In a case decided on December 10, Veritas Software Corp. won a big victory over the Internal Revenue Service when the tax court upheld its transfer-pricing calculation.
Veritas Software, which is in the business of developing, manufacturing, marketing, and selling software products, went through several corporate changes a few years back; mostly notably, it was purchased by Symantec Corp. on July 2, 2005. Prior to that, on November 3, 1999, Veritas Software assigned all its existing sales agreements with its European-based sales subsidiaries to a new corporation — Veritas Ireland. In addition, on the same date, Veritas Software and Veritas Ireland entered into a research and development agreement, as well as a technology license agreement.
Based on the licensing agreement, Veritas Software granted Veritas Ireland the right to use certain “covered intangibles,” as well as the right to use Veritas Software’s trademarks, trade names, and service marks. In exchange for the rights granted by licensing agreement, Veritas Ireland agreed to pay royalties, as well as a “prepayment amount.”
In 2000 Veritas Ireland made a $166 million “lump sum buy-in payment” to Veritas Software. This amount was later adjusted downward to $118 million. At issue, from a tax perspective, is whether the buy-in payment was “arm’s-length.” The IRS concluded it was not, but the tax court found the payment was, indeed, arm’s length.1 In fact, in ruling against the IRS, the court found that the Service’s determination was arbitrary, capricious, and altogether unreasonable.
Clear Reflection of Income
The Internal Revenue Code, specifically Section 482, authorizes the IRS commissioner to allocate income, deductions, credits, or other allowances between or among controlled entities if he determines an allocation is necessary to prevent evasion of taxes, or “to clearly reflect the income” of such entities. Section 482, therefore, curbs the natural inclination of corporate groups to deal with one another in a manner that shifts income to lower-tax jurisdictions.
“[T]o prevail, the taxpayer first must show that the Section 482 allocation is arbitrary, capricious, or unreasonable.” — Robert Willens
When a controlled participant to a qualified cost-sharing arrangement makes preexisting intangible property available, that participant is deemed to have transferred interests in the property to the other participant and the latter must make a “buy-in payment” as consideration for the transferred intangibles. Indeed, Regulation Section 1.482-4(a) states that the arm’s-length amount charged in a controlled transfer of intangible property must be determined under one of four methods: (1) the “comparable uncontrolled transaction” (CUT) method, (2) the “comparable profits” method, (3) the “profit-split” method, or (4) other unspecified methods.
If the recipient of the intangibles fails to make an arm’s-length buy-in payment, the commissioner is authorized to make appropriate adjustments to reflect an arm’s-length payment. In the Veritas case, the commissioner set the arm’s-length amount at $1.675 billion.
The court noted that the Section 482 allocation must be sustained absent a showing of “abuse of discretion.” So to prevail, the taxpayer first must show that the Section 482 allocation is arbitrary, capricious, or unreasonable. If the taxpayer proves that the IRS’s allocation is arbitrary, capricious, or unreasonable but fails to prove its allocation meets the arm’s-length standard, the court must determine the proper allocation.
The IRS contended that the transfer of preexisting intangibles by Veritas Software was “akin to a sale” and should be evaluated as such. The court disagreed. It concluded that the IRS’s theory does not produce the most reliable result. To be sure, the agency’s akin-to-a-sale theory encompasses short-lived intangibles valued as if they had perpetual life and takes into account intangibles that were subsequently developed rather than preexisting.
Regulation Section 1.482-7(g)(2) requires a buy-in payment with respect to transfers of preexisting intangible property: no payment is required for subsequently developed intangibles. Moreover, in calculating the buy-in payment, the IRS assigned a perpetual useful life for the transferred intangibles.
The court found, however, that the useful life of the product intangibles was, on average, four years, and was certainly not perpetual. Moreover, the court found that the IRS used the wrong “beta,” the wrong equity risk premium, and therefore the wrong discount rate, to calculate the buy-in. The IRS also used — erroneously — large and unrealistic growth rates into perpetuity. Thus, the court had no difficulty concluding that the IRS’s allocations were arbitrary, capricious, and unreasonable.
CUT Method Preferable
The taxpayer employed the CUT method to arrive at an arm’s-length buy-in amount. In its CUT valuation, the taxpayer referenced, as comparables, agreements between Veritas Software and certain original equipment manufacturers (OEMs). The IRS contended that the OEM agreements involve substantially different intangibles. But the court disagreed: it concluded that, collectively, the more than 90 “unbundled” OEM agreements the parties stipulated were sufficiently comparable to the controlled transaction.
In noting the comparability, the court also pointed out the following: (1) Veritas Ireland and the OEMs undertook similar activities and employed similar resources in conjunction with such activities, (2) there were no significant differences in contractual terms, (3) the parties to the controlled and uncontrolled transactions bore similar market risks and other risks, and (4) there were no significant differences in property or services provided.
As a result, the court was satisfied that the unbundled OEM agreements were sufficiently comparable to the controlled transaction with the result that the CUT method is the best method to determine the appropriate buy-in price. The buy-in payment actually charged met the arm’s-length standard with the result that the IRS commissioner’s conception of what the buy-in payment should be was summarily rejected.
Contributing editor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 See Veritas Software Corporation & Subsidiaries v. Commissioner, 133 T.C. No. 14 (2009).