The Ninth Circuit’s rejection of the IRS’s valuation method in Amazon under old law may not affect new cost-sharing disputes, but its observation on later revisions raises other questions regarding the transfer pricing regulations.
Barring a successful petition for rehearing en banc or certiorari petition, the Ninth Circuit Court of Appeals’ August 16 decision in Amazon v. Commissioner, No. 17-72922, dealt a potentially fatal blow to the government’s campaign to persuade courts that a discounted cash flow (DCF) valuation may be the best method to value the buy-in under the 1995 cost-sharing regulations. Beginning with Veritas v. Commissioner, 133 T.C. 297 (2009), and again in Amazon v. Commissioner, 148 T.C. No. 8 (2017), the Tax Court has held that the buy-in need account only for the value of preexisting intangibles covered by the definition contained in reg. section 1.482-4(b). Until their amendment in January 2009, the cost-sharing regulations cross-referenced reg. section 1.482-4(b) — an almost verbatim reproduction of former IRC section 936(h)(3)(B) — for purposes of the buy-in requirement for intangibles contributed to a cost-sharing arrangement (CSA).
The Ninth Circuit similarly held in Amazon that the best interpretation of the ambiguous definition in reg. section 1.482-4(b) — which includes a list of traditional intellectual property items and the catchall “other similar items” — covers only individually transferable assets and not goodwill, going concern value, or other “residual business assets.” Affirming the Tax Court, the Ninth Circuit panel held that the IRS’s DCF valuation cannot be the best method because it aggregates the value of reg. section 1.482-4(b) intangibles with the value of residual business assets.
Although the Ninth Circuit explicitly refrained from condemning any valuation method outright, DCF valuations are ill-suited to make the kind of distinctions that the Amazon decision requires. A business’s cash flows do not come pre-assigned to categories created by tax law and there is no obvious way to subtract the value of assets that, by definition, cannot be directly valued. However, Judge Consuelo Callahan’s opinion also says in the first footnote that the government would have won if either the 2009 cost-sharing regulations or the 2017 Tax Cuts and Jobs Act had been in effect.
“This case is governed by regulations promulgated in 1994 and 1995. In 2009, more than three years after the tax years at issue here, 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,” the opinion says. “If this case were governed by the 2009 regulations or by the 2017 statutory amendment, there is no doubt the commissioner's position would be correct.”
End of an Era
Ultimately, the government could not overcome statements made over 25 years ago regarding the scope of intangible property under reg. section 1.482-4(b).
The 1993 temporary regulations defined intangible property as “any commercially transferable interest in any item included in the following six classes of intangibles, that has substantial value independent of the services of any individual.” In the preamble to its contemporaneous proposed regulations, Treasury requested comments on whether the definition “should be expanded to include items not normally considered to be items of intellectual property, such as workforce in place, goodwill, or going concern value.”
According to the Ninth Circuit panel, Treasury confirmed that residual business assets were excluded from the definition when it addressed the issue in the 1994 final regulations. The preamble to the final regulations explains that the definition of intangible property is essentially similar to the definition under the 1968 regulations and that the changes to the 1993 temporary regulations’ definition were intended as clarifications.
“It differs from the 1993 regulations in that the requirement that the property be ‘commercially transferable’ has been deleted. This language was not included in the definition because it was superfluous: if the property was not commercially transferable, then it could not have been transferred in a controlled transaction,” the preamble to the 1994 regulations says. “In addition, the reference to ‘other similar items’ under [reg.] section 1.482-4(b)(6) has been clarified to refer to items that derive their value from intellectual content or other intangible properties rather than physical attributes.”
The opinion does not directly assess the government’s argument, made in its brief for the appellant, that “if [reg. section] 1.482-4(b) were never promulgated, or was withdrawn tomorrow, that would not — and could not — imply that controlled taxpayers could transfer valuable assets ‘for free,’ whether defined as intangibles or otherwise.” However, it rejects as circular the government’s argument that everything of value must be accounted for under the arm's-length standard, noting that the arm's-length standard is relevant only for determining how, and not what, to value.
No Doubt?
The good news for the government came in the opinion’s first footnote, which strongly suggests that the IRS need not wait until the 2018 tax year to enforce the interpretation rejected in Amazon.
Well before the TCJA’s amendments to section 482, which now explicitly authorizes aggregation and the use of realistic alternatives to value intangible transfers, Treasury and the IRS tried to address the issue by revising the cost-sharing regulations. Unlike in Altera Corp. v. Commissioner, Nos. 16-70496, 16-70497, which also concerns the cost-sharing regulations, the Ninth Circuit framed Amazon as the choice between competing interpretations of an ambiguous regulation.
The 2009 temporary cost-sharing regulations replace references to “intangibles” or “intangible property” with the broader term “platform contribution,” which is defined as “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 CSA) that is reasonably anticipated to contribute to developing cost-shared intangibles.” They also change the term for the required payment from “buy-in” to “platform contribution transaction” (PCT) and list a set of specified methods for calculating the PCT that includes the income method, which resembles the DCF method the IRS tried to apply in Amazon.
The preamble to the temporary regulations confirms that the term “platform contribution” is meant to be more expansive than the definition of the term “intangible property” and that an aggregated valuation approach applies by default.
“The temporary regulations, like the 2005 proposed regulations, do not limit platform contributions that must be compensated in PCTs to the transfer of intangibles defined in section 936(h)(3)(B). For example, to the extent a controlled participant (the PCT payee) contributes the services of its research team for purposes of developing cost-shared intangibles pursuant to the CSA, the other controlled participant (the PCT payor) would owe compensation for the services of such team under temp. Treas. reg. section 1.482-9T, just as would be the case in a contract research arrangement,” the preamble to the 2009 temporary cost-sharing regulations says. “Where 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.”
The Amazon opinion footnote is a strong indication that the Ninth Circuit believes the 2009 cost-sharing regulations successfully removed the constraints imposed by reg. section 1.482-4(b), according to Barbara Mantegani of Mantegani Tax PLLC.
The footnote “is as clear a signal as the Ninth Circuit could make that the Amazon argument will not work going forward, that Congress fixed what some might call a loophole — I would not, I would call it an ambiguity — and that taxpayers will not be able to rely on the holding in Amazon for any set of facts that arose after 2009,” Mantegani told Tax Notes. “To me, the opinion itself is pretty clear, even though the footnote is not, in and of itself, binding authority.”
However, David Rosenbloom of Caplin & Drysdale cautioned against placing too much weight on the Ninth Circuit opinion’s footnote. Unlike the statutory changes made by the TCJA, the 2009 cost-sharing regulations may still be vulnerable to challenge, Rosenbloom told Tax Notes. "I don't think you could assume that the 2009 regulations are beyond attack. All you've got is the statement of dictum, and it's interesting as far as it goes, but it is dictum and it is one circuit," he said.
The 2009 regulations could be subject to procedural challenges along the lines of Altera, especially if the Ninth Circuit agrees to rehear the case en banc, according to Rosenbloom.
“Depending on how Altera goes, someone could come in and say the 2009 regulations were adopted inconsistently with the Administrative Procedure Act," Rosenbloom said. “The [act] is a real wild card here. I don't know that anybody's arguing that the 2009 regs were done without adherence to the [act], but those regs were obviously put out before Altera came down and therefore I'd be surprised if the procedures met the original standards discussed by the Tax Court.”
According to Mantegani, however, the message is clear whether it constitutes dicta or not.
“I will grant you that that footnote meets the technical legal definition that we all learned the first year of law school of dicta, because it isn't necessary to the holding of the case. Nevertheless, it’s a flashing red light,” Mantegani said. “They couldn't have said any more clearly that the IRS and Congress have spoken.”
Unanswered Questions
Because the particular transaction at issue in Amazon was a CSA, the Ninth Circuit did not address the consequences, if any, of its holding for intangibles transferred outside a CSA. All controlled intangible transfers that do not qualify as a CSA are generally subject to reg. section 1.482-4, including arrangements that meet every requirement of a CSA other than the administrative requirements of reg. section 1.482-7(k). And, unlike the cost-sharing regulations, reg. section 1.482-4 was never revised to cover a broader range of assets or to include specified methods — including the income method and acquisition price method — that capture residual business asset value by default.
Transactions subject to reg. section 1.482-4 can also involve residual business asset value, and nothing in the Amazon opinion clearly indicates that any restrictions imposed by reg. section 1.482-4(b) can be relevant only for intangible transfers carried out through a CSA. Although qualitative distinctions are often drawn between CSAs and other intangible transfers, including claims that CSAs aren't really “transfers” and that the cost-sharing regime serves as a safe harbor shielding taxpayers from application of reg. section 1.482-4, the significance of these distinctions — which has been questioned by IRS officials and downplayed by the OECD in its transfer pricing guidelines — under Amazon is not immediately apparent.
If the holding in Amazon imposes a parallel restriction for residual business asset value transferred under reg. section 1.482-4, and the 2009 cost-sharing regulations lifted the restriction for CSAs only, economically similar arrangements could be treated differently for the nine years in between January 2009 and the effective date of the TCJA amendments. An example of the potential inconsistency could arise if a U.S. start-up with no significant assets other than technology were acquired by a foreign multinational at a price that exceeds the sum of the values of the start-up’s separately identifiable intangibles.
One option would be for the U.S. company to contribute its technology to a CSA, under which the parent would acquire non-U.S. rights to all current and future versions of the technology in exchange for a royalty — calculated by dividing the PCT by discounted projected sales — and cost-sharing payments reimbursing the U.S. company’s ongoing research and development costs as necessary for the parties’ cost contribution shares to equal their reasonably anticipated benefit shares. Under the 2009 cost-sharing regulations, the residual business asset value — the excess of the U.S. company’s acquisition price over the total value of its identifiable intangibles — must be included in the aggregate value of the U.S. entity’s platform contribution and fully accounted for in the parent’s PCT payment.
The parties could create an economically similar arrangement if the U.S. company instead transferred non-U.S. rights to all current and future versions of its technology through a series of perpetual licenses and, under a separate cost-plus services agreement, allocated a share of ongoing R&D costs to the parent on the basis of sales by territory. Although the two arrangements could be made alike in almost every respect other than what may be a single-digit percentage markup on U.S. R&D services, the parties could argue under Amazon that the license option allows the U.S. company to charge royalties only for the separately identifiable intangibles and price each license on a stand-alone basis.
The regulations do include provisions that at least partially address inconsistencies between the rules for CSAs and other intangible transfers, including a coordination rule in reg. section 1.482-4 recognizing that a specified method for valuing a platform contribution under reg. section 1.482-7(g) may be an appropriate “unspecified method” for other intangible transfers under reg. section 1.482-4(d). Reg. section 1.482-4(g), which applies to “an arrangement for sharing the costs and risks of developing intangibles other than a cost-sharing arrangement covered by [reg. section] 1.482-7,” provides that the “principles, methods, comparability, and reliability considerations set forth in [reg. section] 1.482-7 [are] relevant in determining the best method, including an unspecified method, under this section, as appropriately adjusted in light of the differences in the facts and circumstances between such arrangement and a cost-sharing arrangement.”
However, it is unclear whether a general coordinating rule is enough to allow the IRS to apply concepts and methods in reg. section 1.482-7 to a transaction subject to reg. section 1.482-4 when doing so would nullify a definition that the Ninth Circuit has interpreted, at least in the cost-sharing context, to be a hard boundary on the type of assets that require compensation.
The Amazon decision also raises the question of whether a regulatory definition could be given a meaning that differs from the statutory definition it essentially duplicates. The main differences between reg. section 1.482-4(b) and former section 936(h)(3)(B) are that the regulation includes the phrase “substantial value independent of the services of any individual” in the sentence preceding the entire list instead of as a description specific to “similar items” and explains that an item is similar “if it derives its value not from its physical attributes but from its intellectual content or other intangible properties.”
That the two definitions should match is logical considering that one of reg. section 1.482-4’s purposes is to enforce section 482’s commensurate with income requirement, which applies to transfers of intangible property “within the meaning of section 936(h)(3)(B)” until the cross-reference was updated in 2018. The second sentence of section 482 requires that the income in a controlled intangible transfer be commensurate with the income attributable to the intangible, a 1986 statutory mandate rendered partially inert by the IRS’s inability to actually value intangibles using income-based methods.
Although the definitions in reg. section 1.482-4(b) and section 936(h)(3)(B) before its amendment and relocation to section 367(d)(4) are nearly identical, the basis for the Ninth Circuit’s decision — that Treasury contradicted itself — does not apply to a statute enacted by Congress. If the same ambiguity that exists under both definitions were resolved differently for purposes of section 936(h)(3)(B), an item could theoretically fall within the scope of the statutory commensurate with income requirement but outside the scope of the regulation intended to enforce it.
Even after the Amazon opinion’s apparent confirmation that the 2009 cost-sharing regulations and post-TCJA statute are sufficient to support its intangible valuation approach, it remains to be seen whether the IRS will actually win cases under the revised law, according to Reuven Avi-Yonah of the University of Michigan Law School. Expanding the types of intangible assets covered may not prevent courts from allowing taxpayers to undervalue transfers of interrelated intangibles, for which the aggregate value exceeds the sum of the individual assets’ values, on an asset-by-asset basis, Avi-Yonah said.
“My worry is that even the new regs and the 2017 legislative change still rely on identifying discrete assets, even if the type of assets identified is a broader category. Thus I’m not sure that the government will win on trying to value everything that is transferred, e.g., growth options or corporate culture, that is not a distinct asset,” Avi-Yonah said. “I would have preferred a reg or law that says that when a business is transferred, the arm's-length value of the business as a whole minus tangibles (presumably determined by a discounted cash flow valuation) is subject to the buy-in rather than an expanded list of discrete intangibles.”