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Directory Assistance Provider Petitions Tax Court in Transfer Pricing Dispute

FEB. 25, 2013

kgb and Subsidiaries v. Commissioner

DATED FEB. 25, 2013
DOCUMENT ATTRIBUTES
  • Case Name
    KGB AND SUBSIDIARIES, F.K.A. INFONXX INC. AND SUBSIDIARIES Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
  • Court
    United States Tax Court
  • Authors
    Magee, John B.
    Stark, Sanford W.
    Mezei, Saul
  • Institutional Authors
    Bingham McCutchen LLP
    kgb
  • Cross-Reference
    Related coverage 2013 TNT 46-9: News Stories.
  • Code Sections
  • Subject Area/Tax Topics
  • Industry Groups
    Communications
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2013-5408
  • Tax Analysts Electronic Citation
    2013 TNT 46-18

kgb and Subsidiaries v. Commissioner

[Editor's Note: For the complete text of this document, including attached exhibits, see Doc 2013-5408 .]

 

UNITED STATES TAX COURT

 

Washington, D.C. 20217

 

 

PETITION

 

 

kgb and Subsidiaries, formerly known as InfoNXX, Inc. and Subsidiaries ("Petitioner") hereby petitions for redetermination of the federal income tax deficiencies for the 2004, 2005, and 2007 tax years set forth by the Commissioner of Internal Revenue in a notice of deficiency dated November 28, 2012.1 As the basis for this proceeding, Petitioner alleges as follows:

1. Taxpayer Identification. kgb is a privately held corporation incorporated in the State of Delaware with its principal office at 3864 Courtney Street, Suite 411, Bethlehem, PA 18017. Founded in 1992, kgb is the world's largest independent provider of outsourced directory assistance ("DA") and enhanced directory assistance ("EDA") services, among other businesses. kgb is the parent of a global group of companies engaged in such business and the common parent of Petitioner, a domestic group of corporations that joined in the timely filing of consolidated corporate income tax returns (Forms 1120) for the 2004, 2005, and 2007 tax years. Those returns were filed with the Internal Revenue Service Center at Ogden, Utah. kgb's taxpayer identification number is as stated in the Statement of Taxpayer Identification Number filed together with this Petition. kgb changed its name from InfoNXX, Inc. to kgb on April 29, 2008.

a. kgb US. kgb, the other members of its consolidated group, and a limited partnership owned by kgb and another member of its consolidated group together conducted the U.S. portion of kgb's global business during the years at issue. As used herein, the term "kgb US" refers to both kgb's consolidated group (i.e., Petitioner) and the non-corporate legal entities owned by members thereof.

b. InfoNXX Operating Company, Inc. During the years at issue, InfoNXX Operating Company, Inc. ("Info US Operating") was a corporation organized under the laws of Delaware and a member of kgb's consolidated group. Info US Operating was renamed kgb USA, Inc. in 2008.

c. InfoNXX Capital Management, Inc. During the years at issue, InfoNXX Capital Management, Inc. ("InfoNXX Capital Management") was a corporation organized under the laws of Delaware and a member of kgb's consolidated group. InfoNXX Capital Management was renamed kgb Capital Management, Inc. in 2008.

d. InfoNXX Texas, LP. During the years at issue, InfoNXX Texas, LP was a Texas limited partnership owned entirely by kgb (1%) and InfoNXX Capital Management (99%. InfoNXX Texas, LP was renamed kgb Lonestar, LP in 2008.

e. Grape Technology Group, Inc. During the years at issue, Grape Technology Group, Inc. ("Grape") was a corporation organized under the laws of Delaware and a member of kgb's consolidated group. Grape's primary function was to hold intellectual property.

f. InfoNXX Philippines, Inc. During the years at issue, InfoNXX Philippines, Inc. ("IPI") was a company organized under the laws of the Philippines and a direct subsidiary of InfoNXX Capital Management. IPI's DA and EDA activities conducted at its call centers in the Philippines give rise to the contested tax deficiencies that are the subject of this proceeding. IPI was renamed kgb Philippines, Inc. in 2008.

g. The Number UK Limited and 118 Limited. During the years at issue, The Number UK Limited ("TNUK") and 118 Limited were companies organized under the laws of the United Kingdom ("U.K.") and subsidiaries of InfoNXX Capital Management. As used herein, the term "INFO UK" refers to the combined operations of TNUK and 118 Limited.

2. Notice of Deficiency.

a. On or about November 28, 2012, the notice of deficiency and its accompanying statements and schedules (collectively, the "Notice"), attached hereto as Exhibit A, was sent by certified mail to Petitioner by Respondent through the Internal Revenue Service Appeals Office at 290 Broadway, 11th Floor, New York, New York 10007. The Notice reflects federal income tax deficiency determinations for Petitioner's 2004, 2005, and 2007 tax years. The Notice identifies February 26, 2013, as the last day on which to file a petition with this Court contesting the deficiencies in the Notice.

b. The Notice also reflects increases to Petitioner's taxable income in the 2006 and 2008 tax years due to Respondent's reduction of Petitioner's net operating losses ("NOLs") for those years. Respondent has not determined deficiencies for those years because there is no tax due even after Respondent's reductions of Petitioner's NOLs.

3. Amounts in Dispute. The federal income tax deficiencies determined by Respondent in the Notice are as follows:

   Tax Year Ended                                     Tax Deficiency

 

 _____________________________________________________________________

 

 

 December 31,  2004                                       $427,465

 

 December 31,  2005                                     $4,350,636

 

 December 31,  2007                                       $166,587

 

 

a. Petitioner disputes the tax deficiencies in their entirety because they are premised on adjustments under section 482 of the Internal Revenue Code of 1986, as amended (the "Code") that are arbitrary and capricious or unreasonable and constitute an abuse of Respondent's discretion. As used herein, the term "transfer pricing adjustments" refers to Respondent's income adjustments under Code section 482.

b. Petitioner also disputes Respondent's transfer pricing adjustments with respect to Petitioner's 2006 and 2008 tax years. Although Respondent did not determine deficiencies for those tax years, Code section 6214(b) authorizes the Court to consider the transfer pricing adjustments in those years because they bear directly on Petitioner's tax liabilities, if any, for the years before the Court.

c. In addition, Petitioner affirmatively claims the setoff adjustments set forth in Paragraph 4.d., below, in amounts to be determined and any other allowable setoff adjustments.

4. Assignments of Error. Respondent's determinations set forth in the Notice are based upon the following errors.

a. Respondent's transfer pricing adjustments (and the tax deficiencies resulting from them) are arbitrary, capricious, or unreasonable and constitute an abuse of Respondent's discretion, as they are inconsistent with Code section 482 and the regulations promulgated thereunder.

b. Through his transfer pricing adjustments, Respondent erroneously reduced the payments that kgb US made to IPI for the functions and activities performed and risks assumed by IPI, thereby increasing Petitioner's taxable income.

c. The Notice provides no economic basis for, or explanation of, the transfer pricing adjustments.

d. Respondent erred in refusing to allow setoff adjustments under Treasury Regulation section 1.482-1(g)(4)(i) against Respondent's proposed transfer pricing adjustments for Petitioner's 2004, 2005, 2006, 2007, and 2008 years, with respect to the prices paid by kgb US to IPI for calls that originated in the U.K. and were routed through the U.S. to IPI-owned call centers in the Philippines.

e. Respondent's various secondary computational adjustments to Petitioner's charitable contributions, NOL carryforwards and carrybacks, alternative minimum tax, general business credits, and minimum tax credits are erroneous because they result directly from Respondent's arbitrary, capricious, or unreasonable primary adjustments.

f. The 2006 transfer pricing adjustment reflected in the Notice is inexplicably $70,000 greater than the 2006 transfer pricing adjustment reflected in the revenue agent's report for that year, which has the effect of erroneously further reducing Petitioner's 2006 NOL.

5. Supporting Facts. The facts upon which Petitioner bases its case are as follows.

 

Introduction

 

a. kgb is a calendar year taxpayer that timely filed consolidated federal corporate income tax returns for each of the tax years at issue.

b. During the tax years at issue, kgb operated a business through which it provided DA services (i.e., business, government, and residential telephone listings) and EDA services (e.g., movie listings, driving directions, weather forecasts, and sports scores) to individual end users, the telecommunications industry, and major corporations.

c. kgb's largest customers were unrelated telecommunications service providers, including Sprint, Comcast, U.S. Cellular, and Cox Communications (each individually a "Carrier", and collectively "Carriers").

d. kgb entered into contracts with each Carrier pursuant to which it provided DA and EDA services to the Carrier's customers (i.e., individual end users) in the U.S.

e. The Carriers billed their customers for use of the DA and EDA services. The customers paid the Carriers, and the Carriers, in turn, paid kgb on a price-per-call basis.

f. The provision of DA and EDA services is essentially a commodity business in which competitive pricing and service quality drive volume and profits.

g. Carriers based their decisions to outsource DA and EDA services on the price and quality of the services provided.

 

kgb US and IPI

 

h. kgb discharged its obligations under the Carrier contracts by providing DA and EDA services to Carrier customers either by an automated system or by live customer service representatives ("CSRs") working in call centers in the U.S. and the Philippines.

i. kgb US owned and operated kgb's U.S. call centers. IPI owned and operated kgb's Philippine call centers.

j. kgb's U.S. call centers provided requested DA and EDA services on a portion of the U.S.-originated calls routed to kgb. IPI provided requested DA and EDA services on the remainder of the U.S.-originated calls routed to kgb as well as on all calls originating in the U.K. and not serviced there.

k. IPI opened its first call center in Makati City, Philippines, one of the 16 cities that constitute metropolitan Manila, on or about August 24, 2001.

l. IPI was an early mover in the Philippine call center industry, and its Makati City call center was among the first major call centers in the Philippines to provide DA and EDA services to end users in the U.S. and the U.K.

m. IPI benefited from cost savings relative to the U.S., due to lower operational and labor costs in the Philippines

n. IPI's business expanded over time. It opened its second call center in Santa Rosa, Philippines, in December 2005.

o. IPI grew substantially between 2004 and 2008, as reflected in the following table:

                                     U.S.-               U.K.-

 

                Number of IPI        Originated          Originated

 

 Tax Year       Employees            Calls               Calls

 

 _____________________________________________________________________

 

 

   2002                690           24.3 million        0

 

   2003              1,958           72 million         12.5 million

 

   2004              1,668          152 million         42 million

 

   2005              2,508          160 million         49.7 million

 

   2006              2,655          283.6 million       62.7 million

 

   2007              2,801          237 million         74 million

 

   2008              3,829          247.4 million       76.5 million

 

   2009              3,052          207.1 million       87.7 million

 

   2010              2,424          173.7 million       83.5 million

 

   2011              1,932          148.6 million       57.5 million

 

 

p. The cost savings provided by IPI gradually eroded as the Philippine call center industry grew increasingly competitive and Carriers negotiated for lower DA and EDA rates.

 

IPI's CSRs and EDAS

 

q. IPI required that its CSRs possess college degrees.

r. IPI provided its CSRs with training designed and conducted by IPI employees in the Philippines.

s. CSRs used enhanced directory assistance software ("EDAS") to search for information requested by end users.

 

i. EDAS data comprised phone listings and other information purchased from Carriers and supplemented with information purchased from third-party data providers such as Dun and Bradstreet and The Thomson Corporation (now Thomson Reuters).

ii. kgb US initially developed EDAS in 2000 using an off-the-shelf software database product.

 

t. Prior to April 2007, kgb US was responsible for developing and maintaining EDAS. IPI thereafter assumed full responsibility for developing and maintaining EDAS.

 

The Network Operations Center

 

u. In addition to its DA and EDA activities, during the years at issue IPI was solely responsible for operating and maintaining kgb's global network operations center ("NOC").

v. The NOC, located in IPI's Makati City facility, monitors the global system that routes calls to the appropriate call center.

w. The NOC is essential to kgb's global business because it ensures that kgb's network is functioning properly.

x. The NOC's critical importance is reflected by the fact that Carriers contracting with kgb generally sent representatives to the Philippines to meet with IPI personnel and view the NOC in operation.

 

kgb US-IPI Agreement

 

y. The original agreement between kgb US and IPI, under which IPI provided DA and EDA services to kgb US, was effective February 1, 2002.

z. kgb US purchased the call center services from IPI during the years at issue under a services agreement effective January 1, 2003 ("IPI Services Agreement") that superseded and replaced the February 2002 agreement.

aa. Grape, which owned intellectual property relating to EDAS, was made a party to the IPI Services Agreement effective June 30, 2003.

bb. The terms of the IPI Services Agreement are intended to mirror the terms of the Carrier contracts to pass through the responsibilities of kgb reflected in those contracts.

cc. Consistent with the terms of the IPI Services Agreement, IPI bore the financial risk of its call centers.

 

i. The IPI Services Agreement subjected IPI to the same performance standards and penalty provisions contained in the Carrier contracts.

ii. kgb US did not guarantee IPI any minimum call volume.

iii. IPI was solely responsible for adequately staffing its call centers with CSRs, and bore the financial consequences of understaffing or overstaffing its call centers.

iv. IPI paid its CSRs on an hourly basis regardless of the number of calls they handled or their success rates.

v. IPI bore the cost of training its CSRs.

vi. IPI bore foreign currency risk because kgb US paid IPI in U.S. dollars and IPI paid its expenses in Philippine Pesos.

Petitioner's Transfer Pricing

 

dd. For tax years 2004, 2005, and 2006, Petitioner applied the comparable uncontrolled price ("CUP") method set forth in Treasury Regulation section 1.482-3(b), primarily using the Carrier contracts as CUPs, to determine whether the prices per call paid by kgb US to IPI were of an arm's length nature.

ee. For tax years 2007 and 2008, Petitioner applied the comparable uncontrolled services price ("CUSP") method set forth in Treasury Regulation section 1.482-9T(c), primarily using the Carrier contracts as CUSPs, to determine whether the prices per call paid by kgb US to IPI were of an arm's length nature.

ff. For all of the years at issue, Petitioner made appropriate adjustments to the prices per call paid by kgb US to IPI to account for differences between the CUPs/CUSPs transactions and the transactions between kgb US and IPI.

gg. Petitioner's application of the CUP and CUSP methods as adjusted resulted in the payment of arm's length compensation to IPI for IPI's functions, activities, and risks associated with its provision of DA and EDA services to kgb US.

hh. The CUP and CUSP methods as adjusted were the best methods by which to price IPI's provision of call center services to kgb US.

ii. Over time, the significant cost savings attributable to operating call centers in the Philippines have been bargained away by Carriers. Consistent with the increasing competition and resulting lower Carrier prices for Philippine DA and EDA services, kgb US paid decreasing amounts to IPI for its provision of DA and EDA services.

      YEAR                  PRICE-PER-CALL PAID BY KGB US TO IPI

 

 _____________________________________________________________________

 

 

      2004                                    $0.23

 

      2005                                    $0.23

 

      2006                                    $0.18

 

      2007                                    $0.16

 

      2008                                    $0.14

 

 

jj. The amounts above include an offsetting $0.01 per-call charge paid by IPI to kgb US for access to EDAS.

kk. The offsetting $0.01 per-call EDAS charge remained in place even after IPI assumed sole responsibility for developing and maintaining EDAS in April 2007.

ll. In every year from 2004 to 2008, kgb US earned higher gross margins on calls handled by IPI than it did on calls handled by its own call centers in the U.S.

 

Respondent's Notice Position

 

mm. The Notice does not specify which transactions between kgb US and IPI are the subject of Respondent's transfer pricing adjustments.

nn. The Notice does not explain the methodology used by Respondent to determine the transfer pricing adjustments.

oo. The adjustments in Respondent's Notice are similar to those determined by Respondent's examination teams through application of the comparable profits method ("CPM") set forth in Treasury Regulation section 1.482-5 during their audits of Petitioner. The transfer pricing adjustments set forth in the Notice therefore appear to be premised upon Respondent's application of the CPM.

pp. Respondent's CPM is not the best method and produces results that are arbitrary, capricious and unreasonable.

 

Setoff Issue

 

qq. The U.K. was a deregulated market with respect to DA and EDA services. In contrast to the U.S., in which Carriers control DA/EDA access, consumers in the U.K. had the option of obtaining DA/EDA services through Carriers or directly from independent service providers.

rr. INFO UK was an independent provider of DA/EDA services in the U.K. during the years at issue, dealing directly with consumers.

ss. U.K. callers who dialed 118-118, INFO UK's DA number, were routed to kgb call centers, including IPI's call centers in the Philippines.

tt. All U.K.-originated calls initially routed to kgb US were further routed through kgb US to IPI. Such calls were not routed directly from the U.K. to the Philippines because routing such calls through the U.S. resulted in fewer switches (and lower costs) than routing calls directly from the U.K. to the Philippines.

uu. kgb US allowed U.K.-originated calls to be routed to IPI through kgb US's circuits, but provided no value-added functions or activities and bore no risk with respect to U.K.-originated calls serviced by IPI.

vv. INFO UK paid kgb US $0.29 per call for all U.K.-originated calls routed through the U.S. and serviced by IPI.

ww. kgb US paid IPI the same prices per call on U.S.-originated and U.K.-originated calls, resulting in the retention of increasing amounts per-call by kgb US as follows:

                             PRICE-PER-CALL

 

                             FROM KGB US TO

 

          PRICE-PER-CALL     IPI ON U.K.-       AMOUNT PER CALL

 

          FROM INFO UK       ORIGINATED         RETAINED BY KGB US ON

 

 YEAR     TO KGB US          CALLS              U.K.-ORIGINATED CALLS

 

 _____________________________________________________________________

 

 

 2004          $0.29              $0.23                  $0.06

 

 2005          $0.29              $0.23                  $0.06

 

 2006          $0.29              $0.18                  $0.11

 

 2007          $0.29              $0.16                  $0.13

 

 2008          $0.29              $0.14                  $0.15

 

 

xx. The prices paid by kgb US to IPI under the IPI Services Agreement should be increased for U.K.-originated calls in amounts to be determined to reflect arm's length pricing for kgb US's limited functions, activities, and risks with respect to U.K.-originated calls serviced by IPI.

6. WHEREFORE, Petitioner prays that this Court determine that:

a. Respondent erred as alleged in each assignment of error set forth in paragraph 4 and supported by the facts set forth in paragraph 5;

b. There is no deficiency in federal income tax for Petitioner's 2004, 2005, or 2007 tax years;

c. Respondent erroneously reduced Petitioner's NOLs in the 2006 and 2008 tax years;

d. Petitioner is entitled to the affirmative adjustments referenced in Paragraph 4.d, above, and to any other setoff adjustments allowable by law; and

e. Petitioner is entitled to such other relief as the Court may deem appropriate.

Respectfully submitted,

 

 

John B. Magee

 

(Tax Court Bar No. MJ0060)

 

 

Sanford W. Stark

 

(Tax Court Bar No. SS0902)

 

 

Saul Mezei

 

(Tax Court Bar No. MS0625)

 

 

Bingham McCutchen LLP

 

2020 K Street, N.W.

 

Washington, D.C. 20006

 

Telephone No. (202) 373-6229

 

 

Counsel for Petitioner

 

Dated: February 25, 2013

 

FOOTNOTE

 

 

1 The notice of deficiency identifies Petitioner as "kgb Inc. and Subsidiaries." Petitioner's official name does not include an "Inc."

 

END OF FOOTNOTE
DOCUMENT ATTRIBUTES
  • Case Name
    KGB AND SUBSIDIARIES, F.K.A. INFONXX INC. AND SUBSIDIARIES Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent
  • Court
    United States Tax Court
  • Authors
    Magee, John B.
    Stark, Sanford W.
    Mezei, Saul
  • Institutional Authors
    Bingham McCutchen LLP
    kgb
  • Cross-Reference
    Related coverage 2013 TNT 46-9: News Stories.
  • Code Sections
  • Subject Area/Tax Topics
  • Industry Groups
    Communications
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 2013-5408
  • Tax Analysts Electronic Citation
    2013 TNT 46-18
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