Neal Kochman Comments on Amazon Case Challenging IRS Income Method for Valuing Intangibles

Potential for Change

Amazon has the potential to change that, though the dollar impact could be limited, according to Neal Kochman of Caplin & Drysdale in Washington, D.C.

Kochman noted that Amazon, because it concerns tax years 2005-06, is governed by cost sharing regulations that have since been revised. So it is unclear whether an adverse ruling to Amazon would have broad implications for other taxpayers.

"My understanding is that most of the inventory of buy-in cases under the old regulations have worked their way through the system," Kochman said. "At one time there was information that there were 100 buy-in cases that were working their way through Exam and Appeals, and only a small number made it to court."

Now it appears that many of those cases have been resolved, he said.

However, the IRS maintains that the temporary cost sharing regulations issued in late 2008—and finalized in December 2011—serve merely to clarify regulations that were in place in the years at issue in Amazon and Veritas. Given that position, the IRS could conclude that a ruling on the old regulations also would apply to the new.

The key distinction is that the old regulations did not specify the use of an income method for valuing the buy-in payment in a cost sharing arrangement, Kochman noted; the new regulations do.
Economist John Hatch of Transfer Pricing Associates in Washington, D.C., told Bloomberg BNA that Amazon "has a bearing on any open audits from that era, but it also probably solidifies the issues."
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Common Valuation Method

Economist Patrick Breslin of Bates White Consulting in Washington, D.C., told Bloomberg BNA it is clear that a number of taxpayers and practitioners think the decision in Veritas was a rejection of the income method itself.

"But the present value of income streams is how you price many things in a market economy, at least implicitly," he said. "It explains the value of a share of stock, for example. At arm's length, income methods like the discounted cash flow are commonly applied explicitly. Business decisions are made daily using these methods."

Kochman agreed.

"It is crazy to me that the income method would ever be challenged because it is used by businesses for valuation all the time," he said.

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Prospects for Reversing Veritas

Whether in Amazon the IRS can achieve a full reversal of Veritas —through a ruling that overtly affirms the income method—will depend on a number of factors, including the distinct facts and circumstances of the case.

As in any transfer pricing case, the precedential value will hinge on how broadly or narrowly the court rules.

"You have facts and you have law," Kochman said.

Some of the elements that tripped up the IRS in Veritas, he noted, are not present in Amazon—such as a dispute over the use of "make or sell" rights.

"Make or sell rights isn't an issue because they were not licensing website rights," he said.

The worst outcome for the IRS would be a ruling that invalidates the discounted cash flow method altogether—though Kochman does not think that is likely.

However, he said, "a key element of the decision would be the judge's view on perpetual life versus the limited life approach taken by Deloitte and taxpayers in general."

One result of Lauber's decision should be to reveal more details about the methods used by both parties, Kochman said.

"The IRS approach is to essentially value the business and then carve out from the value of the business returns to routine activities, and then take the position that everything that is left is attributable to the intangibles," he said. "The Deloitte approach is more a build-up approach where you separately attempt to value the intangibles."

The vast difference between the results may be owing to a "disconnect as to what is being valued," he said. So it is possible that the court could affirm the IRS's method but take issue with the way it was applied.

Cost Accounting Issue

One key issue in Amazon is that the company's cost accounting system at the time did not specifically segregate intangible development costs (IDCs) from other operating costs. Rather, the company developed a formula that it used to allocate to IDCs a portion of costs from scores of cost centers—tracked in six broad categories: cost of sales, fulfillment, marketing, technology and content (T&C), general and administrative, and "other."

Amazon is challenging the IRS's position that 100 percent of T&C costs are IDCs. If it wins on that point, Amazon could see a reduction in the assessment. To get there, however, Amazon must show that the T&C category contains "nontrivial costs that are properly characterized as something other than IDCs" (23 Transfer Pricing Report 503, 8/7/14).

Said Kochman, "If the decision ended up coming out that the income method was the best method and they end up carving back from that and making some changes to the assumptions and coming out with a different valuation, that to me would be, if not a complete victory, a partial victory for the IRS."

Another result of the case, he said, could be a ruling by the court that it is appropriate to use the income method for valuation under Regs. §1.482-4, which covers valuation of intangibles generally. He noted that the 2008 revisions to the regulations focused on cost sharing under Regs. §1.482-7. No changes were made to Regs. §1.482-4.

"It could very well tell you something very significant about the ‘dash four' rules and whether it is legitimate to use the income method to do intangible valuations" under those rules, Kochman said. "That might be more significant than what it says about cost sharing itself."