Internal Revenue Code §482 (“§482”) provides standards governing transactions between entities “owned or controlled directly or indirectly by the same interests.” The parties to these “controlled” transactions have the opportunity to reduce their exposure to U.S. income taxes by transacting with foreign-owned subsidiaries based in countries with lower tax rates. §482 gives the Department of the Treasury the power to reallocate these controlled transactions if necessary “to prevent evasion of taxes or clearly to reflect the income of” a taxpayer. The IRS utilizes the “arm’s length standard” to determine whether controlled transactions between related parties clearly reflect the income of the U.S. taxpayer.
According to §482:
“A controlled transaction meets the arm-s length standard if the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances (arm’s length result). However, because identical transactions can rarely be located, whether a transaction produces an arm’s length result generally will be determined by reference to the results of comparable transactions under comparable circumstances.”
This article describes a recent court case involving the IRS challenging the nature of Amazon.com, Inc.’s (“Amazon US” or the “Company”) controlled transactions with one of its foreign subsidiaries.
In 2004, Amazon US created a European subsidiary (“Amazon Europe”) to operate the Company’s European website business. The Company transferred intangible assets (website technology, trademarks, customer information, etc.) to Amazon Europe to support its website business for a “buy-in” payment of $255 million to be paid over seven years (resulting in a present value of the buy-in of $217 million). The IRS determined that Amazon US had deficiencies in Federal income tax for 2005 and 2006 because of this controlled transaction with Amazon Europe. Invoking §482, the IRS made substantial transfer-pricing adjustments reallocating income to Amazon US from Amazon Europe. Amazon challenged these adjustments and won its Tax Court case that was later upheld in the U.S. Court of Appeals for the 9th Circuit. Here are the facts of the case:
When: The appeals court decided the case in August 2019.
Amazon Europe paid Amazon US an initial buy-in payment of $217 million (the present value of $255 million paid over seven years) for the transfer of certain of Amazon US’s intangible assets. The IRS asserted that the buy-in payment had not been determined at arm’s length and that the appropriate buy-in should be approximately $3.6 billion.
Amazon’s valuation expert utilized a comparable uncontrolled transaction (“CUT”) method to value the specific transferred intangible assets with a definite useful life for the various intangible assets.
The IRS’s expert used a discounted cash flow analysis with an essentially indefinite useful life for the intangible assets.
The court determined that the IRS’s method of valuing the intangible assets included other inseparable parts of the business that are non-transferrable and were thus not part of the controlled transaction: workforce, going concern value, goodwill and growth options. The court interpreted the regulations to show that the definition of an “intangible” is limited to independently transferrable assets.
The court also determined that there should be a definite useful life for the intangible assets and that Amazon Europe’s annual cost-sharing payments gave it ownership in any intangible assets developed in the future.
The court determined that the CUT method was the best method to determine the buy-in payment, but disagreed with certain aspects of Amazon’s determination of that buy-in payment and increased it to $779 million.
The court’s decision is consistent with §482, which explicitly outlines the CUT method as one acceptable method to determine whether a controlled transaction meets the arm’s length standard.
Schneider Downs has significant experience in preparing valuations of intangible assets for transfer pricing, financial reporting and litigation support purposes. Please contact [email protected] for more information about our valuation services
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