US Tax Court rules in Amazon’s favour; Rejects …...intangible assets: (1) software and other technology required to operate its European websites, fulfillment centres and related

US Tax Court rules in Amazon’s favour; Rejects “perpetual life”

assumption for website technology, marketing intangibles

News item offered by Taxsutra, 27 March 2017

US Tax Court rules in favour of Amazon US in respect of transfer pricing adjustments amounting

to USD 8.3 million and USD 225 million for 2005 and 2006 made by the IRS on account of the

transfer of intangible assets required to operate Amazon’s European website business to its

Luxembourg subsidiary.

In 2005 and 2006, Amazon.com, Inc., and its domestic

subsidiaries (Amazon US) transferred to Amazon Europe

Holding Technologies SCS (AEHT), a Luxembourg subsidiary,

the intangible assets required to operate its European website

business. The IRS determined deficiencies in the taxpayer’s

federal income tax of USD 8.3 million and USD 225 million for

2005 and 2006, respectively, arising from substantial transfer

pricing adjustments on account of the transfer of intangible

assets that arose by reallocating income from Amazon US to

AEHT. The two main issues to be decided by the Court are: (i)

the proper amount of AEHT’s buy-in obligation with respect to

the assets transferred; and (ii) the volume of costs properly

treated as intangible development costs (IDCs) bearing in

mind that the larger the volume is, the larger the cost sharing

payments that AEHT must make.

Facts

Product overview

• Amazon.com, Inc., which began operations in Washington in 1995, is an online retailer that sells

products exclusively through Amazon.com and related websites. Initially, Amazon would identify

unrelated product vendors, buy the products, manage the inventory and price the products, list the

products for sale on Amazon.com and ship the items to customers from its warehouses.

• In 2000, Amazon began allowing third parties to sell items on its websites and made available a set

of e-commerce platforms, services and tools that enabled third parties to list their own products and

services for sale on Amazon.com and related websites. This branch of Amazon’s business was

called Marketplace. Amazon received commissions on these third-party sales and recorded the

commission amounts (not the sale prices) as revenue.

• Amazon also built and operated e-commerce websites, custom-made for a particular merchant,

through which that merchant could carry out online sales of its products under its own brand name.

This branch was called Merchants.com or M.com.

Restructuring in Europe

Amazon initially expanded its business in Europe with wholly owned subsidiaries in the United Kingdom,

France and Germany. In 2004, Amazon US formed AEHT, the Luxembourg headquarters entity that

would serve as the holding company for all of the European businesses. Amazon Luxembourg would




perform various functions essential to the operation of the European businesses including holding title to

the inventory sold in Europe, licensing Amazon’s intellectual property, housing the servers and

maintaining call centres. Amazon Germany, Amazon UK and Amazon France thereafter supplied to

Amazon Luxembourg the same types of customer-related, fulfillment and support services that they had

previously furnished to Amazon US. Amazon effected the restructuring by completing six related

transactions:

(1) cost sharing arrangement;

(2) license agreement for pre-existing intellectual property (License Agreement);

(3) assignment agreement for pre-existing intellectual property (Assignment Agreement);

(4) European subsidiary contribution;

(5) European business contribution; and

(6) four-party agreement.

Accordingly, Amazon US entered into a cost sharing

arrangement requiring AEHT to make an up-front “buy-

in payment” to compensate Amazon US for the value

of the intangible asset, and to further make annual cost

sharing payments to compensate Amazon US for

ongoing IDCs, to the extent those IDCs benefited

AEHT. In a series of transactions in 2005 and 2006,

Amazon US transferred to AEHT three groups of

intangible assets:

(1) software and other technology required to

operate its European websites, fulfillment

centres and related business activities;

(2) marketing intangibles, including trademarks, trade names and domain names relevant to the

European business; and

(3) customer lists and other information relating to its European clientele.

A. The buy-in payment

The taxpayer reported a buy-in payment from AEHT of USD 254.5 million, to be paid over 7 years. In

determining the value of transferred assets, the taxpayer assumed that each group of assets (website

technology, marketing intangibles and customer information) had a 7-year useful life. At trial, the

taxpayer submitted that to properly value the pre-existing intangibles, each group of transferred assets

must be valued separately under the comparable uncontrolled transaction (CUT) method.

However, the IRS contended that the transferred property had an indeterminate useful life, and it had to

be valued not as three distinct groups of assets, but as integrated components of an operating business.

Applying a discounted cash flow (DCF) methodology to the expected cash flows from the European




business, the IRS determined a buy-in payment of USD 3.6 billion, later reduced to USD 3.468 billion.

The taxpayer’s experts derived an internal CUT by reference to the prices Amazon charged its M.com

clients for the technology needed to run those clients’ e-commerce websites and arrived at a transfer

value for the website and related technology of between USD 117 million and USD 182 million. As

regards marketing intangibles, the taxpayer used an external CUT methodology and computed transfer

value between USD 115 million and USD 165 million. In respect of customer information consisting of

information regarding European retail customers, the taxpayer contended that this had a short useful life

and used referral fees as CUTs and arrived at a value of between USD 52 million and USD 66 million.

The taxpayer thus submitted that the transfer would yield a buy-in payment ranging from USD 284

million to USD 413 million.

Opinion of the Court

The Court observed that the required buy-in

payment “is the arm’s length charge for the use

of the intangible” multiplied by the controlled

participant’s share of reasonably anticipated

benefits. The Court also noted that as per the

regulations, the buy-in payment represents

compensation solely for the use of pre-existing

intangibles, whereas the compensation for

subsequently developed intangible property is

covered by future cost sharing payments,

whereby each qualified cost sharing

arrangement (QCSA) participant pays its ratable

share of ongoing IDCs. The Court thus noted

that adjustments are permitted only to ensure that (i) an arm’s-length buy-in payment is made for pre-

existing intangible property and (ii) each participant pays its appropriate share of ongoing IDCs.

The Court relied on the case of Veritas Software, wherein this Court had interpreted and applied these

cost sharing regulations and had found several deficiencies in Revenue’s methodology, such as treating

the core product as having a perpetual life. In the Veritas case, the Court had held that the buy-in

payment for transfer of pre-existing intangible property represented an abuse of discretion, and CUT was

the best method for determining the requisite buy-in payment. The Court noted essential similarities

between the DCF methodology employed by Revenue in Veritas vis-à-vis the present case, such as,

valuation of buy-in payment under the assumption of perpetual useful life for the pre-existing intangibles

and treatment of transfer of pre-existing intangibles as economically equivalent to the sale of an entire

business. Following the Veritas ruling, it rejected Revenue’s determination of the arm’s-length buy-in

payment.

I. Rejection of Revenue’s DCF methodology

• The Court noted that the valuation carried out by Revenue’s expert proceeded in three main steps:

Step 1: Estimate the future cash flows of AEHT’s European business.




Step 2: Select the discount rate to convert these estimated cash flows into 2005 dollars.

Step 3: Calculate the buy-in payment as equal to present value of the cash flows determined in step

1, discounted at the rate determined in step 2.

Perpetual useful life

• The Court firstly held that Revenue’s expert, by assuming a perpetual useful life, had failed to restrict

his valuation to the “pre-existing intangible property” that Amazon US actually transferred to AEHT in

2005. The Court noted that the website technology that Amazon US initially transferred to AEHT had

a useful life of 7 years, which, after decaying or “ramping down” in value, as on January, 2005 the

website technology would have had relatively little value left by year-end 2011.

Subsequently developed intangibles

• The Court further held that the value of subsequently developed intangibles had been improperly

included in the buy-in payment. The Court observed that Amazon’s projections for the European

business were based on extremely high growth rates that Amazon had achieved in the past, which

could be sustained only through constant innovation, including innovations concerning new products

and services. However, the Court reasoned that AEHT would have paid its ratable share of these

future IDCs via cost sharing, and would thus co-own these subsequently developed intangibles,

therefore it was held that, “No buy-in payment is required for subsequently developed intangibles.”

Business enterprise valuation

• Noting that Revenue’s methodology was based in essence on an “akin to a sale” theory wherein the

buy-in payment was computed not by valuing the specific intangible assets transferred under the

CSA but by determining an enterprise value for Amazon’s entire European business, the Court

referred to the definition of “intangible” as per the cost sharing regulations and held that “An

enterprise valuation of a business includes many items of value that are not “intangibles”, as these

items cannot be bought and sold independently, and are an inseparable component of an

enterprise’s residual business value.

• The Court also rejected Revenue’s arguments that adoption of a business enterprise valuation was

supported by the “aggregation” principle or the “realistic alternatives” principle.

• Aggregation principle – The Court held that Revenue’s business-enterprise approach improperly

aggregated pre-existing intangibles (subject to the buy-in payment) and subsequently developed

intangibles (subject to IDCs). It further held that such an approach had improperly aggregated

compensable “intangibles” (such as software programs and trademarks) and residual business

assets (such as workforce in place and growth options) that do not constitute “pre-existing intangible

property” under the cost sharing regulations in effect during 2005-2006.

• Realistic alternatives principle – Revenue argued that parties entering into a QCSA have the “realistic

alternative” of not entering into one, therefore the buy-in payment must be determined as if the

parties had not elected cost sharing but had instead continued to operate the business as they had

done previously. In this regard, the Court held that the cost sharing election, which is explicitly made

available to taxpayers by the regulations, would be rendered meaningless. The Court further held




that even where a realistic alternative exists, the Commissioner “will not restructure the transaction

as if the alternative had been adopted by the taxpayer,” so long as the taxpayer’s actual structure

has economic substance.

Reliability of Veritas ruling

• The Court rejected Revenue’s attempt to distinguish the Veritas ruling on the ground that it was

highly fact-bound opinion, and also refused to overrule the same.

The Court rejected Revenue’s argument that the discounting process by which the buy-in payment was

computed would arguably afford AEHT a limited return on the investment represented by its share of the

IDCs. The Court held that, “the regulations simply do not authorize such an artificial cap on the expected

returns that AEHT could realize as co-owner of Amazon’s future intangible assets”. It was further held

that, “By allocating to Amazon US all of AEHT’s future profits in excess of the discount rate, (Revenue’s)

approach is irreconcilable with the governing regulations”.

II. Acceptance of taxpayer’s CUT

The Court observed that for a comparison of intangibles involved in controlled and uncontrolled

transactions, both intangibles must be “used in connection with similar products or processes within the

same general industry or market” and must have “similar profit potential.” The Court thus agreed with

taxpayer that the CUT method provides the best method for determining the fair market value of all three

species of intangible property, however, it proceeded to make certain adjustments under the CUT

method.

1. Website technology

The taxpayer considered M.com transactions

between Amazon and its clients as reliable

internal CUTs for the transaction by which

Amazon US made its website technology

available to AEHT. The taxpayer’s expert

observed that the M.com agreements stated a

“headline” commission rate that covered not only

the website technology but also ancillary services

that Amazon furnished to that particular client.

The taxpayer therefore made certain adjustments

to the commission rates appearing in 12 M.com agreements to eliminate profit attributable to ancillary

services, such as downward “volume adjustment” and useful life and a decay curve.

a. Royalty rate

• The Court agreed that the Target arrangement offered the best comparable M.com

transaction for purposes of implementing the CUT approach, since Target was the largest

M.com retailer and the most comparable to AEHT in terms of sales volume, and also had a

broad product line and wide product selection similar to AEHT. Further, Target was

contractually entitled to receive from Amazon US all technology updates as they occurred.

However, the Target agreement included a variety of ancillary services, such as fulfillment




and customer service, that Amazon US did not provide to AEHT. The Court observed that the

Target agreements bracketed the range of acceptable royalty rates between 2.05% and 4%.

• Expanding the analysis to consider other M.com agreements, the Court arrived at an arm’s-

length base royalty rate for the website technology, before applying any volume adjustment,

of 3.3%, as it properly backed out revenues attributable to ancillary services and was near the

midpoint of the commission rates bracketed by the various Target agreements.

• As regards volume adjustment, the Court considered Amazon’s agreements with its largest

M.com clients namely Target, Mothercare, Marks & Spencer and Sears Canada and rejected

a 200-basis-point downward adjustment made by Revenue’s expert. Since the agreements

did not indicate any mathematical formula for calculating a proper volume adjustment, the

Court, using it best judgment, allowed a 25-basis-point adjustment and computed an arm’s-

length royalty rate of 3.05%.

b. Useful life and decay curve

• Referring to the evidence on record, the Court concluded that Amazon’s website technology

did not have a perpetual or “indefinite” useful life. In comparison with the Obidos and Gurupa

websites, some of which survived 9 years or more, the Court rejected the Revenue expert’s

estimate of a 6-year useful life. Using its best judgment, the Court arrived at an average

useful life of 7 years.

• The Court also allowed adjustment of the starting royalty rate to reflect a decay in value of the

original technology over its 7-year useful life on a decay curve. The Court noted that all of

Amazon’s M.com clients received technology updates for free as they paid constant royalty

rates for the package of pre-existing and subsequently developed intangibles, whereas AEHT

did not receive technology updates for free, but made cost sharing payments by which it

became a co-owner of the subsequently developed intangibles. The Court calculated a

ramping-down of the royalty rate at 33% per year.

• The Court further approved a higher royalty rate for the 3.5-year ‘tail’ period commencing 1

January 2012 so as to adequately compensate Amazon US not only for the continued

presence of source code but also for the research value of its original technology.

c. Revenue base & discount rate

• The Court accepted a starting date for payment of royalties of 1 May 2006 (agreed by both

parties) and an appropriate discount rate of 18%.

2. Marketing intangibles

Amazon used the CUT method for determining the ALP of marketing intangibles using licensing

information reported in the ktMINE database, which includes 15,000 intangible agreements and allows

user to conduct customized searches. Amazon’s expert identified six comparable agreements with




royalty rates ranging from 0.125% to 1% of sales, and

selected the median of these rates, or 0.59%, as his

base rate, which was then reduced to reflect a volume

discount. He estimated that the marketing intangibles

had a remaining useful life of 10 to 15 years, and

identified the revenue stream associated with their use

on the basis of management’s projections and a

growth assumption after 2011. Applying a discount

rate of 18%, he calculated a value of USD 251 million

to USD 312 million. Another expert employed by

Amazon opined the value should be adjusted to reflect

the fact that European subsidiaries already owned certain intangibles. Thus, considering a value for such

previously owned intangibles of 50%, he determined the value at USD 115 million to USD 165 million. In

contrast, the IRS’s expert determined the value at USD 3.13 billion, considering a royalty rate of 2%,

indefinite life for intangibles, a discount rate of 13.3%, no volume discount and a set of four comparables

(including one from Amazon’s selection).

a. Royalty rate

• During trial, the Court accepted three licence agreements as comparable, having royalty rates

of 1%, 1% and 0.75%, which was agreed by both parties. The Court also accepted a fourth

comparable agreed by both parties having a royalty rate declining from 1.2% (in 2003) to

0.5% (in 2005). The Court agreed with Amazon’s expert to consider a 0.85% royalty rate for

this comparable, which was the rate for most of the initial period.

• Based on four comparables, the Court determined a comparable royalty rate at 1% agreeing

with Revenue’s expert that, considering the strength of Amazon’s brand in 2005, the highest

rate should be considered.

• The Court rejected Amazon’s claim of volume discount observing that a flat royalty rate was a

norm in agreements of similar types and evidence on volume adjustment was conflicting as to

whether the rate should be adjusted upward or downward.

b. Useful life of marketing intangibles

• The Court agreed with Amazon’s claim that the life of marketing intangibles cannot be

perpetual as held by Revenue. The Court’s conclusion was based on numerous factors

including the fact that the Internet retail industry was young, Amazon had operated in Europe

for only 6 years and Amazon’s success depended heavily on short-lived technology assets,

but the chief reason was the fact that AEHT assumed sole responsibility to maintain and

develop the marketing intangibles in Europe and paid, through cost sharing, for the

technological improvements essential to maintaining the value of those marketing intangibles.

• Considering the experts’ analysis of the useful life of intangibles, the Court estimated a useful

life to be at the top of the range i.e. 20 years, holding that Amazon was a strong brand in

Europe in 2004 which supports relatively longer life.




c. Revenue base

• The parties agreed that royalties for the marketing intangibles should be based on the same

revenue base as royalties for the website technology. The parties also agreed on adopting

management projections for 2005 to 2011. The Court also agreed with Amazon’s method of

applying a 50% declining balance method to determine AEHT’s post-2011 revenue. Accordingly,

the Court accepted that AEHT’s revenue growth rate was to be reduced by 50% for each year

post-2011 until it reached a 4% stable growth rate.

• The Court also upheld Amazon’s claim that revenues attributable to gift wrap, shipping, and

miscellaneous services should be excluded from AEHT’s projected revenue stream for the

purposes of calculating royalties for the marketing intangibles.

d. Starting date and discount factor

• The Court adopted 1 May 2006 as the starting date of payment for royalty and an 18% discount

rate as done in the case of website technology.

• While determining a 13.3% discount rate, Revenue’s expert considered a beta derived from

companies whom he regarded as comparable, such as eBay, Yahoo!, Netflix, Overstock.com,

Barnes & Noble, etc. Noting that data for Amazon’s beta was readily available and it was actively

traded stock, the Court held that there was no need to look at data regarding other companies.

e. Reduction for European portfolio

• Amazon contended that half of the value of marketing intangibles was owned by European

subsidiaries before the transfer and thus should be excluded from buy-in payments. However,

Revenue contended that Amazon US was the true equitable owner of any marketing intangibles

legally owned by the European subsidiaries as Amazon US made all the investments and took all

risks involved in building up the value of any items of IP that were registered in the European

affiliates’ names. Thus, Revenue urged the Court to impute an agreement whereby Amazon US

held an exclusive licence to use any marketing intangibles nominally owned by the European

subsidiaries, or, alternatively, that the European subsidiaries acted as “agents” of Amazon US in

holding title to these assets.

• The Court held that Amazon US had valid business reasons for localizing ownership of the

European portfolio in the European subsidiaries. Under the laws of Germany and France at the

relevant times, only local companies could obtain country-specific domain names (e.g.

Amazon.de and Amazon.fr). Accordingly, Amazon Germany and Amazon France had registered

for their country-specific domain names.

• Further, the European subsidiaries had used these domain names and marks in the active

conduct of their business. Before January 2005, the European subsidiaries were service

providers for Amazon US. They had numerous employees of their own who were responsible for

vendor and customer relationships. Because of differing cultural preferences, retail traditions and




national regulations, the details of these operations often varied from country to country. Local

teams were thus integral to Amazon’s success in Europe. At the relevant times, the European

subsidiaries bore significant marketing risk. The Court held that European subsidiaries had borne

meaningful business risk because they received only a percentage of revenues. There was no

guarantee that they would earn a profit based on their marketing efforts. Thus, the Court rejected

Revenue’s contention that Amazon US “took all of the risk.”

• The Court also observed that the European subsidiaries also owned and operated the physical

infrastructure supporting the European websites. This entailed complete responsibility for the

warehouses, inventory and fulfilment. The ultimate value of the European portfolio hinged on the

European subsidiaries’ ability to fulfil Amazon’s promise of fast and accurate delivery. Their

success in doing so contributed meaningfully to the value of these domain names and marks.

Thus, the Court held that “the European Subsidiaries were mere “agents” of Amazon US for the

purpose of holding title to the European Portfolio. As the ultimate parent, Amazon US had the

ability to decide how ownership of the marketing intangibles would be dispersed within the

corporate family. But there was a valid business justification for the European Subsidiaries’

ownership of these domain names and marks, and they actually used these assets in the active

conduct of their business.” Noting that the domain name and marks were used in active conduct

of business by European subsidiaries, the Court refused to impute contractual agreement

between the controlled taxpayers to deem Amazon US the equitable owner of the European

portfolio.

• Noting various discrepancies in the valuation methodology of the taxpayer’s expert, the Court

held that there was overstatement of the value of the European portfolio. The Court finally agreed

with Revenue’s expert in determining the value of the European portfolio at 25% of the overall

value of marketing intangibles and held that the same should be excluded while computing buy-in

payments.

3. Customer information

The customer information that Amazon US made

available to AEHT consisted of data regarding

European retail customers who had transacted with

the European subsidiaries before 1 May 2006. This

data included names, email addresses, phone

numbers, credit card information and purchasing

history. By making this information available to

AEHT, Amazon US in effect was referring its existing

European customers to AEHT and furnishing it with

certain information about them.

• The parties agreed that the Associates and Syndicated Stores agreements between Amazon and

its business partners provide useful internal CUTs for purposes of determining the fair market

value of the customer information. Under those agreements, Amazon paid referral fees, in the

form of “commissions,” to a third party when the latter’s customers or website visitors made

purchases from Amazon. While concurring that these agreements supply useful data for valuing




the customer information, the parties disagreed about the mechanics of the valuation exercise.

• The Court accepted Amazon’s method of valuation with some modification. The Court noted that

the average referral fee that Amazon actually paid under the Associates and Syndicated Stores

programs was approximately 5.9% of referred sales. Thus it was adopted as an arm’s length rate

for a referral fee.

• Thereafter, the Court considered the revenue on which this rate was to be applied, and noted that

reliable data for 10 years of subsequent spending by European customers who had originally

arrived at Amazon’s website via referral was available. Thus, the Court considered the period of

10 years for valuation as compared to 6 years used by Amazon.

• The Court agreed with Revenue that Amazon’s expert had understated the revenue stream for

computing referral fees by using the median rather the average amounts that customers were

expected to spend per visit. The analysis showed that a small subset of customers was

responsible for a disproportionate dollar amount of sales. Thus the average spending per

customer was significantly higher than the median spending per customer. Accordingly, the Court

agreed with Revenue’s expert that the average should be considered and not the median,

observing that AEHT, operating at arm’s length, would not insist on paying referral fees

calculated to exclude these customers as high spending customers are the customers whom

retailers most desire to have.

• Consequently, the Court determined the ALP for customer information at USD 129 million

considering a referral fee of 5.9% on a revenue stream based on average spending by customers

referred by other websites and taking a period of

10 years.

B. Cost sharing payments

The regulations define IDCs and provide that

costs that contribute both to intangible

development activity and to other business

activities must be allocated “on a reasonable

basis.” The taxpayer’s cost accounting system

during 2005-2006 did not specifically segregate

IDCs or R&D expenses from other operating

costs, but tracked expenses in six high-level

cost centres: (1) Cost of Sales, (2) Fulfillment, (3) Marketing, (4) Technology and Content (T&C), (5)

General and Administrative (G&A), and (6) Other.

The taxpayer employed a QRE survey data compiled by PwC that identified qualifying research activities

for purposes of claiming section 41 research and experimentation (R&E) credits for 2005 and 2006, and

reported cost sharing payments from AEHT of USD 116 million and USD 77 million, respectively.

However, the IRS determined that 100% of the costs captured in one important high-level cost centre

(“Technology and Content”), which consisted of mixed costs, must be allocated to IDCs, thereby

increasing the cost sharing payments that AEHT was required to make in 2005 and 2006 by USD 23




million and USD 109.9 million, respectively.

Opinion of the Court

The Court noted that the T&C category costs included mixed costs. The Court also noted the taxpayer’s

argument that on treatment of 100% of T&C costs as IDC, AEHT’s future cost sharing payments would

be so large as to produce a negative buy-in payment under income method analysis.

• As regards Revenue’s observation that the taxpayer cannot use an allocation methodology until it

first establishes, on a cost-by-cost basis, which particular costs relate only partially to intangible

development, the Court noted that it had addressed this point in the prior opinion issued in this

case, wherein it had stated that “It is not necessary that the parties painstakingly examine each

cost in the 200-plus baseline cost centers in order to determine whether a nontrivial portion of

T&C category costs are ‘mixed.’” The Court further held that, “We see no logical reason for

imposing harsher requirements on petitioner before allowing it to allocate costs within the T&C

category.”

• The Court agreed with the taxpayer that Revenue had abused his discretion in determining that

100% of the costs accumulated in the T&C cost centres constitute IDCs. The Court held that

taxpayer had established through documentary evidence and expert testimony that substantial

non-IDCs were captured in these cost centres.

• The Court further held that Revenue’s approach in deeming 100% of T&C category costs to be

IDCs violated the regulatory command that “[c]osts that do not contribute to the intangible

development area are not taken into account.” (section 1.482-7(d)(1) of the Income Tax

Regulations)

• The Court agreed with Amazon’s expert’s allocation methodology based on PWC survey data,

and rejected Revenue’s challenge to the reliability of PWC survey data on the ground that the

taxpayer’s employees did not record their time contemporaneously. The Court agreed that

contemporaneous time records are always preferable, however observed that PwC had

apparently secured its data within a year of the period in which the employees rendered their

services. Since the regulations required the petitioner to devise a formula that would allocate

costs “on a reasonable basis”, the Court held that the taxpayer had acted logically in using the

best data it had.

• The Court also accepted certain modifications regarding use of the T-ratio to yield a

“development ratio” for the T&C category, and treatment of certain indirect costs. The Court

noted that these two modifications were significant, increasing the petitioner’s IDCs by more than

USD 50 million for each year at issue. The Court held that, “We conclude that results, as thus

adjusted, yield a formula that allocates costs “between the intangible development area and the

other areas or business activities on a reasonable basis.” (section 1.482-7(d)(1) of the Income

Tax Regulations)

• However, the Court rejected the modifications proposed by Revenue for the inclusion of costs

that were deemed by the taxpayer as unrelated to intangible development and costs ineligible for




section 41 credit, namely, “routine engineering” and “routine data collection”. The Court observed

that the costs of field testing a new invention are not comparable to the costs of routine data

collection and routine engineering, and agreed with the taxpayer’s contention that the QRE

survey properly captured such costs.

C. Stock-based compensation

The CSA defined IDCs to “include all direct and indirect costs (including Stock-Based Compensation

Costs)” relating to intangible development. The parties elected to take into account “all stock-based

compensation in the form of stock options in the same amount, and as of the same time, as the fair value

of the stock options reflected as a charge against income” in either party’s financial statements.

However, the taxpayer questioned the validity of this regulation. Further, the CSA included a clawback

provision that will apply in the event that this regulation is ultimately invalidated or withdrawn, wherein

the stock-based compensation shall not be included in the determination of IDCs.

• This Court, in Altera Corp. v. Commissioner, had invalidated section 1.482-7(d)(2) of the Income Tax

Regulations, the provision that requires stock-based compensation costs to be included in the IDC

pool. This decision in pending on appeal to the US Court of Appeals for the Ninth Circuit.

• Accordingly, the Court held that stock-based compensation was correctly included in the cost pool

and CSA’s clawback provision was not yet operative.

Documents

US Tax Court rules in Amazon’s favour; Rejects …...intangible assets: (1) software and other technology required to operate its European websites, fulfillment centres and related