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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 5 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 6 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 2013 CCH Incorporated. All Rights Reserved © 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 7 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- 8 ©2013 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 permission is prohibited. To subscribe to the Journal of INTERNATIONAL TAX JOURNAL or other CCH Journals please call 800-449-8114 or visit CCHGroup.com. All views expressed in the articles and columns are those of the author and not necessarily those of CCH, a part of Wolters Kluwer or any other person. INTERNATIONAL TAX JOURNAL 9