The US Internal Revenue Service (IRS) acted in an arbitrary, capricious, and unreasonable manner when it applied a discounted-cash-flow method to a cost-sharing arrangement that Amazon.com made with its Luxembourg subsidiary, the US Tax Court held on Thursday (Amazon.com, Inc., 148 T.C. No. 8 (2017)). The case involved over $234 million in assessed tax deficiencies for 2005 and 2006.
The court agreed with Amazon that its method for determining the requisite buy-in payment was the best method to use and that its cost-allocation method generally provides a reasonable basis for allocating certain costs. The court also found the IRS abused its discretion in allocating certain costs.
The case stemmed from a cost-sharing arrangement (CSA) that Amazon.com Inc. entered into with its Luxembourg subsidiary, Amazon Europe Holding Technologies SCS, in 2005. The CSA was intended to qualify as a “qualified cost sharing arrangement” under US Treasury Regs. Sec. 1.482-7(a)(1). Under the CSA, Amazon granted the Luxembourg subsidiary the right to use certain pre-existing intangible assets in Europe, including the software and other technology required to operate Amazon’s European website business, various trademarks, and customer lists. Under this arrangement, the subsidiary was required to make an upfront “buy-in payment” of $254.5 million to compensate Amazon for the value of the intangible assets that were to be transferred to the subsidiary and annual cost-sharing payments to compensate Amazon for ongoing intangible development costs (IDCs), to the extent those IDCs benefited the subsidiary.
Amazon used a multistep allocation system to allocate costs from its various cost centres to IDCs. While generally accepting Amazon’s allocation method, the IRS determined that 100% of the costs captured in one cost centre (Technology and Content) should be allocated to IDCs. Amazon argued that the IRS’s allocation of 100% of the Technology and Content costs to IDCs is inconsistent with the regulations.
The IRS also determined that the buy-in payment had not been negotiated at arm’s length. It applied a discounted-cash-flow (DCF) method to the expected cash flows from the European business to determine that the buy-in payments should have been $3.6 billion (the IRS later reduced this to $3.468 billion). Amazon argued that the DCF method used by the IRS is substantially similar to one rejected by the Tax Court in Veritas Software Corp., 133 T.C. 297 (2009). The DCF method, Amazon argued, inflated the buy-in payment by improperly including in it the value of subsequently developed intangible property, in contravention of US Treasury Regs. Sec. 1.482-7(g)(2). Amazon argued that the comparable-uncontrolled-transaction (CUT) method is the best method to calculate the requisite buy-in payment.
The Tax Court agreed with Amazon on almost all points.
On the question of the proper amount of the buy-in payment, the court held that the IRS’s determination was “arbitrary, capricious, and unreasonable.” It held that Amazon’s use of the CUT method – with some adjustments – was the best method to determine the amount of the buy-in payment.
The court also held that the IRS abused its discretion in determining that 100% of the Technology and Content costs should be allocated to IDCs, and further held that Amazon’s method for allocating costs was reasonable.
—Alistair Nevius (Alistair.Nevius@aicpa-cima.com) is CGMA Magazine’s editor-in-chief, tax.