The Ninth Circuit Court of Appeals has affirmed the Tax Court’s determination that the definition of “intangible” in the 1994/1995 version of Reg. §1.482-4(b) was not intended to embrace “residual-business assets,” only independently saleable intangible assets. Therefore, the “buy-in” required for “pre-existing intangible property” was not required to include compensation for such assets.
Background. Generally, In the case of a transfer or license of intangible property, Code Sec. 482 requires the income with respect to such transfer or license to be commensurate with the income attributable to the intangible. To ensure this requirement, the IRS may require transferred intangible property, including intangible property transferred with other property or services, to be valued on an aggregate basis or based on the realistic alternatives to such transfer, when the IRS determines that such basis is the most reliable means of valuing such transfers. (Code Sec. 482)
Reg. §1.482-4(b)(1)-(5) provide a list of items that are intangible assets; (1) patents, inventions, formulae, processes, designs, patterns, or know-how; (2) copyright and literary, musical and artistic compositions; (3) trademarks, trade names or brand names; (4) franchises, licenses and or contracts; (5) methods, programs, systems, procedures, campaigns, surveys, studies, forecasts, estimates, customer lists or technical data.
Reg. §1.482-4(b)(6) provides that an item is similar to those listed in Reg. §1.482-4(b)(1)-(5) if it derives its value not from its physical attributes but from its intellectual content or other intangible properties (catchall provision).
Reg. §1.482-7A(a) specifies the requirements of a qualified cost-sharing arrangement (CSA) and the methods for determining the taxable income resulting from such an arrangement.
Under the regs in effect in 2005 when the taxpayer entered into its CSA, when one participant makes pre-existing intangible property available for purposes of research under a CSA, that party is deemed to have transferred an interest in such property to the other participant. This requires the other participant to make a “buy-in payment” to the transferor. (Reg §1.482-7(g)(1)) The buy-in payment must only reflect the pre-existing intangibles. (Reg §1.482-7(g)(2))
Under Supreme Court precedent, courts review administrative regulations while giving them certain deference. Auer deference requires a federal court to uphold an agency’s interpretation of an ambiguous regulation unless that interpretation is plainly erroneous or inconsistent with the regulation. (Auer v. Robbins, (S Ct 1997) 519 US 452)
Facts. As part of the restructuring of its European businesses, Amazon entered into a CSA in which a holding company for its European subsidiaries made a “buy-in” payment for the right to use Amazon’s intangible assets and was required to make cost-sharing payments going forward for its share of future research and development (R&D) efforts.
At the time of this restructuring, the 1994/1995 version of the Code Sec. 482 transfer-pricing regulations were in effect. The 1994/1995 regulations required the buy-in payment to reflect the fair market value of Amazon’s pre-existing intangibles and defined the word “intangible.”
The IRS determined that, under the 1994/1995 regulations then in effect, the European holding company’s buy-in payment had not been determined at arm’s length as required by Reg. §1.482-7A(g)(1). The IRS then performed its own calculation to determine the buy-in payment. In its calculation, the IRS included all intangible assets of value, including “residual-business assets” such as Amazon’s culture of innovation, the value of workforce in place, going concern value, goodwill and growth options.
Amazon then filed a petition in the Tax Court challenging that calculation. Amazon argued that the IRS’s calculation, which was based on the definition of “other similar” intangible items in Reg. §1.482(b)(6) (the catchall provision) was too sweeping. Amazon argued that, to qualify as an intangible under the regulation, an item must be capable of being bought and sold independently of the business and the assets the IRS referred to as “residual-business assets” are inseparable from the business.
The IRS argued that the regulatory definition of intangible was broad enough to include all intangible assets of value, including residual-business assets, such as Amazon’s culture of innovation, the value of workforce in place, going concern value, goodwill, and growth options.
Tax Court’s decision. The Tax Court agreed with Amazon, concluding that, unlike the specific intangibles listed in the regulation, workforce in place, going concern value, goodwill, growth options and corporate “resources or opportunities” cannot be bought and sold separately. (Amazon (2017) 148 TC 108) The Tax Court determined that the IRS’s calculation of the buy-in payment was arbitrary, capricious and unreasonable. The Tax Court found that the IRS’s valuation method was based on a “sale theory” and swept into the calculation assets that were not transferred under the CSA and assets that were not “intangibles” under the regulation to begin with.
Instead, the Tax Court found that Amazon’s uncontrolled transaction (CUT) method, with appropriate upward adjustments, was the best method to determine the buy-in payment.
Ninth Circuit Court of Appeal’s decision. The Ninth Circuit Court of Appeals has affirmed the Tax Court’s determination the definition of “intangible” in the 1994/1995 version of Reg. §1.482-4(b) was not intended to embrace residual-business assets. Therefore, the buy-in required for pre-existing intangible property was not required to include compensation for such assets.
In coming to its decision, the Appeals Court considered the regulatory definition of an “intangible,” the overall transfer pricing regulatory framework, the rulemaking history of the regulations, and whether the IRS’s position is entitled to Auer deference.
The Appeals Court found that the definition of “intangible” was ambiguous; however, it understood the regulation’s drafting history to limit “intangible” to independently transferable assets.
The Appeals Court read the catchall provision together with the introductory language of the definition, to mean that residual-business assets are intangibles if they (1) have substantial value independent of the services of any individual and (2) derive their value from intellectual content or other intangible properties. It rejected the IRS’s argument that residual-business assets qualified as intangibles even if they could not be transferred independently from the business.
The Appeals court also found that the the IRS’s interpretation of Reg. §1.482-4(b) was not entitled to Auer deference. The drafting history of the 1994/1995 regulations did not express the position the IRS was advancing. Indeed, the contemporaneous explanations of the regulations are contrary to the IRS’s position. Thus, Amazon and other taxpayers were not given fair warning of the IRS’s current interpretation of the regulatory definition of an “intangible.” Therefore, that interpretation was not entitled to deference.