Last month a unanimous Ninth Circuit affirmed the Tax Court thereby preserving Amazon’s victory in a major transfer pricing dispute.[1] The decision is also a victory for taxpayers generally because of the Ninth Circuit’s rejection of the Government’s opportunistic interpretation of its own regulation. The main issue, as framed by the Ninth Circuit, involved the interpretation of applicable Treasury regulations under section 482 which defined intangibles. The Ninth Circuit held that the definition of intangibles in those regulations did not include “residual-business assets” such as workforce in place or goodwill as proposed by the IRS.

Background

Amazon US restructured its European operations utilizing AEHT, a Luxembourg entity, as a holding company and headquarters for such operations. Amazon transferred its valuable intangibles to AEHT through a cost sharing arrangement pursuant to applicable regulations. As part of that arrangement, Amazon determined a buy-in cost to AEHT based on an estimated seven-year life for the transferred intangibles. Amazon arrived at a buy-in payment of $254.5 million to be paid over the seven-year period. Amazon undertook to create its massive online retail system and at trial explained how the intangibles developed through those efforts from inception had a built-in obsolescence. This approach was true not only of various software applications such as Amazon.com’s shopping cart, personalization and payment features, but of the overarching software architecture itself. From its beginning in 1995 to 2008, Amazon utilized three different such architectures. Amazon did not include the value of any residual-business assets in the determination of the buy-in payment.

Tax Court Decision

The Tax Court rejected the IRS’s $3 billion plus proposed transfer pricing adjustment to Amazon’s returns. Though the trial was an epic battle of experts (18 for Amazon and 12 for the IRS), as with other losses for the Government in the transfer pricing arena, the decision turned on core facts that supported the taxpayer, such as the built-in obsolescence of Amazon’s intangibles. Ultimately, because of the IRS’s unreasonable disregard of these facts and because of its improper application of key regulations, the Tax Court determined that the IRS had abused its discretion and threw out the proposed deficiency. The Tax Court then considered Amazon’s specific transfer pricing determinations, agreed with some, disagreed with others, and came to a final ruling largely upholding Amazon’s tax return position.

The Key Issue on Appeal

Though the Tax Court had identified and resolved several legal issues,[2] the Ninth Circuit focused on one issue: Did Treas. Reg. § 1.482-4(b) (as in effect for the tax years at issue) require Amazon to include the value of residual-business assets in its buy-in valuation? The Ninth Circuit undertook a comprehensive review of the regulatory history and explained how ultimately, despite an interim suggestion by Treasury to include one type of business-residual asset, i.e., goodwill, in the definition of intangibles, Treasury retained a definition in the final regulation that excluded any type of intangible such as residual-business assets. The Ninth Circuit essentially agreed with the Tax Court that the IRS had misinterpreted the regulation. In the course of its analysis the Ninth Circuit made two key points. The first involved recognition that the transfer of assets in a cost sharing arrangement is not necessarily the economic equivalent of a sale of business. The second was that an agency’s post-hoc rationalizations for its litigation position are not entitled to deference.

Cost-Sharing Arrangement ≠ Sale

As part of its argument before the Ninth Circuit, the Government appeared to contend that, because any purchaser of a business would, at arm’s length, pay for the value of growth options (a catch-all term for unique residual-business assets) AEHT must pay for residual-business assets. To quote the court:

The Commissioner relies on deposition testimony from one of Amazon’s experts that parties dealing at arm’s length would pay for growth options. But the expert explained at trial the difference between an investor or purchaser of the entire business (who would pay for the full value of the business) and a partner (who would not). The question becomes whether a cost sharing arrangement is akin to the sale of a business or like a partnership in certain assets or aspects of the business. The Commissioner assumes, but does not explain why, the transfer of intangible assets under Amazon’s cost sharing arrangement with AEHT should be treated the same as the sale of the business.

Slip op. at 22-23. The transfer within a cost-sharing arrangement is typically done through a limited license. The clear implication of the court’s analysis here is that, without showing that such a license is the substantive equivalent of a sale of the business, the IRS cannot enlarge the assets transferred as if the license transfer were a sale.[3]

The Ninth Circuit’s footnote 1 is understood in this context. In that footnote, the court stated that if Amazon’s cost-sharing arrangement were governed by either the 2009 temporary regulations or the Tax Cuts and Jobs Act (TCJA) amendments, “there is no doubt the Commissioner’s position would be correct.” Slip op. at 6. The temporary regulations effectively expanded the definition of intangibles for cost sharing purposes to include residual assets such as going concern value and goodwill. The TCJA expanded the definition of intangibles in section 482 to include business-residual assets when such intangibles are transferred to a related party. Thus if the question is, “What are intangibles for the purposes of determining what a transferee must pay for?” the newly expanded definition would be applied, consistent with the Commissioner’s attempt to retroactively expand that definition. However, where a transfer would not, at arm’s length, include such intangibles, then the transferee should not be required to pay for them.

No Deference to Post-Hoc Position

Try as it might, the Government could not shake the taint of opportunism from its position. The Ninth Circuit found that, while Treas. Reg. § 1.482-4(b) was ambiguous, the regulatory history supported Amazon’s, not the Government’s, interpretation of the rule. Undeterred, the Government played its last, and fading, card: Auer deference. The Ninth Circuit, however, taking its cue from the Supreme Court, determined that no deference was due. The principle at work here is that a regulator must give fair notice of its position to regulated parties. The Government’s interpretation of Treas. Reg. § 1.482-4(b) was announced for the first time in a tax audit and was contrary to the regulatory history. As such, no fair notice was given to taxpayers, and therefore no deference was warranted. Slip op. at 35.

Impact on Altera Rehearing Petition?

The Ninth Circuit is currently considering a rehearing petition filed by Altera. A divided panel in Altera accepted the Government’s post-hoc rationalization as to the regulatory authority for the cost-sharing rule at issue in that case. Unlike Amazon, the rule in Altera was clear on its face: parties to a cost-sharing arrangement must share equity-based compensation costs. But as in Amazon, the Government’s position in Altera was born in litigation and was not discernible as part of the process leading up to the final rule. Similarly, in Amazon the interpretation proffered by the Government was not discernible in the regulatory process and instead was created in the heat of controversy with the taxpayer. Or, put another way, in Amazon the Government said this is what we really mean by our regulation despite our having said otherwise in the rule-making process; and in Altera the Government said this is really the authority underlying our rule despite our having said otherwise during the rule-making process. In considering the rehearing petition, the Ninth Circuit should recognize this similarity and also bear in mind the Supreme Court’s recent admonition of the Government in Department of Commerce v. New York, No. 18-966 (June 27, 2019), which cast aside pretextual justification for agency action in favor of holding the Government to a “reasoned explanation requirement meant to ensure that agencies offer genuine justifications for important decisions, reasons that can be scrutinized by courts and the interested public.” Where justifications or interpretations of regulatory events are born of litigation, they should be given little or no deference.