IRS Files Answer to Tax Court Petition in Transfer Pricing Dispute

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

UNITED STATES TAX COURT

ANSWER

RESPONDENT, in answer to the Petition filed in the above-entitled case, admits, denies, and alleges as follows:

1. and 2. Admits.

3. First sentence: Admits. Second sentence: Admits, except denies that the notice of deficiency ("Notice") disallowed foreign tax credit carryforwards. Third sentence: Admits that petitioner seeks a refund of overpayments plus interest, but denies that petitioner is entitled to such.

4.a. First sentence: Denies. Second sentence: Denies that respondent erred as alleged.

4.a.1. through 4.g., inclusive. Denies that respondent erred as alleged.

5.a.1. Denies for lack of sufficient knowledge or information to form a belief. Alleges that hard disk drive ("HDD") technology and the reliability of HDDs have been and still are critical factors in the HDD industry.

5.a.1.i. Denies for lack of sufficient knowledge or information to form a belief.

5.a.1.ii. Denies. Alleges that HDD manufacturer profits were dependent on numerous factors, including technology resulting from research and development ("R&D") efforts and acquisitions, developing new products and manufacturing expertise.

5.a.1.iii. Denies. Alleges that HDD manufacturers competed in many aspects.

5.a.1.iv. Denies for lack of sufficient knowledge or information to form a belief.

5.a.2. Admits, except denies that the worldwide Western Digital group (the "Company") produced cost-effective HDDs.

5.a.2.i. Admits.

5.a.2.ii. First sentence: Denies. Alleges that the Company's success, or failure, in the HDD industry depended on numerous factors, including but not limited to technology resulting from R&D efforts and acquisitions, reliability of the HDDs, development of new products, and manufacturing expertise. Second sentence: Denies. Alleges that there were numerous critical elements of HDD manufacturing, including technology resulting from R&D efforts and acquisitions, as well as cost-efficient, high-yield production and rigorous component and product testing.

5.a.2.iii. Admits that the Company's competitors included large multinationals that manufactured HDDs, except denies the remaining allegations for lack of sufficient knowledge or information to form a belief.

5.a.3.i. and 5.a.3.ii. Denies for lack of sufficient knowledge or information to form a belief.

5.a.3.iii. First sentence: Denies for lack of sufficient knowledge or information to form a belief. Second sentence: Denies, except admits that Western Digital (Malaysia) Sdn. Bhd. ("WDM") manufactured finished HDDs during the years in issue.

5.a.3.iv. Denies for lack of sufficient knowledge or information to form a belief, except admits that Western Digital (Thailand) Company Ltd. ("WDTh") operated in Thailand during the years in issue.

5.a.3.v. First sentence: Admits. Second sentence: Denies for lack of sufficient knowledge or information to form a belief. Third sentence: Admits.

5.a.3.vi. First sentence: Admits. Second sentence: Admits, except denies that Western Digital Bang Pa-In Co., Ltd. ("WDB") and WDTh played a role in designing sliders. Third sentence: Denies. Alleges that, during the years in issue, the wafers made by Western Digital (Fremont) LLC ("WDF") were purchased and used by WDM and WDTh for use in manufacturing the sliders.

5.a.3.vii. Denies, except admits that for Federal income tax purposes, from June 30, 2007, through the years in issue, WDM was treated as a disregarded entity with no existence separate from Western Digital Ireland, Ltd. ("WDI").

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

5.a.3.ix. Denies for lack of sufficient knowledge or information to form a belief, except admits that the Company acquired Komag, Inc. ("Komag") during petitioner's tax year ended June 27, 2008 ("2008 taxable year").

5.a.3.x. Denies for lack of sufficient knowledge or information to form a belief.

5.a.3.xi. Denies.

5.a.3.xii. Denies for lack of sufficient knowledge or information to form a belief.

5.a.4.i. and 5.a.4.ii. Denies for lack of sufficient knowledge or information to form a belief.

5.a.4.iii. First sentence; Denies for lack of sufficient knowledge or information to form a belief. Second sentence: Denies. Alleges that during the years in issue, all sliders manufactured by the Company were manufactured by WDTh.

5.a.4.iv. Admits.

5.a.4.v. through 5.a.4.ix., inclusive. Denies for lack of sufficient knowledge or information to form a belief.

5.a.4.x. Denies.

5.a.4.xi. through 5.a.4.xv., inclusive. Denies for lack of sufficient knowledge or information to form a belief.

5.a.5.i. First and second sentences: Denies for lack of sufficient knowledge or information to form a belief. Third sentence:. Denies.

5.a.5.ii. Denies for lack of sufficient knowledge or information to form a belief.

5.a.5.iii. First sentence: Admits. Second and third sentences: Denies for lack of sufficient knowledge or information to form a belief.

5.a.6.i. First sentence: Denies, except admits that Western Digital Technologies, Inc. ("WDT") sold HDDs to third-party customers or foreign company affiliates. Alleges that WDM and WDTh sold the finished HDDs to WDT. Second sentence: Admits.

5.a.6.ii. Admits.

5.a.6.iii. Denies for lack of sufficient knowledge or information to form a belief.

5.a.7.i. First sentence. Admits. Second sentence: Admits, except alleges for clarification that under the Technology License Agreement ("TLA"), WDT and WDF granted to WDI for four years: "a worldwide, irrevocable, exclusive license, with the right to grant sublicenses, under [WDT's and WDF's] IP to market, distribute, sell, and otherwise commercially exploit Magnetic Storage Products, and . . . a worldwide, irrevocable, non-exclusive license, with the right to grant sublicenses, under [WDT's and WDF's] IP to make, have made, and use Magnetic Storage Products and Magnetic Storage Manufacturing Tools and to use Marks solely on Products manufactured for distribution by WDT." Further alleges that the TLA defines "Magnetic Storage Products" as "hard disk drives, sliders, head gimbal assemblies, and any components thereof," "Magnetic Storage Manufacturing Tools" as "any manufacturing systems and processes used in the manufacture of hard disk drives or any components thereof, including without limitation wafer fabrication tools for wafer manufacturing processes and any samples of Magnetic Storage Products used for testing or development purposes," and "marks" as "those trademarks, service marks, trade names, domain names, trade dress, logos and similar designations, whether registered or unregistered, which are . . . owned or licenses by [WDT or WDF], and used in connection with any or all of the Magnetic Storage Products." Third sentence: Admits that pursuant to the TLA, WDI would be the owner of the Improvements (as that term is defined in the TLA) which were created by or for WDI, subject to WDT's and WDF's rights under the TLA.

5.a.7.i.A. Denies.

5.a.7.i.B. and 5.a.7.i.C. Admits.

5.a.7.i.D. Denies.

5.a.7.ii. First sentence: Admits. Second sentence: Admits, except denies that the compensation was guaranteed. Third sentence: Admits, except alleges for clarification that WDI's rights to the R&D-related developments resulting from the services performed under the R&D. services agreements between WDI and WDT and WDI and WDF effective June 30, 2007 (the "R&D services agreements") are subject to WDT's rights to the Existing IP as defined in the R&D services agreements. Fourth sentences: Admits.

5.a.7.iii.A. First sentence: Admits, except alleges for clarification that WDI itself never manufactured HDDs in Asia, but that WDM and WDTh, disregarded entities of WDI for Federal income tax purposes, manufactured HDDs in Asia. Second sentence: Denies that all of the Company's marketing, distribution, and sales activities were conducted by foreign affiliates of the Company. Alleges that WDT also conducted marketing, distribution, and sales activities.

5.a.7.iii.B. Denies.

5.a.7.iii.C. Admits.

5.a.8.i. First sentence: Denies. Second sentence: Admits that the transfer pricing adjustment in the Notice of Proposed Adjustment ("NOPA") was based, inter alia, on a report prepared by IRS Economist Mariko Killion, dated March 25, 2015, and a report prepared by Shirley Tessler and Professor Gio Wiederhold of MITRE Corporation dated July 21, 2014, except denies that the transfer pricing adjustment was based solely on such reports.

5.a.8.ii. First sentence: Admits, except denies for lack of sufficient knowledge or information to form a belief, the timing of when petitioner determined profit projections. Second sentence: Denies.

5.a.8.iii. First sentence: Admits, except denies for lack of sufficient knowledge or information to form a belief, the timing of when petitioner determined the decay period and decay rate. Second sentence: Denies that respondent accepted either a five-year decay period or the rate of decay determined by petitioner. Alleges that the transfer pricing adjustment in the Notice did not make any adjustments to the decay period and rate of decay. Third sentence: Admits. Fourth sentence: Denies.

5.a.8.iv. Denies, except admits that in computing the transfer pricing adjustment in the Notice, respondent factored in the prices charged, or compensation earned, by petitioner for the R&D services agreements. Distribution Transactions, and Wafer Fabrication Transactions.

5.a.8.v. First sentence: Denies. Alleges that the transfer pricing adjustment in the Notice is based on a discounted cash flow analysis which is sometimes referred to as an application of the income method. Further alleges that there is only one transfer pricing adjustment in the Notice and that the Notice provides an alternative computation of that adjustment. Second sentence: Denies.

5.a.8.vi. First sentence: Denies. Alleges that the increase in annual royalties is an alternative computation, rather than an alternative adjustment, of the transfer pricing adjustment in the Notice. Further alleges that the transfer pricing adjustment in the Notice is based on a discounted cash flow analysis which is sometimes referred to as an application of the income method. Second and third sentences: Denies.

5.b.1. Denies, except admits that before and during petitioner's 2008 taxable year and the taxable year ended July 3, 2009 ("2009 taxable year"), WDM and WDTh manufactured HDDs in Asia. Alleges that WDI itself never manufactured HDDs in Asia, but that WDM and WDTh, disregarded entities of WDI for Federal income tax purposes, manufactured HDDs in Asia.

5.b.2. Denies, except admits that after manufacturing HDDs, WDM and WDTh sold the finished HDDs to WDT, and that WDT sold some of the finished HDDs to third-party customers. Alleges that WDT also sold some of the finished HDDs to related entities that sold the finished HDDs to third-party customers.

5.b.3. Denies.

5.b.4. Denies. Alleges that the entirety of the relevant accounts payable are investments in United States property. Further alleges that the Code section 956 adjustment reflects the fact that accounts payable outstanding for 75 days or less during the relevant time period were treated as eligible for the exception described in Code section 956(c)(2)(C).

5.b.5. Denies. Alleges that the Notice explains that the intercompany payables petitioner owed to its controlled foreign corporations ("CFCs") which remained outstanding for over 75 days represent an investment of such CFCs in the United States property that are not eligible for an exception under Code section 956(c)(2), as stated in paragraph 5.b.4. of the petition. Further alleges that the NOPA issued on August 20, 2014, contains a detailed explanation of the basis for respondent's Code section 956 adjustment.

5.b.6. Denies.

5.c.1.i. Responses to subparagraphs 5.b.1. through 5.b.6., inclusive, supra, are incorporated by reference.

5.c.1.ii. Denies, except admits that the adjustment to WDT's net operating loss ("NOL") deduction for the 2008 taxable year was based, in part, on applying the adjustment described in petition ¶ 5.b.4. Alleges that the adjustment to WDT's NOL deduction for the 2008 taxable year was also based on other adjustments.

5.c.1.iii. Admits.

5.c.1.iv. Admits, except denies that the adjustment was not explained in the Notice,.

5.C.1.v. Admits, except denies that the NOL carryforwards were properly available to petitioner.

5.c.2.i. and 5.c.2.ii. Admits.

5.c.2.iii. Denies.

5.d. Denies.

5.e.1.i. First sentence: Denies, except admits that WD Media, Inc. ("WDMI") (formerly known as Komag) and WD Media (Bermuda) Ltd. ("WDM Bermuda") entered into a Research and Development Services Agreement ("RDSA") under which WDM Bermuda engaged WDMI to perform R&D services in exchange for a service fee equal to WDMI's costs for R&D services plus seven percent (7%). Second sentence: Admits.

5.e.1.ii. First sentence: Denies. Second sentence: Denies, except admits that WDMI reported $88,088,233 of R&D service income from WDM Bermuda for the 2008 taxable year.

5.e.1.iii. Admits, except denies for lack of sufficient knowledge or information to form a belief that the overcharge was due to manual error.

5.e.1.iv. Denies. Alleges that WDMI undercharged WDM Bermuda by $719,279 for the 2008 taxable year, and that such undercharge must be taken into account in determining the net amount, if any, overcharged by WDMI under the RDSA for the 2008 taxable year.

5.e.1.v. Denies. Alleges that taxpayers do not have the authority to decrease taxable income pursuant to Treas. Reg. § 1.482-1(a)(3) and that only respondent has the authority to decrease WDMI's income to account for any overcharge by WDMI. Further alleges that WDMI's income should be reduced by $6,440,751, and that petitioner is required to make conforming adjustments in accordance with Treas. Reg. § 1.482-1(g)(3).

5.e.1.vi. Denies.

5.e.2.i. Admits.

5.e.2.ii. Denies. Alleges that R&D services agreements were amended, effective June 30, 2007, to modify WDT's charge from five percent (5%) to seven percent (7%) on costs. Further alleges that the term "costs" is defined under the R&D services agreements as "direct and indirect costs attributable to the R&D Services performed by WDT."

5.e.2.iii. Denies for lack of sufficient knowledge or information to form a belief.

5.e.2.iv. Admits, except alleges for clarification that Code section 482 and the principles and guidelines of the Treasury regulations thereunder, including the arm's length standard, apply in determining the amount of service fees owed by WDI to WDT and WDF as compensation for R&D services in the 2008 and 2009 taxable years.

5.e.2.v. First sentence: Admits, except denies for lack of sufficient knowledge or information to form a belief that the costs plus a seven percent (7%) mark-up on those costs was an arm's-length mark-up. Second sentence: Denies for lack of sufficient knowledge or information to form a belief.

5.e.2.vi. Admits.

5.e.2.vii. Denies for lack of sufficient knowledge or information to form a belief.

5.e.2.viii. and 5.e.2.ix. Denies.

5.e.2.ix.A, First sentence: Admits. Second sentence: Denies. Alleges that Prop. Treas, Reg. § 1.482—9T(j) (2003) defines "total service costs" as including "all costs of rendering those services for which total service costs are being determined" and provides that: "[t]otal service costs include all costs, based on analysis of the facts and circumstances, that can be directly identified with the act of rendering the services, and all other costs reasonably allocable to the services"; that "costs for this purpose should comprise full consideration for all resources expended, used, or made available to achieve the specific objective for which the service is rendered"; and that "[r]eference to generally accepted accounting principles or Federal income tax accounting rules (where Federal income tax data for comparable transactions or business activities are available) may provide a useful starting point but will not be conclusive."

5.e.2.ix.B. Denies.

5.e.2.ix.C. Denies, except admits that effective for tax years beginning after December 31, 1996, Treasury promulgated Temp. Treas. Reg. § 1.482-9T(j).

5.e.2.ix.D. Denies. Alleges that Treas. Dec. 9278 (August 4, 2006), the preamble to the temporary regulations promulgated at Temp. Treas. Reg. § 1.482-9T provides that "§ 1.482-9T(j) of the temporary regulations clarifies that all contributions in cash or kind (including stock-based compensation) are included in total services costs." (Emphasis added.)

5.e.2.ix.E. and 5.e.2.ix.F. Denies for lack of sufficient knowledge or information to form a belief.

5.e.2.ix.G. Denies.

5.e.2.X. Denies.

5.e.3.i. through 5.e.3.ix., inclusive. Denies for lack of sufficient knowledge or information to form a belief.

5.e.3.x. Denies that respondent erred as alleged.

5.f.1. and 5.f.2. Admits.

5.f.3. Denies that respondent erred as alleged.

5.f.4. Admits.

5.f.5. First sentence: Denies, except admits that the amount of minimum tax credits available for carryover to the 2008 taxable year is $4,568,306. Second sentence: Denies.

5.f.6. and 5.f.7. Admits.

5.g. Denies.

6.a. through c. inclusive. Admits that petitioner prays that this Court hear this proceeding, except denies that respondent erred as alleged, that petitioner overpaid Federal income tax for the 2008 and 2009 taxable years, and that petitioner is entitled to any relief.

7. Denies generally each and every allegation of the petition not herein specifically admitted, qualified, or denied.

WHEREFORE, it is prayed:

WILLIAM M. PAUL
Acting Chief Counsel
Internal Revenue Service

LLOYD T. SILBERZWEIG
Special Trial Attorney
IRS Office of Chief Counsel
(CC:LB:5:SLSF)
Tax Court Bar No. SL0630
100 First Street, Suite 1800
San Francisco, CA 94105
Telephone: (415) 547-3806

Dated: November 30, 2018

for ERICA WU
Attorney
IRS Office of Chief Counsel
(CC:LB:5:LN)
Tax Court Bar No. WE0327
24000 Avila Road, Suite 4404
Laguna Niguel, CA 92677
Telephone: (949) 575-6564

for JIMEEL R. HAMUD
Attorney
IRS Office of Chief Counsel
(CC:LB:5:LN)
Tax Court Bar No. HJ1564
24000 Avila Road, Suite 4404
Laguna Niguel, CA 92677
Telephone: (949) 575-6513

OF COUNSEL:

ROBIN L. GREENHOUSE
Division Counsel (CC:LB)
EWAN D. PURKISS
Area Counsel (CC:LB:5)

H. CLIFTON BONNEY, JR.
Deputy Area Counsel (CC:LB:5:SLSF)