IRS Says Facebook Understated Income in Transfer Pricing Dispute

FACEBOOK, INC. & SUBSIDIARIES,
Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent.

UNITED STATES TAX COURT

Judge Pugh

RESPONDENT'S PRETRIAL MEMORANDUM

RESPONDENT hereby submits respondent's Pretrial Memorandum.

RESPECTFULLY SUBMITTED,

MICHAEL J. DESMOND
Chief Counsel
Internal Revenue Service

Date: January 15, 2020

JUSTIN L. CAMPOLIETA
Special Trial Attorney (LB&I)
Tax Court Bar No. CJ1671
1600 Stewart Ave., Ste. 601
Westbury, NY 11590
justin.l.campolieta@irscounsel.treas.gov

OF COUNSEL:
ROBIN L. GREENHOUSE
Division Counsel (LB&I)
MICHAEL P. CORRADO
Acting Deputy Division Counsel (LB&I)
JOHN M. ALTMAN
Senior Level Counsel (SL) (LB&I)

PRETRIAL MEMORANDUM FOR RESPONDENT

NAME OF CASE: Facebook, Inc. and Subsidiaries

ATTORNEYS:

For Petitioner:

ANDREW CROUSORE, et al.
Baker & McKenzie LLP
(650) 856-2400

For Respondent:

JUSTIN L. CAMPOLIETA, et al.
Office of Chief Counsel, I.R.S.
(516) 688-1754

AMOUNTS IN DISPUTE:¹

Year	Deficiency
2010	$3,807,601

STATUS OF CASE: Definite Trial

CURRENT ESTIMATE OF TRIAL TIME: 4-6 weeks 

MOTIONS RESPONDENT EXPECTS TO MAKE & EVIDENTIARY ISSUES:

STATUS OF STIPULATION OF FACTS: Completed In Process X

The parties are in the process of negotiating stipulations of facts. Respondent filed a Rule 91(f) motion to compel stipulation on September 11, 2019, that addressed respondent's proposed stipulations described as follows:

Stipulation Subject Matter	Number of Paragraphs	Number of Exhibits
Board of Directors	451	46
Facebook User Blogs	9	351
Facebook Newsroom	8	67
Facebook Terms	81	64
Technology Development	157	35
Intercompany Agreements	45	41
Growth and Internationalization	298	53
Company Goals	33	28
International Newsletters	21	16
Developer Blogs	6	431

The parties lodged a First Stipulation of Facts on November 19, 2019, comprised of 654 stipulation paragraphs, exclusive of subparagraphs, and 1,128 joint exhibits. Of the subject matter listed above, the First Stipulation of Facts addressed Board of Directors, Facebook User Blogs, Facebook Newsroom, Facebook Terms (in part), Intercompany Agreements, and Developer Blogs. For the remaining subject matter listed above (Technology Development, Growth and Internationalization, Company Goals, and International Newsletters), the parties have exchanged subsequent drafts and correspondence. Given that there are multiple outstanding matters yet to be stipulated, respondent may be required to file a supplemental Rule 91(f).

The following summarizes the status of the various stipulations proposed by the parties, which involve more than 2,000 documents proposed for stipulation: 

Proposed Oil	By	Subject Matter	Status
5/3/2019	Respondent	Pre-CSA expenses	In process
6/17/2019	Respondent	Technology Development	In process
7/3/2019	Respondent	Growth and Internationalization	In process
7/18/2019	Respondent	Goals	In process
7/31/2019	Respondent	International Newsletters	In process
8/22/2019	Respondent	Developers/Platform	In process
8/26/2019	Respondent	Financing	Not started2
10/10/2019	Respondent	Project Famous	Not started
10/24/2019	Respondent	Media and Transcripts	Not started
11/13/2019	Respondent	Business Overview	Not started
11/21/2019	Respondent	Intercompany Draft Documents	Not started
12/11/2019	Respondent	European Editions Newsletters	In process
12/13/2019	Respondent	Facebook UK	Not started
12/31/2019	Respondent	Secondary Market Transactions	Not started
12/31/2019	Respondent	Growth Dashboards and FB Models	Not started
1/9/2020	Respondent	Advertising	Not started
1/10/2020	Petitioner	Financial Statements	Not started3
1/14/2020	Petitioner	International Sales Expansion	In process
1/15/2020	Respondent	Audit Committee/Foreign Directors	Not Started
1/15/2020	Respondent	Employee Records Data	Not Started
1/15/2020	Respondent	Audit Committee and Foreign Entity Directors' Reports	Not started
1/15/2020	Respondent	Employee Records and Data for 2007 through 2010	Not started

In addition, there are several other stipulation topics that should be drafted, negotiated, and agreed upon by the parties.

ISSUES:

1. Whether, for the 2010 taxable year, additional income should be allocated under section 482⁴ to Facebook from its newly-formed foreign subsidiary FIH in connection with a cost sharing arrangement ("CSA") having a stated effective date of September 15, 2010. Respondent determined that the pricing between Facebook and FIH was not arm's length and allocated income in the amount of 5200,124,290 to Facebook for the 2010 taxable year,⁵

2. Whether Facebook's deductions should be disallowed that exceed its share of reasonably anticipated benefits ("RAB") allocated under section 482 for the 2010 taxable year in connection with the CSA. An adjustment of $5,390,144 is impacted by this issue.⁶

WITNESSES RESPONDENT EXPECTS TO CALL:

Respondent may call the following witnesses.⁷ Respondent reserves the right to call rebuttal witnesses, and to call any witness identified or called by Facebook.

As noted above, the stipulation process in this case is ongoing, and respondent anticipates that, if the parties reach agreement on respondent's outstanding and forthcoming stipulation proposals, several of the witnesses identified below will not need to testify at trial.

FACT WITNESSES (Alphabetically)

Andrew Bosworth (Facebook, Director, Engineering). Mr. Bosworth is expected to testify about his experience at Facebook, including the development of Facebook's technologies (including those relating to ads, mobile, Photos, News Feed) and Facebook's Boot Camp (its orientation program for new hires).

William Blake Chandlee (Facebook, Vice President, Sales). Mr. Chandlee is expected to testify about his time at Facebook, including his experience with growing Facebook's international advertising business, and Facebook's relationships with advertisers, agencies, and third-party resellers.

Christopher Cox (Facebook, Vice President, Product Management). Mr. Cox is expected to testify about his time at Facebook, including his experience with Facebook's strategies, the development of Facebook's products, and Facebook's culture and recruiting.

David Ebersman (Facebook, Chief Financial Officer). Mr. Ebersman is expected to testify about his tenure at Facebook, including his knowledge of Facebook's financial planning and budgeting processes, the preparation of a three-year financial forecast referred to by Facebook as the "Long-Range Plan" ("2010 LRP"), presentations to the Board of Directors ("Board"), various valuations of Facebook, including those done for both transfer pricing and section 409A purposes, and external investments in Facebook.

Donald Faul (Facebook, Director, User Operations). Mr. Faul is expected to testify about his time at Facebook, including his experiences with Facebook's online operations and self-service advertising operations.

David Fischer (Facebook, Vice President, Advertising and Global Operations). Mr. Fischer is expected to testify about his experience at Facebook, including those relating to the growth and scaling of Facebook's advertising and global operations.

Naomi Gleit (Facebook, Director, Product Management). Ms. Gleit is expected to testify about her experience at Facebook, including Facebook's growth, the development of Facebook's products, and the use of data, testing, and analytics in product development.

Lori Goler (Facebook, Human Resources Vice President). Ms. Goler is expected to testify about her experience at Facebook, including those relating to Facebook's recruiting and retention of talent.

Robert Goodlatte (Facebook, Product Designer). Mr. Goodlatte is expected to testify about his work at Facebook, including his work on Lite Site.

Stephen Haines (Facebook, Head of Sales). Mr. Haines is expected to testify about his time at Facebook, including his experience with growing Facebook's international advertising business, and Facebook's relationships with advertisers, agencies, and third-party resellers.

Jonathan Heiliger (Facebook, Vice President, Technical Operations). Mr Heiliger is expected to testify about his time at Facebook, including his experience with managing Facebook's servers and network infrastructure, storage and scaling capacity, and data centers that operated Facebook's site and served its users.

Cipora Herman (Facebook, Vice President, Finance). Ms. Herman is expected to testify about her experience at Facebook, her knowledge of Facebook's finances, financial planning, stock valuations, and the creation of its Dublin location. Ms. Herman will also testify about her role as a Board member for FIH.

Mike Hoefflinger (Facebook, Director, Marketing). Mr. Hoefflinger is expected to testify about his time at Facebook, including his experience with growing and marketing Facebook's advertising business, and the development of Facebook's advertising products.

Timothy Kendall (Facebook, Director, Monetization Product Marketing in 2007-2009). Mr. Kendall is expected to testify about his time at Facebook, including his experience with growing Facebook's advertising business, and the development of Facebook's advertising products.

Christopher Kim (Facebook, Associate General Counsel in 2009-2010). Mr. Kim is expected to testify about his experience in Facebook's legal department, including the specific functions, projects, and tasks he worked on during 2009 and 2010.

David Kling (Facebook, Deputy General Counsel). Mr. Kling is expected to testify about his time at Facebook, including his experience with the rights and provisions associated with the classes of Facebook's stock, the sale of Facebook stock in various financing rounds, and the sale of Facebook stock on secondary markets.

Raymond Ko (Facebook, Manager, Technical Analytics). Mr. Ko is expected to testify about his time at Facebook, including his experience with growing Facebook's user base and engagement, use of data and analytics, and the development of Facebook's user growth forecasts supporting the 2010 LRP.

Deborah Liu (Facebook, Vice President, Marketplace). Ms. Liu is expected to testify about her time at Facebook, including her experience with Facebook's third-party developer Platform, Facebook's relationships with third-party developers, Facebook Payments, Facebook Credits, and Facebook's mobile payment systems.

Alok Mahajan (KPMG). Mr. Mahajan is expected to testify about the valuation services he provided to Facebook, his valuations of Facebook's common stock, which were prepared for financial and tax reporting purposes, and the methodologies, assumptions, and projections used.

Dustin Moskovitz (Facebook, Chief Technology Officer in 2007).⁸ Mr. Moskovitz is expected to testify about his time at Facebook, including his experience with co-founding Facebook, Facebook's early growth, and Facebook's technology development.

Michael Murphy (Facebook, Vice President, Media Sales in 2007-2009). Mr. Murphy is expected to testify about his time at Facebook, including his experience with growing Facebook's advertising business, and Facebook's relationships with agencies, advertisers, and third-party resellers.

Javier Olivan (Facebook, Director, Product Marketing). Mr. Olivan is expected to testify about his experience at Facebook, including those relating to Facebook's growth and internationalization, the development of Facebook's products, and the use of data and analytics.

Chamath Palihapitiya (Facebook, Vice President, Growth, Mobile, and Internationalization). Mr. Palihapitiya is expected to testify about his time at Facebook, including his experience with Facebook's mobile strategies, growing Facebook's user base and engagement, and internationalizing Facebook.

Ted Price (Facebook, Director, Accounting). Mr. Price is expected to testify about his experience at Facebook, including Facebook's creation of its Dublin location, its tax planning, and its transfer pricing.

Evan Priestley (Facebook, Software Engineer). Mr. Priestley is expected to testify about his time at Facebook, including his experience with developing Facebook's software and infrastructure, and Facebook's processes and tools in connection with technology development.

Daniel Rose (Facebook, Vice President, Partnerships and Platform Marketing). Mr. Rose is expected to testify about his time at Facebook, including his experience with Facebook's partnership strategies, Facebook's monetization strategies, Facebook Credits, and Facebook's relationships with third-party developers.

Itamar Rosenn (Facebook, Software Engineer). Mr. Rosenn is expected to testify about his time at Facebook, including his experience with Facebook's use of data science, testing, experimentation, and other analytics in connection with users and product development.

Sheryl Sandberg (Facebook, Chief Operating Officer). Ms. Sandberg is expected to testify about the matters discussed in public statements and presentations contained in materials that respondent proposed for stipulation.

Elliot Schrage (Facebook, Vice President, Corporate Communications & Public Policy). Mr. Schrage is expected to testify about his time at Facebook, including his experiences with Facebook's governance, and marketing and communications strategies.

Michael Schroepfer (Facebook, Vice President, Engineering). Mr. Schroepfer is expected to testify about his experience at Facebook, including those relating to Facebook's technology strategy, the development of Facebook's technology and products, Facebook's third-party developer Platform, and Facebook's strategies in recruiting and retaining employees.

Alexander Schultz (Facebook, Manager, Product Analytics). Mr. Schultz is expected to testify about his experience at Facebook, including those relating to Facebook's growth, its use of data and analytics, the development of its self-service advertiser products, and the development of Facebook's products.

Scott Stanford (former Goldman Sachs, Managing Director) and/or Ian Spaulding (former Goldman Sachs Vice President, Investment Banking Division). Messrs. Stanford and/or Spaulding are expected to testify regarding the investment Goldman Sachs made in Facebook in December 2010 including the diligence Goldman Sachs performed and its conclusion regarding Facebook's value.

Mark Zuckerberg (Facebook, Chief Executive Officer). Mr. Zuckerberg is expected to testify about the matters discussed in public statements and presentations contained in materials that respondent proposed for stipulation.

A Representative from the U.S. Securities and Exchange Commission ("SEC”) is expected to testify about Facebook's submissions to and discussions with the SEC prior to and during the process of Facebook becoming a publicly traded company.

CUSTODIAL WITNESSES

Custodian of Records (Ernst & Young, LLP ("EY”)). This witness may be necessary to authenticate and provide other testimony concerning documents used by EY in performing tax and audit-related services for Facebook.

Custodian of Records (Facebook). To the extent Facebook objects to documents produced or maintained by Facebook on the grounds of authentication or hearsay, respondent may call witnesses to show that the documents are authentic and not inadmissible hearsay.

Custodian of Records (The Goldman Sachs Group, Inc. ("Goldman Sachs")). This witness may be necessary to authenticate and provide other testimony concerning documents used by Goldman Sachs for investments it made in Facebook.

Custodian of Records (Houlihan Lokey, Inc. ("Houlihan Lokey")). This witness may be necessary to authenticate and provide other testimony concerning documents used by Houlihan Lokey to prepare valuations for Facebook.

Custodian of Records (KPMG, LLP ("KPMG")). This witness may be necessary to authenticate and provide other testimony concerning documents used by KPMG to prepare valuations for Facebook.

Custodian of Records (SEC). This witness may be necessary to authenticate and provide other testimony concerning documents provided to the SEC from Facebook or its representatives.

EXPERT WITNESSES (Alphabetical)

Geoff Cohen. Dr. Cohen is an expert in the field of computer science and technology development. He is expected to testify about matters set forth in his opening report, including:

• By September 15, 2010, Facebook had created a large and sophisticated technological operation, capable of providing multiple complex services to users. Its technological operation was composed of, and enabled by, a number of different projects, systems, and technologies (collectively, "Systems". At that time, Facebook relied on many of these Systems to more efficiently and effectively develop new products, improve the performance of its Systems, better monitor and collect data from its Systems, and support new types of services and features. Facebook would have reasonably anticipated that its Systems in place by September 15, 2010 would continue to contribute to its technological development in similar ways in the future.⁹

• By September 15, 2010, Facebook stored data regarding its users and their connections to other users and entities. Additionally, Facebook had also accumulated a vast amount of data created by monitoring and recording the interactions of these users over time. At that time, Facebook used this data to develop products and services that more effectively appealed to users, worked more efficiently, and increased engagement and other metrics important to Facebook. Facebook would have reasonably anticipated that this data would continue to contribute to its ability to develop products and services in similar ways in the future.¹⁰

Michael Cragg. Dr. Cragg is an expert in the field of economics. He is expected to testify about the matters contained in his opening report, including:

• As of September 15, 2010, Facebook was operating a multi-sided market, bringing together users, advertisers, and third-party software application developers ("developers"). The value of Facebook was determined by highly complementary intangible property assets ("IP Assets") because the IP Assets together amplified each asset's value, ultimately creating a valuable aggregate Facebook entity.¹¹

• Because each IP Asset was developed and optimized to support the Facebook multi-sided market, each generated the highest value when employed within Facebook. This asset-specificity is both a source of value for an integrated Facebook, and a source of inefficiency if there were separate owners for each Facebook IP Asset.¹²

• The most reliable way to value the IP Assets is an aggregate method that accounts for the complementarities. Attempting to value the IP Assets as if they were separate leads to methods of pricing and apportioning value that do not reliably account for the complementary value of the IP Assets.¹³

Michelle Hanlon. Dr. Hanlon is an expert in the field of financial accounting. She is expected to testify about the matters contained in her opening report, including:

• Although Facebook claims that FIH incurred $41.6 million in Market Development Expenses ("MDE") from January 19, 2009 through September 14, 2010, Facebook's financial records suggest that the MDEs recorded by FIH total between $34.6 million and $38.2 million during that time.¹⁴

• Dr. Hanlon produced "as-if' consolidated income statements for Facebook's entities outside of the United States and Canada ("ROW Entities") for the years 2009 and 2010, assuming those entities were all part of a separate consolidated group. She will testify about the preparation of these “as-if' consolidated income statements.¹⁵

• Dr. Hanlon analyzed FIH's equity accounts and constructed equity roll-forwards for FIH for 2009 through 2012. She will testify about the preparation of these equity roll-forwards.¹⁶

Lorin Hitt. Dr. Hitt is an expert in the field of information technology economics. He is expected to testify about the matters contained in his opening report, including:

• As of September 15, 2010, Facebook's investments in technology assets that implemented and supported its social networking capabilities prior to September 15, 2010 are expected to contribute to Facebook's ability to make and generate value from its technology investments after September 15, 2010.¹⁷

• The value of Facebook technology assets that deliver the capabilities of Facebook's social networking is linked to Facebook's user base — their value together is greater than the sum of the value of the user base and technology separately.¹⁸

• The "70/30" split of Facebook Credits revenue between third-party developers and Facebook does not have an appropriate economic foundation to approximate the relative contributions of Facebook's technology and user base in generating Facebook's revenue.¹⁹

Emer Hunt. Ms. Hunt is an expert in the field of Irish tax law and procedure. She is expected to testify about the matters contained in her opening report, including:

• Between 2008 and 2010, Facebook implemented the "Double Irish" as its international tax structure by establishing its subsidiary, Facebook Ireland Limited ("FIL"), as an Irish resident and its other subsidiary FIH as an Irish non-resident company in the Cayman Islands.²⁰

• Facebook's international tax structure was aimed to lower Facebook's global effective tax rate by, among other things, subjecting FIL'S worldwide income at the Irish corporate tax rate of 12.5 percent, limiting FIH's Irish tax liability to only Irish-source income, and ensuring certain royalties paid from FIL to FIH were deductible for Irish tax purposes and exempted from Irish withholding tax.²¹

Kinshuk Jerath. Dr. Jerath is an expert in the field of marketing, including digital marketing. He is expected to testify about the matters contained in his opening report, including:

• The UBMI Agreement²² licensed to FIH marketing intangibles associated with Facebook's user, advertiser, and developer constituents that are expected to contribute to the growth of Facebook's constituent bases after September 15, 2010. In particular, for each constituent, Facebook licensed marketing intangibles related to its brand as well as its marketing capabilities.²³

• By September 15, 2010, Facebook had developed a brand for its user, advertiser, and developer constituents. It also developed, for each of these constituents, marketing capabilities, including accumulated knowledge about the marketplace and processes to identify and continuously meet constituent needs.²⁴

• The marketing intangibles developed by Facebook do not contribute to Facebook's growth in isolation. Marketing intangibles reinforce the strength of Facebook's user base, which in turn strengthens Facebook's marketing intangibles. In addition to strong user, advertiser, and developer brands, by September 15, 2010, Facebook established a strong employer brand that would allow Facebook to enhance its technology by attracting and retaining top engineers. As a result, Facebook's technology was enhanced by its marketing intangibles.²⁵

James Malackowski. Mr. Malackowski is an expert in the field of intangible and intellectual property transactions and industry practice. Mr. Malackowski is expected to testify about the matters contained in his report, including:

• The 2009 Agreements²⁶ had many vague, problematic, and missing terms that introduced significant risk to the parties involved. One of the key components of the 2009 Agreements that was not properly addressed relates to ownership of any intangible property, including user base intangibles, developed through the agreements. If a licensor intends to grant a licensee ownership rights to intangible property developed in a licensing arrangement, the licensor should be compensated for that benefit under the consideration terms of the agreement. Facebook US would have retained ownership of any intangible property, including user base intangibles, developed during the term of the 2009 Agreements.²⁷

• The Facebook intangible assets transacted in the 2010 Agreements²⁸ are core to Facebook's operations and are both complementary and interrelated to each other. The separation of Facebook's complementary intangible property rights creates various negative ramifications, including increased operational, value, and intangible property ownership/use risks. The terms and rights conveyed in the 2010 Agreements should be considered together, not individually, when making business and value determinations.²⁹

Ian Maude. Mr. Maude is an expert in the field of advertising. He is expected to testify about the matters contained in his opening report, including:

• By September 15, 2010, Facebook had built significant resources and capabilities underpinning its success as an advertising company, including (1) a large and growing user base and unmatched engagement both globally and in leading advertising markets around the world; (2) a proprietary social graph, delivering huge amounts of information about its users and providing it with unrivalled ad targeting capabilities; (3) a unique social advertising system which enabled advertisers to tap into personal connections and word of mouth marketing at scale; (4) growing international sales operation and market presence, including its online sales channel and sales teams in key advertising markets; and (5) growing global advertiser base and partnerships with the “big six” advertising agency groups and many of the world's largest advertisers.³⁰

• Four aspects of Facebook's ad proposition set it apart in the advertising market: — (1) Facebook was the #1 social networking service available globally and faster growing in terms of users and engagement than other Internet media; (2) Facebook's targeting capabilities were unique; (3) Facebook Ads offered a triad of paid, owned, and earned media to companies, delivering additional value over its competitors; and (4) Facebook uniquely offered word-of-mouth marketing due to the operation of direct network effects within the social graph.³¹

• The unique combination of Facebook's user base, platform, and social graph enabled Facebook to deliver a unique advertising system, which underpinned Facebook's commercial success.³²

T. Scott Newlon. Dr. Newlon is an expert in the fields of economics and valuation, including transfer pricing valuation. Dr. Newlon is expected to testify about the matters contained in his report, including:

• Any estimate of arm's length payments for the PCT Agreement³³ and UBMI Agreement should evaluate the compensation to be paid by FIH on an aggregate basis.³⁴

• The present value of arm's length PCT Payments³⁵ should be estimated using the income method of Treas. Reg. § 1,482-7T(g)(4), in particular, the discounted cash flow ("DCF") method, by comparing the projected future stream of cash flows Facebook US would receive under the CSA ("Cost Sharing Alternative") to the projected stream of cash flows that Facebook US would have received under an alternative in which Facebook US retained the rights to profit from the Facebook Online Platform outside of the United States and Canada ("ROW") and compensated any affiliates performing functions in support of the ROW business as service providers ("Services Alternative").

• Aggregate PCT Payments with a present value in a range from approximately $18,757 million to $21,147 million, with a median estimate of $20,073 million, would adequately compensate Facebook US for the present value of the cash flows that Facebook US was projected to forgo by choosing the Cost Sharing Alternative instead of the Services Alternative.³⁶

• A plausibility test of three key inputs to Dr. Newlon's analysis — (1) the financial projections, (2) the discount rate to discount to present value Facebook's projected cash flows, and (3) the long-run growth rate used in the terminal value calculation — demonstrates that the business enterprise value implied by the core assumptions in Dr. Newlon's analysis is reasonably consistent with contemporaneous estimates of the value of Facebook (based on secondary market sales of Facebook stock and equity investments in Facebook).³⁷

Geoffrey Parker. Dr. Parker is an expert in the field of platform economics. He is expected to testify about the matters contained in his opening report, including:

• Platforms are systems designed to create matches among users and facilitate value, creating interactions among those users. Platforms provide the infrastructure for user interactions and create rules and enforcement mechanisms to govern what users can and cannot do. Platforms also work to foster positive network effects, which is the phenomenon whereby a system becomes more valuable to users as more people use it. By these standards, and in the words of its founder and management team, Facebook operates as a platform.³⁸

• The value to consumer users of Facebook comes from the presence of other consumer users of the system, that is, through the creation of positive network effects. The value that Facebook users create for one another also creates switching costs such that users would abandon significant benefits should they leave the system without taking their social network with them.³⁹

• Facebook's focus on tipping in international markets and its ability to predict when tipping would occur is consistent with a recognition of network effects and an interest in developing and exploiting them, in international as well as domestic markets. Facebook has enjoyed strong network effects that drove its rapid growth in domestic and international markets and created a "snowball" effect whereby users would attract other users to the system.⁴⁰

• Facebook exhibits strong network effects that drove its unusually rapid growth up to and after September 15, 2010. In addition, Facebook's network effects created significant barriers to entry for rival social networks and high switching costs for users who wished to leave the system.⁴¹

• The appropriate economic framework in which to analyze Facebook's operations is that of a platform business with strong network effects, domestically and internationally.⁴²

Carl Saba. Mr. Saba is an expert in the field of valuation, including the appraisal of technology companies. Mr. Saba is expected to testify about the matters contained in his report, including:

• The application of three methods (DCF, guideline public company, and the back-solve method from Facebook stock transactions) provides an estimate of the fair market value of Facebook's equity and the equity in Facebook's ROW operations on a controlling, marketable, and post-tax basis, as of September 14, 2010, and September 15, 2010.⁴³

• As applied, the fair market value of Facebook's equity is estimated to be $29.34 billion as of September 14, 2010, and $33.68 billion as of September 15, 2010. The value of the equity in Facebook's ROW operations is estimated to be $700 million as of September 14, 2010, and $14.23 billion as of September 15, 2010.⁴⁴

Ilya A. Strebulaev. Dr. Strebulaev is an expert in the field of finance and the valuation of venture capital-backed companies. He is expected to testify about the matters contained in his opening report, including:

• During the period from, at least, May 26, 2009 through December 27, 2010, Facebook belonged to the category of late-stage venture capital ("VC")-backed companies.⁴⁵

• Using a methodology to value late-stage VC-backed companies based on well-established option pricing theory, Facebook was valued as of September 15, 2010, based on (1) the investment round led by Digital Sky Technologies ("DST") that was closed on May 26, 2009, and (2) the investment round led by Goldman Sachs that first closed on December 27, 2010.⁴⁶

• The application of this methodology arrives at an estimated value of Facebook's equity of $37.7 billion as of September 15, 2010, with a range between $35.5 billion and $38.0 billion depending on the sensitivity analysis.⁴⁷

SUMMARY OF FACTS & SYNOPSIS OF LEGAL AUTHORITIES:

See attached Summary of Facts and Synopsis of Legal Authorities.

EVIDENTIARY PROBLEMS:

See Motions Respondent Expects to Make and Evidentiary Issues above.

RESPECTFULLY SUBMITTED,

MICHAEL J. DESMOND
Chief Counsel
Internal Revenue Service

Date: January 15, 2020

JUSTIN L. CAMPOLIETA
Special Trial Attorney (LB&I)
Tax Court Bar No. CJ1671
1600 Stewart Ave., Ste. 601
Westbury, NY 11590 justin.1.campolieta@irscounsel.treas.gov

OF COUNSEL:
ROBIN L. GREENHOUSE
Division Counsel (LB&I)
MICHAEL P. CORRADO
Acting Deputy Division Counsel (LB&I)
JOHN M. ALTMAN
Senior Level Counsel (SL) (LB&I)

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SUMMARY OF FACTS AND SYNOPSIS OF LEGAL AUTHORITIES

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TABLE OF CONTENTS

I. SUMMARY OF FACTS

II. RESPONDENT'S LEGAL POSITION

III. CONCLUSION

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I. SUMMARY OF FACTS

A. Facebook's Business and History

Facebook US is and was the U.S. parent of affiliated companies that filed consolidated Federal income tax returns. Facebook US was also the ultimate parent of the worldwide Facebook group.

Facebook developed and operated a social networking service, allowing persons, including without limitation, users, advertisers, and third-party software application developers ("developers"), to interact with each other on the service.

At its core, the Facebook service allows individual users to create profiles and interact with other users (both individuals and groups), advertisers, and developers through an online platform hosted on the company's servers and made globally available through the Internet. Users interact with the service and each other through a range of actions including: sharing text and photo updates, chatting, "liking" and commenting on others' updates, playing games, and sharing content from external websites.

i. Facebook's Launch and Early Rapid Growth

Facebook's service was initially launched as a website on February 4, 2004, by Harvard sophomore Mark Zuckerberg and three fellow Harvard students. At its founding, Facebook permitted registrations only from users with a Harvard.edu email address, where each user could populate profile pages. Within a week, hundreds of Harvard students had registered, and within a few months the website expanded its user base to other universities in the United States. By December 2004, Facebook grew to nearly 1 million active users. In September of 2006, Facebook expanded its registration to anyone over the age of 13 with a valid email address. By opening its service beyond schools, Facebook experienced significant growth of its user base in the United States and internationally.

ii. User Growth and Engagement through Product Development

One of Facebook's key strategies during the year at issue was to expand its worldwide user base (i.e., "to make the world more . . . connected"⁴⁸). Facebook prioritized product quality and long-term user growth over short-term monetization objectives.

To attract new users and promote positive experiences and engagement for existing users, Facebook developed technology to create and improve website features and products, as well as to improve its underlying site infrastructure.

In May 2007, Facebook introduced the Facebook Platform, through which developers could create applications (or apps) that were integrated with Facebook's website to deliver engaging experiences for users,⁴⁹ Many such apps were games; and gaming became one of the most popular activities on the Facebook website.

Facebook Connect, made generally available in December 2008, allowed Facebook users to sign on to mobile devices, gaming systems, and other websites with their Facebook credentials and, in turn, provided external websites with certain of the user's data to offer a more personalized experience on the website. The feature also broadcasted the user's interactions with the external websites on Facebook. By June 2010, one million websites had incorporated Facebook Connect.

iii. Site Translation and International Growth

By the end of October 2007, almost 60 percent of Facebook's users were outside the United States. By January 2008, more than 60 percent of Facebook's worldwide user base was outside the United States.

Until 2008, Facebook's site was only in English. By February 2008, Facebook developed software that leveraged its users to translate Facebook's site, i.e., it "crowd-sourced" the translation. When Facebook opened its translation tool to its users, within two weeks, its users submitted translations on tens of thousands of strings of text in Spanish and voted on the translations. Facebook then opened its translation tool to French, and its users translated the text in one day. During 2008, Facebook translated its website into 23 languages, including French, German, and Spanish. As early as September 2008, Facebook was considered the leading social networking service provider worldwide.⁵⁰ By December 2009, more than 300,000 users contributed translations to Facebook and helped make the site available in more than 70 languages.

iv. Monetization

Through 2010, Facebook's large and engaged user base attracted advertisers, developers, and other business partners, including websites that incorporated Facebook Connect. Facebook earned revenue primarily by selling online advertisements.⁵¹ To a far lesser extent, Facebook earned revenue by receiving a share of revenues from payments related to virtual and digital goods purchases.⁵² Despite its ability and potential to monetize its worldwide user base through advertising and payments, from early on, Facebook's primary focus remained establishing itself as the dominant social network by focusing on user growth and product development.⁵³

v. The Social Graph — Facebook Connects the World

Facebook's business involved, among other things, the development of the "social graph" — a digital mapping of people's connections through their actions on the Facebook site, Facebook Platform, and Facebook Connect.⁵⁴ Facebook developed technologies to facilitate the sharing of information among its users to provide more data for the social graph. The social graph provided the underlying structure and data to support Facebook's advertising and other monetization products, including the data needed to present advertisements to users who would be most receptive to those advertisements.

As of May 2010, Facebook's databases stored the entire history of a user's site interactions, including "likes," friends, and comments. In an email circulated to senior executives and engineering staff, Mr. Zuckerberg characterized the social graph as "our philosophy," writing:

Our Philosophy: The Social Graph

[I]'m going to summarize how I see our overall philosophy. This is important because our philosophy isn't just a high-level mission statement, it's the base abstraction through which we see the world. In our case, viewing the world as graph includes many assumptions about [how] we see things. . . . Apart from our product strategy, we should note that this will also be our high-level technical strategy and will be represented in our software stack.⁵⁵

vi. Outside Investment in Facebook

As early as 2004, Facebook attracted the interest of venture capital investors with significant experience in the technology industry.

• In October 2004, entrepreneur and venture capitalist Peter Thiel invested in Facebook.

• In 2005, Linked ln founder Reid Hoffman and tribe.net (one of the first social network sites) founder Mark Pincus, who later founded the gaming juggernaut Zynga, invested in Facebook.

• In 2005, Facebook raised over $12 million from other Silicon Valley venture capitalists.

• In 2006, Facebook raised over $27 million from venture capital investors.

• In late 2007 and early 2008, Facebook sold preferred stock to investors, including Microsoft, for $375 million.

• In 2009, Facebook sold preferred stock to Digital Sky Technologies (“DST”) for $200 million.

• In December 2010 and January 2011, Facebook raised SI.5 billion by selling common stock in an investment round led by Goldman Sachs at an announced $50 billion valuation for Facebook.

B. Facebook Entities

The commonly controlled legal entities involved in the transactions at issue include Facebook US (the U.S. parent), FIH, FIL, and the Service Companies, described more fully below.

1. Facebook US

Facebook US was originally named "TheFacebook, Inc." and was a privately held corporation from July 29, 2004 until May 18, 2012.⁵⁶ Facebook US was the legal owner of substantially all Facebook patents, trademarks, copyrights, domain names, and other valuable intangible property to operate Facebook's social networking business worldwide on (and well before) September 15, 2010.⁵⁷

2. FIH and FIL

Around June 2008, Facebook engaged in tax planning in connection with its international expansion and sought to "consolidate international profitability in a low-tax jurisdiction (and minimize profitability and tax exposure at the local country level), and thereby lower [its] effective global corporate tax rate."⁵⁸ In August 2008, Facebook indicated internally that it selected Ireland as the low-tax jurisdiction to establish its international headquarters.⁵⁹ On October 2, 2008, Facebook publicly announced that it selected Ireland as Facebook's international headquarters.⁶⁰

Facebook's planned international tax structure was a "typical two tiered resident/non-resident structure" that was colloquially known as the "Double Irish," requiring, among other things, two Irish companies — one resident and one nonresident.⁶¹

Facebook's subsidiary FIL was incorporated in Ireland on October 6, 2008. At that time, other than one foreign subsidiary, Facebook UK Limited ("Facebook UK"),⁶² Facebook's worldwide operations were based in the United States. FIL was treated as Irish-resident for Irish tax purposes.⁶³ Facebook's subsidiary FIH was incorporated in Ireland on January 19, 2009, with its stated place of management and control in the Cayman Islands. FIH was treated as non-resident for Irish tax purposes.⁶⁴

FIL became a disregarded entity of FIH for Federal income tax purposes as of September 1, 2010.⁶⁵ While FIL had employees principally involved in user operations and sales functions during the 2009 and 2010 taxable years, FIH had no employees and was a holding company.⁶⁶ FIH had no access to financial or accounting systems until September 1, 2010, at the earliest.⁶⁷ FIH was not fully capitalized until August 31, 2009, at the earliest.⁶⁸

3. Service Companies

During the 2009 and 2010 taxable years, some of Facebook's sales and marketing functions outside the United States and Canada were performed by FIL and other Facebook foreign subsidiaries ("Service Companies").⁶⁹ During the 2010 taxable year, certain limited research and development ("R&D") functions were performed by Service Companies.⁷⁰

Although Facebook's sales and marketing activities contributed to its monetization efforts, Facebook understood that establishing a large and engaged user base through its product development efforts would result in greater monetization potential in the future. For example, Mr. Zuckerberg explained, in an October 2009 interview, how Facebook prioritized its growth over sales and marketing:

Our philosophy on having offices in these local countries is that we don't want to do it until there are a large enough number of users that we could support kind of [sic] local sales and marketing. So all of our development is done out of Palo Alto in California. . . . And we don't think that ad sales really drive user growth. So what we've done is we've just focused on first building the product out so that it grows in the country, then if it grows, then we put an office there.⁷¹

C. Intercompany Agreements

1. 2009 Agreements

Facebook US and FIH signed the following purported agreements⁷² having a stated effective date of January 19, 2009 and execution date of December 28, 2009: the "Intangible Property License Agreement" ("2009 IPLA"), the "Growth and Development Services Agreement" ("2009 GDSA"), the "Sales Costs Reimbursement Agreement" ("2009 SCRA"), and the "General and Administrative Services Agreement" ("2009 G&AA").⁷³

FIH and FIL entered into an "Expense Reimbursement Agreement" ("2009 ERA") having a stated effective date of January 19, 2009 and execution date of December 28, 2009.⁷⁴ FIL also entered into various Sales and Marketing Services Agreements ("SMSA") with Service Companies having effective dates during 2009 that provided for compensation to the Service Companies on a cost-plus basis with a markup of about 8 percent.⁷⁵

a. 2009 IPLA

Under the 2009 IPLA, Facebook US purportedly granted FIH a nonexclusive license to "the Facebook System and Confidential Information" and "Marks" in all countries worldwide, excluding the United States and Canada ("ROW").⁷⁶ Either party could terminate the 2009 IPLA at any time without cause upon ninety days' prior written notice,⁷⁷ The 2009 IPLA did not contain any exhibits that identified the licensed intangible property, and Facebook believes such exhibits were either not prepared or not attached to the executed 2009 IPLA.⁷⁸ The 2009 IPLA did not contain any provision explicitly addressing ownership or rights to improvements to licensed intangible property upon termination of the agreement.⁷⁹

Under the terms of the 2009 IPLA, FIH purportedly agreed to pay Facebook US a royalty equal to 25 percent of FIH's net revenues.⁸⁰ However, FIH was not able to perform under the terms of the IPLA as it had no access to financial or accounting systems. Facebook US also recognized all revenues derived in the ROW before September 15, 2010, and FIH did not pay any royalties under the 2009 IPLA.⁸¹

b. 2009 GDSA

According to the terms of the 2009 GDSA, Facebook US agreed to perform for FIH services to develop, expand, and maintain the international online social networking community of users, advertisers, and developers outside the United States and Canada ("ROW User Base") to satisfy FIH's stated obligations under the 2009 IPLA.⁸² The services to be performed by Facebook US included general, administrative, technical, management, human resources, accounting, legal, and certain support services related to the development of the ROW User Base, including; (1) user acquisition, retention, and optimization services; (2) advertiser acquisition, retention, and optimization services; and (3) third-party services. In exchange, according to the terms of the 2009 GDSA, FIH was to reimburse Facebook US its costs plus a 10 percent markup on the services, but with no markup on third-party costs.⁸³

c. 2009 SCRA

The purported purpose of the 2009 SCRA was to allocate expenses related to the ROW User Base because, during the period January 19, 2009 through September 14, 2010, FIH did not, and could not, recognize any revenue related to the ROW User Base as contemplated in the 2009 IPLA.

The SCRA made a distinction between two types of costs: (1) costs related to the generation of current revenue in the ROW, termed "Direct Sales Expenses," and (2) costs related to the generation of future revenues in the ROW, termed "Market Development Expenses" ("MDE"). Under the stated terms of the 2009 SCRA, Facebook US was to reimburse FIH or its affiliates for Direct Sales Expenses.

d. 2009 G&AA

Under the terms of the 2009 G&AA, Facebook US was to perform for FIH general, administrative, technical, management, human resources, accounting, legal, and support services.⁸⁴ In exchange, FIH was to reimburse Facebook US its costs plus a markup, with the amount of the markup based upon the type of service performed.⁸⁵

e. 2009 ERA

According to the terms of the 2009 ERA, FIH was to reimburse FIL monthly for both MDEs and Direct Sales Expenses on a cost plus 10 percent basis, unless Facebook US previously reimbursed FIL. The 2009 ERA does not identify Facebook US as a party to the agreement and Facebook US was not a signatory to the agreement. According to the terms of the 2009 ERA, however, FIL and FIH intended that Facebook US would bear the Direct Sales Expenses related to the generation of current revenue, while FIH would bear the MDEs related to the generation of future revenue in the ROW.

The 2009 ERA defines MDEs as including expenses related to: (1) marketing and demonstrating the Facebook website, advertising system, developer platform, community features, and procedures; (2) providing market and strategic analysis; and (3) other similar activities that were intended to develop or support future revenues from advertisers with invoicing or billing addresses in the ROW. The 2009 ERA defines Direct Sales Expenses as including expenses that were "directly allocable" to "external gross revenue" derived from advertising sales to advertisers with invoicing or billing addresses in the ROW.

2. 2010 Agreements

Facebook US and FIH entered into the following agreements, having a stated effective date of September 15, 2010: the "Online Platform Intangible Property Buy-In License Agreement" ("PCT Agreement"), the "User Base Transfer and Marketing Intangibles License Agreement" ("UBMI Agreement"), and the "Agreement To Share Costs And Risks Of Online Platform Intangible Property Development" ("Cost Sharing Agreement").⁸⁶ FIH and FIL entered into an "Operating License Agreement" having a stated effective date of September 15, 2010.⁸⁷

Facebook US entered into other agreements having stated effective dates during 2010, including September 15, 2010, with FIL and other related entities.⁸⁸ FIL entered into SMSAs and contract research and development agreements ("R&D Agreements") with Service Companies having stated effective dates during 2010 that provided for compensation to the Service Companies on a cost-plus basis.⁸⁹

a. PCT Agreement

Under the terms of the PCT Agreement, Facebook granted FIH a license to "Facebook US PCT Property and Confidential Information" in the ROW.⁹⁰"Facebook US PCT Property" was defined, among other things, as "all Intangible Property, including computer software, relating to the Facebook Online Platform existing and owned or licensed by [Facebook] as of the Effective Date [September 15, 2010]."⁹¹ "Intangible Property" included "any and all intellectual property rights, proprietary rights, procedures, processes, know-how, patents . . ., copyrights . . ., trade secrets . . ., and any other similar intangible property as defined under U.S. Treasury Regulation § 1,482-4(b) or rights to such intangible property."⁹² Under the terms of the PCT Agreement, the definition of "Intangible Property" excluded the "User Base and Marketing Intangibles" defined in the UBMI Agreement.⁹³

b. UBMI Agreement

Under the terms of the UBMI Agreement, Facebook transferred all rights to the User Base in the ROW to F1H and granted FIH a license to the Marketing Intangibles in the ROW.⁹⁴ "User Base" was defined as "the contracts and other relationships with persons comprising the various user communities developed and maintained by [Facebook and FIH], information about such users, and networks developed by users on the various Facebook sites."⁹⁵

c. Cost Sharing Agreement

Under the terms of the Cost Sharing Agreement, Facebook US and FIH agreed to share the costs of intangible development ("IDC") with respect to developing technology for the Facebook Online Platform based on each party's RAB share to be derived by the parties from the "Cost Shared Intangibles."⁹⁶ Under the Cost Sharing Agreement, "Cost Shared Intangibles" meant and included "any Intangible Property developed as a result of the Intangible Development Activity."⁹⁷ Under the Cost Sharing Agreement, the definition of "Intangible Property" excluded the "User Base and Marketing Intangibles" defined in the UBMI Agreement.⁹⁸

Under the terms of the Cost Sharing Agreement, Facebook US granted FIH "the exclusive right to commercialize the Facebook Online Platform by concluding (or having a licensee conclude) contracts with advertisers, users, developers and other persons or entities that are based in" the ROW.⁹⁹

d. Operating License Agreement

Under the terms of the Operating License Agreement, FIH granted to FIL an exclusive license to collectively utilize and commercialize the Facebook Online Platform, User Base, and FIH's Confidential Information in the ROW.¹⁰⁰ FIH also granted to FIL a non-exclusive license to utilize the Marketing Intangibles. The Operating License Agreement specified a royalty payable by FIL to FIH that was calculated to provide FIL a return equal to 10 percent of its direct operating expenses.¹⁰¹

D. Facebook Technology

The technology supporting Facebook's service, like most web-based software systems, is composed of "front-end" components that are responsible for the presentation of content and information to the user, "back-end" components that are responsible for managing information and generating content for users in response to requests, and a data infrastructure or database system that is responsible for efficiently storing and retrieving information.¹⁰² Facebook also maintains a set of tools and systems for developing, building, deploying, and operating the site.¹⁰³

By September 15, 2010, Facebook had created a large and sophisticated technological operation, capable of providing multiple complex services to users. It was composed of, and enabled by, a number of different projects, systems, and technologies (collectively, "Systems").¹⁰⁴ At that time, Facebook relied on many of these Systems to more efficiently and effectively develop new products, improve the performance of its Systems, better monitor and collect data from its Systems, and support new types of services and features.¹⁰⁵ Facebook stored data regarding each of its users and their connections to other users and entities.¹⁰⁶ Additionally, Facebook had accumulated a vast amount of data created by monitoring and recording the interactions of these users with the Systems over time,¹⁰⁷ Facebook used this data to develop products and services that more effectively appealed to users, worked more efficiently, and increased engagement and other metrics important to Facebook.¹⁰⁸ Facebook would have reasonably anticipated that by September 15, 2010, its Systems in place and accumulated user data would continue to contribute to Facebook's technological development in the same ways in the future.¹⁰⁹

Facebook delivers its service, including the features and products associated with the service, through its technology. To attract new users and promote positive experiences and engagement for existing users, Facebook developed technology to create and improve website features and products, as well as to improve its underlying site infrastructure.

Facebook fostered a corporate culture to spur and support technical innovation. To allow rapid innovation, Facebook used software development processes that are faster than more traditional processes.¹¹⁰ Facebook provided opportunities for employees to explore new ideas and different areas of focus.¹¹¹ It also created an environment where failure was not fatal and employees felt empowered to innovate.¹¹²

Facebook has continued to incrementally improve its products and services. Facebook's core products, such as Profile, Photos, and News Feed, have been central to the user experience on Facebook since well before September 15, 2010, even as Facebook has continued to improve these products.¹¹³ Many of Facebook's technology assets are built upon the existing base of technology investments that predate the CSA.¹¹⁴

Facebook's creative environment, its software design and support tools, and its investments in technology development and experience prior to the CSA contributed to Facebook's future ability to innovate, improve, and develop new technology.¹¹⁵ These features also provided an advantage to Facebook when faced with technological challenges and competitive threats.¹¹⁶

E. Facebook Users, Advertisers, and Developers

Facebook operates an economic platform.¹¹⁷ An economic platform or network is a business model that enables interactions and exchanges among users of the platform, facilitating value creation for the users.¹¹⁸ A multisided platform enables interactions among different types of users.¹¹⁹ The Facebook service connected Facebook's user, advertising, and developer communities.¹²⁰ Facebook's technology enables interactions and the exchange of value among users, advertisers, developers, and others.¹²¹

The Facebook service demonstrates "network effects." Network effects exist when the value of a network to one participant depends on the number of other participants on the network.¹²² Same-side (or direct) network effects are between the same type of platform participant (e.g., between two users or between two advertisers on Facebook), and cross-side (or indirect) network effects are between different types of platform participants (e.g. between a user and an application developer on Facebook),¹²³ Network effects can be positive or negative.¹²⁴ For example, a user may experience positive networks effects from interactions with other users (e.g., "likes" from other users) or negative network effects from interactions with other users (e.g., offensive content posted by other users).¹²⁵

Network effects have important implications for platform businesses. Markets that exhibit network effects can become dominated by one firm, a "winner-take-all" or "winner-take-most" outcome.¹²⁶ This is because network effects provide significant competitive benefits. Network effects can become self-reinforcing, i.e., at a certain size, growth continues as users attract new users.¹²⁷ Network effects create barriers to entry for rivals.¹²⁸ In markets that exhibit network effects, a small advantage, which attracts more participants to a particular platform, attracts more users.¹²⁹

Homing costs and switching costs play a role, too. Homing costs are the costs to a user of affiliating with a platform.¹³⁰ Switching costs are the costs to a user of changing from one platform to another.¹³¹ The presence of strong network effects can create switching costs. In general, if a user leaves a large network for a small one, then that user forgoes the benefits of the larger network.¹³² When switching costs are high, then one firm may come to dominate a market.¹³³ Switching costs for Facebook users meant leaving friends, connections, and data behind to leave Facebook for another platform.¹³⁴

From the early stages of Facebook's development as a business, Mr. Zuckerberg recognized the importance of network effects. The concept of network effects was reflected in Facebook's strategy to dominate the social networking industry and make Facebook the standard as quickly as possible. For example, in November 2008, Mr. Zuckerberg wrote:

Facebook leveraged the network effects among its users to develop products and features designed to attract more users, developers, advertisers, and other platform participants, and to increase user engagement. For example, Facebook used contact importers (which enabled new user to import their email address books) and "People You May Know" ("PYMK") (which used imported contacts and other data to display other users with whom a user might want to connect) to help users find friends quickly, invite other users, and engage on site. Facebook used the Photos application and News Feed to accelerate the creation, sharing of, and interaction with content created by other platform participants. The Facebook Platform enabled outside developers to create applications within Facebook where users created content, made connections, and engaged with other platform participants.¹³⁶

Facebook also exploited network effects to "tip" markets. That is, Facebook's organic growth in many markets exemplified how a market will continue to grow through network effects after the achievement of a certain critical mass of users (the proverbial snowball rolling downhill) without particularized efforts by Facebook in that market.¹³⁷ Facebook sought to have enough users in a market that would allow it to eventually become the dominant social networking site.¹³⁸ The strength of its network effects provides, among other things, an element of insulation from competitors.¹³⁹

1. users

Facebook's mission from 2008 through 2010 was to give "people the power to share and make the world more open and connected."¹⁴⁰ Facebook prioritized user growth over short-term revenue growth to fulfill the company's mission.¹⁴¹ Facebook focused on increasing value for users by developing its overall product to enhance user experience and keep audiences engaged on the site for longer periods of time. This included giving users the ability to, among other things, upload photos and tag friends, create a Friends list, explore a News Feed of relevant posts, and join Groups.¹⁴²

Since opening access to all Internet users aged over 13 in September 2006,¹⁴³ Facebook has attracted more users than any other social network.¹⁴⁴ By the end of Q4 2007, Facebook had 58.5 million monthly active users. Of these, 21.5 million were in the United States and 37 million were in other countries.¹⁴⁵

By 2008, Facebook established a dedicated growth team whose sole responsibility was to optimize Facebook's user growth, as measured by monthly active users.¹⁴⁶ The growth team's goal was to get "as many people in the world to use Facebook."¹⁴⁷ The growth team adopted a data-driven approach to optimize Facebook's features to increase user growth and invites, including, for example, contact importers, PYMK, and the various elements of the new user experience.

Given the growth opportunities available outside the United States, increasing adoption among international markets was a top priority. Facebook's initial efforts to internationalize the site include providing translated versions of the website in Spanish, German, and French.¹⁴⁸ Facebook's goal was to translate the site into as many languages as possible.¹⁴⁹ The company used community translation, or crowd-sourcing, to translate the site into more than 70 different languages by December 2009.¹⁵⁰ By removing the language barrier, the translation tool led to explosive international growth.

In March 2008, the company produced an "International Go-To-Market Strategy" which set out a framework for identifying and prioritizing certain markets based on monetization potential of Internet users.¹⁵¹ Facebook made efforts to drive adoption of Facebook in some of these markets by, among other methods, negotiating agreements with local email providers for contact importers, marketing partnerships with organizations with email databases, and search engine marketing.¹⁵²

As a result of Facebook's growth and internationalization efforts, Facebook's monthly active users grew to 608 million by the end of 2010, of which international users accounted for 77 percent.¹⁵³ In August 2010, Facebook projected that monthly active users would increase worldwide to over 1 billion users by 2013.¹⁵⁴ When asked about Facebook's growth trajectory in an interview in June 2010, Mr. Zuckerberg answered that "it's almost a guarantee" that Facebook will reach a billion users.

2. Advertisers

Advertising has always been Facebook's primary revenue source. Access to the site has always been free of charge to users in order to attract the largest possible audience for advertisers.¹⁵⁵ As Facebook's user base grew, its social graph expanded and became more dense, encompassing more users, providing more information on its users. This expansion of the social graph enabled Facebook to deliver revolutionary targeting capabilities to advertisers not available from other Internet media.

In 2007, Facebook revolutionized Internet advertising with the launch of Facebook Ads.¹⁵⁶ Mr. Zuckerberg described Facebook Ads as "a completely new way of advertising online."¹⁵⁷ Facebook's new social advertising proposition contained three components: (1) Facebook Pages, a new way for companies to build pages on the social network free of charge; (2) a social ad system that included socially enhanced ads which combined social actions by Facebook users' friends with advertisers' messages, and Facebook Ads Manager, an online self-service tool enabling advertisers to plan and buy targeted Facebook Social Ads campaigns; and (3) Facebook Insights, a tool to enable advertisers to track fans of their Pages and monitor their social ad campaign performance.¹⁵⁸ These innovations allowed Facebook to provide a "unique combination of benefits" for advertisers including huge audience reach and engagement, unrivalled targeting capabilities, and unique advertising and marketing products that allowed advertisers to establish a direct connection with users and benefit from "word-of-mouth" marketing through the social graph.¹⁵⁹

Because of these capabilities, Facebook positioned itself as a competitor for both brand and direct response advertisers, offering solutions throughout the advertising funnel.¹⁶⁰ Its advertising proposition attracted all types of companies, from large international companies engaged through Facebook's Direct Sales Organization to small and medium sized local enterprises purchasing ads through Facebook's self-service advertising tool.¹⁶¹

By 2010, Facebook secured global partnerships including research, pricing guarantees, and service level agreements with three of the largest advertisers in the world: Proctor & Gamble, Unilever, and Diageo.¹⁶² Facebook also secured large spending commitments from 14 large brand advertisers by August 2010.¹⁶³ Additionally, Facebook established relationships with the largest global advertising agencies in the world.¹⁶⁴ The big six agency groups almost tripled their global Facebook expenditure from 2009 to 2010 alone.¹⁶⁵

Facebook established its first international office in London in September 2007 and by 2010 had nine more offices outside of North America providing direct sales coverage in major advertising markets in Europe and Asia-Pacific.¹⁶⁶ Facebook further engaged resellers in emerging markets where it had monetizable users, but where it lacked a sales presence.¹⁶⁷ In August 2010, Facebook set out its plans to quadruple the number of sales related staff in 2011, opening up sales offices in key ad markets and upgrading coverage in others using telesales teams and resellers.¹⁶⁸

These resources and capabilities fortified the success of Facebook's advertising business. By February 2010, Ms. Sandberg believed Facebook's advertising business was "tipping" in the brand advertising market, writing to her fellow executives:

As I have said since I joined . . . I think we can be the future of brand advertising. This is a hard world to crack — a world based on perception, entrenched agencies, and relationships. . . . We just might be tipping in the market. . . . Momentum feels strong. I have never felt better about where we are and our prospects.¹⁶⁹

3. Developers

In May 2007, Facebook widely launched the Facebook Platform, making it available to any developer worldwide. This feature of the Facebook service allowed developers to integrate their applications with the Facebook website. This integration was enabled by Facebook's creation of application programming interfaces ("APIs"). These APIs allowed developers to integrate their applications with Facebook and gave developers access to some of Facebook's user data. Facebook did not charge developers to use the Facebook Platform, as access to the APIs was free for all developers.

Facebook Platform provided many benefits to Facebook. Facebook Platform allowed users to enjoy a wider variety of products, contributing to user engagement with Facebook through additional users and additional page views. The additional data provided to Facebook from users' engagement with Platform applications further strengthened the social graph. This development improved the performance of Facebook's ads by further socially enabling advertisers' experience and by providing the additional user data with which Facebook could serve more relevant ads. To entice Facebook users to engage with their apps, developers also purchased advertising directly from Facebook. Illustratively, app developer Zynga was Facebook's largest advertiser by advertising expenditure in 2009 and 2010.

Moreover, Facebook sold advertising on its "canvas" page, in which the Platform's apps would be displayed.

As of December 2009, Facebook had more than 1 million developers building apps for use with Facebook Platform. As of August 2010, more than 200 million people played gaming apps on Facebook's website every month, making its website one of the largest game platforms in the world. As of August 2010, 19 apps had more than 10 million active users. Facebook Platform was strategically important to Facebook, and as of August 2010, Facebook expected to continue investing heavily in this product.

Beginning in 2009, Facebook also earned revenues from sales of digital goods and services sold on the Facebook Platform. In June 2009, Facebook introduced Facebook Credits, which allowed users to use a single payment method across all apps on the Facebook Platform. When users purchased digital goods from developers, the developers would redeem the Facebook Credits with Facebook (i.e., Facebook retained $0.30 for each $1 of credit expenditures). In July 2011, Facebook began requiring developers of games to use Facebook Credits to charge users for app purchases on the Facebook Platform. In June 2012, Facebook discontinued Facebook Credits. Facebook still processed payments for developers and retained 30 percent of the payment revenue.

F. Facebook Marketing

Marketing refers to the set of activities undertaken by a firm to identify and meet customer needs, as well as to capture value from customers.¹⁷⁰ By September 2010, Facebook had established marketing intangibles to attract, retain, and grow its constituent groups: users, developers, and advertisers.¹⁷¹ Facebook's marketing intangibles for each of these constituent groups fit under two broad classes: (1) "brand" and (2) "marketing capabilities."

Brands are represented by names and/or symbols, and can influence consumer behavior when they are infused with meaning through a firm's branding activities.¹⁷² By the time of the CSA, Facebook had developed its brand for each of its constituents (users, advertisers, and developers) and its brand would be expected to contribute to future growth of these constituents.¹⁷³ Facebook also nurtured an employment brand to attract the best software engineering candidates in a competitive market and ensured that these marketing intangibles enhance Facebook's technology.¹⁷⁴

"Marketing capabilities" refer to the accumulated market knowledge underlying marketing strategies, as well as processes and tools that a firm develops to further accumulate market knowledge.¹⁷⁵ To identify and meet its customer needs, Facebook developed a set of marketing strategies associated with each of its constituents.¹⁷⁶ By 2010, Facebook had developed high-level overarching marketing strategies that guided its overall expansion, with respect to each of its constituencies.¹⁷⁷ These marketing strategies were developed using the market knowledge that Facebook accumulated through September 2010; Facebook also developed processes to continuously acquire knowledge so that its strategies could remain up to date.¹⁷⁸

Facebook's marketing intangibles do not act in isolation; they affect each other and the size of the user base, which affects the marketing intangibles.¹⁷⁹ Facebook's user base served to make its marketing intangibles more effective, and Facebook's marketing intangibles helped grow the company's user base. This virtuous cycle manifested itself through Facebook's brand as well as marketing capabilities. While Facebook positioned its brand differently to each customer constituent, the size and quality of its user base (e.g., the number of users and the extent of engagement of an average user) were key brand attributes across all three constituencies. A stronger user base would strengthen Facebook's user, developer, and advertiser brands, and the resulting stronger brands would attract more users, developers, and advertisers.

Facebook's user base and marketing intangibles also reinforce one another through the firm's marketing capabilities. In particular, a strong user base enhances marketing capabilities because Facebook's marketing capabilities are built through user data analysis and user experimentation. Generally speaking, the higher the quantity and richness of the data emanating from users, the better Facebook can harness knowledge from the data to refine its marketing capabilities?¹⁸⁰

In addition, marketing intangibles — specifically a strong brand — can help attract and retain employees. Facebook invested in developing a strong "employer brand" and by 2010 did so successfully. This helped Facebook to recruit high-quality engineering talent, which, in turn, generated high-quality technology that powered Facebook's systems (and attracted top talent throughout the rest of the company). In this manner, Facebook's employer brand marketing intangible interacted with and contributed to the development of the technology intangible. In addition, because the quality of Facebook's open source contributions affected the Firm's reputation among potential recruits, technology can enhance Facebook's employer brand.¹⁸¹

G. Facebook's Projections and Valuations during 2010

1. Long-Range Plan

Throughout 2010, Facebook management prepared a three-year financial forecast, the "Long-Range Plan" ("2010 LRP"), that projected Facebook's financial results for the remainder of 2010 and the following three years.¹⁸² The Facebook management team, which included Mr. Zuckerberg and Ms. Sandberg, reviewed and discussed the 2010 LRP.¹⁸³ The management team had input into what the projections were as well as the assumptions behind them.¹⁸⁴

The 2010 LRP was presented to the Facebook Board and incorporated in an August 26, 2010 presentation to the Board.¹⁸⁵

In developing the 2010 LRP, Facebook benchmarked itself against Yahoo and Google across key metrics such as active user count, average revenue per user ("ARPU"), annual revenue and revenue growth, employee headcount, capital expenditures, and EBITDA/EBITDA margins.¹⁸⁶

The 2010 LRP was used by Facebook to identify Facebook's financial goals, provide context for decision-making and enable alignment across Facebook, and obtain Board feedback and identify areas for additional consideration.¹⁸⁷ The 2010 LRP was presented externally to investors from whom Facebook was raising money in 2010, in particular, Goldman Sachs.¹⁸⁸ The 2010 LRP was also used for tax valuation purposes, as discussed below.

In addition to the 2010 LRP, Facebook management also developed different upside and downside scenarios, which were included in the August 26, 2010 presentation to the Board.¹⁸⁹ The 2010 LRP (also referred to as the "Base Case") was considered the most likely scenario to occur, while the upside case was considered the more optimistic scenario to occur and the downside case the most conservative scenario to occur.¹⁹⁰

2. Section 409A Valuations

For Section 409A purposes relating to stock-based compensation in privately-held companies, Facebook engaged Houlihan Lokey and KPMG to perform stock valuations.

During the 2010 taxable year, Houlihan Lokey issued the following Section 409A valuation report:¹⁹¹

Valuation Date	Issuance Date
March 31, 2010	April 15, 2010

During the 2010 and 2011 taxable years, KPMG issued the following Section 409A valuation reports:¹⁹²

Valuation Date	Issuance Date
June 30, 2010	July 23,2010
September 30, 2010	October 18, 2010
December 31, 2010	January 25, 2010
March 31, 2011	April 8,2011
June 30, 2011	July 12,2011
September 30, 2011	October 7, 2011
December 31,2011	January 12, 2011

Facebook's management and its Board reviewed, provided feedback, and ultimately approved the Section 409A valuation reports.¹⁹³ The Section 409A valuation reports were also used for financial reporting purposes to support the calculation of stock-based compensation expenses on Facebook's financial statements.¹⁹⁴ EY, Facebook's auditors, audited and signed off on the Section 409A valuation reports, since they supported expenses on Facebook's financial statements.¹⁹⁵

The KPMG Section 409A valuation report as of September 30, 2010 ("September 30, 2010 KPMG Report") incorporated and relied upon the 2010 LRP.¹⁹⁶ KPMG's projections beyond 2013 were developed by extrapolating the projections in the 2010 LRP through 2020 "based on discussions with management and industry benchmarks."¹⁹⁷ The September 30, 2010 KPMG Report's revenue projection for 2020 was $35,975 million.¹⁹⁸

The KPMG Section 409A valuation reports as of December 31, 2010; March 31,2011; and June 30,2011 also incorporated the 2010 LRP for the 2012 and 2013 projections.¹⁹⁹ For these reports, KPMG updated the 2011 projections using more recent Facebook management projections.²⁰⁰

3. EY Transfer Pricing Valuation

EY prepared the following reports for Facebook to satisfy section 6662 documentation requirements in connection with the CSA entered into between Facebook US and FIH with the stated effective date of September 15, 2010:²⁰¹

In the EY PCT Report, EY created consolidated income statement projections through 2020 as part of its valuation of the intangible property purportedly covered by the PCT Agreement and UBMI Agreement.²⁰² By contrast to the September 30, 2010 KPMG Report, EY did not use the 2010 LRP for its projections. Rather, it generally relied on the more conservative downside scenario included in the August 26, 2010 presentation to the Board in which the revenue projections and margins were lower than the 2010 LRP and the projections used in the September 30, 2010 KPMG Report.

EY reduced the 2010 LRP financial projections primarily as follows:

Lower operating margin projections for 2012 and 2013 based on a downside scenario. According to EY:

Rather than relying on the 2010 LRP margins, EY used operating margin projections based on a downside scenario and extrapolated the lower operating margin assumptions to post-2013 years through 2020.

As a result, EY's total revenue projection for 2020 was $27,693 million²⁰⁵ — 23 percent lower than the September 30, 2010 KPMG Report total revenue projection for 2020 at $35,975 million.²⁰⁶

H. Facebook's Foreign Reporting Position

1. FIH and FIL

FIH did not file any returns for 2009 and 2010 with the Irish tax authorities, the Office of the Revenue Commissioners ("Irish Revenue"), as FIH described itself as being a resident, for tax purposes, in the Cayman Islands.²⁰⁷

FIL filed returns for 2009 and 2010 with Irish Revenue on the basis of being resident in Ireland for tax purposes.²⁰⁸ Facebook had a transfer pricing study prepared for 2010 with respect to the 2010 Operating License Agreement between FIH and FIL.²⁰⁹ The agreement specified a royalty calculated to provide FIL with a return equal to 10 percent of its direct operating expenses.²¹⁰ The study applied the "transactional net margin method" ("TNMM") of the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations — a method similar to the comparable profits method ("CPM") under Treas. Reg. § 1.482-5 — to validate the royalty payable to FIH by FIL.²¹¹ The study determined that the interquartile range of markups on total cost was 3 percent to 13.3 percent, with a median of 5.2 percent.²¹²

2. Service Companies

Facebook had various transfer pricing studies prepared that applied the TNMM to validate the cost-plus profit markups of about 8 percent specified in Facebook's SMSAs with Service Companies.²¹³

I. Facebook's Federal Tax Reporting Position

1. PCT and Royalty Income

For the 2010 taxable year, Facebook included in income $100 million under the PCT and UBMI Agreements. Specifically, Facebook included in income $59,561,111 based on a $1,685 million NPV of Facebook US PCT Property and Confidential Information payments; $37,626,671 based on a $4,078 million NPV of User Base payments; and $2,812,217 based on an annual contingent royalty of one percent of FIH's revenue for the licensed Marketing Intangibles.²¹⁴ According to Facebook, FIH paid $5 million upon signing the PCT and UBMI Agreements in November 2010 and signed an intercompany note for $95 million payable to Facebook, effective December 31, 2010.²¹⁵

The payment amounts under the PCT and UBMI Agreements were based on the EY PCT Report. To determine an arm's length price for Facebook's so-called "rights to the pre-existing technology intangibles" in the ROW under the PCT Agreement, the EY PCT Report determined that the income method under Treas. Reg. § 1.482-7T(g)(4) (2009) was the best method.²¹⁶ The EY PCT Report acknowledged that "[Facebook US] held resources, capabilities or rights which it had developed outside of the CSA that the participants reasonably anticipated would contribute to the development of cost shared intangibles."²¹⁷

In pricing the so-called "rights to the pre-existing user base" in the ROW under the UBMI Agreement, the EY PCT Report selected the CPM under Treas. Reg. § 1.482-5 as the best method for intangible property transfers under Treas. Reg. § 1.482-4.²¹⁸ In EY's view, applying a "CPM analysis to the stream of profit projected to derive from the pre-existing international user base is equivalent to an income method application."²¹⁹

The EY PCT Report acknowledged that "[Facebook] owns a significant portion of the IP related to the existing international user base as of 15 September 2010, which is the subject asset in the valuation."²²⁰ Similarly, EY considered, but rejected, the residual profit split method as the best method, in part, because "FBUS owns most all valuable user IP as of 15 September 2010."²²¹

In applying the income method and CPM, EY created consolidated income statement projections through 2020. See Part I.G.3. EY noted that that the 2010 LRP identified three lines of business: advertising ("Ads"), Facebook Credits, and Other.²²² EY allocated income items that it determined were derived from each of these lines of businesses between (1) the United States and Canada and (2) the ROW.²²³ For the income EY attributed to the ROW, EY generally allocated 70 percent of Ads and Facebook Credits income items to technology intangibles to create a "technology P&L," based upon which EY purportedly applied the income method, and 30 percent of Ads and Facebook Credits income items to User Base intangibles to create a "user P&L," based upon which it purportedly applied the CPM ("70/30").²²⁴ This 70/30 allocation was based on Facebook agreements with third-party developers in which Facebook took a 30 percent fee on payments related to virtual and digital goods purchases by users.²²⁵

Finally, to price the "rights to marketing intangibles" in the ROW under the UBMI Agreement, the EY PCT Report selected the comparable uncontrolled transaction ("CUT") method under Treas. Reg. § 1.482-4(c) as the best method.²²⁶

2. RAB Share and Deductions

According to the Petition, Facebook US's RAB share was 57 percent and FIH's RAB share was 43 percent under the Cost Sharing Agreement, resulting in a cost sharing payment by FIH to Facebook US in the amount of $44 million, based on total IDCs of $102 million.²²⁷ The EY CSA Report indicated that the total cost sharing pool was $49,001,311; FIH's RAB share was 44 percent; FIH's cost sharing payment was $21,560,577; and FIH's net cost sharing payment was $21,160,536 (after deducting $400,041 of FIH's directly incurred costs) for the 2010 taxable year.²²⁸ Facebook US appeared to have deducted $27,440,734 ($49,001,311x 56%) in IDCs and reported $21,160,536 of cost sharing payments on its 2010 return. The EY CSA Report determined the RAB share by using less than three years of Facebook's and FIH's present-valued gross profit projections and by calculating forecasted ROW revenue using "the latest projected international share data."²²⁹

J. Respondent's Adjustments

Respondent's Notice adjusted Facebook's "Gross Royalties" income in the amount of $84,915,248 for the 2010 taxable year based upon an after-tax NPV of approximately $13,884 million for the property Facebook US transferred to FIH, using a payment period of six years.²³⁰ On December 20, 2019, respondent lodged his First Amendment to Answer, increasing the Gross Royalties adjustment by approximately $115,209,042 for the 2010 taxable year based upon a pre-tax NPV of approximately $21,147 million for Facebook's platform contributions in connection with the CSA. Accordingly, the total Gross Royalties adjustment is approximately $200,124,290 ($84,915,248 + $115,209,042). The increased Gross Royalties adjustment was based on a report by Dr. T. Scott Newlon of Horst & Frisch ("Newlon Report").

Respondent's Notice also adjusted Facebook US's "Other Deductions" income in the amount of $5,390,144 for the 2010 taxable year. Respondent determined that the correct RAB shares allocable to Facebook US and FIH should be 45 percent and 55 percent, respectively. Respondent therefore decreased Facebook US's deductions by the amount of its reduced share of total IDCs.

II. RESPONDENT'S LEGAL POSITION

A. Overview

Since 2004, Facebook operated a social networking service and became the leading social networking service worldwide by September 2008. Facebook US had the resources, capabilities, and rights, including the technology, user base, and marketing intangibles, required to operate the service worldwide. By January 2008, more than 60 percent of Facebook's worldwide user base was outside the United States, even before Facebook US began implementing any focused internationalization growth strategies.

Before September 15, 2010, and throughout much of its history, Facebook's key strategy was to prioritize user growth and product improvements over monetization. Facebook's strategy was based on the premise that revenues and cash flow will grow once the user base grows and Facebook's site is the dominant social networking site in the relevant market. Facebook, through its management and Board, took into Account Facebook's growth strategies when determining Facebook's revenue and profit projections, including at the time of the CSA.

Facebook also viewed its technology, user base, and marketing intangibles as being complementary and interrelated with each other. Since Facebook's key strategy was growing the user base, Facebook's technology and marketing intangibles were developed, and were expected to be developed, with the view of growing the number of engaged users. Facebook developed its technology by, among other things, utilizing user data to create and improve its products and leveraging its marketing intangibles to recruit engineers to develop its technology. Facebook developed and grew its user base by, among other things, utilizing its technology and marketing intangibles to grow its user base and encourage user engagement, which in turn attracted advertisers and developers to Facebook's site.

B. Section 482 and Applicable Regulations

1. Petitioner's Burden of Proof and the Arm's Length Standard

Section 482 provides that the Commissioner may "distribute, apportion, or allocate gross income, deductions, credits, or allowances" between or among commonly controlled entities when such distribution, apportionment, or allocation is necessary "to prevent evasion of taxes or clearly to reflect the income" of such entities. Section 482 puts a controlled taxpayer on a tax parity with an uncontrolled taxpayer by determining the true taxable income of the controlled taxpayer. Treas. Reg. § 1.482-1 (a)(l). In every case, including this case, the standard applied to determine true taxable income of a controlled taxpayer is the arm's length standard — that is, the results of the controlled transaction must be consistent with the results that would be realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances. Treas. Reg. § 1.482-1(b)(1). Respondent's section 482 allocations are presumptively correct and must be sustained absent a showing of abuse of discretion. Amazon.com, Inc. & Sub, v. Commissioner, 148 T.C. 8, 68 (2017), affd 934 F.3d 976 (9th Cir. Aug. 16, 2019).

2. Best Method

The arm's length result for a particular controlled transaction or group of controlled transactions is determined by applying the best method — the method that, under the facts and circumstances, provides the most reliable measure of an arm's length result. Treas. Reg. § 1.482-1(c)(1). The two primary factors to consider in determining the best method are the degree of comparability between the controlled transaction (or taxpayer) and any uncontrolled comparables, and the quality of the data and assumptions used in the analysis. Treas. Reg. § 1.482-1(c)(2). The regulations do not impose a priority of methods: ”[N]o method will invariably be considered to be more reliable than others." Treas. Reg. § 1.482-1(c)(1).

3. Methods to Price Cost Sharing Arrangements

The regulations provide specific methods to evaluate whether transactions between controlled parties satisfy the arm's length standard. Treas. Reg. § 1.4821 (b)(2)(i). Included in the list of specified methods are methods that apply to transfers of intangible property and CSAs. Treas. Reg. §§ 1.482-l(b)(2)(i), 1.4824, 1.482-7T (2009).

Related parties may enter into CSAs to share IDCs in proportion to their respective RAB shares. Treas. Reg. § 1.482-7T(a)(l), (b). A CSA must produce results consistent with an arm's length result within the meaning of Treas. Reg. § 1.482-l(b)(l). Treas. Reg. § 1.482-7T(a)(4).

Among the requirements for a CSA, all controlled participants must commit to, and in fact, engage in cost sharing transactions ("CST") in which the controlled participants make payments to each other as appropriate, so that in each taxable year each controlled participant's IDC share is in proportion to its respective RAB share. Treas. Reg. § 1,482-7T(b)(l)(i).

In general, a RAB share is:

Treas. Reg. § 1.482-7T(e)(l)(i).

In addition, all controlled participants must commit to, and in fact, engage in platform contribution transactions ("PCT"), to the extent applicable, in which each other controlled participant ("PCT Payor") is obligated to, and must in fact, make arm's length payments ("PCT Payments") to each controlled participant ("PCT Payee") that provides a platform contribution. Treas. Reg. § 1.482-7T(b)(l )(ii).

In promulgating Treas. Reg. § 1.482-7T (the operative regulation in this case), Treasury specifically made clear the regulations “do not limit platform contributions that must be compensated in PCTs to the transfer of intangibles defined in section 936(h)(3)(B)." 74 Fed. Reg. 340, 342 (Jan. 5, 2009); see also Amazon, 934 F.3d at 979 n.l (noting that the Department of Treasury issued temporary regulations broadening the scope of contributions for which compensation must be made as part of the "buy-in payment" as it was then termed under the former CSA regulations, § 1.482-7A(g)(2) (1995), which the 2009 temporary regulations call a "PCT Payment").

In general, a platform contribution is:

any resource, capability, or right that a controlled participant has developed, maintained, or acquired externally to the intangible development activity (whether prior to or during the course of the cost sharing arrangement) that is reasonably anticipated to contribute to developing cost shared intangibles. The determination of whether a resource, capability, or right is reasonably anticipated to contribute to developing cost shared intangibles is ongoing and based on the best available information.

Treas. Reg. § 1.482-7T(c)(l) (emphasis added).

The applicable methods for determining the arm's length amount charged in a PCT must be determined under the method or methods applicable under the other sections of the section 482 regulations, as supplemented by Treas. Reg. § 1.482-7T(g), including the CUT method, the income method, the acquisition price method, the market capitalization method, the residual profit split method, and unspecified methods. Treas. Reg. §§ 1.482-7T(a)(2), (g)(l)(i)-(vi). Each applicable method must be applied in accordance with the provisions of Treas. Reg. § 1.482-1, including the best method rule, such that it provides the most reliable measure of an arm's length result. Treas. Reg. §§ 1.482-1(c)(1), 1.482-7T(g)(2)(i).

But in determining the best method in the context of valuing the arm's length amount charged in a PCT, the relative reliability of an application of any method depends on the degree of consistency of the analysis with the presumption that, as of the date of the PCT, each controlled participant's aggregate net investment in the CSA Activity (i.e., the activity of developing and exploiting cost shared intangibles) is reasonably anticipated to earn a rate of return equal to the appropriate discount rate for the controlled participant's CSA Activity over the entire period of such CSA Activity ("investor model"). Treas. Reg. § 1.482-7T(c)(2)(i), (g)(2)(ii).

In addition, the relative reliability of an applicable method for valuing the arm's length amount charged in a PCT depends on the degree of consistency of the analysis with the assumption that uncontrolled taxpayers dealing at arm's length would have evaluated the terms of the transaction, and only entered into such transaction, if no alternative is preferable (i.e., consistency of evaluation with "realistic alternatives"). Treas. Reg. § 1.482-7T(g)(2)(iii). This condition is not met where, for any controlled participant, the total anticipated present value of its income attributable to entering into the CSA, as of the date of the PCT, is less than the total anticipated present value of its income that could be achieved through an alternative arrangement realistically available to that controlled participant. Treas. Reg. § 1.482-7T(g)(2)(iii).

For example, the income method is a specified method under Treas. Reg.§ 1.482-7T(g)(4) that evaluates whether the amount charged in a PCT is arm's length by reference to a controlled participant's best realistic alternative to entering into a CSA. Under this method, the arm's length charge for a PCT Payment will be an amount such that a controlled participant's present value, as of the date of the PCT, of its cost sharing alternative of entering into a CSA equals the present value of its best realistic alternative. Treas. Reg. § 1.482-7T(g)(4)(i)(A). Furthermore, "[w]here there is a combined contribution of research services, intangibles in process, or other resources, capabilities, or rights, the temporary regulations provide for an aggregate valuation where that would provide the most reliable measure of an arm's length result for the aggregated PCTs and other transactions." 74 Fed. Reg. 340, 342 (Jan. 5, 2009).

In determining the best method, the combined effect of multiple contemporaneous transactions, consisting either of multiple PCTs, or of one or more PCT and one or more other transactions in connection with a CSA that are not governed by Treas. Reg. § 1.482-7T, may require evaluation in accordance with the principles of aggregation described in Treas. Reg. § 1.482-1 (f)(2)(i). Treas. Reg. § 1.482-7T(g)(2)(iv). In such cases, it may be that the multiple transactions are reasonably anticipated, as of the date of the PCT, to be so interrelated that the method that provides the most reliable measure of an arm's length charge is a method under Treas. Reg. § 1.482-7T applied on an aggregate basis for the PCT and other transactions. Treas. Reg. § 1,482-7T(g)(2)(iv).²³¹

C. Dr. Newlon's Income Method Is the Best Method

Facebook's income must be increased to reflect additional amounts due from FIH for Facebook's platform contributions in connection with the CSA.

The best method rule must be utilized for evaluating the arm's length compensation from FIH for Facebook's platform contributions in connection with the CSA. Treas. Reg. §§ 1.482-1 (c)(1), 1.482-7T(g)(2)(i). In the context of a CSA, Treas. Reg. § 1.482-7T (2009) provides supplemental guidance on the application of the best method rule by reference to the investor model, realistic alternatives, and aggregation principles, among others. Id. § 1.482-7T(g)(2)(ii)-(iv). As described in the EY PCT Report and in Facebook's expert reports,²³² the transfer pricing methods advanced by Facebook, which, among other things, separately value Facebook's technology, user base, and marketing intangibles, do not result in arm's length payments to Facebook in accordance with the arm's length standard and the best method rule..

To begin with, Facebook counterfactually valued its technology separately from its user base and marketing intangibles, disregarding that these assets are complementary and interrelated and only deliver value to Facebook and its various user communities as an integrated whole. Furthermore, Facebook treated technology intangibles as a platform contribution under Treas. Reg. § 1.482-7T but treated its user base and marketing intangibles as intangible property transfers under Treas. Reg. § 1.482-4, determining separate values for each. By doing so, Facebook wholly ignores the entirety of Facebook's resources, capabilities, and rights that are reasonably anticipated to contribute to developing the Cost Shared Intangibles, which include Facebook's user base and marketing intangibles. As explained above, and as will be demonstrated through the evidence presented at trial, including through the testimony of fact- and expert-witnesses from both sides, Facebook's user base and marketing intangibles directly contribute to the development of Facebook's technology intangibles in numerous and meaningful ways, and were reasonably expected to do so as Facebook continued to develop its technology intangibles after the CSA. Facebook's valuation approach, which disaggregates interrelated assets solely for the purposes of transfer pricing, finds no support in the facts, the economics, or the regulations. To the contrary, Facebook's valuation approach violates the regulations by ignoring that these inseparable resources, capabilities, and rights are platform contributions within the meaning of Treas. Reg. § 1.482-7T(c)(l) and must be valued in the aggregate to determine a reliable arm's length price, as required by Treas. Reg. § 1.482-7T(g)(2)(iv).

The income method under Treas. Reg. § 1,482-7T(g)(4) is the best method in this case — in particular, a discounted cash flow ("DCF") method that compares the future expected cash flows Facebook would be projected to receive in connection with the CSA to the projected cash flows under its best realistic alternative. As the evidence at trial will make abundantly clear, Facebook's technology, user base, and marketing intangibles are highly interrelated and, in addition to other related resources, capabilities, or rights, are reasonably anticipated to contribute to developing the Cost Shared Intangibles. Furthermore, contemporaneous with entering into the CSA, Facebook's management viewed these intangibles as being highly interrelated and expected these intangibles to contribute to the development or improvement of technology, user base, and marketing intangibles. See Part I.D.-F. To apply the best method, the income method must be applied to these platform contributions on an aggregate basis under Treas. Reg. § 1.482-7T(g)(2)(iv).

Dr. Newlon performed a best method analysis and concluded that the income method, in particular, the DCF, is the best method to evaluate whether the transactions between Facebook US and FIH produced aim's length results. Dr. Newlon determined the value of payments an uncontrolled Facebook US would have been willing to accept, and an uncontrolled FIH would have been willing to pay, in September 2010 to enter into the CSA, which included the PCT Agreement, the UBMI Agreement, and the Cost Sharing Agreement.

Dr. Newlon found that "Facebook's business is an ecosystem in which the online platform, the user base, and the marketing intangibles are worth far more in combination than they would be if they were somehow separated from each other."²³³ And in negotiating the CSA, "Facebook US had the realistic alternative of retaining the expected future stream of benefits by replacing Facebook Ireland, [i.e., FIH and FIL, collectively,] and Facebook US could have replaced Facebook Ireland at relatively low cost" for about $25 million under a "no-deal alternative."²³⁴ In making his determination, Dr. Newlon concluded that: (1) payments under the PCT Agreement and the UBM1 Agreement should be evaluated in the aggregate and (2) FIH's bargaining position in entering into the CSA was weak.²³⁵

Given these conclusions, Dr. Newlon estimated the present value of PCT Payments using the income method by comparing the projected future stream of cash flows Facebook US would receive under the CSA ("Cost Sharing Alternative") to the projected stream of cash flows Facebook US would have received under an alternative in which Facebook US retained the rights to profit from the Facebook site in the ROW and compensated FIL and other Service Companies as service providers in the ROW business ("Services Alternative").²³⁶ The income method was the best method because, among other things, the 2010 LRP — contemporaneous financial projections determined and used by Facebook management for internal and external purposes — was available for developing cash flow projections that would reasonably reflect Facebook's expectations under both alternatives as of the stated effective date of the CSA.²³⁷

1. Services Alternative

Dr. Newlon found that the Services Alternative is the best realistic alternative to the Cost Sharing Alternative. See Treas. Reg. § 1.482-7T(g)(4)(i)(A), Before the CSA in 2010, FIL and the Service Companies, which performed functions to support the ROW business, were treated as service providers and were compensated on a cost-plus basis. See Part I.C. Before the CSA in 2010, Facebook US possessed substantially all the resources, capabilities, and rights to operate the ROW business. Facebook's own transfer pricing documentation recognized that that the sales, marketing, and other functions performed by FIL and the Service Companies were "routine," i.e., benchmarkable, and applied the TNMM — a method similar to the CPM — to determine their arm's length compensation. See Part I.H. Dr. Newlon therefore determined that the best realistic alternative to the Cost Sharing Alternative was for Facebook US to retain ownership of all income rights from the ROW business, retaining the revenues derived from the ROW and bearing the operating costs in the ROW, including the costs of paying the Service Companies as service providers on behalf of Facebook US.²³⁸

2. DCF Method

Dr. Newlon compared the projected future stream of pre-tax cash flows, consistent with Treas. Reg. § 1.482-7T(g)(2)(x) and (g)(4)(i)(G), Facebook US would receive under the Cost Sharing Alternative to the projected stream of cash flows Facebook US would have received under the Services Alternative. The pretax value of the cash flow differences between these two alternatives were composed of the following principal components:²³⁹

Cost Sharing Alternative	Services Alternative
ROW revenue received by FIH and no ROW received by Facebook US	ROW revenue received by Facebook US
FIH cost sharing payments received by Facebook US	No cost sharing payments received by Facebook US
Payments from FIH to Facebook US for non-R&D ROW costs incurred by Facebook US	No payments from FIH for non-R&D ROW costs incurred by Facebook US
FIL and Service Company ROW costs not paid by Facebook US	FIL and Service Company ROW costs paid by Facebook US

Dr. Newlon calculated these four pre-tax cash flow differences and made adjustments for the timing of receipt of revenue and intercompany payments associated with these cash flow differences, among other adjustments.²⁴⁰ Dr. Newlon projected these cash flows in future periods and then discounted that projected stream of future cash flows to a present value at the time of entering into the CSA, thereby determining the cash flow forgone by Facebook US, before receipt of PCT Payments, under the Cost Sharing Alternative instead of the Services Alternative.²⁴¹

a. Financial Projections

In determining the projected future stream of pre-tax cash flows, Dr. Newlon used financial projections for 2011 through 2013 from the 2010 LRP. For 2014 through 2020, Dr. Newlon relied on assumptions from the EY PCT Report with two significant adjustments.²⁴²

First, in contrast to the EY PCT Report projections, Dr. Newlon extended projections of business and intellectual property acquisition expenditures included in the 2010 LRP to post-2013 years. Dr. Newlon assumed these expenditures were for future PCTs for which Facebook US and FIH would share the costs under the CSA. Including these projected expenditures reduces the projected cash flows forgone by Facebook US under the Cost Sharing Alternative instead of the Services Alternative.²⁴³

Second, Dr. Newlon applied the 2010 LRP operating margin projections for 2012 and 2013,²⁴⁴ whereas the EY PCT Report lowered operating margin projections for those years as compared to the 2010 LRP. Applying the 2010 LRP operating margin projections for 2012 and 2013 increases the projected cash flows forgone by Facebook US under the Cost Sharing Alternative instead of the Services Alternative.²⁴⁵

b. Long-Run Growth Rate

Dr. Newlon found that the expected cashflows under the alternatives were anticipated to continue into the future indefinitely and therefore computed the terminal value of the expected future cash flows.²⁴⁶ To compute the terminal value, Dr. Newlon selected a conservative growth rate — a one percent long-run real growth rate for Facebook's business in the ROW, which was one third of the OECD's forecast of the long-run real growth rate of the world economy.²⁴⁷

c. Discount Rates

In determining the rate to discount the expected future cash flows to a present value, Dr. Newlon estimated an appropriate cost of capital²⁴⁸ for (1) Facebook's operating profit attributable to the ROW ("ROW Cash Flow") and (2) Facebook's operating profit from services, other than R&D, that support the ROW business ("Services Cash Flow").²⁴⁹

For the ROW Cash Flow, Dr. Newlon estimated the cost of capital using a weighted average cost of capital ("WACC") that was equal to the cost of equity capital.²⁵⁰ To estimate the cost of equity capital, Dr. Newlon used the capital asset pricing model ("CAPM")²⁵¹ and incorporated a three percent risk premium.²⁵² As a result, Dr. Newlon determined a median discount rate of 14,44 percent.²⁵³

For the Services Cash Flow, Dr. Newlon estimated the cost of capital using a WACC for comparable third-party service providers in the United States, Canada, and Western Europe, the same regions where Facebook entities performed similar non-R&D business functions — (1) sales and marketing services, (2) data center services, and (3) general and administrative ("G&A") services.²⁵⁴ As a result, Dr. Newlon determined median discount rates of 8.81 percent, 9.63 percent, and 8.31 percent, respectively, for these three categories of services cash flows.

d. Services Cost-Plus Markup Rates

To calculate the cash flow differences between the Cost Sharing and Services Alternatives, Dr. Newlon determined the appropriate markup rate for calculating the operating profit for performing the non-R&D services that support the ROW business.²⁵⁵ Dr. Newlon considered, among other things, the markuprates implied by the profit markups earned by the third-party comparables used to determine the Services Cash Flow WACCs as well as the markup rates set forth in Facebook's own intercompany services agreements and corroborating transfer pricing studies.²⁵⁶ See Part I.C., H.2. As a result, Dr. Newlon determined markup rates of 10 percent for data center costs and 8 percent for selling, marketing, and G&A ("SG&A") costs.²⁵⁷

As described above, Dr. Newlon applied the DCF method based on Facebook's expectations at the time of the CSA, the 2010 LRP, and made reasonable assumptions about Facebook's expected future cash flows. Dr. Newlon's method yielded an arm's length pre-tax NPV result ranging from approximately $18,757 million to $21,147 million, with a median estimate of $20,073 million.²⁵⁸

D. FIH Made No Non-Routine Platform Contributions

FIH did not develop any non-routine platform contributions, including ROW User Base growth, based on the IPLA and other 2009 Agreements by incurring expenses of either $35 or $41 million prior to September 15, 2010. While Facebook's expert, Dr. Reichert, attributes $4.2 billion in value to FIH stemming primarily from these expenses,²⁵⁹ Facebook has not established that these claimed expenses developed any non-routine platform contributions, much less $4.2 billion worth?²⁶⁰ Nor could it. The suggestion that FIH, in its less than two years of existence, was able to generate $4.2 billion in value simply by picking up the tab on $35 or $41 million in expenses allocated to it by Facebook US, lacks credibility. Further, there is no basis to attribute valuable rights or other assets to FIH, or even to define what those rights or assets would have been, based on the 2009 IPLA or other 2009 Agreements in exchange for these expenses?²⁶¹

First, the 2009 IPLA, according to its terms, in no way granted ownership of any intangibles developed or enhanced for the duration of the 2009 IPLA to FIH.²⁶² Key terms and provisions regarding ownership of intangible property developed or improved under the 2009 IPLA were vague or missing.²⁶³ In addition, the 2009 IPLA granted a non-exclusive license to FIH that could be terminated by either party on 90-days' notice. Such terms do not comport with basic industry standard practices if FIH were intended to own any intangibles that were purportedly developed or enhanced under the agreement. Among other things, FIH, as a nonexclusive licensee, could not bar Facebook US from exploiting the licensed intangibles in the same market, which indicates that Facebook US retained ownership of any developed intangibles.²⁶⁴ Furthermore, if FIH were intended to own any developed or improved intangible property under the agreement, Facebook US's compensation should increase accordingly, all else being equal.²⁶⁵ But FIH generated no revenues and paid no royalties under the 2009 IPLA to Facebook US.²⁶⁶

Second, Facebook has not established that the 2009 IPLA, despite its terms, was ever implemented, and FIH did not have the resources and capabilities to implement the basic terms of the 2009 IPLA, which would require, at a minimum, operating capital and accounting systems that would enable FIH to earn revenue and remit royalties (systems that were not in place until September of 2010, at the earliest).²⁶⁷ FIH had no employees, and as structured in the 2009 Agreements, FIH was to outsource its obligations under the 2009 IPLA to FIL and Facebook US.²⁶⁸ Under the terms of sections 2.1 and 2.2 of the 2009 ERA, Facebook US could bypass FIH and directly reimburse FIL for Direct Sales Expenses and MDEs. FIH's role could therefore be eliminated.²⁶⁹

In short, Facebook has not established, as a matter of fact, law, or economics, that FIH made any non-routine contributions that would impact the value of its PCT payment obligations to Facebook US in connection with the CSA.

E. Other Analyses Support the Income Method and the Application of the Income Method on an Aggregate Basis

1. Alternative Valuations Corroborate Dr. Newlon's DCF Method

Dr. Newlon's DCF method produces arm's length results and is corroborated by other analyses performed by Dr. Newlon, as well as two independent analyses performed by Dr. Ilya Strebulaev and Mr. Carl Saba.

Dr. Newlon tested three key inputs he used in his method — 1) financial projections, 2) discount rate, and 3) long-run growth rate — and used them to perform a DCF method valuation to estimate Facebook's global business enterprise value as of September 15, 2010, the stated effective date of the Cost Sharing Agreement.²⁷⁰ He compared that estimate against contemporaneous third-party estimates of Facebook's value based on secondary market sales of Facebook stock or implied by equity investments in Facebook.²⁷¹ Dr. Newlon's comparison demonstrated that Facebook's business enterprise value — ranging from $25.3 billion to $33.6 billion — implied by the key inputs in his DCF method was consistent with contemporaneous estimates of Facebook's value that ranged from $28.5 billion to $50 billion.²⁷²

Dr. Strebulaev analyzed direct equity investments in Facebook, including the DST preferred stock purchase in 2009 and the Goldman Sachs investments in December 2010, to derive an implied value of Facebook's equity as of the stated effective date of the Cost Sharing Agreement.²⁷³ As a result of his analyses, Dr. Strebulaev estimated a value of Facebook's equity ranging from $35.5 billion to $38 billion as of the stated effective date.²⁷⁴

Mr. Saba estimated a fair market value of Facebook's equity on a controlling, marketable, and post-tax basis as of September 15, 2010 and as of September 14, 2010 on the assumption that Facebook's effective tax rate would not be reduced due to implementation of the international tax structure.²⁷⁵ To perform his valuation, Mr. Saba used the DCF method and two market approaches on a weighted basis,²⁷⁶ For the DCF method, Mr. Saba relied on the 2010 LRP as the basis for his financial projections through 2013, similar to Dr. Newlon, but unlike Dr. Newlon, Mr. Saba used the projections through 2020 based on the September 30, 2010 KPMG Report.²⁷⁷ The application of Mr. Saba's method resulted in a fair market value of Facebook's equity of $33.68 billion as of September 15, 2010 and $29.34 billion as of September 14, 2010.²⁷⁸

2. Analyses of Facebook's Operations Support Applying the Income Method on an Aggregate Basis

Dr. Newlon's aggregate valuation of Facebook US's resources, capabilities, and rights contributed in the CSA was appropriate and grounded in the realities of Facebook's business. One of Facebook's experts, Dr. Reichert, also concluded that it was reasonable to value the contributions in the aggregate.²⁷⁹

As the evidence and respondent's experts will show, Facebook's user base and its technology assets are worth more together than when broken up. The interplay between Facebook's user base and its technology is multifaceted.

First, the size of the user base directly impacts the returns from, and marginal value of, any investments in technology.²⁸⁰

Second, Facebook's technology both facilitates and benefits from user actions. Facebook's technology enables a users' explicit sharing of information or content for the consumption of other users, providing engagement for both the sharing and consuming users alike.²⁸¹ Facebook's technology allows users to invite new users, and Facebook benefits from the presence of those additional users.²⁸² Facebook's technology also utilizes all the actions of its users to improve the user experience and target advertising.²⁸³

Facebook leveraged its users to create and improve its technology through many ways. These ways included, for example, crowd-sourced translations and other features,²⁸⁴ relying on user data and feedback to create new technologies and improve existing ones, and leveraging user co-production (e.g., activities of other users that engage other users) to improve the utility of its existing technologies.²⁸⁵ Facebook's technology investments benefited from complementarities, i.e., an increase in value when combinations of technologies or combinations of technologies with other assets (the user base and marketing intangibles) create more value than in isolation.²⁸⁶ Facebook's future investments in technologybenefit from its prior investments in technology and its user base, in part, due to these complementarities.²⁸⁷ The presence of network effects among Facebook users magnifies the loss of complementarities within the user base when the user base is artificially separated from the technology.²⁸⁸

Third, the joint operation of Facebook's intangible assets allows for their most efficient, value-maximizing use and arguably their only use given the nature of the social graph — the mapping of connections between objects or nodes (people, products, or ideas).²⁸⁹

Divorcing complementary intangibles from each other in practice — in a counterfactual scenario where this would even be possible — would create economic coordination problems, in particular, the "holdup problem" and "double marginalization."²⁹⁰

A "holdup problem" exists when a firm invests in a relationship-specific asset, such as Facebook technology intangibles that are specific to Facebook's operation needs and are complementary with user base intangibles.²⁹¹ In that counterfactual, the technology intangible owner would potentially avoid making optimal investments in that asset for fear of becoming so specialized that the owner is vulnerable to unreasonable demands from a separate and unrelated user base owner.²⁹²

"Double marginalization" exists when firms independently set prices for complementary goods. Double marginalization leads to over-pricing and underinvestment by separate owners of complementary assets, and therefore profitability and quality improvements of the complementary assets are not maximized.²⁹³

While a contract could address these coordination issues between the owners of inherently connected assets, a contract that could address every potential contingency, be susceptible to measurement, and not limited by either party's knowledge or capabilities (i.e., cover all risks) would be difficult if not impossible to specify.²⁹⁴

Artificially separating Facebook's complementary assets by transferring them in separate contracts creates other risks, too. If one agreement is deemed invalid, FIH would not have rights to all assets necessary to operate the ROW business.²⁹⁵ For example, the separation of the trade and service marks from their associated goodwill risks invalidating the trademarks.²⁹⁶ Similarly, the transfer of technology rights without related trademarks prevents a business from marketing a product under its known brand and could reduce customers' perception of the value of the product.²⁹⁷ A transfer of the technology and trademarks without the user base would result in the technology transferee having no immediate source of revenue and the need to build a user base.²⁹⁸ Likewise, the transfer of the user base without the technology would leave the transferee with the need to design and build the hardware and software necessary during which it would have no product to offer its user base.²⁹⁹ Facebook's separation of its technology, user base, and marketing intangibles is inconsistent with value maximizing behavior, and creates risks that are unnecessary when the transferee of all the assets was the same party, FIH.³⁰⁰

F. RAB Share and Deductions

Facebook US's income must be increased to disallow Facebook US's IDC deductions that exceed its RAB share.

A controlled participant's RAB share is equal to its reasonably anticipated benefits divided by the sum of the reasonably anticipated benefits of all the controlled participants. Treas. Reg. § 1.482-7T(e)(l)(i). Reasonably anticipated benefits must be estimated over the entire period, past and future, of exploitation of the cost shared intangibles. Id. The reliability of an estimate of RAB shares depends, in part, upon the reliability of projections used in making the estimate. Id. § 1.482-7T(e)(2)(iii). In determining Facebook US's and FIH's RAB shares, among other errors, Facebook inappropriately limited the period over which the cost shared intangibles would be exploited and understated the projected share of revenue growth in the ROW.

Respondent contends that the entire period of exploitation of the Cost Shared Intangibles is indefinite. Facebook's own income projections in the ROW indicate higher growth than in the projections used in the EY CSA Report. Facebook's IDC deductions should therefore be reduced by the amount of additional cost sharing payments due from FIH based on Facebook US's and FIH's correct RAB shares.

Dr. Newlon calculated the RAB share for 2010 based on the present value of the projected gross profits he determined in 2010 and future years.³⁰¹ Dr. Newlon used a discount rate of 13.44 percent and determined a 53.5 percent RAB share for FIH for 2010.³⁰² Using Dr. Newlon's calculations, FIH's net cost sharing payment to Facebook US would be increased from $21,160,536 to $25,815,660 for 2010, and Facebook US's deductions for its share of IDCs would be disallowed by $4,655,124, equal to the increase to FIH's net cost sharing payment ($25,815,660 - $21,160,536).³⁰³

If the RAB share is computed based on section 6.1 of the Cost Sharing Agreement, then FIH would be projected to make lower cost sharing payments to Facebook US (based on lower projected RAB shares for FIH, e.g., 45.1 percent in 2011) in the early years of the CSA because the gross profit in the ROW was projected during the early years to grow more rapidly than the gross profit of the worldwide business.³⁰⁴ Lower cost sharing payments would increase operating profits and net cash flows to FIH in those early years.³⁰⁵ This increase in projected operating profits and cash flows would increase Dr. Newlon's present value of arm's length PCT payments by $265 million.³⁰⁶

III. CONCLUSION

The primary issue in this case is whether the compensation Facebook received in connection with the CSA was arm's length, or whether an adjustment is warranted under section 482. As explained above, the record in this case will establish that Facebook substantially understated its taxable income and that a significant section 482 allocation is necessary to achieve an arm's length result.