Now that Facebook is in its 16th year, the social networking site is enduring considerable teenage growing pains, some of which stem from business decisions drawing attention to the company’s ethics, financials, and more. All eyes are on Facebook as the United States gears up for a potentially grinding presidential election campaign, and there’s pressure on Facebook to demonstrate how it will ward off foreign interference.
Internationally, the company’s tax record — along with that of other digital giants — is being trotted out as evidence that the global corporate tax system is ineffective and needs a substantial overhaul. As if that isn’t enough attention, there’s yet another new book, Facebook: The Inside Story, chronicling the company’s rise from a Harvard dorm room start-up to a tech giant that may not have fully understood the global imprint it would make on privacy, data usage, truth telling, and the like.
Amid all this, Facebook is trying to stave off a potential $9 billion tax bill from the IRS, which contends that the company in 2010 should have paid more U.S. taxes on intellectual property it transferred to its Irish business under a cost-sharing agreement.
The transfer pricing rules at issue in Facebook’s case have gone through several iterations, from the 1990s to the early 2000s, and into the Tax Cuts and Jobs Act era. In every iteration the government has attempted to refine the definition of intangibles subject to cost-sharing regs. Some of the results have been less than satisfactory in the eyes of the U.S. Tax Court, which addressed the issue in recent court challenges launched by Amazon (Amazon.com Inc. v. Commissioner, 148 T.C. No. 8 (2017)) and Veritas (Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009)). Both successfully showed that the government’s interpretation of intangibles extended beyond the plain language of the regs.
Despite a 2009 IRS and Treasury tightening of the rules, Facebook is relying on similar arguments to make the case that the IRS is again overstepping its bounds. It will be worth watching to see how the Tax Court addresses the language issues within regs that were the operating rules between 2009 and 2017, but that have been again updated via the TCJA.
Background
Was Facebook successful in 2010? It depends on to whom you talk. Facebook says it was very much an emerging six-year-old company that didn’t even have the capability to present advertisements on mobile devices. Further complicating the issue, the company faced difficulty convincing advertisers that it could monetize ads as well as “conventional” outfits like Yahoo and Google.
But it had huge international ambitions and designs on connecting the globe through the Facebook network, according to the company’s pretrial memorandum. In 2010 the company’s global network was surely growing but not yet where it needed to be. Decisions had to be made. Should it develop technology alone or delegate some of the responsibility to its foreign affiliates via cost-sharing agreements? It had to determine who would sell the company’s ads.
Facebook ultimately decided to delegate some of those responsibilities to its Irish operations, referred to collectively as Facebook Ireland in the company’s pretrial memorandum. In 2009 the parties inked an intangible property license agreement and an expense reimbursement agreement. These gave Facebook Ireland the right to develop users, advertisers, and developers for territories outside North America. Within the first 20 months, Facebook Ireland spent over $35 million to grow users in its territories from 101 million to roughly 392 million, according to Facebook’s pretrial memorandum.
Then in September 2010 Facebook Ireland and Facebook launched a cost-sharing agreement and Facebook Ireland began billing and collecting advertising revenue within its territories. The two entered into another agreement, the Online Platform Intangible Property Buy-In License Agreement (PCT license), in which Facebook licensed software and hardware systems to Facebook Ireland enabling ad sales for desktop users, app development, and user interactions. According to Facebook, between 2010 and 2016 Facebook Ireland paid it more than $4.1 billion in cost-sharing payments and $10 billion in royalties.
Facebook says the cost-sharing agreement was key because it enabled both parties to jointly develop Facebook’s mobile platform and mobile ad technology.
While all of this was happening, both parties entered into a new agreement that superseded the 2009 intangible property license agreement for users outside North America. Under the new agreement, Facebook transferred to Facebook Ireland rights it still held as of September 2010 to users outside North America. The new agreement also established that Facebook Ireland would retain all rights it had created within its territories.
While Facebook contends that its international growth efforts were just ramping up in 2010, the IRS contends that the company was already well on its way and had grown its international share to nearly 80 percent of users by the end of 2010. According to the IRS’s pretrial memorandum, by 2008 Facebook was already considered the world’s top social media network, and the company counted more than 60 percent of its user base outside the United States. According to the IRS (citing a media interview involving Facebook CEO Mark Zuckerberg), in the initial years of its existence, Facebook prioritized growth over advertising monetization because it allegedly believed the eventual monetary payoff would be greater.
Although Facebook’s court documents highlight the difficulties the company faced in developing a mobile ad system, the IRS argues in its pretrial memorandum that the company’s overall advertising machine was extremely robust because advertising had always been the company’s main revenue source.
The IRS and Facebook disagree over the transfer pricing valuation methods used in conjunction with the company’s cost-sharing arrangement. The company used the comparable uncontrolled transaction method to determine Facebook Ireland’s compensation, and used Facebook’s agreements with third-party ad resellers as a floor. At the time, third-parties received 30 percent of the revenue they generated, so Facebook contends that 30 percent of Facebook Ireland’s revenue was excludable from a platform contribution transaction royalty payment.
The IRS says the income method (particularly the discounted cash flow method) under 2009 Treas. reg. section 1.482-7T is the best method for Facebook’s case because it aggregates all relevant assets instead of valuing them separately. According to the IRS, Facebook wrongly valued its technology separately from its user base and marketing intangibles and treated technology intangibles as a platform contribution under Treas. reg. section 1.482-7T while treating its user base and marketing intangibles as intangible property transfers under Treas. reg. section 1.482-4. The IRS contends that the assets are complementary and interrelated and deliver value as a whole.
At issue are three royalties Facebook Ireland paid to Facebook:
a platform contribution transaction royalty for platform technology in existence as of September 2010;
a user royalty for access to Facebook users to which Facebook still had rights as of that date; and
a royalty for trademark and marketing intangibles.
Facebook contends the royalties at issue met or exceeded the amount required under section 482 because Facebook Ireland and foreign affiliates (not Facebook) sold Facebook ads internationally and assumed the attendant risks. Also, Facebook Ireland had rights to the Facebook user base outside North America and Facebook says the user royalty Facebook Ireland paid didn’t credit itself for its rights to the user base outside North America as of September 2010 and as such exceeded an arm’s-length amount.
Facebook also contends that it is not entitled under section 482 to the profits Facebook Ireland and other foreign affiliates generated from developing an international workforce, foreign goodwill, and foreign going concern value, and argues they that do not qualify as platform contributions under the regs. As such, the items cannot be aggregated and must be valued separately.
Regulatory Back and Forth
The IRS has endured considerable litigation over its cost-sharing regs, including whether assets like foreign goodwill and going concern value classify as intangible property. In 1994 it issued final section 482 regs, which clarified the definition of intangible property for purposes of cost-sharing agreements under Treas. reg. section 1.482-4. However, this clarification seemingly did not go far enough in the Tax Court’s eyes, as evidenced by the Amazon and Veritas litigation.
The 1994 final regs — which applied to both Amazon and Veritas — covered 28 separate intangible property items, while maintaining a catchall provision for “other similar items” not enumerated. Under the regs, “other similar items” are those that derive their value from their intellectual content and other intangible properties, as opposed to physical attributes, and have “substantial value independent of the services of any individual.”
The IRS later used that catchall provision to contend that assets like workforce, going concern, and goodwill qualify. But the IRS was ultimately undone by the fact that the definition of intangible property under the 1994 regs, Treas. reg. section 1.482-4(b), did not explicitly include assets like goodwill and going concern. The Tax Court rejected the IRS argument in both cases, and the Ninth Circuit, on appeal in Amazon.com Inc. v. Commissioner, 934 F.3d 976 (2019), followed suit.
In 2009 the government released temporary regs, reg. section 1.482-7T, that offered new language covering so-called platform contributions that add to the development of an intangible. Under these regs, 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.
Based on that definition, the IRS contends that Facebook should have included its user base and marketing intangibles as a platform contribution.
The Section 936 Issue
Even with this updated language, Facebook says the IRS is wrong because Treas. reg. section 1.482-4(b) mentioned its definition of intangibles in the context of section 482, which in turn based its definition of intangibles on section 936(h)(3)(B). In 2010 the section 936(h)(3)(B) definition of intangible property required that assets have “substantial value independent of the services of any individual,” in addition to falling under one of the 28 intangible categories. Facebook notes that foreign goodwill, workforce, and going concern value were not mentioned on that list. Furthermore, foreign goodwill, workforce, and going concern value were not platform contributions under the 2009 regs because they could not be reasonably anticipated to contribute to the intangibles listed under Treas. reg. section 1.482-4(b) and section 936(h)(3)(B).
Facebook argues the government’s temporary section 367(a) regs on foreign property transfers — which were in place in 2010 — served as an indication that foreign goodwill and going concern value were not platform contributions. These section 367 regs defined foreign goodwill and going concern value as the residual value of a business operation.
“Such a residual value cannot reasonably be anticipated to contribute to developing future intangibles such as copyrighted software, under a cost-sharing arrangement,” Facebook said. “Congress intended, and Treasury, and Respondent have long acknowledged, that as of 2010, FGGCV [foreign goodwill going concern value] was separate and distinct from so-called platform intangibles. Congress intended that gain or income would not be recognized on an outbound transfer of FGGCV used in an active trade or business,” Facebook said.
The IRS pretrial memo doesn’t spend a lot of time on the issue; it appears from its filing that the agency believes the issue is clear cut, based on the language in the preamble of the 2009 regs. Its memo doesn’t even get to a discussion of section 367:
In promulgating Treas. reg. section 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).”
The agency focused more attention on the risks it believes are generated when Facebook’s assets are transferred separately. The IRS argues that separating trade and service marks from their associated goodwill could invalidate the trademarks, and that transferring technology rights without related trademarks would block the company from marketing products under its brand:
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. 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. 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.
For the Tax Court in both Amazon and Veritas, its decision was fairly straightforward, based on the governing regs at the time. According to the Veritas court, the cost-sharing regs at the time did not provide an “explicit authorization” to include goodwill, workforce, and going concern value in a valuation, and as such, “taxpayers [were] merely required to be compliant, not prescient.”
Similarly in Amazon, the Tax Court found that workforce in place, going concern value, and goodwill were among many business items that did not qualify as intangibles under the regs because they could not be bought and sold independently like the intangibles enumerated under section 936(h)(3)(B) and reg. section 1.482-4(b). In the court’s eyes, goodwill, going concern value, and workforce were rather an “inseparable component” of residual business value and generally lacked “substantial value independent of the services of any individual.”
The question in Facebook’s case is whether the 2009 preamble language will establish that the items the IRS looks to include in the company’s valuation are platform contributions. In the years since, the government has made the “intangibles” definition even clearer under the TCJA, which updated sections 936(h)(3)(B) and 367(d)(4) to include “any goodwill, going concern value, or workforce in place (including its composition and terms and conditions (contractual or otherwise)) of its employment.”
But the operative 2009 temporary regs do not have such clear language. Although the IRS says the definition stretches beyond section 936(h)(3)(B) and provides examples of how that could work, it still links the definition back to reg. section 1.482-4(b), which, at the time, did not explicitly list the items that Facebook says are at question. According to the regs, a cost-shared intangible “means any intangible, within the meaning of section 1.482-4(b), that is developed by the IDA [intangible development activity], including any portion of such intangible that reflects a platform contribution.”
The language goes on to state that “therefore, an intangible developed by the IDA is a cost shared intangible even though the intangible was not always or was never a reasonably anticipated cost shared intangible.”
As for what it means for an intangible to be developed via an IDA, that language is open- ended as well. The 2009 regs say it encompasses all activities from controlled participants that “could reasonably be anticipated to contribute to developing the reasonably anticipated cost shared intangibles.” But that definition circles back to one of the key issues at hand: What does it mean to be a reasonably anticipated intangible — which the regs define as any intangible within the meaning of reg. section 1.482-4(b) that the participants planned to develop under the cost-sharing agreement — considering that the 2009 regs say intangibles are not limited to section 936(h)(3)(B)?