing that its purported “culture of innovation” is “inseparable from the individuals in the company’s workforce.” And Judge Christen appeared unmoved by government counsel’s attempt to explain away that language by arguing that while the “value” of the intangible needs to be independent of services, the “intangible itself” does not need to be independent and that other expressly listed items—like “know-how”—were not entirely independent of services.

Regulatory History

Taxpayer’s counsel attacked the government’s case as based on reading the regulatory language in the abstract, divorced entirely from its context and history. The applicable definition of “intangibles” in Treas. Reg. § 1.482-4(b) was the result of regulatory changes in 1994. Before making those regulatory changes, Treasury asked for comments on whether it should “expand” the definition of “intangibles” to include observed assets like goodwill and going concern. It received comments that the definition should not be expanded, and when Treasury issued revised regulations, it noted that it added language to the “other similar items” subparagraph but described the change as a “clarifi[cation].” Amazon’s counsel recounted this history and argued that since Treasury acknowledged that the definition would have to be expanded to include residual business assets, “Treasury could not thereafter ‘clarify’ that these intangibles had been included all along.” This was, in the words of taxpayer’s counsel, a classic case of “regulator’s remorse.”

In questioning government counsel, both Judge Callahan and Judge Christen recounted the same regulatory history and observed that Treasury asked if it should expand the definition and ultimately called its change a clarification. Judge Callahan asked whether the government could point the panel to specific language where Treasury said it intended to expand its definition to include residual business assets.

Government counsel acknowledged that Treasury used the word “clarified” in the preamble but offered a different history of the regulatory language. She argued that some initial Treasury guidance included “goodwill, consumer acceptance, and market share” as intangibles (all of which could not be transferred independent of the business) and pointed to other statutory changes and another court decision as narrowing the definition beyond what Treasury initially intended.

Government counsel also had to explain why, if Treasury had in fact expanded the definition of “intangibles” to include residual business assets, it did so by amending the definition of “other similar items” rather than just adding residual business assets to the list. She argued that Treasury opted for the latter because merely listing residual business assets like “goodwill” would just precipitate fights about whether intangibles (like the so-called “growth options” that the government says Amazon US contributed to its cost-sharing agreement) fell within the scope of the listed residual business assets. Judge Callahan acknowledged that potential issue but replied that if Treasury had expressly included “goodwill” or “going concern” the taxpayers “wouldn’t have had as good of an argument” that the disputed residual business assets here are excluded, and government counsel conceded that it was less likely that the taxpayer would have won below in that circumstance.

Subsequent Statutory Changes

In the tax reform legislation enacted in 2017 (the TCJA), Congress took steps to address the concern that government counsel raised at oral argument—the transfer of residual business assets without compensation. Congress amended section 936(h) (which is the operative definition of “intangible” for purposes of section 482 by cross-reference) to expressly include goodwill and going concern. Government counsel acknowledged that with the TCJA, “Congress has codified our interpretation of” the “other similar items” provision.

Judge Callahan observed that Congress did not say that they were clarifying what has always been true, and government counsel agreed. And Judge Callahan rehearsed Amazon’s argument that if Congress needed to amend that definition, then it’s reasonable to infer that—contrary to the government’s interpretation—the definition did not always include those residual business assets. She then gave Amazon’s counsel the opportunity to identify what he thought was the best indication in the legislative history that the statutory addition of goodwill and going concern value is a revision and not a clarification of the definition of “intangible.” He answered that the best indicator is the conference report’s description of the change as a “revision” of the definition. He then went on to argue that given the statutory language, no one could “realistically think that isn’t a vast shift” in the definition’s scope. And he added that because the TCJA effected an enormous rewrite to the Code, it is only reasonable to think that the change to add goodwill and going concern was a substantial revision.

But the legislative change did not categorically favor Amazon’s case. Although Judge Christen remarked that the legislative history for the TCJA change is “compelling,” she pressed Amazon’s counsel on the tension between, on the one hand, the new statutory requirement to include the value of goodwill and going concern as pre-existing intangibles and, on the other hand, Amazon’s argument that Treasury opted to exclude those assets from the definition of “intangibles” because they are “impossible” to value independent of the entire business. And government counsel tried to capitalize on this tension in her rebuttal, arguing that although it is difficult to value residual business assets, the DCF—which values all intangibles together—is the panacea to this problem and that is why the government seeks the Ninth Circuit’s endorsement of that method.

Cost Sharing and the Arm’s-Length Standard

One cornerstone of government counsel’s argument was that the government’s interpretation of the definition of intangible must be correct because “nothing of value can be transferred for free.” And the government—both on brief and in oral argument—made much of the taxpayer’s expert’s admission on cross-examination that parties at arm’s length would have paid for all the value associated with residual business assets because “‘no company is going to give away something of value without compensation.’” The government tried to tie this admission in with the arm’s length principle that is the lodestar of section 482. The government argued on brief that the Tax Court was “not free to disregard” the arm’s-length principle, which meant, according to the government, that the Tax Court was required to adopt a valuation that included residual business assets.

Amazon observed in its brief, however, that the arm’s-length principle also arguably supports its position. The Commissioner conceded that residual business assets “generally cannot be transferred independently from the business enterprise” and thus are not independently transferred in an arm’s-length transaction (absent the extraordinary alternative of selling the entire business), thus making it all the more plausible to think that Treasury did not contemplate taxpayers valuing them and paying a buy-in for those residual business assets in a cost-sharing agreement.

At oral argument, taxpayer’s counsel observed that the government’s argument is hard to reconcile with the very existence of the safe harbor created by the cost-sharing regulations. He argued that those regulations contemplated precisely what happened here—AEHT paid a buy-in for static intangibles, the parties shared R&D and other costs for developing new and better intangibles going forward “in a way that’s formulaic,” and then the parties benefitted from those co-developed intangibles according to that formula. Government counsel flatly disputed the notion that the 1986 and 1994 changes created a safe-harbor for cost-sharing arrangements. Although it didn’t receive significant attention at oral argument, whether the Ninth Circuit agrees with the taxpayer or the government on this point might be pivotal in the outcome.

The Nature and Life of the Residual Business Assets

One interesting feature of the government’s argument—both on brief and at oral argument—was its attempt to articulate the precise nature of the residual business assets that Amazon US transferred to its cost-sharing agreement “for free.” Counsel closely hewed to the brief’s description of those assets in oral argument, saying that the “other similar items” category was broad enough to include residual business assets like “growth options” and “corporate culture” (although the latter of these raises the obvious question of whether that culture can be independent of the services of any individual).

Amazon raised other problems with these purported assets in its brief, including the observation that the residual business assets (at least as the government conceives them) have apparently perpetual useful lives. If the government were to conceive of the assets as having unlimited useful lives, then its theory runs headlong into caselaw and the common-sense notion that no asset, however valuable, lasts forever. The government nevertheless bit the bullet on this issue, arguing in its brief that “[q]uite simply, existing technology begets new technology.” Judge Christen asked government counsel to answer for this position, and government counsel conceded that the government’s argument assumes perpetual lives for “certain assets in the bundle,” stating that under the government’s theory, “the corporate culture will last as long as the corporation is there.” But government counsel tried to downplay this concession, arguing that the terminal value of the perpetual assets was very small and that the Tax Court could have done with those residual assets what it had done with some marketing intangibles in the case—limit their useful lives to something like 20 years.

Taxpayer’s counsel reminded the panel of this useful-life problem in the context of responding to the government allegations that taxpayer transferred assets to the cost-sharing agreement for free. He argued that the Tax Court assigned substantial value to the intangibles that Amazon US contributed to the cost-sharing agreement, and in so doing, characterized those assets “static intangibles” with values that will ultimately dissipate.

Other Issues

A couple of other items from oral argument are worth noting. First, the government had argued on brief that the IRS’s interpretation of the regulation was owed deference. Perhaps wary that this deference principle may disappear in a few months when the Supreme Court decides the Kisor case (see our reports here), government counsel was quick to downplay that argument when Judge Callahan probed the topic: “That is a back-up argument; I don’t think the court needs to get there.” And the panel took issue with the fact that the government had no argument for the reasonableness of the IRS’s interpretation other than pointing to Congress’s 2017 change to the pertinent law as after-the-fact evidence. It was clear that deference argument did not sit well with Judge Callahan or Judge Christen, both of whom questioned how taxpayers were conceivably on notice of the interpretation of “other similar items” that the government was advocating in this case.

Second, Judge Callahan expressed a keen interest in how the court’s decision would affect other taxpayers, including those without Amazon’s “firepower.” Government counsel conceded that if the government were to prevail, the IRS could pursue other taxpayers using the Ninth Circuit’s interpretation of the 1994 regulations. Amazon’s counsel argued that the “entire business community” relied on the understanding that residual business assets were not compensable and structured their cost-sharing arrangements accordingly. But when the panel asked whether a reversal would affect taxpayers in all years before the TCJA, he acknowledged that the 2009 changes to the cost-sharing regulations that require a buy-in for “platform contributions,” which arguably already include some residual business assets.

Finally, at oral argument, government counsel repeatedly raised the “realistic alternatives” principle (which is now part of section 482 and was in the 482 regulations already), arguing that principle is “central to the arm’s-length standard” because no entity is going to accept a price that is less than one of its realistic alternatives and that the Tax Court’s opinion amounted to a “rewriting” of that principle. But on brief, the government posed no alternative transaction that achieved the ends of the cost-sharing agreement. Instead, it argued that the “realistic alternative” to the cost-sharing arrangement was “not entering into the cost-sharing arrangement and continuing to operate the European Business as it had before.” The taxpayer’s brief took this point head on, arguing that the regulations implementing the realistic-alternatives principle “did not allow the Commissioner to consider alternatives to cost-sharing itself.” The Tax Court had rejected the Commissioner’s argument at trial, finding that empowering the Commissioner to use the realistic-alternatives principle to price the transaction as if it never happened at all would “make the cost sharing election, which the regulations explicitly make available to taxpayers, altogether meaningless.”

On balance, the panel’s questions and remarks appear to favor affirmance of the Tax Court. But both parties faced hard questions at oral argument. There is no deadline for the court’s ruling, and it will likely be several months before a decision is issued.

Amazon.com Tax Court Opinion

Ninth Circuit to Hear Oral Argument in Amazon Transfer-Pricing Dispute Friday

Post by
April 10, 2019

We wanted to alert our readers that oral argument in the Ninth Circuit in Amazon.com Inc. v. Commissioner will be held this Friday. Similar to Veritas Software Corp. v. Commissioner, this transfer-pricing dispute is about the value of intangibles that the U.S. parent contributed to a cost-sharing arrangement with a foreign subsidiary. In particular, the parties dispute whether particular intangibles, like goodwill and going concern values, are compensable and thus require a buy-in payment upon their contribution to a cost-sharing arrangement. The government lost in the Tax Court.

The briefs are below. The Ninth Circuit will stream the oral arguments (held in Seattle) live on its website here; Amazon is the last of five oral arguments to be heard beginning at 9:00 a.m. Pacific/12:00 p.m. Eastern Friday. There are 90 minutes of oral argument scheduled before Amazon (see the schedule here). You can also watch or listen to oral arguments after the fact in the Ninth Circuit’s archive here.

Amazon.com Government Opening Brief

Amazon.com Taxpayer Response Brief

Amazon.com Government Reply Brief

Divided Tax Court Decides E&P Computation Issue in Eaton

Post by
March 12, 2019

In Eaton Corp. v. Commissioner, 152 T.C. No. 2 (2019), a divided Tax Court decided (by a 10-2 margin) that the CFC partners in a U.S. partnership must increase earnings and profits (E&P) for the partnership’s subpart F inclusions. Members in the taxpayer’s group owned several CFCs (the “CFC partners”) that were partners in a U.S. partnership. That partnership in turn owned several lower-tier CFCs (the “lower-tier CFCs”) that generated subpart F income. There was no dispute that the U.S. partnership had to include the subpart F income of the lower-tier CFCs. The question before the Tax Court on motions for summary judgment was whether the CFC partners were required to increase their E&P in the amount of the U.S. partnership’s income inclusions (which ultimately determined whether the U.S. parent must include income from a section 956 investment in U.S. property by the CFC partners).

In an opinion by Judge Kerrigan, the majority held that the law required the CFC partners to increase E&P for the U.S. partnership’s income inclusions. Although the opinion does not expressly state so, it appears to adopt the IRS’s arguments for increasing the CFC partners’ E&P.

The court began with the language of section 964(a), which provides that “[e]xcept as provided in section 312(k)(4), for purposes of this subpart the earnings and profits of any foreign corporation…for any taxable year shall be determined according to rules substantially similar to those applicable to domestic corporations, under regulations prescribed by the Secretary….” (emphasis added). The court then held that because the rules “applicable to domestic corporations” are those in section 312 and its accompanying regulations, the computation of foreign corporation E&P under 964(a) should be made under the “elaborate, technical rules” of section 312 and its regulations.

The court observed that under Treas. Reg. § 1.312-6(b), the computation of E&P includes “all items includible in gross income under section 61….” Although there “is no explicit rule in section 312, section 964, or their accompanying regulations specifying how a CFC’s distributive share of partnership income…should be treated for purposes of computing its E&P,” the court looked to “the general rules set forth in subpart F and section 312.” Under those general rules, the court reasoned that the CFC partners should compute gross income “as if they were domestic corporations,” which meant including their distributive share of partnership income under section 702. And since the U.S. partnership’s gross income “includes subpart F income and section 956(a) inclusions from the lower-tier CFCs,” the court concluded that the CFC partners must increase their E&P by the subpart F amounts that are included in their gross income.

According to the court, the taxpayer’s “primary argument” was that “the section 964 regulations supply a freestanding, self-contained, and comprehensive system for determining the E&P of a foreign corporation” without need for recourse to section 312 or its regulations. Specifically, the taxpayer relied on Treas. Reg. § 1.964-1(a)(1), which provides that the E&P of a foreign corporation is computed “as if such corporation were a domestic corporation by” following three enumerated steps. The court portrayed the taxpayer’s argument as interpreting “the preposition ‘by’ in an extremely narrow sense, to mean ‘by doing these three things and nothing else.’”

The court rejected that reading of Treas. Reg. § 1.964-1(a)(1) on the grounds that the three enumerated steps in that regulation are insufficient for computing E&P. To compute E&P at all, it is necessary to know how corporate transactions and events—like property distributions, stock distributions, redemptions, discharge of indebtedness income, and depreciation—affect E&P. And since the regulations under section 964 address none of these transactions or events, the court held that they cannot alone determine foreign corporation E&P. Rather, recourse to section 312 and its regulations is necessary. The court also observed that the section 964 regulations specifically provide that the depreciation rules in section 312(k) do not apply in computing foreign corporation E&P. And the court inferred that this meant that section 312 and its regulations must apply in computing foreign corporation E&P, otherwise there would be no need to explicitly bar the application of the section 312(k) depreciation rules.

Presumably because it dismissed the taxpayer’s primary argument, the court took the opportunity to explain what the three steps enumerated in Treas. Reg. § 1.964-1(a)(1) are meant to do if they are not—as the taxpayer’s argument maintained—the sole mechanism for computing foreign corporation E&P. The court referred to paragraph (ii) of that regulation, which provides that foreign corporation E&P requires conforming the foreign corporation’s P&L statement to U.S. GAAP. The court concluded that the three steps under Treas. Reg. § 1.964-1(a)(1) “specify a preliminary process by which a foreign corporation’s P&L statement is conformed to, or made to resemble, that of a domestic corporation by making a series of tax accounting adjustments.”

The court also addressed the taxpayer’s other argument that the CFC partners’ subpart F inclusions “do not increase the dividend[-]paying capacity of the upper[-]tier CFC partners.” The court observed that “[t]here are many instances in which E&P are increased when amounts are included in income but no cash is received,” citing original issue discount and income accrual as examples.

Most of the rest of the Tax Court joined Judge Kerrigan’s opinion, with Judge Pugh abstaining and Judge Morrison writing a brief concurrence (in which he clarifies his opinion that it is the language in Treas. Reg. § 1.964-1(a)(1)—and not, as the majority stated, the language in section 964(a)—that imports section 312 and its regulations into the computation of foreign corporation E&P). Judge Foley, however, wrote a dissent in which Judge Gustafson joined.

The brunt of that dissent is that if Treasury wanted to import the section 312 regulations into the computation of foreign corporation E&P under section 964, then it should have done so expressly. After criticizing the majority’s inference about the 312(k) depreciation rules excluded under section 964(a), the dissent offers support for the taxpayer’s primary argument that the regulations under 964 are the exhaustive source of instruction on computing foreign corporation E&P. The dissent observes that there were previously five steps under Treas. Reg. § 1.964-1(a)(1) and that the calculation of E&P “was complete upon the conversion to U.S. dollars.” Moreover, the dissent argues that Treasury could have expressly incorporated the rules under section 312 but did not do so. (The majority held that the language under 964(a) instructing that foreign corporation E&P is computed “under regulations prescribed by the Secretary” could be “reasonably read to include regulations promulgated under section 312,” even if those regulations predate section 964(a). The dissent disagreed, asserting that the majority’s analysis “sets bad precedent and is a rickety analytical construct.”)

Given that it involves a purely legal issue and a divided Tax Court, the case seems destined for appeal, so stay tuned for further updates.

Eaton Tax Court Opinion

Tax Court Overrules Its BMC Software Decision in Analog Devices

Post by
December 5, 2016

In its recent reviewed decision in Analog Devices, the Tax Court revisited and overruled its decision in BMC Software. We previously covered the BMC Software decision and the Fifth Circuit’s reversal of the Tax Court here. Analog Devices involves facts nearly identical to those in BMC Software: The taxpayer claimed a one-time dividends received deduction under section 965 for its 2005 tax year. Pursuant to a 2009 closing agreement with respect to some section 482 adjustments, the taxpayer elected to establish accounts receivable via a closing agreement under Rev. Proc. 99-32 in order to repatriate amounts included in U.S. income for the 2005 tax year (among others). And just as it did in BMC Software, the IRS determined that the retroactive creation of those accounts receivable for 2005 constituted related party indebtedness under section 965(b)(3) for the 2005 tax year, thus reducing the taxpayer’s dividends received deduction for 2005.

Analog Devices is appealable to the First Circuit, and therefore the Fifth Circuit’s decision in BMC Software is not binding precedent under the Golsen rule. Nevertheless, the Tax Court’s decision begins with an explanation of why the court was willing to reconsider its prior decision in BMC Software. Acknowledging the importance of stare decisis, the Tax Court stated that it was “not capriciously disregarding” its prior analysis and held that the principles that it articulated in BMC Software are “not entrenched precedent.” The Tax Court also observed that while its BMC Software decision implicates contract rights (specifically, closing agreements under Rev. Proc. 99-32), it was “unlikely” that the IRS would have relied on BMC Software in structuring later closing agreements.

The Tax Court then proceeded to follow the Fifth Circuit on both issues presented in the case. One issue was whether, as a statutory matter, section 965 required the parties to treat the accounts receivable as related party indebtedness. Following the Fifth Circuit, the Tax Court held that there was no such statutory requirement because section 965(b)(3) looks only to indebtedness “as of the close of the taxable year for which the [section 965] election . . . is in effect.” Because the taxpayer’s closing agreement did not create the accounts receivable until 2009—long after the testing period for the taxpayer’s 2005 year—the Tax Court held that the accounts receivable did not constitute related party indebtedness under section 965.

The other issue was whether the parties had agreed to treat the accounts receivable as related party indebtedness under the closing agreement. In what the Tax Court termed an “introductory phrase,” the closing agreement provided that the accounts receivable were established “for all Federal income tax purposes.” The Commissioner argued that with this language, the parties had agreed to treat the accounts receivable as related party indebtedness for purposes of section 965. But looking to the facts and circumstances of the closing agreement, the Tax Court concluded that the taxpayer made no such agreement. The Tax Court cited law for the principle that each closing agreement is limited to the “matters specifically agreed upon and mentioned in the closing agreement” as well as some self-limiting language in the agreement itself. Since there is no specific mention of section 965 in the agreement, the Tax Court held that to treat the accounts receivable as related party indebtedness would be to ignore the intent of the parties.

But the introductory phrase in the closing agreement in BMC Software—which had the phrase “for Federal income tax purposes”— was different from that in Analog Devices—“for all Federal income tax purposes.” Four judges on the Tax Court concluded that this difference was material and dissented. The dissent invoked interpretive canons for giving effect to the word “all” and addressed the equities of the situation, stating that even if the parties did not bargain over the wording of the introductory phrase, the “wording was not foisted on an unrepresented or unsuspecting taxpayer, or rendered in fine print, or hidden in a footnote, or even inserted in the midst of other terms of the agreement.” Several judges joined in a concurring opinion stating that the dissent “points to a distinction without a difference” and observing that the phrase “for Federal income tax purposes” means the same thing as the phrase “for all Federal income tax purposes.”

If the government appeals Analog Devices (which it may well do given the dissent), we will cover that appeal.

Analog Devices Tax Court Opinion

Federal Circuit Decides Interest-Netting Dispute in Wells Fargo Case

Post by
July 1, 2016

On Wednesday, the Federal Circuit issued its decision in the Wells Fargo interest netting case, affirming in part the trial court’s decision in favor of the taxpayer but also reversing in part. We previously covered the trial court decision and the oral argument here. As our prior coverage explained, the case presented three different fact patterns (termed “situations” in the decision) in which the taxpayer’s entitlement to interest netting hinged on the extent to which corporate mergers resulted in distinct corporations becoming the “same taxpayer” under the relevant Code section governing interest netting (§ 6621(d)). And as the questioning at oral argument had indicated, the Federal Circuit’s decision did not categorically adopt either party’s position, finding for the taxpayer in one situation and for the government in another.

The Federal Circuit did not have to address all three situations because in one of them—Situation Two—the government conceded that the taxpayer was entitled to interest netting. In Situation Two, the corporation that made the overpayment had the same Taxpayer Identification Number (TIN) as the corporation that had the later underpayment, even though the corporation had been through several intervening mergers between the time of the overpayment and the underpayment.

The government effectively had to make this concession—that interest netting is available when the underpaying corporation and overpaying corporation have the same TIN—in order to be consistent with its argument regarding Situation Three. In Situation Three, the corporation that had an overpayment (CoreStates) later merged into First Union, and after the merger the resulting First Union entity (which kept First Union’s TIN) had an underpayment. Relying on the decision in Magma Power (see our prior coverage of Magma Power here), the government argued that the taxpayer was not entitled to interest netting because CoreStates had a different TIN when it made its overpayment than First Union had at the time of the underpayment.

As the Federal Circuit observed, however, the only difference between Situation Two and Situation Three was “the choice of who is the named surviving corporation.” The choice of the name (and TIN) of the surviving corporation in a merger is hardly the sort of thing that ought to determine whether a taxpayer is entitled to interest netting. As the Federal Circuit astutely observed, every merger results in the surviving corporation becoming “automatically liable for the underpayments and entitled to the overpayments of its predecessors,” regardless of which TIN the surviving corporation adopts. Hewing to Congress’s intent for the statute to serve a remedial purpose, the Federal Circuit concluded that the CoreStates-First Union merger made the surviving corporation the “same taxpayer” as either of the pre-merger entities under section 6621(d).

With respect to Situation One, however, the Federal Circuit drew a limit on how broadly it was willing to interpret the “same taxpayer” requirement. In Situation One, the 2001 merger of Old Wachovia and First Union came after both Old Wachovia’s overpayment (1993) and First Union’s underpayment (1999). The Federal Circuit agreed with the government that under the decision in Energy East, the “same taxpayer” requirement is applied by asking whether “the entity that made the underpayment at the time of the underpayment is the ‘same taxpayer’ as the entity who made the overpayment at the time of the overpayment.” And since the merger postdated both the underpayment and the overpayment in Situation One, the Federal Circuit denied the taxpayer’s netting claim.

But is the Energy East test correct that entitlement to netting should be measured at the time of the underpayment or overpayment? One might reasonably argue that in applying the “same taxpayer” requirement, it makes more sense to look the period of overlap. Consider Situation One: After the 2001 merger, the surviving corporation would have been entitled to Old Wachovia’s overpayment and liable for First Union’s underpayment. And since the period of overlap extended beyond the September 2001 merger into later periods, there was good reason to conclude that the surviving corporation was entitled to interest netting from the date of the merger until the overlap periods ended. While the taxpayer did not pursue such a partial resolution on appeal, perhaps a future case will present that issue for decision.

Wells Fargo Federal Circuit Opinion

 

Fifth Circuit Reverses Tax Court in BMC Software

Post by
March 17, 2015

The Fifth Circuit reversed the Tax Court’s decision in BMC Software yesterday. As we speculated that it might at the outset of the case here, the Fifth Circuit’s decision hinged on how far to take the legal fiction that the taxpayer’s accounts receivable created under Rev. Proc. 99-32 were deemed to have been established during the taxpayer’s testing period under section 965(b)(3). While the Tax Court treated that legal fiction as a reality that reduced the taxpayer’s section 965 deduction accordingly, the Fifth Circuit treated that legal fiction as just that—a fiction that had no effect for purposes of section 965: “The fact that the accounts receivable are backdated does nothing to alter the reality that they did not exist during the testing period.” The Fifth Circuit based its decision on a straightforward reading of the plain language of the related-party-indebtedness rule under section 965, holding that for that rule “to reduce the allowable deduction, there must have been indebtedness ‘as of the close of’ the applicable year.” And since the deemed accounts receivable were not created until after the testing period, the Fifth Circuit held that the taxpayer’s deduction “cannot be reduced under § 965(b)(3).”

The Fifth Circuit also rejected the Commissioner’s argument that his closing agreement with the taxpayer mandated treating the deemed accounts receivable as related-party indebtedness. Here, the Fifth Circuit found that the interpretive canon that “things not enumerated are excluded” governed in this case. Because the closing agreement “lists the transaction’s tax implications in considerable detail,” the absence of “a term requiring that the accounts receivable be treated as indebtedness for purposes of § 965” meant that the closing agreement did not mandate such treatment.

BMC Software Fifth Circuit Opinion

Taxpayer’s Reply Brief Filed in BMC Software

Post by
May 5, 2014

The taxpayer filed its reply brief in the BMC Software case last week. As in its opening brief, BMC cites Fifth Circuit precedent for the tax law definition of “indebtedness” as an “existing unconditional and legally enforceable obligation to pay.” BMC argues that it is undisputed that the accounts receivable created under Rev. Proc. 99-32 do not meet that definitionthey neither existed nor were legally enforceable during the testing period for related-party indebtedness under section 965. (BMC observes that instead of disputing this point, the Commissioner tried to distinguish that case law, much of which comes from the debt-equity context. And BMC points out that the Commissioner’s argument implies different definitions of “indebtedness” may apply depending on the posture of the case.) In our first post on this case, we speculated that the outcome in this case may depend on whether the Tax Court took the legal fictions in Rev. Proc. 99-32 too far. That issue lurks beneath this definitional dispute: That the accounts receivable are deemed to have arisen during the testing period does not settle whether those accounts were “indebtedness” during the testing period.

BMC then turns to the closing agreement, which makes no mention of section 965 or the term “indebtedness.” BMC therefore relies on the legal principle that closing agreements must be construed to bind the parties “only to the matters expressly agreed upon.” BMC also addresses the Commissioner’s other arguments based on the closing agreement.

Finally, BMC makes a strong policy argument against the result in the Tax Court. BMC observes that the Commissioner concedes that the clear purpose of the related-party-indebtedness rule in section 965 is that it is meant to ensure “that a dividend funded by a U.S. shareholder, directly or indirectly, and that does not create a net repatriation of funds, is ineligible for the benefits” of section 965. Of course, no taxpayer could fund a dividend by way of deemed accounts receivable created after the dividend was paid. Therefore, BMC concludes, the case does not implicate the underlying purpose of the related-party-indebtedness rule under section 965.

We will provide updates once oral arguments are scheduled.

BMC Software – Taxpayer’s reply brief

Commissioner’s Brief filed in BMC Software

Post by
April 4, 2014

The Commissioner filed his brief in the BMC Software case last week. The brief hews closely to the Tax Court’s decision below. The brief primarily relies on the parties’ closing agreement and trumpets the finality of that agreement.

The Commissioner argues that BMC’s problem is of BMC’s own making—BMC chose to avail itself of the relief available under Rev. Proc. 99-32 and signed a closing agreement under which the accounts receivable were deemed established during the relevant testing period for the related-party indebtedness rule under section 965. And as if to suggest that BMC deserves the reduction in its section 965 deduction, the Commissioner repeatedly asserts that the underlying adjustments that precipitated BMC’s use of Rev. Proc. 99-32 resulted from BMC’s “aggressive” transfer-pricing strategies.

The Commissioner briefly addresses BMC’s primary argument on appeal, which is that the relevant definition of “indebtedness” for purposes of section 965 is the definition established in case law and not—as the Tax Court had found below—the Black’s Law definition. The Commissioner’s brief argues that most of the cases on which BMC relies for a definition of “debt” are inapplicable because they arise in the context of debt-equity disputes or other settlements where the Commissioner was challenging the taxpayer’s characterization of an amount as debt. According to the Commissioner’s brief, those cases address whether the underlying substance of an instrument or payment was truly debt but that “[f]actual inquiries to ascertain whether, and when, debt was created by the parties’ dealings are irrelevant here.”

The brief also addresses BMC’s arguments that the Tax Court misinterpreted the closing agreement. The Commissioner argues that parol evidence is irrelevant because the agreement is unambiguous and that in any event, the extrinsic evidence does not support BMC’s position.

BMC’s reply brief is due April 28.

BMC Software – Commissioner’s brief

Taxpayer’s Opening Brief Filed in BMC Software

Post by
January 28, 2014

The taxpayer filed its opening brief in the Fifth Circuit appeal of BMC Software v. Commissioner.  As we described in our earlier coverage, the Tax Court relied on the legal fiction that accounts receivable created pursuant to Rev. Proc. 99-32 in a 2007 closing agreement were indebtedness for earlier years (2004-06) in order to deny some of the taxpayer’s section 965 deductions.  There are three main avenues of attack in the taxpayer’s brief.

First, the taxpayer argues that the Tax Court incorrectly treated those accounts receivable as “indebtedness” as that term is used in the exception to section 965 for related-party indebtedness created during the testing period.  The taxpayer contends that the Tax Court looked to the Black’s Law definition of “indebtedness” when it should have looked to the tax law definition.  And the taxpayer argues that the tax law definition—that “indebtedness” requires “an existing unconditional and legally enforceable obligation to pay”—does not include the fictional accounts receivable created under Rev. Proc. 99-32.  The taxpayer argues that those accounts did not exist and were not legally enforceable until 2007 (after the section 965 testing period) and therefore did not constitute related-party indebtedness during the testing period for purposes of section 965.

Second, the taxpayer argues that the Tax Court was wrong to interpret the 2007 closing agreement to constitute an implicit agreement that the accounts receivable were retroactive debt for purposes of section 965.  The taxpayer observes that closing agreements are strictly construed to bind the parties to only the expressly agreed terms.  And the taxpayer argues that the parties did not expressly agree to treat the accounts receivable as retroactive debt for section 965 purposes.  Moreover, the taxpayer argues that the Tax Court misinterpreted the express language in the agreement providing that the taxpayer’s payment of the accounts receivable “will be free of the Federal income tax consequences of the secondary adjustments that would otherwise result from the primary adjustments.”  The taxpayer then makes several other arguments based on the closing agreement.

Finally, the taxpayer makes some policy-based arguments.  In one of these arguments, the taxpayer contends that the Tax Court’s decision is contrary to the purpose of section 965 and the related-party-indebtedness exception because the closing agreement postdated the testing period and therefore cannot be the sort of abuse that the related-party-indebtedness exception was meant to address.

BMC Software – Taxpayer’s Opening Brief

Fifth Circuit to Address Section 965 Deduction in BMC Software Appeal

Post by
October 25, 2013

In BMC Software v. Commissioner, 141 T.C. No. 5, the Tax Court was faced with considering the effect that some legal fictions (created under a Revenue Procedure regarding transfer pricing adjustments) have on the temporary dividends-received deduction under section 965.  And while both the section 965 deduction and the legal fictions under the Revenue Procedure appear to have been designed to benefit taxpayers by facilitating tax-efficient repatriations, the Tax Court eliminated that benefit for some repatriated amounts.  The taxpayer has already appealed the decision (filed on September 18) to the Fifth Circuit (Case No. 13-60684), and success of that appeal may hinge in part on whether the Tax Court took the legal fictions in the Revenue Procedure too far.

First, some background on the section 965 deduction:  In 2004, Congress enacted the one-time deduction to encourage the repatriation of cash from controlled foreign corporations on the belief that the repatriation would benefit of the U.S. economy.  To ensure that taxpayers could not fund the repatriations from the United States (by lending funds from the U.S. to the CFC, immediately repatriating the funds as dividends, and then later treating would-be dividends as repayments of principal), Congress provided that the amount of the section 965 deduction would be reduced by any increase in related-party indebtedness during the “testing period.”  The testing period begins on the earliest date a taxpayer might have been aware of the availability of the one-time deduction—October 3, 2004—and ends at the close of the tax year for which the taxpayer elects to take the section 965 deduction.  Congress thus established a bright-line test that treated all increases in related-party debt during the testing period as presumptively abusive, regardless of whether the taxpayer had any intent to fund the repatriation from the United States.

BMC repatriated $721 million from a controlled foreign corporation (BSEH) and claimed the section 965 deduction for $709 million of that amount on its 2006 return.  On that return, BMC claimed that there was no increase in BSEH’s related party indebtedness between October 2004 and the close of BMC’s 2006 tax year in March 2006.  In the government’s view, however, this claim became untrue after the IRS reached a closing agreement with the IRS in 2007 with respect to BMC’s 2003-06 tax years.

That agreement made transfer pricing adjustments that increased BMC’s taxable income for the 2003-06 tax years.  The primary adjustments were premised on the IRS’s theory that the royalties BMC paid to its CFC were too high.  By making those primary adjustments and including additional amounts in income, BMC was deemed to have paid less to its CFC for tax purposes than it had actually paid.

The typical way of conforming BMC’s accounts in this circumstance is to treat the putative royalty payments (to the extent they exceeded the royalty agreed in the closing agreement) as deemed capital contributions to BSEH.  If BMC were to repatriate those amounts in future, they would be treated as taxable distributions (to the extent of earnings and profits).  But Rev. Proc. 99-32 permits taxpayers in this circumstance to elect to repatriate the funds tax-free by establishing accounts receivable and making intercompany payments to satisfy those accounts.  The accounts receivable created under Rev. Proc. 99-32 are, of course, legal fictions—the taxpayer did not actually loan the funds to its CFC.  BMC elected to use Rev. Proc. 99-32 and BSEH made the associated payments.

To give full effect to the legal fiction, Rev. Proc. 99-32 provides that each account receivable is “deemed to have been created as of the last day of the taxpayer’s taxable year for which the primary adjustment is made.”  So although BMC’s accounts receivable from BSEH were not actually established until the 2007 closing agreement, those accounts receivable were deemed to have been established at the close of each of the 2003-06 tax years.  Two of those years (those ending March 2005 and March 2006) fell into the testing period for BMC’s section 965 deduction.  The IRS treated the accounts receivable as related-party debt and reduced BMC’s section 965 deduction by the amounts of the accounts receivable for those two years, which was about $43 million.

BMC filed a petition in Tax Court, arguing (among other things) that the statutory rules apply only to abusive arrangements and that the accounts receivable were not related-party debt under section 965(b)(3).  The government conceded that BMC did not establish the accounts receivable to exploit the section 965 deduction, but argued that there is no carve-out for non-abusive transactions and the accounts receivable were indebtedness under the statute.

The court held that the statutory exclusion of related-party indebtedness from the section 965 deduction is a straightforward arithmetic formula devoid of any intent requirement or express reference to abusive transactions.  The court also held that the accounts receivable fall under the plain meaning of the term “indebtedness” and therefore reduce BMC’s section 965 deduction under section 965(b)(3).  So even though both the section 965 deduction and Rev. Proc. 99-32 were meant to permit taxpayers to repatriate funds with little or no U.S. tax impact, the mechanical application of section 965(b)(3) and Rev. Proc. 99-32 eliminated that benefit for $43 million that BMC repatriated as a dividend.

This does not seem like the right result.  And here it seems the culprit may be the legal fiction that the accounts receivable were established during the testing period.  The statute may not expressly address abusive intent, but that is because Congress chose to use the testing period in the related-party-debt rule as a blunt instrument to stamp out all potential abuses of the section 965 deduction.  This anti-abuse intent is baked into the formula for determining excluded related-party debt because the opening date of the testing period coincides with the earliest that a taxpayer might have tried to create an intercompany debt to exploit the section 965 deduction.  BMC did not create an intercompany debt during the testing period; the accounts receivable were not actually established until after the close of the testing period.  Perhaps the court took the legal fiction that the accounts receivable were established in 2005 and 2006 one step too far.  And perhaps the Fifth Circuit will address this legal fiction on appeal.

BMC Software – Tax Court Opinion

Eleventh Circuit Affirms Tax Court in Peco Foods

Post by
July 7, 2013

In an unpublished opinion, the Eleventh Circuit affirmed the Tax Court’s decision in Peco Foods.  As we described in our earlier coverage here, the Tax Court held that the taxpayer could not subdivide broader classes of assets acquired in two transactions into discernible subcomponents for depreciation purposes because the taxpayer had agreed to an express allocation (in both agreements at issue) to the broader classes “for all purposes (including financial accounting and tax purposes).”  The Tax Court decided that because of that express allocation, the Danielson rule and language in section 1060 prevented the taxpayer from subdividing the asset classes (and thereby getting accelerated depreciation for some of those subclasses).

The taxpayer challenged the Tax Court’s application of the Danielson rule on appeal (among other things).  The taxpayer argued that under the Eleventh Circuit’s decision in Fort, the Danielson rule applies only where a taxpayer challenges the form of a transaction.  And since the subdivision of assets for depreciation purposes is not a challenge to form, the taxpayer argued that the Danielson rule did not apply.

The Eleventh Circuit made no mention of its decision in Fort, nor did it explain whether Peco’s attempt to subdivide the acquired asset classes for depreciation purposes was a challenge to the form of the transactions.  Instead, the Eleventh Circuit summarily affirmed the Tax Court’s holding that the express allocation in the agreements was unambiguous and binding under section 1060 and the Danielson rule.  So unfortunately for taxpayers—for whom the Danielson rule is a one-way street in the IRS’s favor—the Eleventh Circuit did nothing to explain how its decision in Fort limits the breadth of the Danielson rule.

Peco Foods – Eleventh Circuit Unpublished Opinion

When Characterizing Golfer’s Endorsement Income, Image Matters

Post by
May 7, 2013

As a follow-up to our posts on the Goosen case regarding sourcing of a golfer’s income from sponsors (see here), we provide this update on the case involving golfer Sergio Garcia.  While they were not technically related cases, the significant overlap in issues and facts—not to mention witness testimony—meant that the outcome in Goosen partially determined the outcome in Garcia.

Both cases involved the character of the golfers’ endorsement income.  Coincidentally, the golfers each had an endorsement contract with the same brand—TaylorMade.  The golfers both argued that the lion’s share of the endorsement income was royalty income (i.e., paid for the use of the golfer’s name and likeness) and not personal services income (which is typically subject to a higher tax rate than royalties because of tax treaties).

Garcia had sold the rights to his image to a Swiss corporation (of which Garcia owned 99.5%) that in turn assigned the rights to a Delaware LLC (of which Garcia owned 99.8%).  Garcia’s amended endorsement agreement assigned 85% of the contract payments to the LLC as payments for the use of his image rights.  So Garcia argued that at least 85% of the endorsement payments were royalty income by virtue of the terms of the endorsement agreement.  The Service originally argued that none of endorsement payments were royalty income and that all of the payments were for personal services.  But the Service later tempered its position and argued that the “vast majority” of payments were for personal services.

Thanks to some testimony by the TaylorMade CEO that undermined the allocation in the agreement, the Tax Court declined to follow the 85/15 allocation in the amended endorsement agreement.  But the Tax Court also rejected the Service’s argument that the “vast majority” of payments were for personal services.  And the Tax Court determined that a 50/50 split was unwarranted.

In rejecting the 50/50 split, the Court tied the outcome in Garcia directly to the outcome in Goosen.  As we wrote before, the Court opted for a 50/50 split between royalties and personal services for Goosen’s endorsement income.  But expert testimony in Goosen contrasted Goosen’s endorsement income with Garcia’s.  The expert in Goosen (Jim Baugh, formerly of Wilson Sporting Goods) had testified that, while Goosen had better on-course results than Garcia, Garcia had a bigger endorsement deal because of Garcia’s “flash, looks and maverick personality.”  Consequently, the Court found that Garcia’s endorsement agreement “was more heavily weighted toward image rights than Mr. Goosen’s” and decided on a royalty/personal services split of 65/35.

The Tax Court also rejected the Service’s argument that Garcia’s royalty income was taxable in the U.S. under the U.S.-Swiss treaty.  Perhaps the IRS will appeal that legal issue.  Will Garcia appeal?  The Tax Court’s decision is a victory for Garcia relative to the outcome in Goosen.  On the other hand, if Garcia’s brand hinges on his “maverick personality,” then perhaps the “maverick” thing to do is to roll the dice with an appeal.  Decision has not yet been entered under Rule 155, so we will wait to see whether there is an appeal.

Garcia – Tax Court Opinion

Eleventh Circuit to Address Scope of Danielson Rule

Post by
April 1, 2013

With oral argument scheduled for April 18 in Peco Foods v. Commissioner, No. 12-12169, the Eleventh Circuit will soon decide a case that involves the scope of the Danielson rule.  That rule, established in Danielson v. Commissioner, 378 F.2d 771, 775 (3d Cir. 1967), provides that “a party can challenge the tax consequences of his agreement as construed by the Commissioner only by adducing proof which in an action between the parties to the agreement would be admissible to alter that construction or to show its unenforceability because of mistake, undue influence, fraud, duress, etc.”  The Eleventh Circuit has expressly adopted the Danielson rule.

In Peco Foods, the Commissioner used that rule (along with the allocation rules under section 1060) to prevent the taxpayer from subdividing broader classes of purchased assets (to which the purchase agreement had expressly allocated a portion of the purchase price) into discernible subcomponents for depreciation purposes.  The taxpayer is a poultry processor that purchased the assets at two poultry processing plants in the mid- to late-1990s.  In each of the purchase transactions, Peco and the seller agreed to allocate the purchase price among listed assets “for all purposes (including financial accounting and tax purposes).”  The first agreement allocated purchase price among 26 listed assets; the second allocated purchase price among three broad classes of assets.

Prompted by the Tax Court’s decision in Hospital Corporation of America v. Commissioner, 109 T.C. 21 (1997), Peco commissioned a cost segregation study that subdivided the listed assets into subcomponents.  Some of these subcomponents fell into asset classes that are subject to accelerated depreciation methods.  For instance, Peco subdivided the class of assets listed as “Real Property: Improvements” on the original allocation schedule into subcomponents that were tangible personal property subject to a 7- or 15-year depreciation period under section 1245.  If they were classified as structural components of nonresidential real property, the assets would have been subject to a 39-year depreciation period under section 1250.

With the segregation study in hand, Peco applied to change its accounting method for those subcomponents with its 1998 return and claimed higher depreciation deductions on subsequent returns.  The IRS disallowed these deductions and issued a notice of deficiency; the taxpayer filed a petition in Tax Court.

In a Tax Court Memorandum opinion by Judge Laro, T.C. Memo 2012-18, the Tax Court upheld the Commissioner’s deficiencies.  The Tax Court’s decision was based on both the Danielson rule and section 1060(a), the latter of which provides that if the parties in an applicable asset acquisition “agree in writing as to the allocation of any consideration,” the agreement “shall be binding on both the transferee and transferor unless the Secretary determines that such allocation . . . is not appropriate.”  The taxpayer argued that section 1060 serves only to allocate purchase price among assets under the residual method of section 338(b)(5) and that section 1060 does not bar further subdivision of the allocation for purposes of determining useful lives for depreciation.  The Tax Court held that the directive in section 1060 that an allocation by the parties “shall be binding” trumps the application of the residual method of section 338(b)(5).

The Tax Court also rejected the taxpayer’s argument that Danielson was inapposite.  The taxpayer had relied on United States v. Fort, 638 F.3d 1334 (11th Cir. 2011), in which the Eleventh Circuit held that “the Danielson rule applies if a taxpayer ‘challenge[s] the form of a transaction.’”  (citation omitted)  Since the taxpayer in Fort had challenged the specific tax consequences of the form of the transaction but not the form itself, the Eleventh Circuit found that Fort fell outside the scope of the Danielson rule.  The Tax Court held that while the taxpayer in Fort had not challenged the form of the transaction, the taxpayer in Peco—by “seeking to reallocate the purchase price among assets not listed in the original allocation schedules”—sought to challenge the form of the transaction.  Therefore, reasoned the Tax Court, because there was no ambiguity to the allocations in the purchase agreements under the applicable contract laws of the states in which the agreements were entered, Danielson applies to prevent the taxpayer from subdividing the listed into distinct components for depreciation purposes.

On appeal, the taxpayer contests the Tax Court’s holdings with respect to both section 1060 and Danielson.  In its brief, the taxpayer argues that whether an asset is tangible personal property or a structural component of a building is a matter of facts and circumstances and that the words used to describe the asset “are of no utility in connection with its categorization as a structural component.”  The taxpayer also argues that classifying assets for depreciation purposes is not a challenge to the form of the transaction (unlike, for example, treating the transaction as a merger or lease rather than an asset acquisition, which would have been a challenge to form) and therefore, under the holding in Fort, the Danielson rule does not apply.

In his opposition brief, the Commissioner echoes the Tax Court’s holding that the taxpayer’s subdivision of listed assets for depreciation purposes is an attempt to “restructure the form of the transaction” and therefore falls within the purview of the Danielson rule (and is not excluded by the rule articulated in Fort).  The Commissioner then goes a step further, arguing that the taxpayer was not merely “changing the classification of assets” but also “added assets.”  Moreover, the Commissioner insists that what the taxpayer did with respect to depreciation “goes considerably deeper than merely a change to the classification for depreciation purposes.”

Peco Foods – Tax Court Memorandum Opinion

Peco Foods – Taxpayer’s 11th Circuit Brief

Peco Foods – Commissioner’s 11th Circuit Opposition Brief

 

Goosen Appeal Dismissed; Garcia Decision Looms

Post by
June 21, 2012

While this post is significantly belated, it’s still worth noting that the IRS (the original appellant) and Goosen (who had cross appealed) stipulated to dismiss the appeal to the D.C. Circuit back in February.

This doesn’t mark the end of the IRS’s fight with pro golfers over the character and source of income (especially royalty income).  Sergio Garcia disputed deficiencies on similar issues; his case was tried in the Tax Court back in March.  (Case No. 013649-10).  We’ll update you when the decision is issued in that case.

Service Appeals Goosen Tax Court Decision to D.C. Circuit

Post by
January 4, 2012

We posted in November 2011 about the Tax Court’s decision on the character and source of golfer Retief Goosen’s endorsement income.  The Service appealed that decision to the D.C. Circuit in December.  The D.C. Circuit case number is 11-1478.  We’ll post updates as the appeal progresses.

Court of Federal Claims Construes “Same Taxpayer” Requirement for Interest Netting

Post by
December 9, 2011

In Magma Power v. United States, Case No. 09-419T, the Court of Federal Claims tackled the arcane topic of interest netting.  The issue in Magma Power was a narrow question of statutory interpretation, but the broader topic of interest netting warrants a word of explanation. 

The government charges interest on tax underpayments at a higher rate (under section 6601) than it pays on tax overpayments.  Because it often takes several years or more to determine whether a taxpayer has an overpayment or underpayment for a particular tax year and the amount of that overpayment or underpayment, there are sometimes post-return periods during which a taxpayer has overlapping overpayments and underpayments.  When this occurs, the taxpayer should owe no interest on the overlapping amount.  If the overlapping amounts are not netted, however, the rate disparity results in net interest in the government’s favor.  To correct this inequity, Congress enacted section 6621(d), which provides that “to the extent that, for any period, interest is payable . . . and allowable . . . on equivalent underpayments and overpayments for the same taxpayer, . . . the net rate of interest on such amounts shall be zero.” 

The narrow statutory-interpretation issue in Magma Power is the meaning of the term “same taxpayer” under section 6621(d).  The IRS had denied section 6621(d) relief to Magma Power on the theory that Magma Power was no longer the “same taxpayer” after becoming a member of a consolidated group. 

Magma Power filed a return for its 1993 tax year sometime in 1994.  In February 1995, CalEnergy Company acquired Magma Power and subsequently included Magma Power on its consolidated tax returns.  The IRS later determined a deficiency for Magma Power’s 1993 tax year, and Magma Power paid that deficiency and over $9 million in associated underpayment interest in 2000 and 2002.  The CalEnergy consolidated group overpaid its taxes in four consecutive tax years from 1995 through 1998.  Despite some disagreement between the parties, the court found that some portion of these overpayments were attributable to Magma Power’s activities.  In 2004 and 2005, the IRS refunded those overpayments plus the associated overpayment interest to the consolidated group agent (which by then was MidAmerican Energy Holdings Company).  There were overlapping underpayments and overpayments for the period that began with the filing of the 1995-98 returns and ended with the satisfaction of Magma Power’s 1993 underpayment.  Magma Power claimed interest-netting refunds for that period.  The IRS denied the refund on the theory that the consolidated group could not net its overpayments with Magma Power’s underpayments because of the “same taxpayer” requirement of section 6621(d). 

The court’s plain-language analysis of section 6621(d) is straightforward and decisively rebuts what appears to be a flimsy position taken by the IRS.  The essence of the court’s conclusion is that becoming a member of a consolidated group does not fundamentally alter a taxpayer’s identity.  The court rests this decision on the uncontroversial premise that the taxpayer identification number (or EIN, for corporations like Magma Power) is the sine qua non of taxpayer identity.  And because Magma Power retained the same EIN (and therefore same identity) after its inclusion in the consolidated group, the court held that Magma Power was the same taxpayer for section 6621(d) purposes for the 1993 underpayment and its allocable portion of the 1995-98 overpayments. 

Although the court addresses several arguments made by the government, the only notable bump in the court’s road to its conclusion was some language in another Court of Federal Claims decision, Energy East v. United States, 92 Fed. Cl. 29 (2010), aff’d 645 F.3d 1358 (Fed. Cir. 2011).  Interpreting the meaning of “same taxpayer” for interest-netting purposes in Energy East, the lower court cited the dictionary definition of “same” and decided that section 6621(d) requires that the taxpayer must be “identical” and “without addition, change, or discontinuance.”  (The issue on appeal was narrower and the Federal Circuit did not reject or adopt this aspect of the lower court’s opinion.)

The court in Magma Power had little difficulty distinguishing Energy East:  Energy East was trying to net the overpayment years of acquired companies against its own underpayment years.  The hitch was that both the underpayment years and overpayment years came before Energy East acquired those companies.  In Magma Power, the court held that the Energy East situation was “radically different” than Magma Power’s attempt to net its own 1993 underpayment against its own later overpayments (albeit encompassed within the Cal Energy consolidated group).

The government may well appeal Magma Power based on the broad language in the lower court’s decision in Energy East.  If they do, we’ll keep you posted. 

Magma Power opinion 10.28.2011

Tax Court Addresses Character and Sourcing Issues for Golfer’s Endorsement Income

Post by
November 1, 2011

In what appears may be the first in a series of cases on the endorsement income of non-resident aliens, the Tax Court was tasked with characterizing and sourcing the endorsement income for golfer Retief Goosen.  The court’s decision may impact how other athletes and entertainers structure their endorsement deals and indicates how taxpayers should expect the IRS to source royalty income in similar cases. 

Goosen, a native South African who is a U.K. resident, is subject to U.S. tax because playing professional golf in the U.S. amounts to engaging in a U.S. trade or business.  He had endorsement agreements with Acushnet (which makes Titleist golf balls), TaylorMade, and Izod to use or wear their products while playing golf (these are the “on-course” endorsements).  He also had endorsement agreements with Rolex, Upper Deck, and Electronic Arts (the “off-course” endorsements). 

There were three main issues before the Tax Court:

(1)  Was Goosen’s on-course endorsement income personal services income or royalty income or some combination of the two?  (The parties agreed that all of the off-course endorsement income was royalty income.)   The personal services income of nonresident aliens is subject to regular U.S. tax rates; they typically owe less U.S. tax on royalty income under tax treaties. 

(2)  What portion of Goosen’s royalty income was U.S.-source income?  Under section 872, the gross income of nonresidents includes U.S.-source income. 

(3)  What portion, if any, of that U.S.-source royalty income was effectively connected to a U.S. trade or business?  While U.S.-source royalties are generally subject to a flat 30% withholding tax, if  royalties are effectively connected to a U.S. trade or business, they are subject to the graduated rates that apply to U.S. residents. 

On the first issue, Goosen argued that the on-course endorsements were paid for the use of his name and likeness, which is classic royalty income.  The IRS argued that because the on-course endorsement agreements required Goosen to make personal appearances and to play in a minimum number of golf tournaments (all while using Titleist balls and TaylorMade clubs and wearing Izod), the on-course endorsements were paid for personal services.  The court split the difference, deciding that the sponsors paid for both the use of Goosen’s image and likeness and for personal services. 

On the one hand, the court found that the sponsors were paying for more than just Goosen’s golfing—that the sponsors wanted to be associated with Goosen’s image.  The court cited the morals clause in a couple of Goosen’s endorsement agreements as evidence that the sponsorship was about more than just golfing.  (This morals-clause discussion enabled the court—and, conveniently, this blog entry—to meet the requirement that anything written about golf must mention Tiger Woods.) 

The court also cited expert testimony from Jim Baugh (formerly of Wilson Sporting Goods) for the proposition that image is sometimes more important than performance.  Baugh testified that while Goosen has won more and consistently been ranked higher than golfer Sergio Garcia, the two have effectively identical endorsement agreements with TaylorMade.  Baugh attributed this to Garcia’s “flash, looks and maverick personality.”  This is notable testimony because Garcia has his own Tax Court case pending, which is set for trial in Miami in March 2012. By detailing this testimony, the court gifts Garcia with a tailor-made argument that, relative to Goosen, a greater portion of Garcia’s TaylorMade endorsement income is royalty income. 

On the other hand, the court held that the endorsement income could not be solely attributable to Goosen’s image.  After all, the on-course endorsements required Goosen to make personal appearances and to play in a specified number of tournaments, all while wearing or using the sponsors’ products.  Acknowledging that precision in allocating between royalty and personal service income was unattainable, the court settled on a straightforward 50-50 split. 

As for the second issue, the court was left to decide what portion of Goosen’s royalty income was U.S.-source income.  Generally, the source of royalty income from an intangible is where the property (in this case, Goosen’s image) is used.  With respect to the Upper Deck and EA endorsements, the court looked to the relative U.S.-to-worldwide sales percentages of Upper Deck’s golf cards (92% in the U.S.) and EA’s video games (70% in the U.S.) and then sourced Goosen’s royalty income accordingly.  For the three on-course endorsements and the Rolex endorsement, the court determined that while Goosen was marketed worldwide, the U.S. constitutes about half of that worldwide golf market.  The court therefore treated half of the income from those four endorsements as U.S.-source income. 

Finally, the court had to decide whether any of that U.S.-source income was effectively connected to a U.S. trade or business.  The court held that only the on-course endorsement royalty income was effectively connected to a U.S. trade or business.  The court found that since the off-course endorsements didn’t require Goosen to play golf tournaments or to be physically present in the U.S., that royalty income was not effectively connected to the U.S. 

The aspect of the decision that seems to have scared some practitioners (other than the existence of a worldwide market for collectible golf cards, which maybe scares only this practitioner) was how the court sourced royalty income according to the U.S.-to-worldwide sales percentages.  The fear is that the IRS will simply apply those percentages in every case, and taxpayers will have no room to negotiate a more favorable allocation. 

We’ll keep an eye on where this case heads and will post updates on the Sergio Garcia case. 

 Goosen Tax Court opinion