On 16 August 2019, the Ninth Circuit held that the definition of “intangible” in the cost sharing regulations in effect at the time that Amazon.com, Inc. (Amazon) entered into a cost sharing arrangement excluded residual business assets. Amazon.com, Inc. v. Commissioner, 124 A.F.T.R.2d (RIA) (9th Cir. 2019). Based on this determination, the Ninth Circuit affirmed the Tax Court’s holding in Amazon.com, Inc. v. Commissioner, 148 T.C. No. 8 (23 Mar. 2017), that the IRS was arbitrary, capricious and unreasonable in using a discounted cash flow method to value the buy-in of pre-existing intangibles for a cost sharing agreement arrangement. For additional discussion of the Tax Court’s decision, see Tax News and Developments, “Tax Court Rejects IRS’s Indefinite Intangible Useful Life in Amazon Transfer Pricing Case, Just Like VERITAS,” (Vol. 17, Issue 3, April 2017).
Amazon entered into the cost sharing arrangement at the center of this dispute as part of a series of transactions it undertook beginning in 2004 to centralize its operations in Europe. Amazon first established a European headquarters entity in Luxembourg (Amazon Europe) and contributed several of its pre-existing European subsidiaries and the assets of those entities. Amazon and Amazon Europe then entered into the cost sharing arrangement. Amazon also contributed certain pre-existing intangibles necessary to the cost sharing arrangement, and Amazon Europe paid Amazon the “buy-in” payment for those intangibles.
The IRS assessed several deficiencies in relation to the cost sharing arrangement, including that Amazon had substantially undervalued the “buy-in” payment. When the parties brought their dispute to the Tax Court, it largely held in favor of Amazon. The IRS then appealed the Tax Court’s decision on the valuation of the pre-existing intangibles that Amazon contributed and the amount of the buy-in payment. The Ninth Circuit observed the difference between the two, noting that Amazon’s method "isolated and valued only the specific intangible assets … including website technology, trademarks, and customer lists," and the IRS’s method “essentially valued the entire European business [and] necessarily swept into the calculation all contributions of value, including those that are more nebulous and inseparable from the business itself….” (The IRS and the Ninth Circuit both referred to these “nebulous” assets as “residual business assets.”)
To resolve this discrepancy in valuations, the Ninth Circuit had to determine whether Amazon should have included the residual business assets in the buy-in valuation. The Ninth Circuit looked at the issue from four different angles, specifically, “the regulatory definition of an ‘intangible,’ the overall transfer pricing framework, the rulemaking history of the regulations, and whether the Commissioner’s position is entitled to deference under Auer v. Robbins, 519 US 452 (1997).”
The Ninth Circuit began with the definition of “intangible” in Treas. Reg. §1.482-4(b), and applied the standard rules of statutory construction, which are the same for regulations as for statutes. Under the analysis set forth in Chevron USA, Inc. v. Nat. Res. Def. Council, Inc., 467 US 837 (1984), the first step is to determine whether the language is unambiguous. In this case, the operative provision in the regulations states that an intangible is an asset that has “substantial value independent of the services of any individual” and is included on the list of items in the rest of the definition. The list also contains a catch-all provision that states “similar to those listed in paragraph (b)(1) through (5) … if it derives its value not from its physical attributes but from its intellectual content or other intangible properties.” The Ninth Circuit reviewed the arguments of both Amazon and the IRS regarding the interpretation of this provision, and found neither to be convincing.
Finding the first element of the analysis -- the regulatory definition -- inconclusive, the Ninth Circuit then turned to the remaining three elements, which proved more fruitful for Amazon.
Reviewing the overall framework of the transfer pricing regulations, the Ninth Circuit evaluated the IRS’s arguments that the framework mandates that taxpayers include residual business assets because (1) Treas. Reg. 1.482-7A(g)(1) (the Ninth Circuit follows the practice of the parties of using the citations from the 2009 transfer pricing regulations) requires that a taxpayer includes in the buy-in any assets that “are made available” for the cost sharing arrangement and (2) the preamble to the transfer pricing regulations requires that transactions between related parties clearly reflect income and prevent tax avoidance. These arguments failed to convince the Ninth Circuit, because each provision presupposes that a residual business asset is an intangible. Instead, the Ninth Circuit noted that the overall framework of the transfer pricing regulations favored Amazon, because the cost sharing regulations identify “intangibles as being the product of R&D efforts,” i.e., something that arises from a deduction, rather than an income flow.
The third element of analysis the Ninth Circuit focused on was the drafting history of the transfer pricing regulations. The Ninth Circuit found the regulatory history indicated that the definition of intangible was “limited to independently transferable assets,” which does not include residual business assets. The Ninth Circuit walked through the definition of “intangible” as it developed from 1968 regulations to the 1994 regulations currently at issue, including the addition of Code Section 936(h)(3)(B) in 1982. The parts of the drafting history that the Ninth Circuit found the most persuasive were A Study of Intercompany Pricing Under Section 482 of the Code, I.R.S. Notice 88-123, 1988-2 C.B. 458 (the “White Paper”), and Treasury’s response to comments it received on preliminary and temporary versions of the definition in the versions of the regulations Treasury issued following the White Paper. The White Paper recommended that a buy-in agreement include three types of intangibles: “preexisting intangibles at various stages of development that will become subject to the [cost sharing] arrangement,” “basic research not associated with any product,” and “a going concern value associated with a participant’s research facilities and capabilities that will be utilized.” The public comments following the White Paper opposed including any going concern value; when Treasury issued proposed regulations in 1993, it did not include any reference to going concern value, and expressly solicited comments on whether the definition of intangibles should be “expanded to include” residual business assets. In addition, while the 1993 proposed regulations did include a “commercially transferable interest” requirement in the definition, the Ninth Circuit found that the elimination of this term from the definition in the final regulations was insignificant to the interpretation, based on the fact that Treasury specifically noted in the preamble that it omitted the term because it considered the extra language “superfluous.”
Finally, the Ninth Circuit turned to the question of Auer deference, and found that Auer deference was not appropriate here. Under Auer, a court gives controlling weight to an agency’s interpretation of its own regulation if the interpretation is not “clearly erroneous or inconsistent with the regulation.” The Ninth Circuit notes that Auer deference is limited in scope. First, it only applies if the regulation is genuinely ambiguous. Second, agencies still must provide “fair warning of the conduct” that the regulation prohibits or requires, and the agencies are not entitled to Auer deference if the regulation would constitute “unfair surprise.” Here, the Ninth Circuit held that regardless of whether the definition of “intangible” in the transfer pricing regulations at issue is ambiguous, the IRS’s arguments in this particular case were the first time that the IRS or Treasury had advanced this interpretation of the definition of “intangible.” As such, the Ninth Circuit found that Treasury did not give fair warning to taxpayers, including Amazon, of the new interpretation.
On balance, the Ninth Circuit weighed three out of four elements of the analysis in favor of Amazon’s position that it need not include residual business assets in the valuation of the pre-existing intangibles. Further, the remaining element was balanced between Amazon and the IRS, and did not change the overall analysis. Therefore, the Ninth Circuit affirmed the Tax Court’s holding that the discounted cash flow valuation method used by the IRS was inappropriate.