On August 16, 2019, the Ninth Circuit upheld Amazon’s cost-sharing arrangement and valuation of its intangible assets,1 affirming the Tax Court’s 2017 decision.2 In essence, the holding confirms that U.S. companies transferring all intangibles to foreign subsidiaries need not include global goodwill and going concern value of the business when calculating the mandatory buy-in payment (at least with respect to pre-2009 cost-sharing regulations).
In 2005 and 2006, Amazon restructured its European business and subsidiaries. As part of this restructuring, Amazon formed a new European holding company (Amazon Europe Holdings Technologies SCS or “AEHT”) and transferred to it all pre-existing European subsidiaries, their operating assets, and their pre-existing intangible rights. The two entities, Amazon and AEHT, then entered into a cost-sharing arrangement for the pre-existing intangibles that Amazon contributed, pursuant to which both entities became co-owners of the intangible assets. This cost-sharing arrangement became the focus of an IRS investigation and the issue before the Tax Court and the Ninth Circuit.
Section 482 of the Internal Revenue Code and the regulations promulgated thereunder prevent entities “owned or controlled directly by the same interest” from otherwise evading taxes through their transactions. The IRS evaluates these controlled transactions by comparing them against an “arm’s length” dealing to determine whether “the results of the transaction are consistent with the results that would have been realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances.”3
At the time of Amazon’s transactions, cost-sharing arrangements for intangible assets were governed by Treasury Regulation 1.482-7A, as promulgated in 1995. 4 Under these regulations, when a subsidiary enters into a cost-sharing arrangement with its parents, it must make two sets of payments: first, a buy-in payment that corresponds with the value of the pre-existing intangible assets that were contributed by the parent;5 and second, payments for a portion of the intangible assets’ R&D costs that are “equal to [the subsidiary’s] share of reasonably anticipated benefits attributable to such development [of the intangible assets].”6 Both payments serve to increase the tax liability of the parent (here, Amazon), by, respectively, increasing taxable income to the parent and reducing the deductions the parent could otherwise take for R&D costs.
Ultimately at issue was the definition of “intangibles” and the method for valuing pre-existing intangible assets for the buy-in payment. Amazon valued the assets at $217 million, arguing that intangible assets cover three distinct groups of assets—website technology, marketing intangibles, and European-customer information— and that these three groups of assets must be valued separately under the “comparable uncontrolled transaction method.” The IRS, on the other hand, calculated the buy-in payment to be approximately $3.5 billion, asserting first that residual business assets, such as Amazon’s culture of innovation, goodwill, growth value, and the workforce in place, also fell under the definition of “intangibles,” and second that the discounted cashflow method is the proper valuation methodology.
The Tax Court agreed with Amazon, holding that the IRS Commissioner abused his discretion both by including “assets that were not compensable ‘intangibles’ to begin with” and by applying the discounted cash flow methodology.7 The Tax Court reasoned that the valuation proposed by the Commissioner resembled the enterprise valuation of a business which “includes many items of value that are not ‘intangibles’” under the cost-sharing regulations, including “workforce in place, going concern value, goodwill, . . . ‘growth options’ and corporate ‘resources’ or ‘opportunities.’”8 These items “are unlike the ‘intangibles’ listed in the statutory and regulatory definitions” because they “cannot be bought and sold independently.”9 The Tax Court also agreed with Amazon that the “comparable uncontrolled transaction method” was the correct valuation methodology. However, the Tax Court disagreed with certain ways that Amazon implemented this methodology, and, thus, recalculated the buy-in payment to be approximately $779 million.
The Ninth Circuit affirmed the Tax Court’s decision. Reviewing the text of the cost-sharing provisions as a whole, the legislative history of Section 482, and the drafting history of the transfer pricing regulations, the Ninth Circuit reasoned that the 1994 and 1995 cost-sharing regulations do not contemplate including residual business assets in the definition of “intangibles.” Furthermore, the Court did not find that the Commissioner’s interpretation of the regulations’ definition of “intangibles” was entitled to Auer deference.10 Quoting the recent Supreme Court case, Kisor v. Wilkie, 11 the Ninth Circuit noted that “a court should not afford Auer deference unless the regulation is genuinely ambiguous.”12 Based on the textual definition of “intangible,” its context within the transfer pricing regulations, and the legislative history of Section 482, the Ninth Circuit found there was “little room for the Commissioner’s proffered meaning.”13 Additionally, even if the definition were ambiguous, the Commissioner’s interpretation would not be entitled to Auer deference because it would create “unfair surprise” as the interpretation was not communicated prior to the current litigation.
The Ninth Circuit’s holding may have a limited direct application. The 1994 and 1995 cost-sharing regulations at issue were replaced by temporary regulations in 2009 and Section 482 was amended in 2017, and, thus, the decision applies only to cost-sharing arrangements that occurred prior to 2009. Moreover, both the 2009 regulations and the 2017 amendment expanded the definition of “intangibles” such that the Ninth Circuit noted that “there is no doubt the Commissioner’s position would be correct” had either version applied.14 Going forward, the IRS will likely rely on this statement in the context of any challenges to the 2009 cost-sharing regulations.
The Amazon decision may have broader implications for taxpayers arguing against the IRS’ own interpretations of Treasury Regulations. The Court’s application of the Supreme Court’s recent Kisor decision affirms that IRS interpretations of Treasury Regulations expressed for the first time in the pending litigation are not entitled to deference, thus protecting taxpayers from unfair surprise.