Game Developer Argues IRS Erred in Determining $14 Million Tax Debt

HARMONIX MUSIC SYSTEMS, INC.,
Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent.

UNITED STATES TAX COURT

PETITION

Petitioner Harmonix Music Systems, Inc. (“Harmonix” or “Petitioner”) hereby petitions for a redetermination of the tax liability set forth by the Commissioner of Internal Revenue (the “Commissioner”) in the Notice of Deficiency (“Notice” or “Notice of Deficiency”), dated March 17, 2020. As the basis for its petition, Harmonix alleges as follows:

1. Petitioner Information. Petitioner is a Delaware corporation with its principal office in Boston, Massachusetts. Petitioner's mailing address is Harmonix Music Systems, Inc., 40 Broad Street, 7th floor, Boston, Massachusetts, 02109.

2. Notice of Deficiency. The Notice of Deficiency (attached hereto as Exhibit 1) was mailed to Petitioner on March 17, 2020, and was issued by the Internal Revenue Service Appeals Office in Boston, Massachusetts.

3. Amount in Dispute. Petitioner filed a U.S. Corporation Income Tax Return for the year ending December 31, 2010 (the “2010 Return”) and for the year ending December 31, 2011 (the “2011 Return”) electronically. The Notice of Deficiency purports to increase the tax shown on the 2010 Return by $6,483,437, and the tax shown on the 2011 Return by $7,547,642, resulting in a total amount in dispute of $14,031,079, before interest. No penalties are being sought.

4. Assignments of Error. The Notice asserts the following errors:

a. that Respondent erred by determining that $17,250,000 in purported “Other Income” is “not excludible from income as contributions to Taxpayer's capital” (Ex. 1 at 6);

b. that Respondent erred in determining that Petitioner “is required to use the amount realized of $59.99 on the sale of [Harmonix's] stock in the computation of its 'aggregate inside loss'” — instead of the fair market value of the company ($23,343,250) that Harmonix did use — “for purposes of determining [Harmonix's] attribute reduction amount under [Treasury Regulation Section] 1.1502-36(d), resulting in an adjustment to income of $24,024,470” (id. at 7);

c. that Respondent erred in applying Treasury Regulation Section 1.1502-36(d) in a manner that disregarded the substance of the transaction and that is inconsistent with the regulation's express purpose; and

d. that Respondent erred in determining that the 2011 Return “included an [adjusted current earnings] adjustment in error” (id. at 8).

5. Factual Allegations. Petitioner relies, as the basis of its Petition, the following facts:

Viacom Acquires Harmonix from Its Founders in 2006.

a. Harmonix, a developer of music-based video games, was founded in 1995 by Alex Rigopulos and Eran Egozy, two game designers who met while studying at the Massachusetts Institute of Technology.

b. FreQuency, Harmonix's first widely distributed video game, was released in 2001, and it was followed by a sequel, Amplitude, released in 2003.

c. Harmonix began to achieve commercial success with its release of three volumes of Karaoke Revolution in 2003 and 2004, and two volumes of Guitar Hero in 2005 and 2006.

d. In September 2006, the media conglomerate Viacom International Inc. (“Viacom”) purchased all of the outstanding common stock of Harmonix for $175 million, plus additional payments based on future earnings, which ultimately included a $150 million payment in 2008 and an additional $363 million payment following litigation.

e. Despite the release of the Rock Band franchise beginning in November 2007, sales of music-themed video games began to fall across the industry by 2008 as they were surpassed in popularity by other video games genres (including simulated war and other internet enabled multiplayer games).

f. Viacom ultimately lost a substantial amount of money on its investment in Harmonix.

g. Viacom's regulatory filings show that Harmonix had a net loss of $24 million on $678 million in revenue in 2008, accelerating those losses in 2009 to a net loss of $87 million, with revenues falling to $362 million in 2009.

h. Harmonix's financial failings were severe, resulting in the lay-off of close to 40 employees in 2009.

i. Harmonix continued to incur significant expenses, including the payment of licensing fees, which were no longer offset by revenue from sales of Harmonix product. So dismal was Harmonix's sales that they totaled roughly $120 million in 2010, a substantial decline from $362 million in 2009.

Viacom Seeks to Dispose of Harmonix in 2010.

j. Viacom announced its intention to sell Harmonix on November 11, 2010.

k. In its annual report (Form 10-K) for fiscal year 2010 filed the same day, Viacom classified Harmonix as a “discontinued operation.”

l. While Petitioner is not privy to all of Viacom's motivations, Petitioner understands from Viacom's fiscal year 2011 annual report (Form 10-K, filed Nov. 11, 2011) that by selling or otherwise disposing of Harmonix before the end of 2010, Viacom was able to realize a loss of almost $335 million. Viacom disclosed that it ultimately achieved a tax savings of approximately $115 million through this write-down.

m. Around the time of the announcement that it intended to sell Harmonix, Viacom entered into negotiations with Columbus Nova LLC (“Columbus Nova”), a private equity firm potentially interested in acquiring Harmonix.

n. Viacom and Columbus Nova discussed a purchase price in the range of $20 million to $25 million for Harmonix.

o. But, by mid-November 2010, Columbus Nova ended the negotiations and the contemplated transaction never came to fruition.

p. At that time, it was doubtful whether Harmonix could survive as a going concern without a significant capital infusion.

q. Despite owning valuable intellectual property and other intangible assets, Harmonix's liabilities at the time exceeded the value of those assets by approximately $18.65 million.

Viacom Sells Harmonix to Harmonix Holdings for a Symbolic Amount Equal to the Cost of One Video Game ($59.99).

r. Unable to find another buyer (and still eager to dispose of Harmonix before year-end 2010 to obtain $115 million in tax benefits), Viacom decided to effectively give away Harmonix.

s. Petitioner understands that Viacom was unable to find a party interested in accepting ownership of Harmonix — even for little or no consideration — given that Harmonix's liabilities exceeded its assets by approximately $18.65 million and there were limited prospects for revenue. Upon a disposal of Harmonix, even if Viacom were required to pay the purchaser to take over the assets, Viacom could achieve nearly $100 million of value from the expected tax benefits.

t. Believing that a capital infusion would make Harmonix more attractive to a potential transferee, Petitioner understands that Viacom decided to build up Harmonix's capital in a manner that would give Harmonix thewherewithal to continue as a going concern and generate the possibility of future revenue.

u. Viacom ultimately reached an agreement with Harmonix-SBE Holdings, LLC (“Harmonix Holdings”) — a limited liability company, one member of which was Jason Epstein, then a senior manager at Columbus Nova — that, subject to a capital infusion of $17,250,000, Viacom would sell all of Harmonix's stock to Harmonix Holdings for $59.99, a symbolic value equal to the price of one of Harmonix's Rock Band video games.

v. Petitioner understands that the approximately $115 million in tax savings that Viacom could claim by disposing of Harmonix prior to the end of 2010 motivated Viacom to sell Harmonix at a symbolic price far less than the fair market value of the stock.

w. In connection with the transaction, the parties executed a stock purchase agreement (“SPA”), dated December 21, 2010.

x. Attached as Exhibit B to the SPA was a transition services agreement (“TSA”), detailing the services that Viacom “agreed to provide” to Harmonix after the closing of the transaction and how those services would be paid for.

y. Section 4(a) of the TSA required Harmonix to “reimburse [Viacom] for all costs and expenses incurred in the provision of" 13 broad categories of services that Viacom would provide to Harmonix for specified periods of time, generally ranging from 30 days to six months.

z. The specific services to be provided by Viacom included, among other things:

• “[a]ccounts [playable [processing through InvoiceWorks”;

• “[a]ccounts [r]eceivables [m]anagement”;

• the provision of access to Harmonix's general ledger as maintained in a system under the control of Viacom;

• the “[p]rocessing of payroll" through the period ending January 25, 2011;

• continued music licensing support provided by a department under the control of Viacom;

• the administration of certain “existing consumer product licensing arrangements”;

• computer “hardware upkeep and maintenance” and “operating system upkeep and maintenance”;

• the hosting of Harmonix's URLs on servers under the control of Viacom;

• various “telephone services”;

• a limited license to use office space under the control of Viacom; and

• the “disposing of raw materials . . . related to the manufacturing of [Harmonix's] legacy products” stored at facilities in Hong Kong controlled by Viacom.

aa. Section 4(b) of the TSA provided that the reimbursements for these services would be paid from a “Due to Company” account, that Viacom would initially fund with an opening balance of $7.25 million.

bb. Section 4(b) of the TSA further provided that Viacom would wire $10 million to a separate account to be established by Harmonix.

cc. That is, at a time when Viacom owned 100% of Harmonix's stock, Viacom obligated itself contractually to transfer $17.25 million to Harmonix to make Harmonix attractive to a buyer and to help avoid any argument that the transfer of stock was a fraudulent transfer, allowing Viacom a potentially clean exit.

dd. Harmonix provided no goods, services or consideration of any other kind to Viacom in exchange for this capital contribution.

ee. Pursuant to Section 4(b) of the TSA, Viacom wired $10 million to a bank account maintained by Harmonix on December 30, 2010.

ff. During 2011, Viacom provided the services called for by the TSA and the cost of those services was reimbursed from the “Due to Company” account, the balance of which was $0 on December 31, 2011.

Harmonix Excluded Viacom's Capital Contributions from Harmonix's Income.

gg. Harmonix did not treat the payments as revenue, and no product was provided to Viacom in exchange for the payments.

hh. Instead, Harmonix treated the $17.25 million paid by Viacom as “additional paid-in capital” in the 2010 Return; Harmonix did not include this amount in its GAAP net income.

ii. The Estimated Closing Adjusted Net Assets Calculation, a provisional opening balance sheet attached to the SPA as Exhibit 2.07(a), records the $17.25 million as “Cash and Cash Equivalents.”

jj. That is, these funds were treated as an asset of Harmonix at the time of the transaction.

kk. Section 118(a) provides that “[i]n the case of a corporation, gross income does not include any contribution to the capital of the taxpayer.”¹

ll. Treasury Regulation § 1.118-1 explains that “if a corporation requires additional funds for conducting its business and obtains such funds through voluntary pro rata payments by its shareholders, the amounts so received being credited to its surplus account or to a special account, such amounts do not constitute income, although there is no increase in the outstanding shares of stock of the corporation.”

mm. By contrast, Treasury Regulation § 1.118-1 explains that “the exclusion does not apply to any money or property transferred to the corporation in consideration for goods or services rendered, or to subsidies paid for the purpose of inducing the taxpayer to limit production.”

nn. Pursuant to Section 118(a) and the regulations thereunder (and consistent with its GAAP treatment of the funds), Harmonix correctly treated the $17.25 million it received from Viacom as capital contributions and, as such, did not include such amount in its taxable income shown on the 2010 Return.

Harmonix Adjusts the Purchase Price Basis as Required, by the Unified Loss Rule.

oo. In filing its tax return for the year ending December 31, 2011, Harmonix reduced the basis of its assets as required by Treasury Regulation Section 1.1502-36 (the “Unified Loss Rule”) by $22,979,255, which resulted in additional income of $11,278,439.

pp. The Unified Loss Rule has two express purposes: (i) “to prevent the consolidated return provisions from reducing a group's consolidated taxable income through the creation and recognition of noneconomic loss on [a subsidiary's] stock” and (ii) “to prevent members (includingformer members) of the group from collectively obtaining more than one tax benefit from a single economic loss.” Treas. Reg. 1.1502-36(a)(2).

qq. By its own terms, the Unified Loss Rule “must be interpreted and applied in a manner that is consistent with and reasonably carries out the purposes” set forth above. Id.

rr. Because, after all necessary adjustments, Viacom had a deductible loss on the disposition of Harmonix's stock, the Unified Loss Rule required Harmonix to reduce its tax attributes by the lesser of either (i) Viacom's loss on the sale or (ii) Harmonix's aggregate inside loss. See id. (d)(3)(i).

ss. The “aggregate inside loss” is defined in the Unified Loss Rule as: the excess, if any, of —

(1) [The subsidiary's] net inside attribute amount; over

(2) The value of all outstanding shares of [the subsidiary's] stock. Id. (d)(3)(iii).

tt. The subsidiary's net inside attribute amount, “determined as of the transfer,” is “the sum of [the subsidiary's] net operating and capital loss carryovers, deferred deductions, money, and basis in assets other than money, reduced by the amount of [the subsidiary's] liabilities.” Id. (c)(5).

uu. Before the adjustments required by the Unified Loss Rule, Harmonix's basis in its assets was $95,010,847, which exceeded its liabilities of $48,688,242 by $46,322,605.

vv. The term “value,” as used in subsection (d)(3)(iii) of the Unified Loss Rule, is defined as “the amount realized, if any, or otherwise the fair market value.” Id. (f)(11).

ww. In connection with both a contemplated issuance of restricted stock and the preparation of its 2011 tax return, Harmonix engaged Grant Thornton LLP (“Grant Thornton”), an accounting and tax advisory firm, in September 2011 to determine the fair market value of a minority interest in Harmonix as of May 31, 2011.

xx. Grant Thornton considered the following five different scenarios in arriving at its valuation: (i) no hew development and short-term sale at low valuation; (ii) no new development and short-term sale at high valuation; (iii) new development and sale at low valuation; (iv) new development and sale at mid-level valuation; and (v) new development and sale at high valuation.

yy. The valuations for these scenarios ranged from $13,978,000 to $42,332,000.

zz. By adding the product of each valuation multiplied by the estimated probability of the scenario resulting in that valuation, Grant Thornton determined that the fair market value of a minority interest in its business was $23,343,250 as of May 31, 2011.

aaa. Harmonix subtracted its fair market value of $23,343,250 from its net inside attribute amount of $46,322,605 (see supra ¶ 5(uu)) and determined that its aggregate inside loss under the Unified Loss Rule was $22,979,255 (see supra 5(oo)).

bbb. Because this aggregate inside loss amount was substantially less than Viacom's nearly $335 million realized loss on the disposition of Harmonix (see supra ¶ 5(1)), the Unified Loss Rule required Harmonix to reduce the basis in its assets (other than cash) by an amount equal to the aggregate inside loss: $22,979,255.

ccc. Certain assets of Harmonix were recognized in taxable income in 2011, namely, (i) “Royalties Rec. Advance,” (ii) “Advances, Fees & Other” and (iii) “Prepaids.”

ddd. The reduction in the basis of such assets, in accordance with the Unified Loss Rule, resulted in additional income in 2011 of $11,278,439 (the total basis reduction allocated to such assets).

eee. Harmonix included this additional income on Schedule M-3, Part II, Line 25(b) of the 2011 Return as a “Purchase Price Basis Adjustment” of $11,278,439.

fff. Harmonix used its fair market value of $23,343,250 as the value for its calculation of aggregate inside loss because there was no “amount realized” in the disposition of Harmonix by Viacom except for the nominal purchase price of $59.99.

ggg. Had Harmonix used $59.99 as the value for its calculation of aggregate inside loss as Respondent contends Petitioner should have (see Ex. 1 at 10), Harmonix would have realized an instantaneous gain of nearly $23 million immediately upon completion of the sale, in addition to the gain Harmonix had realized resulting from the reduction of basis of Harmonix's assets that were recognized in taxable income in 2011.

hhh. That state of affairs would have no relationship at all with the actual financial position of Harmonix.

iii. This result would have been inconsistent with not only the purposes of why Viacom pursued the Harmonix disposition but also the express purposes of the Unified Loss Rule, which are to prevent taxpayers from recognizing losses where none exist or recognizing two losses whereonly one exists (see supra ¶ 5(pp)) — not to manufacture gains that would not otherwise exist.

Harmonix Includes an Adjusted Current Earnings Adjustment on the 2011 Return.

jjj. Consistent with its tax treatment of the disposition of Harmonix as set forth above, Harmonix included an adjusted current earnings (“ACE”) adjustment of $20,871,412 on the 2011 Return.

kkk. This adjustment was required at the time by Section 55(g) (repealed Dec. 22, 2017), which provided that:

The alternative minimum taxable income of any corporation for any taxable year shall be increased by 75 percent of the excess (if any) of — 

(A) the adjusted current earnings of the corporation, over

(B) the alternative minimum taxable income (determined without regard to this subsection and the alternative tax net operating loss deduction). 

lll. Petitioner and Respondent agree that, if the aggregate inside loss were to be calculated using a value of $59.99 as Respondent contends (see Ex. 1 at 7), instead of $23,343,250 as Petitioner contends (see supra ¶ 5(fff)), the ACE adjustment should not be included in the 2011 Return.

Harmonix Turns Its Business Around.

mmm. Notwithstanding the bleak outlook for Harmonix's financial future in late 2010, by 2015, the business earned a profit again.

nnn. This turnaround was due, in part, to the rising popularity of immersive dance video games, including Harmonix's successful Dance Central franchise; the resurgence of the Rock Band franchise in 2015 on a new generation of game consoles; and substantial fees paid to Harmonix to develop Fantasia: Music Evolved for Disney.

ooo. The Notice recognizes that certain net operating losses (NOLs) from 2012 and 2013 were carried forward to 2015. (See Ex. 1 at 9.)

ppp. In the event that this litigation were to result in an increase in the amount of tax due for the 2010 and 2011 tax years, Petitioner would seek to amend its returns for the 2010, 2011 and 2015 tax years in order to carry the 2012 and 2013 NOLs back to 2010 and 2011, thereby reducing the amount of income tax due stated in the Notice.

qqq. In order to preserve its rights should the limitations period during which such refunds may be claimed expire while this litigation remains pending, Harmonix intends to file protective claims for refunds for 2010, 2011 and 2015.

Respondent Initiates an Examination that Has Resulted in this Action.

rrr. In or around 2014, Respondent informed Harmonix that it was conducting an examination of Harmonix's tax returns for the 2010, 2011 and 2012 tax years.

sss. Harmonix cooperated with the examination, including by responding to Respondent's requests for information.

ttt. On December 16, 2015, Respondent sent Harmonix a Revenue Agent Report detailing the conclusions of the examination.

uuu. Harmonix submitted a protest to what was then known as Respondent's Office of Appeals (“IRS Appeals”) on January 20, 2016.

vvv. IRS Appeals assigned an officer who subsequently retired following an initial conference.

www. A second IRS Appeals officer was assigned to the matter, but she first took maternity leave and subsequently retired before holding a conference.

xxx. Three-and-a-half years after the Protest was submitted, a third IRS Appeals officer, Michael McClane, held a conference on July 2, 2019 and a follow-up conference on October 16, 2019, but Harmonix was not able to reach a mutually agreeable resolution of the dispute with IRS Appeals.

yyy. Respondent issued the Notice, of which Petitioner now seeks review, on March 17, 2020.

WHEREFORE, Petitioner prays that this Court may hear the case and:

1. determine that the Commissioner has erred as alleged in each assignment of error as set forth in Paragraph 4 above;

2. find that the total income tax still due for the tax years ending December 31, 2010 and December 31, 2011 is $0;

3. find that Viacom's transfer of $17,250,000 to Harmonix constituted a non-taxable capital contribution that did not give rise to any taxable income;

4. find that Petitioner's calculation of the adjustment to the basis of its assets pursuant to the Unified Loss Rule was correctly reported on the 2011 Return;

5. find that the ACE Adjustment was correctly reported on the 2011 Return; and

6. grant Petitioner all further relief to which it may be entitled.

Dated: June 30, 2020

Respectfully submitted,

ADMITTED NOT RECOGNIZED
Michael H. Steinberg
Tax Court Bar No. SM1275
steinbergm@sullcrom.com

SULLIVAN & CROMWELL LLP
1888 Century Park East
Los Angeles, California 90067-1725
Tel: (310) 712-6600
Fax: (310) 712-8800

ADMITTED NOT RECOGNIZED
Ronald E. Creamer, Jr.
Tax Court Bar No. CR0936
creamerr@sullcrom.com

ADMITTED
Mark A. Popovsky
Tax Court Bar No. PM0438
popovskym@sullcrom.com

SULLIVAN & CROMWELL LLP
125 Broad Street
New York, New York 10004
Tel: (212) 558-4000
Fax: (212) 558-3588

Counsel for Petitioner
Harmonix Music Systems, Inc.