Awaiting an Amazon ‘Drop’ from Appeals Court
The United States Court of Appeals for the Ninth Circuit (Appeals) is weighing further arguments over the 2017 U.S. Tax Court decision Amazon.com, Inc. v. Commissioner (Opinion). Appeals heard oral arguments on April 12, 2019 regarding the magnitude of the buy-in payment determined in the Opinion.
At the center of the Tax Court case was Amazon’s cost sharing agreement (CSA), whereby Amazon granted to a Luxembourg subsidiary, Amazon Europe Holding Technologies SCS, the right to use certain pre-existing intangible assets in Europe. The CSA took effect Jan. 1, 2005, and essentially involved three types of intangible assets (as noted in the Opinion): software/technology, marketing intangibles, and customer lists and other information relating to European clientele.
A Look at What’s Being Appealed
Several issues are being reviewed and reexamined by Appeals. From an economic perspective, the issues can arguably be reduced to whether—given the cost sharing regulations that were in place at the inception of the CSA—the Opinion’s relatively limited definition of compensable intangibles should be upheld. In the Opinion, compensable intangibles were ultimately limited to those that were deemed to be:
- Independently transferable from the business at CSA inception, and
- Finite-lived at CSA inception.
On the question of whether compensable intangibles should be limited to only those that can be considered to be independently transferable from a business, the IRS argues “No” on the grounds that while commercial transferability is a requirement in the regulations, independent transferability is not. To support its argument, the IRS cites the language from Section 1.482-7(a)(2):“An interest in an intangible includes any commercially transferable interest, the benefits of which are susceptible to valuation.”
On the other side, Amazon argues ”Yes”, compensable intangibles are by definition only those that are independently transferable from the business at CSA inception. To support its argument, Amazon invokes the commonly held theory (and practice) that only those intangibles that can be separated from goodwill are those that can be considered to be independently transferable from a business. The judge in the Opinion agreed with Amazon’s position in this regard.
Accordingly, it may now fall to Appeals to clarify what is meant by commercial transferability, and whether assets such as existing software/technology, existing marketing intangibles and existing customer information are in fact materially different from other intangible assets in terms of not only their ability to be commercially transferred, but also their susceptibility to valuation.
Part of the evaluation of what constitutes an independently transferable intangible asset may come by endeavoring to classify intangible assets into those that arise through “deductions” versus those that arise by “earning income.” Intangible assets that arise from deductions have often been viewed as comprising independently transferable intangibles, but intangibles that arise by “earning income” often have not. But, while it may be relatively easier to characterize intangibles such as software/technology and marketing intangibles as arising from deductions, a similar characterization for customer lists would seem to be more challenging since they appear definitionally to arise from making sales (i.e., earning income).
On the question of whether compensable intangibles should be limited to only those that can be considered to be finite-lived at CSA inception, the IRS argues “No”. The IRS points out that such limitation would result in valuable intangibles, such as Amazon’s so-called “growth options” (e.g., the net present value of the reasonable expectation of garnering future customers, which is typically a material component of goodwill), being transferred “for free” and, thus, would result in a violation of the arm’s length standard required under Section 482.
On the other side, Amazon argues “Yes”, opining that intangible assets such as “growth options” fall outside the regulatory definition of intangibles, lack substantial value independent of the services of individuals, and are inseparable from the business.
Accordingly, it may now be the task of Appeals to clarify whether intangible assets such as “growth options” should have been included in the buy-in payment. Appeals may tackle this issue partly by clarifying the joint intent of Section 1.482-4(b)(5)’s qualifying compensable intangibles of “…forecasts, estimates, customer lists…” and Section 1.482-4(b)(6)’s qualifying “Other similar items”. By the same token, it may also be the task of Appeals to decide whether intangibles that typically comprise goodwill, such as “growth options,” inherently require the services of individuals. If it determines that the answer to that particular question is “yes”, then growth options might reasonably be excluded as an intangible asset under Section 1.482-4(b). The language of Section 1.482-4(b) cited by the Amazon is “an intangible is an asset that comprises any of the following items (§1.482-4(b)(1) through §1.482-4(b)(6)) and has substantial value independent of the services of any individual.”
What the Appeals’ Decision Could Mean for U.S. Companies
This pending decision is a major crossroads for both the IRS and U.S.-based multinationals. Should Amazon prevail, the decision may represent a final door slamming shut on IRS’s pursuit of potential adjustments originating from similar regulatory, legal, and economic arguments to those made in this case. Should the IRS prevail, the decision may represent a door now opening up to the potential pursuit of such adjustments.
For More Information
For more information on the valuation of intangible assets or the details of this case please contact the author of this article, Jim Kelley, CFA of CBIZ Valuation Group. Jim can be reached at 972-406-6917 or firstname.lastname@example.org.