Despite a 2009 regulatory overhaul and unfavorable Ninth Circuit dicta, Facebook will argue in its Tax Court trial that parties to a 2010 cost-sharing arrangement still didn't have to value intangibles on an aggregate basis.
In a pretrial brief filed January 15, Facebook contests the IRS’s valuation under the 2009 temporary cost-sharing regulations of rights transferred from Facebook’s U.S. parent to an Irish subsidiary in exchange for a royalty stream with a net present value of $3.3 billion. Using the income method introduced by the 2009 regulations, the IRS determined that the aggregate value of Facebook’s license of technology rights, transfer of its existing international user base, and agreement to share intangible development costs was $13.9 billion. In its pretrial brief for the respondent, the IRS notes a pending motion to revise that figure to $21.1 billion, which would result in a $115 million transfer pricing adjustment.
According to Facebook, the IRS’s income method valuation wrongly aggregates the value of intangibles contributed to the cost-sharing arrangement with the value of residual business assets and intangibles developed by the Irish subsidiary in subsequent years. Echoing the taxpayer’s argument in Amazon.com v. Commissioner, 148 T.C. 8, 68 (2017), aff’d, 934 F.3d 976 (9th Cir. 2019), concerning the 1995 cost-sharing regulations, Facebook argues that the IRS cannot use a method that includes the value of residual business assets like goodwill and going concern value.
Unlike in Amazon, however, Facebook’s cost-sharing arrangement is subject to the 2009 cost-sharing regulations, which were finalized in 2011 with few changes. Although the Ninth Circuit held in Amazon’s favor under the 1995 regulations, its August 2019 decision also states that “there is no doubt the commissioner's position would be correct” under the 2009 regulations. Any appeal of the Tax Court’s decision regarding Facebook would be decided by the Ninth Circuit.
According to Facebook, the IRS was still barred from using an aggregate valuation method that includes residual business assets even after the 2009 regulations took effect. The company’s brief downplays the differences between the 1995 and 2009 cost-sharing regulations, which replaced the references to "preexisting intangibles" with the term "platform contribution," and referred to the required compensation as a "platform contribution transaction" (PCT) instead of a "buy-in payment." The temporary regs define the term “platform contribution” broadly to include any “resource, capability, or right" reasonably anticipated to contribute to developing cost-shared intangibles.
The 2009 regulations also overhauled the rules for calculating the arm's-length amount of the required payment with a new list of specified valuation methods. The income method used by the IRS to redetermine Facebook Ireland's PCT, which resembles the discounted cash flow valuation method adopted by the IRS in Amazon, was one of the methods included in the new list.
According to Facebook, applying the income method in a way that includes residual business asset value conflicts with legislative intent. To the extent that they require such an approach, the 2009 regulations are invalid, the company’s brief says. Although the preamble to the 2009 regulations specifies that the definition of a platform contribution is not limited by the definition of intangible property in then-section 936(h)(3)(B), Facebook's brief argues that residual business assets should not be considered a platform contribution either because they cannot reasonably be expected to contribute to developing cost-shared intangibles. Unlike platform contributions, cost-shared intangibles are defined in the regulations by a cross-reference to the definition of the term "intangible property" in reg. section 1.482-4(b).
“Foreign going concern value and foreign goodwill were not transferred, were not platform contributions, and were not compensable pursuant to sections 367, 482, or 936. Any aggregate valuation necessarily requires carving out value for these items,” Facebook’s brief says. “In other words, an aggregate valuation necessarily requires disaggregation to identify cash flows attributable to non-platform contribution items, such as the existing users to which Facebook Ireland had rights, future users (including users that have not yet joined today), foreign goodwill, foreign going concern value, the international work force, and other items. Respondent has not made such adjustments, and thus his aggregate valuation approach is not reliable.”
The IRS’s brief counters that the income method, which the updated regulations generally consider to be the best method when only one party to the cost-sharing arrangement makes nonroutine contributions, is clearly the most reliable transfer pricing method. Noting that the subsidiary applied the transactional net margin method — a method generally appropriate only for entities that make no nonroutine contributions — for Irish tax purposes, the IRS argues that attributing significant profit to the subsidiary is inconsistent with economic reality.
“Facebook has not established that these claimed expenses developed any non-routine platform contributions, much less $4.2 billion worth. Nor could it,” the IRS brief says. “The suggestion that [Facebook Ireland Holdings Ltd.], 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 [million] or $41 million in expenses allocated to it by Facebook US, lacks credibility.”
Citing case law interpreting prior versions of the regulations, Facebook also argues that redetermining the arm's-length PCT using an aggregate valuation fails to respect the parties' actual transactions. Reg. section 1.482-1(f)(2), which has been in place since 1994, provides that the IRS will not recharacterize transactions unless they lack economic substance. However, the same section also states that the IRS may use the realistic alternatives to the transaction to determine the arm's-length price or price interrelated transactions in the aggregate if doing so provides the most reliable result.
According to the IRS, an aggregate valuation is necessary because the transferred intangibles must be transferred together to realize their full value. “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,” the IRS argues.
Facebook’s brief argues alternatively that the IRS’s valuation would be incorrect even if an aggregated method were required because the discount rates applied fail to reflect the level of risk borne by the Irish subsidiary. The company’s brief also challenges the reliability of the financial projections used in the IRS’s income method valuation, referring to a substantial portion of projected revenue as “aspirational.” According to the government’s brief, Facebook used the same projections in presentations to outside investors, including Goldman Sachs.