Download Transfer Pricing By Mark A. Oates and James M. O`Brien

November–December 2013
Transfer Pricing
By Mark A. Oates and James M. O’Brien
IRS Economists Say the Darndest Things!
T
Mark A. Oates is a Partner in and the
past Chair of Baker & McKenzie’s North
American Tax Controversy Practice.
hose of us of a certain vintage may recall the
old Art Linklater radio/television program,
“House Party,” which had a recurring, humorous feature known as Kids Say the Darndest Things
in which Art posed various questions to young children. (The series, which ran from 1945 to 1969, was
also resurrected and reprised by Bill Cosby in the
late 1990s.) The answers were hilarious as the kids
often didn’t understand the question asked, misinterpreted the question or just flat out engaged their
wonderful imaginations. The incongruity between
the questions and answers gave rise to many smiles
and chuckles. The authors recently were reminded
of this show while reading the comments made by
Bill Morgan, the Senior Economic Adviser to the
APMA Program, at a Bloomberg BNA function in
July 2013.1
In particular, we read with interest Morgan’s lament
over the Tax Court’s opinion in VERITAS Software
Corp. v. Commissioner:2
To me as an economist, the decision in Veritas really drove a wedge between the way the
economics and the law work in attempting to
abide by an arm’s length standard and clearly
reflect income.3
James M. O’Brien is a Partner in and
the past Chair of Baker & McKenzie’s
North American Tax Practice Group.
INTERNATIONAL TAX JOURNAL
Morgan’s lament, like the kids’ answers to Art
Linklater’s questions, shows a complete disconnect
between the real question posed in VERITAS and the
answers Morgan and the IRS would like to give.4
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Transfer Pricing
Just Whose Arm
Are We Measuring, Anyway?
At issue in VERITAS was the amount of the arm’s
length payment required under Treas. Reg. §1.4827(g)(2) for the use of pre-existing intangible
property in the development of new products under
a cost sharing agreement. The principal dispute in
VERITAS was whether the taxpayer had to make a
buy-in payment for the pre-existing intangible property used in new products developed under the cost
sharing agreement as determined by reference to
comparable licenses of the pre-existing intangible
property (the taxpayer’s argument), or whether the
combination of the license of pre-existing intangibles together with the cost sharing agreement
should be treated “as ‘akin’ to a sale” of the business
outside the United States and thus require a buy-in
payment equivalent to a hypothetical sale price of
the business (the IRS’s argument).
In short, the taxpayer and the IRS were measuring
two different things. The taxpayer, in reliance on the
regulations in effect at the time, was valuing only the
intangible property used in the development of new
products under the cost sharing agreement as of the
date of the cost sharing agreement. The taxpayer’s theory of the case looked to royalties paid by unrelated
parties for similar intangible property in comparable
transactions and applied such royalties over the useful
life of the pre-existing intangible property.
The IRS, on the other hand (or should we say,
“arm”), was attempting to determine a hypothetical
acquisition price for the sale of the entire business
within the geographic territory of the license and
cost sharing agreement (e.g., the business outside the
United States). Under its theory of the case, the IRS
attempted to determine the present value of all future
cash flows into perpetuity of the business conducted
within the license territory. The IRS valuation not only
included the value of the pre-existing intangible property, but it also explicitly included sales of products
to be developed in the future long after the useful life
of the pre-existing intangibles had ended.
The parties’ positions as to the arm’s length value
of the required buy-in payment demonstrate just
how different the taxpayer and IRS approaches were
in VERITAS. The taxpayer, based on comparable license transactions for the same or similar intangible
property, contended that the buy-in value was approximately $124 million. The IRS, based on what
it calculated a hypothetical purchase price of the
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business to be, contended in the Notice of Deficiency
that the buy-in value should be $2.5 billion. By the
time of trial, the IRS had hired a new expert, Dr. John
Hatch, had sharpened its pencil and had determined
the acquisition-based, buy-in payment to be “only”
$1.675 billion.
Why did VERITAS and the IRS reach such different conclusions as to buy-in value? Because they
measured vastly different things. Judge Foley ruled
in favor of VERITAS because he found that the IRS
“disregarded section 1.482-7(g)(2), Income Tax Regs.,
which limits the buy-in payment to preexisting intangibles.”5
The case was really that simple. You have to value
the right thing. The IRS valued the wrong thing and
lost. End of story.
What Wedge?
Judge Foley’s opinion in VERITAS drove no “wedge
between the way the economics and the law work”
as asserted by Mr. Morgan. As Judge Foley recounted
in his opinion, the IRS used a discounted cash flow
method (an “income method”) to value the buy-in
payment. There is certainly nothing wrong with a
discounted cash flow method of valuation—this is a
fundamental tool of finance. The problem was that the
IRS specified the wrong parameters in its discounted
cash flow method. If the IRS had used the correct
parameters, their income method would have produced comparable results to the values determined
by VERITAS. Of course, those parameters would not
have yielded the IRS the kind of money they were
looking for in terms of result.
Judge Foley did not mince words regarding the
errors he found in the IRS discounted cash flow
analysis: “Respondent’s predicament was primarily attributable to the implausibility of respondent’s
flimsy determination.”6 Among other things, Judge
Foley found that: (a) Hatch’s akin to a sale theory
valued the wrong cash flows;7 (b) Hatch used the
wrong useful life for the products;8 (c) Hatch used
the wrong discount rate;9 (d) Hatch used the wrong
growth rate;10 (e) Hatch did not know what items
he had valued;11 and (f) Hatch attributed significant
value to items that either were not transferred or had
insignificant value.12
Mr. Morgan would have you believe that Judge
Foley’s opinion departed from mainstream economics. To the contrary, Judge Foley understood the
financial principles at play and how a discounted
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©
November–December 2013
cash flow is supposed to be calculated. He just simply
found that the IRS did a horrible job of applying the
discounted cash analysis to the facts of the case. In
Judge Foley’s words:
[O]ur analysis of whether respondent’s $1.675
billion allocation is arbitrary, capricious or unreasonable hinges primarily on the testimony of
Hatch. Put bluntly, his testimony was unsupported,
unreliable, and thoroughly unconvincing. Indeed,
the credible elements of his testimony were the
numerous concessions and capitulations.13
Contrary to Morgan’s lament, it was the IRS’s
“specious” “akin to a sale” theory14 and Dr. Hatch’s
bungled application of his discounted cash flow
analysis that attempted to drive a wedge between
mainstream economics and the law, not Judge Foley’s
well-reasoned and amply supported opinion.15
as the item has substantial value independent of the
services of any individual. Specifically, the statute
defines “intangible property” to mean any:
(i) patent, invention, formula, process, design, pattern or know-how;
(ii) copyright, literary, musical or artistic composition;
(iii) trademark, trade name or brand name;
(iv) franchise, license or contract;
(v) method, program, system, procedure, campaign,
survey, study, forecast, estimate, customer list or
technical data; or
(vi) any similar item, which has substantial value
independent of the services of any individual.
Code Sec. 936(h)(3)(B)
As Judge Foley recognized in VERITAS, goodwill,
going concern value and work force in place are
neither listed in Code Sec. 936(h)(3)(B) nor are they
similar to the items listed in the statute.18
Judge Foley’s conclusion is neither novel nor
surprising.
Treasury and the IRS have long held the
It’s the LAW, Mr. Morgan
same view. In 1993, Treasury and the IRS requested
comments as to “whether
In the article, Morgan also
the definition of intangible
criticizes Judge Foley’s
legal analysis in VERITAS,
Contrary to Morgan’s complaints, property incorporated in
Treas. Reg. §1.482-4(b)
specifically Judge Foley’s
Judge
Foley’s
opinion
in
VERITAS
should be expanded to
conclusion that goodwill,
did not drive a wedge between
include items not norgoing concern value and
mally considered to be
workforce in place are
law and economics. Judge Foley
items of intellectual propnot items of intangible
started
with
the
straightforward
erty such as workforce in
property within the defilanguage of the statute and the
place, goodwill or gonition set forth in Code
ing concern value.”19 In
Sec. 936(h)(3)(B). Morgan
applicable regulation.
complains that, based
2009, the Treasury and the
on VERITAS, “taxpayers
IRS again recognized this
are claiming that ‘purely as a legal issue,’ goodwill,
point when the administration sought to change the
going concern and workforce in place—and other
law to expand the definition of “intangible property”
intangibles not identified in section 936(h)(3)(B)—are
under Code Sec. 482 to include work force in place,
16
not compensable in a related party transaction.”
goodwill and going concern value.20
According to Morgan, “such arguments lead to the
Morgan’s complaint that Foley’s legal analysis
‘wrong economic result.’”17
“lead[s] to the wrong economic result” stands the law
on its head. The LAW says that the buy-in payment
What Morgan would characterize as an aberrational legal analysis leading to the “wrong economic
under Treas. Reg. §1.482-7(g)(2) includes only the
result,” the authors view as a fairly straightforward
value of pre-existing intangible property, with “inand mandated result under the controlling statutory
tangible property” defined by Code Sec. 936(h)(3)(B)
and regulatory provisions. Code Sec. 482 and Treas.
to NOT include goodwill, going concern value and
Reg. §1.482-4(b) adopt the same definition of “inwork force in place. Morgan thinks they should be
tangible property” as set forth in Code Sec. 936(h)(3)
valued and included in the buy-in payment. But that’s
(B). Code Sec. 936(h)(3)(B) sets forth a laundry list of
not the law. The result is that Morgan, like Hatch in
items that constitute “intangible property” and further
VERITAS, would value the wrong thing by including
extend the definition to other similar items, so long
items in his valuation that the law says are not within
INTERNATIONAL TAX JOURNAL
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Transfer Pricing
the scope of the things to be valued. This does not
lead to the wrong economic answer—Morgan simply
makes up a different economic question.
Morgan’s real complaint is two-fold. First, like
Hatch in VERITAS, he cannot justify the buy-in values
asserted by the IRS unless he can value more than
pre-existing intangible property. Second, Morgan also
claims that it is too hard to value goodwill, going
concern value and work force in place.
The first complaint is obviously result-oriented and
should be ignored.
The second complaint is also flawed. In Morgan’s
words21 “Until or unless VERITAS is overturned, the
agency’s options are limited. It could accept the legal
argument as it stands, but that would mean asking
economists to determine the value of goodwill or going
concern and carve them out of the value of compensible
(sic) intangibles.” “That is not a workable solution,” he
said. “I don’t think it’s enforceable; it’s wrong economically; and we can’t even decide what the definition of
goodwill is—so how can we possibly value it?”
Think about this for just a second. Morgan says he
can’t even define what it is he should value, and he
doesn’t see how he could possibly value it. Morgan’s
proposed solution is not to worry about what he is
valuing or what that value is, but rather to just include
it. If you just take the hypothetical sale price of the
foreign territory it makes the valuation nice and easy.
The problem, of course, is that the “easy answer”
once again answers the wrong question. Morgan’s
problem emanates from the IRS desire to value everything rather than just the pre-existing intangible
property at issue under the pre-2009 buy-in regulation.
Morgan’s problem can be easily avoided: valuation
of the pre-existing intangible property need not start
with an acquisition price and work down. Obviously,
for example, one could directly value the pre-existing
intangible property by reference to comparable transactions, or one could do a present value of the cash
flows expected to be generated by the pre-existing
intangible property over the life of those pre-existing
intangibles. Finally, if Morgan and the IRS really want
to start with a hypothetical acquisition price and
then subtract out everything except the value of the
pre-existing intangible property, that is within their
prerogative. However, if they elect to follow such an
approach, they necessarily have chosen to take on
the task of valuing all the items of value other than
the pre-existing intangible property and should not be
heard to complain that their chosen path is “too hard.”
Morgan also makes the proverbial “the sky is fall-
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ing” argument, claiming that Judge Foley’s opinion
“undermine[s] ‘one of the most powerful enforcement
tools the IRS has—which is our ability to test arm’s
length results by analyzing profits or expected profits
of the parties in a transaction.’”22 Nothing could be
further from the truth. A present value analysis of
the expected cash flows (i.e., operating profits) to be
derived from the pre-existing intangible property is
an entirely appropriate means by which to value the
pre-existing intangible property. Judge Foley’s opinion
is in accord with such an approach. As discussed
above, however, Judge Foley’s problem with the IRS
analysis in VERITAS was simply that the IRS botched
the present value analysis by valuing more than the
pre-existing intangible property, using the wrong
cash flows, using the wrong useful life and using the
wrong discount rate. Judge Foley pulled no punches
in explaining where the IRS went wrong:23
[A]s a practical and legal matter respondent was
forced to justify the $1.675 billion allocation by
reference only to the preexisting intangibles. As
discussed herein, he simply could not. Respondent, in a futile attempt to escape this dilemma,
ignored the parties’ settlement relating to the
RDA24 and disregarded section 1.482-7(g)(2), Income Tax Regs., which limits the buy-in payment
to preexisting intangibles. In addition, respondent
inflated the determination by valuing short-lived
intangibles as if they have a perpetual useful
life and taking into account income from future
products created pursuant to the RDA.
Conclusion
Contrary to Morgan’s complaints, Judge Foley’s opinion in VERITAS did not drive a wedge between law
and economics. Judge Foley started with the straightforward language of the statute and the applicable
regulation. He read “pre-existing” intangible property
to mean exactly what one would think—intangible
property that existed before the parties entered into
a cost sharing agreement. He looked to the statutory
definition of “intangible property” and adopted the
same view previously publicly pronounced by the
Treasury and the IRS, namely, that goodwill, going
concern value and work force in place did not constitute intangible property under Code Sec. 936(h)(3)(B).
Judge Foley rejected the IRS present value analysis for a
host of valid reasons, not the least of which was the absurdity of the IRS claim that the pre-existing intangible
CCH Incorporated. All Rights Reserved
November–December 2013
property at issue—software —would last forever. In so
doing, Judge Foley made a plain vanilla application
of economics to the questions framed under the law.
VERITAS was a straightforward application of the
law and economics that the Justice Department and
the IRS knew could not be reversed and thus was
not appealed.
IRS economists do say the darndest things! Unfortunately, Morgan’s views reflect the steadfast views
of the IRS Transfer Pricing Organization, which has
designated at least one pre-2009 regulations buy-in
case for litigation and is queuing up other taxpayers
on audit in its quest to elevate its view of economics
over the governing law.
ENDNOTES
1
2
3
4
5
6
7
Veritas is “Wedge” Between Law, Economics
Weakening Profits Method, IRS Official Says,
22 BNA TRANSFER PRICING REPORT 355 (Jul. 25,
2013) (“Morgan’s Wedge”).
Veritas Software Corporation & Subsidiaries,
Symantec Corporation, 133 TC 297, Dec.
58,016 (2009), non-acq. A.O.D. 2010-005,
IRB 2010-49, 1 (Dec. 6, 2010).
Morgan’s Wedge at 1.
In the interests of transparency, the authors
tried the Veritas case.
VERITAS, 133 T.C. at 315.
133 T.C. at 315.
Id. at 315, 320-21, 323-24.
8
9
10
11
12
13
14
15
16
17
18
Id. at 315, 321, 324.
Id. at 315, 324-26.
Id. at 326-27.
Id. at 321-23.
Id. at 321.
Id. at 315.
Id. at 320-21.
Recognizing that there was little or no
chance of success in appealing Judge Foley’s
opinion, the Justice Department and the IRS
did not even attempt an appeal.
Morgan’s Wedge at 2.
Id.
VERITAS, 133 T.C. at 315-16.
19
20
21
22
23
24
T.D. 8470, 1993-1 CB 825, 827 (emphasis
added).
See VERITAS, 133 T.C. at 316 and n. 25,
citing Department of the Treasury, General
Explanations of the Administration’s Fiscal
Year 2010 Revenue Proposals 32 (May
2009).
Morgan’s Wedge at 2.
Morgan’s Wedge at 1.
VERITAS, 133 T.C. at 315.
Prior to trial, the parties had agreed on the
arm’s length reasonably anticipated benefit
shares under the cost sharing agreement.
This article is reprinted with the publisher’s permission from the INTERNATIONAL TAX JOURNAL, a bimonthly
journal published by CCH, a part of Wolters Kluwer. Copying or distribution without the publisher’s
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please call 800-449-8114 or visit CCHGroup.com. All views expressed in the articles and columns are
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