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Western Digital Files Another Petition Challenging Deficiencies

MAR. 8, 2019

Western Digital Corp. et al. v. Commissioner

DATED MAR. 8, 2019
DOCUMENT ATTRIBUTES

Western Digital Corp. et al. v. Commissioner

[Editor's Note:

The attachments can be viewed in the PDF version of the document.

]

WESTERN DIGITAL CORPORATION AND SUBSIDIARIES,
Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent

UNITED STATES TAX COURT

PETITION

Western Digital Corporation and Subsidiaries (“petitioner”) hereby petitions for a redetermination of the deficiencies in Federal income tax for its tax years ended July 2, 2010 (“FY 2010”); July 1, 2011 (“FY 2011”); and June 29, 2012 (“FY 2012”), as set forth by the Commissioner of Internal Revenue (“respondent”) in a Notice of Deficiency dated December 10, 2018 (the “NOD”). Petitioner previously received a Notice of Deficiency for its tax years ended June 27, 2008 (“FY 2008”) and July 3, 2009 (“FY 2009”) and filed a petition in response to that Notice of Deficiency on September 25, 2018. That case was assigned Docket No. 18984-18. Respondent filed his answer in that case on November 30, 2018.

Petitioner anticipates moving to consolidate that case and this case after respondent files his answer in this case.

As the basis for this case, petitioner alleges as follows:

1. Taxpayer Information.

1.a. Western Digital Corporation. Western Digital Corporation (“WDC”) is the parent and consolidated return group agent for the affiliated group that filed consolidated Federal income tax returns for FY 2010 through FY 2012. Petitioner's affiliated group members in FY 2010 through FY 2012 included Western Digital Technologies, Inc. (“WDT”) and WD Media, Inc. (“WDMI”) (formerly known as Komag, Inc.). Western Digital (Fremont) LLC (“WDF”) was an affiliated group member in FY 2010 and FY 2011. In FY 2012, WDF was a single-member LLC with no separate existence from WDT for Federal income tax purposes. HGST, Inc. (formerly known as Hitachi Global Storage Technologies, Inc.) became an affiliated group member in FY 2012. WDC is also the ultimate parent of the worldwide Western Digital group (the “Company”). WDC is organized under the laws of the State of Delaware. Its principal place of business is 5601 Great Oaks Parkway, San Jose, California 95119. Petitioner electronically filed timely Forms 1120, U.S. Corporate Income Tax Return, for FY 2010 through FY 2012 with the Internal Revenue Service (“IRS”).

1.b. WD Media, Inc., Formerly Known as Komag, Inc. Komag, Inc. (“Komag”) was a corporation organized under the laws of the State of California. Petitioner acquired Komag on September 5, 2007. Following the acquisition, Komag became a wholly owned subsidiary of petitioner, changed its name to WD Media, Inc. (WDMI), and became a member of petitioner's affiliated group effective September 6, 2007.

1.c. HGST, Inc. (formerly known as Hitachi Global Storage Technologies, Inc.). On March 8, 2012, Western Digital Ireland, Ltd. (“WDI”) acquired from Hitachi, Ltd. (“Hitachi”), a Japanese company, in a taxable transaction, all the stock of Viviti Technologies, Ltd. (“Viviti”), a company organized in Singapore. Viviti owned, directly or indirectly, various subsidiaries of the Hitachi group, including Hitachi Global Storage Technologies Netherlands B.V. (which later changed its name to HGST Netherlands B.V. (“HGST B.V.”)), HGST Singapore Pte. Ltd., and HGST (Thailand) Ltd.

1.c.1. On March 8, 2012, WDT acquired all the stock of HGST, Inc., a U.S. corporation, from HGST B.V. After this acquisition, HGST, Inc. was a wholly owned subsidiary of WDT and became a member of petitioner's consolidated return group effective on March 9, 2012. Effective on March 10, 2012, HGST Singapore Pte. Ltd. and HGST (Thailand) Ltd. elected to become disregarded entities with no existence separate from WDI for Federal income tax purposes.

2. Notice of Deficiency. The NOD upon which this case is based is dated December 10, 2018, and was issued by respondent through the IRS Small Business and Self-Employed Division office located in Laguna Niguel, California. The NOD identifies March 10, 2019, as the last date for filing a petition in this Court. A copy of the NOD, including the supporting statements and schedules, is attached as Attachment A.

3. Amounts in Dispute. In the NOD, respondent determined Federal income tax deficiencies in the following amounts:

Tax Year

Amount

FY 2010

$60,882,242

FY 2011

$227,470,911

FY 2012

$260,508,196

Total

$548,861,349

Petitioner disputes the entire amount of such deficiencies, which include the disallowance of net operating loss (“NOL”) deductions; the utilization of foreign tax credits (“FTCs”), general business credits (“GBCs”), and minimum tax credits (“MTCs”); and adjustments to NOL carryforwards, FTC carryforwards, GBC carryforwards, and MTC carryforwards originating in previous years and in FY 2010 through FY 2012. These carryforwards are properly available to satisfy petitioner's correct Federal income tax liabilities for FY 2008 through FY 2012, as finally determined by the Court in this case and in Docket No. 18984-18. Petitioner also seeks a refund of overpayments for FY 2010 through FY 2012, to the extent determined by the Court, plus interest as provided by law.

4. Assignments of Error. Respondent's deficiency determinations set forth in the NOD are based on the following errors:

4.a. Code Section 482 and Correlative Adjustments — Intercompany License Transaction.

4.a.1. Respondent's Code section1 482 adjustments are arbitrary, capricious, and unreasonable. Respondent erred in allocating income under Code section 482 to WDT from its foreign subsidiary, WDI.

5.a.2. Respondent erred in allocating income to WDT from WDI in the amounts of $278,360,000, $662,710,000, and $406,820,000 for FY 2010, FY 2011, and FY 2012, respectively, due to respondent's erroneous determinations (i) that he was authorized to adjust a prepayment made in FY 2008 (the “Royalty Prepayment”); (ii) that a lump-sum prepayment of $1,561,800,000 was due for the license of intangible property from WDT and WDF to WDI on June 30, 2007 (“Respondent's Lump Sum”); (iii) that WDI owed additional per-unit royalties in the amounts of $4.16 for FY 2008, $3.89 for FY 2009, $3.67 for FY 2010, and $3.21 for both FY 2011 and FY 2012, based on respondent's application of a discounted-cash-flow valuation method that is sometimes referred to as an application of the income method; (iv) that he was entitled to set aside petitioner's chosen form of payment and petitioner's method for applying the present value of contingent royalties to drawdown either the Royalty Prepayment or Respondent's Lump Sum; and (v) that Respondent's Lump Sum made in FY 2008 should be drawn down and depleted by the nominal royalty amounts yielded by respondent's discounted-cash-flow method, i.e., $556,642,000, $569,585,000, $713,950,000, $662,710,000 and $420,560,000 for FY 2008, FY 2009, FY 2010, FY 2011, and FY 2012, respectively, contrary to the analysis in the Notice of Proposed Adjustment (“NOPA”) dated May 22, 2015 relating to FY 2008 and FY 2009 (“NOPA IE 1-3”) and a subsequent analysis reflected in a NOP A relating to FY 2010 through FY 2012 (“NOPA IE-2”) that respondent later withdrew.

4.a.3. Respondent also erred in proposing alternative allocations of income to WDT from WDI in the amounts of $713,950,000, $662,710,000, and $406,820,000 for FY 2010, FY 2011, and FY 2012, respectively, due to his erroneous determinations of contingent nominal royalty payments with respect to the license of intangible property. These alternative adjustments reflect errors identified in paragraphs 4.a.1 and 4.a.2 above.

4.b. Code Section 956 Adjustment. Respondent erred in increasing WDT's income under Code sections 951 and 956 in the amount of $52,957,567 for FY 2010 due to his erroneous determination that certain accounts payable owed by WDT to Western Digital (Malaysia) Sdn. Bhd. (“WDM”) and Western Digital (Thailand) Company Ltd. (“WDTh”) (each a disregarded entity with no existence separate from WDI for Federal income tax purposes)2 represented investments in United States property by WDI under Code section 956(c). Respondent erroneously determined that the balance of any accounts payable from WDT to WDI that remained outstanding for longer than 75 days was excessive and not ordinary or necessary to carry on the Company's trade or business.

4.c. HGST, Inc. Warranty Expense. Respondent erroneously disallowed the warranty expense reserve claimed in FY 2012 with respect to HGST, Inc. products by $16,723,963.

4.d. Petitioner's NOLs and NOL Deductions. Due to his erroneous determinations of taxable income for FY 2010, respondent improperly disallowed petitioner's NOL generated in FY 2010 of $51,529,893. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously disallowed, Subsequent references in this petition to WDI include WDTh and WDM. in their entirety, petitioner's NOL deductions of $43,080,413 and $56,807,805 for FY 2011 and FY 2012, respectively.

4.e. Petitioner's NOL Carryforwards. Due to his erroneous determinations for FY 2008 through FY 2011, respondent erroneously decreased the amounts of NOL carryforwards available to petitioner as of the end of FY 2009, FY 2010, and FY 2011 by $87,065,663, $139,776,019, and $67,605,296, respectively.

4.f. Code Section 382 Komag NOL Deductions. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously disallowed Code section 382 Komag NOL deductions of $29,814,001 and $21,031,184 for FY 2011 and FY 2012, respectively. Due to his erroneous determinations for FY 2008 through FY 2010, respondent erroneously utilized Code section 382 Komag NOL deductions of $19,408,232 for FY 2010.

4.g. Code Section 382 Komag NOL Carryforwards. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously decreased (increased) the Code section 382 Komag NOL carryforwards available to petitioner as of the end of FY 2009, FY 2010, FY 2011, and FY 2012, by $266,567,135, $285,978,367, $35,534,261 and ($31,377), respectively.

4.h. Petitioner's AMT NOLs and NOL Deductions. Due to his erroneous determination of taxable income for FY 2010, respondent erroneously disallowed petitioner's $59,371,116 AMT NOL generated in FY 2010. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously disallowed, in their entirety, petitioner's AMT NOL deductions of $25,973,161 and $71,246,524 for FY 2011 and FY 2012, respectively.

4.i. Petitioner's AMT NOL Carryforwards. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously decreased the AMT NOL carryforwards available to petitioner as of the end of FY 2009, FY 2010 and FY 2011 by $111,901,332, $172,452,911, and $147,959,413, respectively.

4.j. Code Section 382 Komag AMT NOL Deductions. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously disallowed the Code section 382 Komag AMT NOL deductions of $29,814,001 and $86,174,340 for FY 2011 and FY 2012, respectively, and erroneously absorbed Code section 382 Komag AMT NOLs of $39,730,467 in FY 2010.

4.k. Code Section 382 Komag AMT NOL Carryforwards. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously decreased (increased) the Code section 382 Komag AMT NOL carryforwards available to petitioner as of the end of FY 2009, FY 2010, FY 2011, and FY 2012 by $266,416,449, $306,146,916, $96,957,747, and ($4,375,858), respectively.

4.l Charitable Contribution Deduction. Respondent erroneously increased the amount of petitioner's Code section 170 limitation and allowed additional charitable contributions of $1,180,463 and $1,479,817 for FY 2010 and FY 2011, respectively.

4.m. Foreign Source Income — General Basket. Due to his erroneous determinations for FY 2010 through FY 2012, respondent erroneously increased petitioner's foreign source income for FY 2010, FY 2011, and FY 2012 by $332,692,180, $662,339,706, and $410,889,398, respectively.

4.n. Foreign Tax Credit Applied. Respondent erroneously utilized current year FTCs of $6,046,459 and $7,682,568 to offset his erroneous determinations of income tax liability for FY 2010 and FY 2011, respectively. Respondent also erroneously disallowed FTC carryforwards of $50,772,945 that petitioner utilized for FY 2012, due to his erroneous determination of Federal income tax liabilities for FY 2008 through FY 2011.

4.o. Foreign Tax Credit Carryforwards. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously decreased the FTC carryforwards available to petitioner as of the end of FY 2009, FY 2010, and FY 2011 by $44,549,939, $43,237,919, and $50,772,945, respectively.

4.p. AMT Foreign Tax Credit Applied. Respondent erroneously utilized current year AMT FTCs of $6,046,459, $7,682,555, and $3,472,219 to offset his erroneous determinations of AMT liabilities for FY 2010, FY 2011, and FY 2012, respectively.

4.q. AMT Foreign Tax Credit Carryforwards. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously decreased the AMT FTC carryforwards available to petitioner as of the end of FY 2009, FY 2010, and FY 2011 by $35,553,261, $34,241,241, and $39,364,565, respectively.

4.r. General Business Credits Applied. Respondent erroneously utilized current year GBCs that are not subject to Code section 382 of $17,396,038, $17,094,151, and $20,953,921 to offset his erroneous determinations of Federal income tax liability for FY 2010, FY 2011, and FY 2012, respectively.

4.s. General Business Credit Carryforwards. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously decreased the GBC carryforwards not subject to Code section 382 that are available to petitioner as of the end of FY 2009, FY 2010, FY 2011, and FY 2012 by $51,051,640, $61,371,480, $79,755,920, and $62,618,592, respectively.

4.t. Code Section 382 Komag General Business Credits. Respondent erroneously utilized Code section 382 Komag GBC carryforwards of $8,999,593 and $4,368,261 for FY 2010 and FY 2011, respectively, to offset his erroneous determinations of Federal income tax liability for FY 2010 and FY 2011 and erroneously disallowed petitioner's utilization of Code section 382 Komag GBC carryforwards of $14,364,754 for FY 2012.

4.u. Code Section 382 Komag General Business Credit Carryforwards. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously decreased the Code section 382 Komag GBC carryforwards available to petitioner as of the end of FY 2010, FY 2011, and FY 2012 by $9,344,950, $13,713,211, and $1,818,009, respectively.

4.v. Minimum Tax Credits Applied and Minimum Tax Credit Carryforwards. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously disallowed MTCs of $4,568,306 to offset his erroneous redetermination of petitioner's AMT liabilities for FY 2012 and decreased (increased) the MTC carryforwards available to petitioner as of the end of FY 2009, FY 2010, FY 2011, and FY 2012 by $4,451,451, $4,451,451, $4,454,126, and ($114,180), respectively.

4.w. Affirmative Adjustments. Respondent erred in failing to decrease petitioner's taxable income and determine overpayments of income tax owed to petitioner for FY 2010 through FY 2012 due to his failure to consider and allow the following affirmative claims by petitioner:

4.w.1. Respondent erred in failing to decrease petitioner's taxable income under Code section 482 for FY 2010, FY 2011 and FY 2012 by $24,285,452, $33,570,527, and $38,024,327, respectively, as setoffs against his erroneous Code section 482 adjustments, to reflect that stock-based compensation is not a cost required to be reimbursed to petitioner by WDI.

4.w.2. Respondent erred in failing to allow petitioner to claim additional FTCs under Code sections 901 and 902 of $910,366, $606,898, and $699,524, reflecting the final assessments of contested Italian income taxes for FY 2010, FY 2011, and FY 2012, respectively.

4.w.3. Respondent erred in failing to allow petitioner to claim additional FTCs under Code sections 901 and 902 of $197,471, $281,790, and $289,683, reflecting the final assessments of contested German income taxes for FY 2010, FY 2011, and FY 2012, respectively.

4.x. Failure to Determine Overpayment. Respondent erred in failing to determine any overpayment of petitioner's Federal income tax for FY 2010, FY 2011, and FY 2012.

5. Factual Basis for Assignments of Error. The facts upon which petitioner relies as the basis for the assignments of error are as follows:

5.a. Respondent's Code Section 482 and Correlative Adjustments — Intercompany License Transaction.

5.a.1. The Hard Disk Drive Industry. Before and during the years in issue, the hard disk drive (“HDD”) industry was characterized by intense price competition, substitutable products, and minimal switching costs for original equipment manufacturers (“OEMs”) and other industry participants.

5.a.1.i. Participants in the HDD industry developed products in accordance with industry standards, including those regarding form factors (i.e., HDD size), speed (measured in rotations per minute (“RPM”)), and interfaces for drives, which meant that customers were not locked into a particular manufacturer and instead could source HDDs from any HDD manufacturer.

5.a.1.ii. HDD manufacturer profits were highly dependent on efficient manufacturing operations in the face of intense price competition, substitutable products, and minimal switching costs.

6.a.1.iii. HDD manufacturers competed primarily on cost, quality, and availability, all of which were tied directly to efficient manufacturing operations.

4.a.1.iv. The ability to manufacture low-cost, high-quality HDDs at high volume while satisfying rapidly changing customer demand provided a significant competitive advantage.

5.a.2. The Company's Business. The Company produced cost-effective HDDs for digital information storage utilized in desktop and mobile personal computers, enterprise applications (e.g., servers and network attached storage devices), video game consoles, digital video recorders, satellite and cable set-top boxes, and external storage devices.

5.a.2.i. The Company sold its products worldwide to OEMs, original design manufacturers (“ODMs”), and distributors for use in computer systems, subsystems, or consumer electronic devices. The Company also sold its HDDs as stand-alone storage products by integrating them into finished enclosures, embedding applications software, and offering the products as external storage applications for personal data backup and portable or expanded storage for digital music, photographs, video, and other digital data through distributors and retailers.

5.a.2.ii. The Company's success, or failure, in the HDD industry depended on its ability to maintain a competitive cost structure through a relentless focus on highly efficient manufacturing operations. The critical elements of HDD manufacturing included cost-efficient, high-yield production and rigorous component and product testing.

5.a.2.iii. The Company's competitors included both large, vertically integrated multinationals that manufactured HDDs and other storage devices for their own products and other manufacturers that, like the Company, sold predominantly to OEMs, ODMs, distributors, and retail channels.

5.a.3. History of the Company's Business Structure.

5.a.3.i. Originally founded in 1970 as a manufacturer of specialized semiconductors, the Company entered the HDD industry in March 1988.

5.a.3.ii. The Company established manufacturing operations in Southeast Asia to reduce costs and avail itself of a sophisticated local engineering and manufacturing workforce.

5.a.3.iii. WDM opened in Kuala Lumpur, Malaysia in 1973 and began manufacturing HDDs in 1988. WDM operated continuously from 1988 through the years in issue.

5.a.3.iv. WDTh commenced operations in January 2002 in the Navanakom Industrial Park outside of Bangkok, Thailand. WDTh manufactured HDDs continuously from 2002 through the years in issue.

5.a.3.v. The Company acquired substantially all of the assets of Read-Rite Corporation (“Read-Rite”) in 2003. The Read-Rite acquisition included the Bang Pa-in, Thailand facility, which the Company operated through Western Digital Bang Pa-In Co., Ltd. (“WDB”), a wholly owned subsidiary of WDM. WDB was responsible for manufacturing sliders (i.e., the components in HDDs that read and write data), head gimbal assemblies (“HGAs”), and head stack assemblies (“HSAs”) until its July 3, 2006 merger into WDTh, with WDTh surviving.

5.a.3.vi. In the Read-Rite acquisition, the Company also acquired Read-Rite's wafer fabrication facility in Fremont, California and thereafter operated it through WDF. Before and during the years in issue, the wafers fabricated by WDF were purchased and used by WDB and subsequently WDTh and WDI in their design and manufacture of sliders.

5.a.3.vii. From June 30, 2007 through the years in issue, WDM was treated as a disregarded entity with no existence separate from WDI for Federal income tax purposes.

5.a.3.viii. From September 29, 2007 through the years in issue, WDTh was treated as a disregarded entity with no existence separate from WDI for Federal income tax purposes.

5.a.3.ix. Before and during the years in issue, WDI manufactured sliders, HGAs, HSAs, and finished HDDs.

5.a.3.x. On September 5, 2007, the Company acquired Komag, a manufacturer of thin-film rotating magnetic disks used to store and access data (“media”) in an effort to reduce costs through the continued vertical integration of the Company's manufacturing. The acquisition included Komag, Inc., a U.S.-based corporation, and its subsidiary Komag (Bermuda) Ltd., a controlled foreign corporation. Following the acquisition, Komag, Inc. was renamed WD Media, Inc. (WDMI) and Komag (Bermuda) Ltd. was renamed WD Media (Bermuda) Ltd. (“WDM-Bermuda”).

5.a.3.xi. Before the acquisition of Komag, all media used in the Company's HDDs were purchased from third parties.

5.a.3.xii. Following the acquisition of Komag, WDM-Bermuda manufactured media for sale to WDI. Effective February 24, 2012, WDM-Bermuda merged with and into WDI.

5.a.3.xiii. As of July 4, 2009, WDTh, WDM, and WDM-Bermuda collectively had approximately 42,000 employees, composing more than ninety percent of the Company's total headcount, including substantial engineering and technical headcount.

5.a.4. Manufacturing.

5.a.4.i. HDD manufacturing was a highly complex process involving hundreds of discrete steps and requiring a range of expertise.

5.a.4.ii. The main components of finished HDDs were sliders, HGAs, HSAs, media, printed circuit board assemblies, and motor base assemblies.

5.a.4.iii. Before the years in issue, all sliders manufactured by the Company were manufactured by WDB and subsequently by WDTh and WDI. During the years in issue, all sliders manufactured by the Company were manufactured by WDI.

5.a.4.iv. Before and during the years in issue, slider manufacturing was preceded by wafer fabrication at WDF.

5.a.4.v. Wafer fabrication involved a series of processes through which silicon wafers were grown, lapped, polished, and etched, followed by processes in which additional layers were added, subtracted, and magnetically altered.

5.a.4.vi. During the years in issue, WDF shipped wafers to WDI. Employees of WDI and WDM-Bermuda were responsible for all of the Company's remaining steps in the manufacture of finished HDDs, including the manufacture of media, sliders, HGAs, HSAs, and finished HDDs.

5.a.4.vii. The narrow tolerances driving HDD performance demanded extremely precise manufacturing, most of which occurred in a clean-room environment. Manufacturing standards were measured in single-digit Angstroms (“A”), approximately the radius of an atom, and any contaminant of virtually any size could have caused HDD failure.

5.a.4.vii.A. WDI created tens of thousands of individual sliders from each wafer. Slider manufacturing required WDI to grind, cut, and chemically lap each individual slider to achieve a slider surface roughness of approximately two A.

5.a.4.vii.B. WDI then used photolithography to etch into the slider the air bearing surface (“ABS”), with differences in surface height of between 5 and 50 microinches or between 0.000005 and 0.00005 inches. The ABS was designed to interact with the airstream created by the rotating media to allow the head to fly at a specified height.

5.a.4.vii.C. WDI physically and electrically attached the slider to a suspension, creating the HGA.

5.a.4.vii.D. WDI tested the HGA's roll static attitude and pitch static attitude, characteristics of flexibility that must remain in narrow parameters due to the low fly height during read and write operations. WDI also tested the HGA's gram load, a downward biasing force exerted on the slider to keep it in close proximity to the media during read and write operations.

5.a.4.vii.E. WDI connected one or more HGAs to an actuator arm assembly, which included the recording preamp and the flex circuit, to create an HSA. The HGA was adjoined to the actuator arm through ball swaging, a process in which a steel ball is forced through a hole inside the HGA to expand and secure it to the actuator arm.

5.a.4.vii.F. WDI subjected the sliders, HGAs, HSAs, and HDDs to numerous inspections and tests at various steps in the manufacturing process. These included magnetic tests, electrical tests, visual inspections under high-power microscopes, quality tests, and reliability tests, among other tests.

5.a.4.vii.G. Media manufacturing, which was done by third parties before the Komag acquisition and by WDM-Bermuda subsequent to the Komag acquisition, involved producing the patterns used to generate feedback signals on the media. Like the head that read and wrote data to the media, the media itself was subject to extremely narrow tolerances, such as surface roughness, similar to those WDI achieved for the slider, i.e., low single-digit A.

5.a.4.vii.H. WDI assembled and sealed the HSA, the media, and other components, such as the spindle motor that rotates the media, inside a contaminant-free metal casing. Adjustments were made to the media during the assembly process, as needed, to achieve balanced rotation of the media.

5.a.4.vii.1. During the years in issue, the media spun at up to 10,000 RPM, and the mechanical spacing between the head and the media surface (also known as fly height) was approximately 100 A, or 0.00000001 meters, which is roughly the size of a common virus.

5.a.4.viii. Finally, WDI subjected completed HDDs to back-end testing in large-scale and small-scale test machines that were designed to ensure that the completed HDDs met rigorous specifications.

5.a.4.ix. During the years in issue, WDI manufactured and sold more than one hundred million (100,000,000) HDDs per year, each of which had to meet WDI's manufacturing standards.

5.a.4.x. WDI leveraged a highly skilled manufacturing workforce rather than complete automation to enhance manufacturing flexibility, decrease costs, and ensure high quality, WDI's manufacturing expertise was better and more cost-efficient than that of its competition. WDI's manufacturing operations achieved industry leading time-to-volume production at competitive unit costs.

5.a.4.xi. WDI engineers and manufacturing employees were responsible for increased yields, decreased costs, lower scrap, and greater output.

5.a.4.xii. WDI engineers and manufacturing employees developed flexible manufacturing lines that allowed WDI to adapt more quickly to changes in customer or market demand.

5.a.4.xiii. WDI achieved its manufacturing volumes while constantly reducing the costs of the manufacturing process to support the Company's margins without sacrificing manufacturing quality.

5.a.4.xiv. The engineering and manufacturing efforts of WDI during the years in issue and those of WDTh, WDM, and WDB prior to the years in issue were critical to the Company's expected profitability.

5.a.5. Research and Development.

5.a.5.i. To remain competitive, the Company was required to develop products at higher areal densities (i.e., measures of the quantity of information bits that can be stored on a given surface area) that enabled increased storage capacities. Before and during the years in issue, the Company introduced products with new capabilities at a rapid pace. As of the years in issue, the Company had transitioned its business strategy from being a follower of new technologies to being a leader in their innovation and development.

5.a.5.ii. Head technology was a key component affecting the ability to increase areal density. Head technology included technology for recording, or writing, to the media and technology for reading from the media.

5.a.5.iii. The Company's technologies evolved over time. As of June 30, 2007, and continuing in FY 2010 through FY 2012, the Company expected that the technology and product developments in existence on June 30, 2007 would be rapidly replaced by subsequently developed technology. On or after June 30, 2007, the Company's technology generated by R&D was developed on behalf of, and at the risk of, WDI pursuant to the agreements described in paragraphs 5.a.7.i and 5.a.7.ii, infra.

5.a.6. Marketing, Sales, and Distribution.

5.a.6.i. WDI sold finished HDDs to WDT and WDT then sold the HDDs to third-party customers or foreign Company affiliates. The third-party customers included OEMs, ODMs, distributors, and retailers.

5.a.6.ii. The Company maintained sales subsidiaries and offices in selected parts of the world, including the Americas, Asia Pacific, Europe, and the Middle East.

5.a.6.iii. As of July 4, 2009, the Company had approximately 600 employees worldwide (less than two percent of the Company's global workforce) engaged in marketing, sales, and distribution.

5.a.7. Intercompany Transactions.

5.a.7.i. The Technology License Agreement. WDT, WDF, and WDI entered into a Technology License Agreement (the “TLA”), effective June 30, 2007. The TLA granted to WDI for four years (i) exclusive, irrevocable rights to use WDT's and WDF's then-existing intellectual property to market, distribute, sell, and otherwise commercially exploit HDDs and their components and (ii) non-exclusive, irrevocable manufacturing rights relating to WDT's and WDF's then-existing intellectual property. Under the TLA, WDI was the owner of all R&D-related Improvements, as defined in the TLA.

5.a.7.i.A. In exchange for the TLA's grant of rights to then-existing intellectual property, WDI agreed to pay to WDT and WDF a per-HDD-unit royalty for FY 2008 through FY 2011.

5.a.7.i.B. During FY 2008, WDI made a non-refundable prepayment of the contingent royalties forecasted to accrue under the TLA — the Royalty Prepayment.

5.a.7.i.C. The Royalty Prepayment was made in the amount of $140.9 million.

5.a.7.i.D. Under Article 5.2 of the TLA, the Royalty Prepayment was credited to satisfy the per-HDD unit royalties using the discounted net present value of the per-HDD-unit royalties (“NPV per-unit royalties”) multiplied by the actual HDD units sold. The NPV per-unit royalties used by petitioner were $0.40 for FY 2008, $0.31 for FY 2009, $0.23 for FY 2010, and $0.13 for FY 2011.

5.a.7.i.E. Once the Royalty Prepayment was fully credited, Article 5.2 of the TLA provided for annual, nominal per-unit royalties that would be multiplied by the actual HDD units sold.

5.a.7.i.F. WDT, WDF, and WDI entered into a one-year extension of the TLA effective as of July 1, 2011. Pursuant to the extension of the TLA, the nominal-per-unit royalty used by petitioner was $0.11 for FY 2012.

5.a.7.ii. R&D Services Agreements. Effective June 30, 2007, WDI entered into separate R&D services agreements with WDT and WDF wherein WDT and WDF agreed to perform R&D services including, but not limited to, the development of HDDs. Under the R&D services agreements, WDI paid WDT and WDF compensation on a current basis without contingency through a combination of cost-plus service fees and other cost reimbursements. Under the R&D services agreements, WDI was the owner of all R&D-related developments resulting from the services performed for WDI under the agreements. The R&D services agreements remained in effect from June 30, 2007 through the years in issue.

5.a.7.iii. Other Intercompany Transactions.

5.a.7.iii.A. WDI compensated WDT for WDT's functions as a non-exclusive distributor of the HDDs produced by WDI in the WDTh and WDM facilities (the “Distribution Transactions”). For HDD sales in Europe and Asia, foreign affiliates of the Company performed marketing, distribution, and sales activities.

5.a.7.iii.B. WDI compensated WDT for the administrative services provided by WDT for the benefit of WDI (the “Shared Services Transactions”).

5.a.7.iii.C. WDI purchased wafers from WDF (the “Wafer Fabrication Transactions”).

5.a.8. Respondent's Position — Intercompany License Transaction and Correlative Adjustments.

5.a.8.i. Other than NOPA IE-2, which respondent withdrew, respondent did not provide petitioner a NOPA or economist report for the years in issue identifying respondent's transfer-pricing adjustments and their bases.

5.a.8.ii. On information and belief, the transfer-pricing adjustments in the NOD are based, in part, on NOPA IE1-3 issued for FY 2008 and FY 2009 and NOPA IE-2 issued for FY 2010 through FY 2012, the latter of which carried forward the discounted-cash-flow methodology from NOPA IE 1-3 to calculate proposed transfer-pricing adjustments for FY 2010 through FY 2012 with respect to the Intercompany License transaction. On information and belief, the transfer-pricing adjustments in NOPA IE 1-3 (and as carried forward in NOPA IE-2) were based, in part, on a report prepared by IRS economist Mariko Killion dated March 25, 2015 and a report prepared by Shirley Tessier and Gio Wiederhold of the MITRE Corporation dated July 21, 2014.

5.a.8.iii. Respondent determined in NOPA IE 1-3 (and as carried forward in NOPA IE-2) that the prepayment should be $1,829,000,000. On or about April 14, 2017, IRS Exam corrected one input factor in the model that had been reflected in NOPA IE 1-3 and, as a result, calculated that the prepayment due from WDI was instead $1,561,800,000 (the “April 14, 2017 Correction”). Respondent used this exact amount of $1,561,800,000 (i.e., Respondent's Lump Sum) to compute his transfer-pricing adjustment of $1,420,900,000 for FY 2008 made in the Notice of Deficiency at issue in Docket No. 18984-18.

5.a.8.iv. The transfer-pricing adjustment in the Notice of Deficiency at issue in Docket No. 18984-18 increased the Royalty Prepayment made by WDI during FY 2008 based on a discounted-cash-flow analysis using respondent's determination of the contingent royalties forecasted to accrue under the TLA.

5.a.8.v. In connection with the commencement of the TLA, petitioner determined profit projections arising from sales of the products at issue. Respondent's transfer-pricing adjustment calculations in the NOD applied petitioner's profit projections and the NOD did not otherwise dispute them.

5.a.8.vi. In connection with the commencement of the TLA, petitioner determined a five-year decay period and decay rate over that five-year period for the then-existing technology. Respondent's transfer-pricing adjustment calculations in the NOD applied, and the NOD did not otherwise dispute, (i) a five-year decay period and (ii) the rate of decay determined by petitioner. However, respondent incorporated a two-year lag to delay the onset of the five-year decay period. The two-year lag determined by respondent improperly overestimated the time in which technology developed under the R&D services agreements was commercialized, supplanting technology existing as of June 30, 2007.

5.a.8.vii. Respondent's transfer-pricing adjustment calculations in the NOD did not dispute, and the NOD did not otherwise address, the allocations of functions, risks, and financial returns that were reflected in the R&D services agreements, Distribution Transactions, Shared Services Transactions, and Wafer Fabrication Transactions.

5.a.8.viii. Respondent's transfer-pricing adjustment in the NOD and in the Notice of Deficiency for FY 2008 and FY 2009 at issue in Docket No. 18984-18 increased the Royalty Prepayment and the royalties due from WDI for FY 2008 through FY 2012 based on respondent's application of the discounted-cash-flow method. That application of respondent's method resulted in an adjustment to the Royalty Prepayment, in part by incorrectly increasing the total global residual profit by the dollar amount of substantially all of the Company's R&D expenses for FY 2008 through FY 2012, without factual support for doing so.

5.a.8.ix. The transfer-pricing adjustments in the NOD, based on respondent's discounted-cash-flow method, incorrectly accelerated the utilization and drawdown of Respondent's Lump Sum amount reflected in the Notice of Deficiency at issue in Docket No. 18984-18 by improperly applying nominal annual royalties to a discounted Respondent's Lump Sum amount. Applying nominal annual royalties to drawdown a discounted Respondent's Lump Sum amount (i) sets aside petitioner's chosen form of payment for applying NPV per-unit royalties to drawdown the Royalty Prepayment under the TLA; (ii) contradicts respondent's prior analyses reflected in NOPA IE 1-3 relating to FY 2008 and FY 2009 (and as carried forward to NOPA IE-2 relating to FY 2010 through FY 2012, which was subsequently withdrawn) and the April 14, 2017 Correction; and (iii) improperly increases respondent's primary income adjustments by approximately $295,000,000 for FY 2010 through FY 2012.

5.a.8.ix.A. As described in paragraphs 5.a.7.i.D and 5.a.7.i.E, Article 5.2 of the TLA requires that the NPV per-unit royalties multiplied by the actual HDD units sold be applied to calculate the amounts credited against the Royalty Prepayment. NOPA IE 1-3 stated that the discounted net present value of respondent's royalty amounts should be credited against the prepayment amount respondent had computed at the time.

5.a.8.ix.B. Respondent's analyses reflected in NOPA IE 1-3 for FY 2008 and FY 2009 (as carried forward to FY 2010 through FY 2012 in later-withdrawn NOPA IE-2) and in the April 14, 2017 Correction derived the NPV per-unit royalties by dividing the net present value of the residual profit according to the IRS's discounted-cash-flow valuation method by the annual projected HDD units sold. The NPV per-unit royalties were then multiplied by the actual HDD units sold by WDI in each of the years FY 2008 through FY 2012. The product of the NPV per-unit royalties and the actual units sold was then applied against the prepayment amount respondent had computed at the time for FY 2008.

5.a.8.ix.C. Contrary to NOPA IE 1-3 and his withdrawn NOPA IE-2, the NOD for FY 2010 through FY 2012 applied nominal per-unit royalties, which were not discounted using any present value factor or discount rate, to credit and drawdown Respondent's Lump Sum of $1,561,800,000 in FY 2008 through FY 2012 and thereby calculate respondent's transfer-pricing adjustments in FY 2010 through FY 2012.

5.a.8.ix.D. On information and belief, in the NOD for FY 2010 through FY 2012, respondent calculated nominal per-unit royalties of $4.16, $3.89, $3.67, $3.21, and $3.21 for FY 2008, FY 2009, FY 2010, FY 2011, and FY 2012, respectively.

5.a.8.ix.E. On information and belief, respondent multiplied his nominal per-unit royalties by the number of HDD units sold by WDI. That calculation yielded respondent's nominal annual royalty determinations in the amounts of $713,950,000, $662,714,000, and $420,560,000 for FY 2010, FY 2011, and FY 2012, respectively, which give rise to respondent's Code section 482 adjustments of $278,360,000, $662,710,000, and $406,820,000 in the NOD.

5.a.8.ix.F. If respondent had discounted his nominal per-unit royalties in the same manner reflected in his NOPA IE 1-3 and withdrawn NOPA IE-2, then the NPV per-unit royalties would have been $3.93, $3.28, $2.77, $2.16, and $1.93 for FY 2008 through FY 2012. If respondent had multiplied the NPV per-unit royalties by the number of HDD units sold by WDI, then (i) respondent would have had no adjustment for FY 2010 and (ii) a portion of Respondent's Lump Sum amount would still have remained as a credit for a part of the contingent royalties due in FY 2011.

5.a.8.x. Respondent's alternative transfer-pricing computation increased the annual royalties payable by WDI in FY 2010 through FY 2012 and is based on the same nominal per-unit royalties determined by his discounted-cash-flow model and the same nominal royalty amounts calculated in his primary transfer-pricing computation.

5.b. Code Section 956 Adjustment

5.b.1. As described above, before and during the years in issue, WDM and WDTh, and subsequently WDI, manufactured HDDs in Asia.

5.b.2. After manufacturing the HDDs, WDM and WDTh, and subsequently WDI, sold the finished HDDs to WDT, and WDT then sold the finished HDDs to third-party customers.

5.b.3. The Company's policy was to settle within 90 days the accounts payable arising from sales of finished HDDs by WDM and WDTh, and subsequently WDI, to WDT. The terms of WDT's intercompany accounts payable at issue did not exceed the amounts that would have been ordinary and necessary to carry on WDT's and WDI's trade or business had the sales been made between unrelated persons.

5.b.4. Respondent's Code section 956 adjustment is based on his determination that the entirety of accounts payable outstanding represented an investment of WDI's earnings in United States property, subject to his determination that accounts payable outstanding for 75 days or fewer (the 75-day Limit”) are eligible for the exception provided in Code section 956(c)(2)(C).

5.b.5. In the NOD, respondent determined that WDI's investment in United States property for FY 2010 was $56,900,916 and that previously taxed income under Code section 959 was $3,943,349.

5.b.6. The NOD did not explain the basis for the 75-day Limit.

5.b.7. On information and belief, respondent's Code section 956 adjustment is based solely on averages of outstanding days payable in lieu of the Company's business judgment about what was ordinary and necessary for the Company's business operations.

5.c. HGST, Inc. Warranty Expense.

5.c.1. After petitioner's acquisition of HGST, Inc. from HGST BV, HGST, Inc. became a member of petitioner's consolidated return group effective on March 9, 2012. In the Affiliations Statement appended to the NOD, Form 4089, respondent failed to list HGST, Inc. as a member of petitioner's consolidated return group for FY 2012. Nevertheless, the NOD proposed an adjustment to HGST, Inc.'s accrual and deduction of warranty expenses.

5.c.2. Under HGST Inc.'s distribution agreements with certain HGST foreign factories, including HGST (Thailand) Ltd. and HGST Singapore Pte. Ltd., the factories were responsible for the warranty costs and expenses associated with defective products.

5.c.3. HGST accrued warranty expenses of $16,723,963 on its books, but inadvertently failed to charge the warranty expenses to WDI during FY 2012.

5.c.4. On information and belief, petitioner offset the warranty expense accrual in FY 2012 by charging out warranty expenses totaling $16,531,431 to WDI for the tax year ended June 29, 2015 (“FY 2015”). As a result, petitioner reported taxable income from WDI for FY 2015 in the amount of $16,531,431, which corrected petitioner's erroneous expense deduction in FY 2012.

5.c.5. Respondent disallowed the warranty expense accrual in the amount of $16,723,963 for FY 2012. On information and belief, to date respondent has not proposed any decrease in petitioner's taxable income for FY 2015. Consequently, respondent's NOD adjustment for FY 2012 improperly duplicates income reported by petitioner in FY 2015.

5.d. Petitioner's NOLs and NOL Deductions.

5.d.1. Petitioner reported NOLs for FY 2010 of $51,529,893 and claimed NOL deductions of $43,080,413 and $56,807,805 for FY 2011 and FY 2012, respectively.

5.d.2. Respondent improperly disallowed petitioner's NOL generated in FY 2010 of $51,529,893 due to his erroneous determinations of taxable income for FY 2010.

5.d.3. Due to his erroneous determinations for FY 2008 through FY 2012, respondent improperly disallowed petitioner's NOL deductions of $43,080,413 and $56,807,805 for FY 2011 and FY 2012, respectively.

5.d.4. The correct amounts of petitioner's NOL for FY 2012 and petitioner's NOL deductions for FY 2011 and FY 2012 can be determined after the Court determines all other issues affecting petitioner's taxable income and Federal income tax liabilities for FY 2008 through FY 2012.

5.e. Petitioner's NOL Carryforwards.

5.e.1. Petitioner has claimed NOL carryforwards available as of the end of FY 2009, FY 2010, FY 2011, and FY 2012, of $87,065,663, $139,776,019, $67,605,296, and $0, respectively.

5.e.2. Due to his erroneous determinations of taxable income and tax liabilities for FY 2008 through FY 2012, respondent improperly decreased the NOL carryforwards that are properly available to petitioner as of the end of FY 2009, FY 2010, and FY 2011, by $87,065,663, $139,776,019, and $67,605,296, respectively.

5.e.3. The correct amounts of NOL carryforwards available to petitioner for FY 2010 through FY 2012 can be determined after the Court determines all other issues affecting petitioner's taxable income and Federal income tax liabilities for FY 2008 through FY 2012.

5.f. Code Section 382 Komag NOL Deductions.

5.f.1. Petitioner claimed Code section 382 Komag NOL deductions of $0, $38,204,543, and $29,421,726 for FY 2010, FY 2011, and FY 2012, respectively.

5.f.2. Respondent erroneously (increased) decreased petitioner's Code section 382 Komag NOL deductions by ($19,408,232), $29,814,001, and $21,031,184 for FY 2010, FY 2011, and FY 2012 respectively.

5.f.3. The correct amounts of current year Code section 382 Komag NOL deductions, for FY 2010 through FY 2012 can be determined after the Court determines all other issues affecting petitioner's taxable income and Federal income tax liabilities for FY 2008 through FY 2012.

5.g. Code Section 382 Komag NOL Carryforwards.

5.g.1. On its Federal income tax returns, petitioner reported Code section 382 Komag NOL carryforward balances available as of the end of FY 2009, FY 2010, FY 2011, and FY 2012, of $321,977,372, $321,980,372, $63,145,724, and $19,189,544, respectively.

5.g.2. Petitioner advised respondent that it had decreased the Code section 382 Komag NOL carryforward balances available as of the end of FY 2009 to $137,313,408. This amount fully reflects respondent's adjustments reflected in the Closing Agreement on Final Determination for Komag's tax years 2006 and 2007 and agreed IRS audit adjustments for Komag's final short taxable year ended September 5, 2007.

5.g.3. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously decreased (increased) the Code section 382 Komag NOL carryforwards available to petitioner as of the end of FY 2009, FY 2010, FY 2011, and FY 2012, by $266,567,135, $285,978,367, $35,534,261 and ($31,377), respectively.

5.g.4. The correct amounts of Code section 382 Komag NOL carryforwards available to petitioner for FY 2010 through FY 2012 can be determined after the Court determines all other issues affecting petitioner's taxable income and Federal income tax liabilities for FY 2008 through FY 2012.

5.h. Petitioner's AMT NOLs and NOL Deductions.

5.h.1. Petitioner reported AMT NOLs for FY 2010 of $59,371,116 and claimed AMT NOL deductions of $25,973,161 and $71,246,524 for FY 2011 and FY 2012, respectively.

5.h.2. Respondent erroneously disallowed petitioner's AMT NOL generated in FY 2010 of $59,371,116 due to his erroneous determination of taxable income for FY 2010.

5.h.3. Due to his erroneous determinations of alternative minimum taxable income for FY 2008 through FY 2012, respondent improperly disallowed petitioner's AMT NOL deductions of $25,973,161 and $71,246,524 for FY 2011 and FY 2012, respectively.

5.h.4. The correct amounts of AMT NOL deductions for FY 2010 through FY 2012 can be determined after the Court determines all other issues affecting petitioner's AMT taxable income and AMT liabilities for FY 2008 through FY 2012.

5.i. Petitioner's AMT NOL Carryforwards.

5.i.1. Petitioner has claimed AMT NOL carryforwards available as of the end of FY 2009, FY 2010, and FY 2011 of $111,901,332, $172,452,911, and $147,959,413, respectively.

5.i.2. Due to his erroneous determinations of taxable income and tax liabilities for FY 2008 through FY 2012, respondent improperly decreased the AMT NOL carryforwards that are properly available to petitioner as of the end of FY 2009, FY 2010 and FY 2011 by $111,901,332, $172,452,911 and $147,959,413, respectively.

5.i.3. The correct amounts of petitioner's AMT NOL carryforwards available to petitioner for FY 2010 through FY 2012 can be determined after the Court determines all other issues affecting petitioner's alternative minimum taxable income and AMT liabilities for FY 2008 through FY2012.

5.j. Code Section 382 Komag AMT NOL Deductions.

5.j.1. Petitioner has claimed Code section 382 Komag AMT NOL deductions of $0, $38,204,543, and $94,564,882, for FY 2010, FY 2011, and FY 2012, respectively.

5.j.2. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously (increased) decreased utilization of section 382 Komag AMT NOL deductions by ($39,730,467), $29,814,001, and $86,174,240 for FY 2010, FY 2011, and FY 2012, respectively.

5.j.3. The correct amounts of Code section 382 Komag AMT NOL deductions for FY 2010 through FY 2012 can be determined after the Court determines all other issues for FY 2008 through FY 2012.

5.k. Code Section 382 Komag AMT NOL Carryforwards.

5.k.1. On its Federal income tax returns, petitioner reported Code section 382 Komag AMT NOL carryforward balances available as of the end of FY 2009, FY 2010, FY 2011, and FY 2012, of $336,609,951, $336,609,951, $119,030,240, and $9,306,093, respectively.

5.k.2. Petitioner advised respondent that it had decreased the Code section 382 Komag AMT NOL carryforward balances available as of the end of FY 2009 to $152,096,673. This amount fully reflects IRS adjustments in the Closing Agreement on Final Determination for Komag's tax years 2006 and 2007, and agreed IRS audit adjustments for Komag's final short taxable year ended September 5, 2007.

5.k.3. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously decreased (increased) the Code section 382 Komag AMT NOL carryforwards available to petitioner as of the end of FY 2009, FY 2010, FY 2011, and FY 2012, by $266,416,449, $306,146,916, $96,957,747 and ($4,375,858), respectively.

5.k.4. The correct amounts of Code section 382 Komag AMT NOL carryforwards for FY 2010 through FY 2012 can be determined after the Court determines all other issues for FY 2008 through FY 2012.

5.l. Charitable Contribution Deduction.

5.l.1. Respondent's adjustments allowing additional charitable contribution deductions and decreasing petitioner's taxable income by $1,180,463 and $1,479,817 for FY 2010 and FY 2011, respectively, are attributable to respondent's erroneous adjustments increasing petitioner's taxable income.

5.l.2. The correct charitable contribution deductions allowable for FY 2010 through FY 2012 can be determined after the Court determines all other issues affecting petitioner's Federal income tax liabilities for FY 2008 through FY 2012.

5.m. Foreign Source Income — General Basket.

5.m.1. Petitioner reported foreign source income (loss) of ($10,875,692), $0, and $371,128,285 for FY 2010, FY 2011, and FY 2012, respectively.

5.m.2. Respondent increased petitioner's foreign source income by $332,692,180, $662,339,706, and $410,889,398, for FY 2010, FY 2011, and FY 2012, respectively. These adjustments are attributable to respondent's erroneous Code section 482 adjustments, erroneous Code section 956 adjustments, and the “agreed adjustments” identified as IE-1, IE-AL-1, and IE-AL-3 in Form 4549-B, Statement of Income Tax Examination Changes, attached to the NOD.

5.m.3. The correct amount of petitioner's foreign source income can be determined after the Court determines all issues affecting petitioner's foreign source and worldwide taxable income and petitioner's Federal income tax liabilities for FY 2008 through FY 2012.

5.n. Foreign Tax Credit Applied.

5.n.1. Under Code sections 901, 902, and 960, petitioner had available, but unused, current year FTCs of $6,046,459 and $8,052,862 for FY 2010 and FY 2011, respectively.

5.n.2. Additional FTCs are available with respect to the Italian and German income tax assessments set forth in paragraph 5.e.3 of the petition in Docket No. 18984-18 and in paragraph 5.W.2, infra.

5.n.3. Respondent erroneously utilized FTCs of $6,046,459 and $7,682,568 for FY 2010 and FY 2011, respectively, and erroneously disallowed utilization of FTC carryforwards of $50,772,945 that petitioner applied for FY 2012, due to respondent's erroneous determinations of tax liability for FY 2008 through FY 2012.

5.n.4. The correct amounts of FTCs to be applied as credits against petitioner's tax liabilities for FY 2010 through FY 2012 can be determined after the Court determines all issues for FY 2008 through FY 2012.

5.o. Foreign Tax Credit Carryforwards.

5.o.1. Petitioner claimed available FTC carryforwards of $44,549,939, $43,237,919, and $50,772,945 as of the end of FY 2009, FY 2010, and FY 2011, respectively.

5.o.2. The additional FTCs with respect to the Italian and German income tax assessments set forth in paragraph 5.e.3 of the petition in Docket No. 18984-18 and in paragraph 5.w.2, infra, increase petitioner's FTC carryforwards available as of the end of FY 2009, FY 2010, FY 2011, and FY 2012.

5.o.3. Respondent erroneously decreased the FTC carryforwards properly available to petitioner as of the end of FY 2009, FY 2010, and FY 2011, by $44,549,939, $43,237,919, and $50,772,945, respectively.

5.o.4. Respondent failed to increase petitioner's FTC carryforwards to reflect the Italian income German income tax assessments.

5.o.5. The correct amounts of FTC carryforwards available to petitioner can be determined after the Court determines all issues for FY 2008 through FY 2012.

5.p. AMT Foreign Tax Credit Applied.

5.p.1. Petitioner had available, but unused, current year AMT FTCs of $6,046,459 and $8,052,849 for FY 2010 and FY 2011, respectively.

5.p.2. Additional AMT FTCs are available with respect to the Italian and German income tax assessments set forth in paragraph 5.e.3 of the petition in Docket No. 18984-18 and in paragraph 5.W.2, infra.

5.p.3. Respondent erroneously utilized AMT FTCs of $6,046,459 and $7,682,555 for FY 2010 and FY 2011, respectively, and erroneously disallowed utilization of AMT FTC carryforwards of $39,364,565 that petitioner applied for FY 2012, due to his erroneous determinations of Federal income tax liability for FY 2008 through FY 2012.

5.p.4. The correct amounts of AMT FTCs to be applied as credits against petitioner's tax liabilities for FY 2010 through FY 2012 can be determined after the Court determines all issues for FY 2008 through FY 2012.

5.q. AMT Foreign Tax Credit Carryforwards.

5.q.1. Petitioner claimed available AMT FTC carryforwards of $35,553,261, $34,241,241, and $39,364,565 as of the end of FY 2009, FY 2010, and FY 2011, respectively.

5.q.2. The additional AMT FTCs with respect to the Italian and German income tax assessments set forth in paragraph 5.e.3 of the petition in Docket No. 18984-18 and in paragraph 5.w.2, infra, increase petitioner's AMT FTC carryforwards available as of the end of FY 2009, FY 2010, FY 2011, and FY 2012 respectively.

5.q.3. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously decreased the AMT FTC carryforwards available to petitioner as of the end of FY 2009, FY 2010, and FY 2011 by $35,553,261, $34,241,241, and $39,364,565, respectively.

5.q.4. Respondent failed to increase petitioner's AMT FTC carryforwards to reflect the Italian and German income tax assessments.

5.q.5. The correct amounts of AMT FTC carryforwards available to petitioner can be determined after the Court determines all issues for FY 2008 through FY 2012.

5.r. General Business Credits Applied.

5.r.1. Petitioner has accepted respondent's adjustments decreasing petitioner's current year research credits by $1,637,866, $1,290,289, and $2,418,890 for FY 2010, FY 2011, and FY 2012, respectively.

5.r.2. Petitioner utilized current year GBCs and GBC carryforwards in the amounts of $0, $0, and $33,754,277 for FY 2010, FY 2011, and FY 2012, respectively.

5.r.3. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously utilized current year GBCs of $17,396,038 and $17,094,151 for FY 2010 and FY 2011, respectively, and erroneously disallowed utilization of GBC carryforwards of $12,800,356 that petitioner applied for FY 2012.

5.r.4. The correct amounts of GBCs to be applied in FY 2008 through FY 2012 can be determined after the Court determines all issues for FY 2008 through FY 2012.

5.s. General Business Credit Carryforwards.

5.s.1. Petitioner claimed GBC carryforwards of $51,051,640, $61,371,480, $79,755,920 and $62,618,592 as of the end of FY 2009, FY 2010, FY 2011, and FY 2012 respectively.

5.s.2. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously decreased the GBC carryforwards available to petitioner by $51,051,640, $61,371,480, $79,755,920 and $62,618,592 as of the end of FY 2009, FY 2010, FY 2011, and FY 2012, respectively.

5.s.3. The correct amounts of GBC carryforwards available to petitioner for FY 2008 through FY 2012 can be determined after the Court determines all issues for FY 2008 through FY 2012.

5.t. Code Section 382 Komag General Business Credits.

5.t.1. Petitioner utilized Code section 382 GBC carryforwards attributable to Komag of $0, $0, and $14,364,754 for FY 2010, FY 2011, and FY 2012, respectively.

5.t.2. Respondent erroneously applied and absorbed Code section 382 Komag GBCs of $8,999,593 and $4,368,261 as credits to offset his erroneous determinations of Federal income tax liability for FY 2010 and FY 2011, respectively. Respondent also erroneously disallowed petitioner's utilization of Code section 382 Komag GBC carryforwards of $14,364,754 for FY 2012.

5.t.3. The correct amount of Code section 382 Komag GBCs to be utilized for FY 2010 through FY 2012 can be determined after the Court determines all issues for FY 2008 through FY 2012.

5.u. Code Section 382 Komag General Business Credit Carryforwards.

5.u.1. On its Federal income tax returns, petitioner reported Code section 382 Komag GBC carryforward balances available as of the end of FY 2009, FY 2010, FY 2011, and FY 2012 of $26,483,120, $26,565,603, $26,565,603, and $11,855,492, respectively.

5.u.2. Petitioner advised respondent that it had decreased the Code section 382 Komag GBC carryforward balances available as of the end of FY 2009 to $26,220,246. This amount fully reflects IRS adjustments in the Closing Agreement on Final Determination for Komag's tax years 2006 and 2007, and agreed IRS audit adjustments for Komag's final short taxable year ended September 5, 2007.

5.u.3. Due to his erroneous determinations for FY 2008 through FY 2012, respondent erroneously decreased the Code section 382 Komag GBC carryforwards available to petitioner by $9,344,950, $13,713,211, and $1,818,009 as of the end of FY 2010, FY 2011, and FY 2012, respectively.

5.u.4. The correct amounts of GBC carryforwards available to petitioner for FY 2010 through FY 2012 can be determined after the Court has determined the other issues for FY 2008 through FY 2012.

5.v. Minimum Tax Credits Applied and Minimum Tax Credit Carryforwards.

5.v.1. On its Federal income tax returns, petitioner utilized MTC carryforwards in the amounts of $0, $0, and $4,568,306 for FY 2010, FY 2011, and FY 2012, respectively.

5.v.2. Petitioner has available MTC carryforwards in the amounts of at least $11,312,075, $11,312,075, $15,550,440, and $10,982,134 as of the end of FY 2009, FY 2010, FY 2011, and FY 2012, respectively.

5.v.3. Respondent erroneously disallowed utilization of MTCs of $4,568,306 that petitioner applied to offset AMT liabilities for FY 2012.

5.v.4. Respondent erroneously decreased (increased) the amounts of MTC carryforwards available to petitioner by $4,451,451, $4,451,451, $4,454,126, and ($114,180) as of the end of FY 2009, FY 2010, FY 2011, and FY 2012, respectively.

5.v.5. The correct amount of MTCs allowed as credits against petitioner's regular Federal income tax liability and the correct amount of MTC carryforwards available to petitioner can be determined after the Court determines all issues for FY 2008 through FY 2012.

5.w. Affirmative Adjustments.

5.w.1. Setoff for Stock-Based Compensation Included in R&D Services.

5.w.1.i. Pursuant to R&D services agreements effective June 30, 2007, WDI engaged WDT and WDF to perform services to develop products, technologies, modifications, updates, improvements, and enhancements with respect to HDDs, components of HDDs, and manufacturing processes used to produce HDDs.

5.w.1.ii. The R&D services agreements were amended effective June 30, 2007, pursuant to which WDI would pay WDT and WDF arm's-length amounts equal to their costs plus a seven percent mark-up on certain of those costs.

5.w.1.iii. During FY 2010 through FY 2012, WDI reimbursed WDT for certain amounts attributable to stock-based compensation as part of the service fees charged to WDI under the R&D services agreements and paid an arm's-length mark-up equal to seven percent on those costs. On information and belief, the amounts of stock-based compensation (inclusive of the mark-up) reimbursed by WDI were $24,285,452, $33,570,527, and $38,024,327 for FY 2010, FY 2011, and FY 2012, respectively.

5.w.1.iv. The arm's-length standard applies in determining the amount of service fees owed by WDI to WDT and WDF under Code section 482 as compensation for R&D services for FY 2010 through FY2012.

5.w.1.v. Unrelated parties dealing at arm's length did not include any amount attributable to stock-based compensation in service fees or in the computation of reimbursable service costs charged for the provision of services.

5.w.1.vi. Temp. Treas. Reg. § 1.482-9T (2006) did not mandate the inclusion of stock-based compensation in the cost base subject to compensation under Code section 482.

5.w.1.vii. In the alternative, to the extent that Temp. Treas. Reg. § 1.482-9T (2006) is interpreted as mandating the inclusion of stockbased compensation in the cost base subject to compensation under Code section 482, Temp. Treas. Reg. § 1.482-9T (2006) is invalid because it is inconsistent with the arm's-length standard and the Administrative Procedure Act.

5.w.1.vii.A. On September 10, 2003, Treasury published a Notice of Proposed Rulemaking, REG-146893-02, in the Federal Register at 68 FR 53448, to propose regulations addressing the transfer pricing of intercompany services between related parties. The proposed regulations contained no provisions requiring stock-based compensation to be included in the cost base used to compute total services costs that were required to be charged out in related-party transactions involving intercompany services.

5.w.1.vii.B. Treasury did not provide prior notice and an opportunity for public comment on the question whether stock-based compensation should be treated as a cost of services before promulgating Temp. Treas. Reg. § 1.482-9T(j).

5.w.1.vii.C. Effective for tax years beginning after December 31, 2006, Treasury promulgated Temp. Treas. Reg. § 1.482-9T(j), which purports to include stock-based compensation in the “total services cost” of services performed by or for the benefit of related parties.

5.w.1.vii.D. Effective for tax years beginning after July 31, 2009, Treasury promulgated final Treas. Reg. § 1.482-9.

5.w.1.vii.E. Temp. Treas. Reg. § 1.482-9T(j) applies to FY 2010. Final Treas. Reg. § 1.482-9 applies to FY 2011 and FY 2012.

5.w.1.vii.F. Treasury acknowledged in Treas. Dec. 9278 (August 4, 2006) — the preamble to the temporary treasury regulations promulgated at Temp. Treas. Reg. § 1.482-9T — that the proposed regulations, REG-146893-02, contained no provisions requiring stock-based compensation to be included in the cost base used to compute total services costs that were required to be charged out in related-party transactions involving intercompany services.

5.w.1.vii.G. Treasury acknowledged in Treas. Dec. 9456 (August 4, 2009) — the preamble to the final treasury regulations promulgated at Treas. Reg. § 1.482-9 — that commentators objected to the explicit statement in Temp. Treas. Reg. § 1.482-9T(j) that “stock-based compensation can be a total services cost.”

5.w.1.vii.H. In connection with promulgating Treas. Reg. § 1.482-9, Treasury and the IRS Commissioner declined to provide any further guidance regarding stock-based compensation in the context of services between related parties.

5.w.1.vii.I. Treasury made no change to the treatment of stock-based compensation as a total services cost from Temp. Treas. Reg. § 1.482-9T(j) to Treas. Reg. § 1.482-9(j).

5.w.1.vii.J. In advance of promulgating Temp. Treas. Reg. § 1.482-9T and Treas. Reg. § 1.482-9, Treasury did not have any evidence of any actual transactions between unrelated parties in which one party paid or reimbursed the costs of stock-based compensation to the other party.

5.w.1.vii.K. In advance of promulgating Temp. Treas. Reg. § 1.482-9T and Treas. Reg. § 1.482-9, Treasury had received public comments that there was no evidence of any arm's-length transaction, including agreements for the provision of services, under which unrelated parties agreed to reimburse stock-based compensation in the cost of services performed pursuant to their agreement for the provision of services.

5.w.1.vii.L. Treasury's promulgation of Temp. Treas. Reg. § 1.482-9T and Treas. Reg. § 1.482-9, if such provision were interpreted to require related parties to include stock-based compensation as a reimbursable cost of providing intercompany services, is an arbitrary and capricious exercise of discretion that violates the Administrative Procedure Act and the arm's-length standard.

5.w.1.viii. Petitioner is entitled to exclude all stock-based compensation from the amount of costs reimbursed under the R&D services agreements between WDI and WDT and between WDI and WDF for FY 2010, through FY 2012.

5.w.1.ix. Accordingly, petitioner is entitled to a setoff decreasing its taxable income by $24,285,452, $33,570,527, and $38,024,327 for FY 2010, FY 2011, and FY 2012, respectively.

5.w.2. FTCs — Foreign Tax Assessments.

5.w.2.i. The Italian operations of petitioner's wholly owned German subsidiary, Western Digital Deutschland GmbH (“WD Germany”), were audited by the Italian taxing authority for WD Germany's 2010 through 2012 tax years. The Italian taxing authority alleged that WD Germany had a fixed-place-of-business permanent establishment in Italy and was therefore taxable in Italy on income earned and sales made through a such permanent establishment.

5.w.2.ii. Petitioner engaged Italian tax counsel to contest through administrative and judicial proceedings the proposed Italian income tax assessments against WD Germany and its alleged Italian permanent establishment.

5.w.2.iii. On the advice of Italian tax counsel, WD Germany resolved the Italian income tax assessments and paid, on or about December 21, 2015, the following amounts:

Tax Year

Tax Assessment (Euro)

Tax Assessment
(translated to U.S. Dollars on date of payment)

FY 2010

€829,525

$910,366

FY 2011

€553,005

$606,898

FY 2012

€637,407

$699,524

Total

€2,019,937

$2,216,788

5.w.2.iv. Petitioner and WD Germany exhausted their practical and effective remedies to reduce the assessments of Italian tax for FY 2010 through FY 2012.

5.w.2.v. To reflect the final assessments of Italian income tax referenced in paragraph 5.w.2.iii, supra, petitioner is entitled to increase the current year foreign taxes in the general limitation basket that are paid or accrued by WD Germany for FY 2010 through FY 2012 by the amounts alleged in paragraph 5.w.2.iii, supra, and to recompute the amount of FTCs under Code section 960 allowed for the years in issue or as an FTC carryover to the years in issue.

5.w.2.vi. WD Germany was audited by the German taxing authority for its 2010 through 2012 tax years. The German taxing authority assessed €179,935, €256,767, and €263,959 of income taxes for FY 2010, FY 2011, and FY 2012, respectively, at the conclusion of its audit, which translates to $197,470, $281,790, and $289,683.

5.w.2.vii. Petitioner and WD Germany exhausted their practical and effective remedies to reduce the assessment of German tax for FY 2010 through FY 2012.

5.w.2.viii. To reflect the final assessment of German income tax referenced in paragraph 5.w.2.vi, supra, petitioner is entitled to increase the current year foreign taxes in the general limitation basket that are paid or accrued by WD Germany for FY 2010 through FY 2012 by $768,943, and to recompute the amount of FTCs under Code section 960 allowed in the years in issue.

5.w.2.ix. In the alternative, respondent erred in failing to increase the FTCs allowable under Code section 960 that would be deemed paid by petitioner for FY 2010 to the extent the Court sustains any portion of respondent's erroneous Subpart F income adjustments referenced in paragraphs 5.b.1 through 5.b.7, supra.

5.x. Failure to Determine Overpayment. Petitioner is entitled to a refund of overpayments of income tax for FY 2010 through FY 2012 in amounts to be determined by the Court.

6. Prayer for Relief. WHEREFORE, petitioner prays that this Court hear this proceeding and determine:

6.a. that respondent erred in determining that petitioner had deficiencies in Federal income tax for FY 2010, FY 2011, and FY 2012;

6.b. that petitioner overpaid Federal income tax for FY 2010, FY 2011, and FY 2012, to the extent demonstrated by the evidence; and

6.c. that petitioner is entitled to such further relief as this Court may deem proper.

Respectfully submitted,

Sanford W. Stark
TC Bar No. SS0902
Morgan, Lewis & Bockius LLP
1111 Pennsylvania Avenue, NW
Washington, DC 20004
(202) 373-6678

Beth L. Williams
TC Bar No. WB0109
Morgan, Lewis & Bockius LLP
1400 Page Mill Road
Palo Alto, CA 94304
(650) 843-7224

Saul Mezei
TC Bar No. MS0625
Morgan, Lewis & Bockius LLP
1111 Pennsylvania Avenue, NW
Washington, DC 20004
(202) 373-6250

C. Terrell Ussing
TC Bar No. UC0015
Morgan, Lewis & Bockius LLP
1111 Pennsylvania Avenue, NW
Washington, DC 20004
(202) 373-6544

John F. Craig III
TC Bar No CJ1811
Morgan, Lewis & Bockius LLP
1111 Pennsylvania Avenue, NW
Washington, DC 20004
(202) 739-5885

Cecilia Chui Lambert
TC Bar No. CC0632
Western Digital
3355 Michelson Drive, Suite 100
Irvine, CA 92612
(949) 672-7841

Jesse D. Mulholland
TC Bar No. MJ2434
Western Digital
3355 Michelson Drive, Suite 100
Irvine, CA 92612
(949) 672-7478

Dated: March 8, 2019

FOOTNOTES

1All references to “Code section” refer to the Internal Revenue Code of 1986, as amended and in effect for petitioner’s tax years ended June 30, 2000 through FY 2012.

2Subsequent references in this petition to WDI include WDTh and WDM.

END FOOTNOTES

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