Veritas Software Corp. v. IRS: IRS Was "Arbitrary, Capricious and Unreasonable"…and Perhaps Malicious?

By Ron Cohen, CPA, MST
Partner
Greenstein, Rogoff, Olsen & Co., LLP

Here’s the link to Tax Court case decided 12/10/2009. The U.S. Internal Revenue Service (IRS) may appeal to the 9th Circuit Federal Court of Appeals. Tax years involved: 1999 – 2001.

BACKGROUND

Veritas (now part of Symantec Corp.) transferred intellectual property (“IP”) to its wholly-owned subsidiary in Ireland. The Irish subsidiary paid Veritas (US) $118 million in a lump-sum “Buy-In” payment in exchange for the IP as part of a Cost-Sharing Arrangement pursuant to IRS regulations and accepted transfer pricing rules. Therefore, Veritas (US) timely reported the $118 million of additional U.S. taxable income within its federal income tax returns.

The IRS audited Veritas (US) and determined the Buy-In payment should have been $2.5 Billion (21 times higher than the taxpayer’s number of $118M) resulting in taxes due on $758M and additional penalties of $303M. Of course, Veritas went to court when the IRS asked for $1.061 billion.

The Court required what appear to be minor computational adjustments regarding the computation of the “CUT” (Comparable Uncontrolled Transaction, under transfer pricing regulations) before the final $ amount of the judgment is determined. (Tax Court Rule 155)

The law firm of Baker & McKenzie (Palo Alto and San Francisco) represented Veritas. I disclose I am an acquaintance with 3 esteemed members of the legal team in this case.

DISCUSSION

I will leave to others to write about the deep, technical issues involved.

Here, I’d like to address why my wife asked me “why are you laughing?” as I read the case.

I replied: “Veritas is winning against the IRS. You gotta read this.” To which she rolled her eyes and she called me a “tax nerd.”

Stealing from Dave Letterman, here are the Top Ten quotes from the Court’s Opinion. I didn’t order them like Mr. Letterman because I can’t determine which is funniest.

1) “On January 11, 2008, the Court filed petitioner’s [Veritas, the taxpayer] motion for partial summary judgment. In the motion, petitioner contended that respondent [the IRS] had abandoned the $2.5 billion allocation and the methodologies set forth in the notice; the notice was fundamentally defective; and respondent’s determination was arbitrary, capricious, and unreasonable.

On March 7, 2008, respondent submitted to the Court an expert report prepared by John Hatch (Hatch). Hatch, employing a discounted cash-flow analysis, concluded that the requisite lump-sum buy-in payment was $1.67 billion…”

That means, between the time the IRS finished their audit and the trial began, the IRS dropped their determination of the amount of the additional taxable income to the taxpayer from $2.5B to $1.67B. A $830 million downward adjustment.

2) “In essence, respondent’s determination began to unravel with the parties’ pretrial stipulations of settled issues. After the parties’ settlement relating to the arm’s-length value the Research Development Agreement, as a practical and legal matter respondent was forced to justify the $1.67 billion allocation by reference only to the preexisting intangibles. As discussed herein, he simply could not. Respondent, in a futile attempt to escape this dilemma, ignored the parties’ settlement relating to the RDA and disregarded section 1.487-7(g)(2), Income tax Regs., which limits the buy-in payment to preexisting intangibles. In addition, respondent inflated the determination by valuing short-lived intangible as if they have a perpetual useful life and taking into account income relating to future products created pursuant to the RDA.”

Software with a “perpetual” useful life? In Silicon Valley? This also means the IRS took IP developed after the Buy-In occurred to value what was transferred at the time of the Buy-In. Not fair.

3) “Respondent’s predicament was primarily attributable to the implausibility of respondent’s flimsy determination. In calculating the $1.67 billion allocation, Hatch [the IRS consultant/economist] used the wrong useful life for the products and the wrong discount rate and admittedly did not know precisely which items were valued.”

4) “Furthermore, respondent’s trial position reflected sections 1.482-1T through 1.482-9T, Temporary Income Tax Regs.., 74 Fed. Reg. 349 (Jan.. 5, 2009) – regulation that were promulgated [became effective] 10 years after the transaction and 5 months after trial.”

This means the IRS was applying the wrong law to the case. They were only off by 10 years.

5) “Hatch was certainly in a position to know whether his valuation method took into account the collective assets’ “synergies”, yet his defense, of the respondent’s “akin” to a sale theory was akin to a surrender. On redirect examination, Hatch testified:

Q: (Counsel for respondent) Do you believe your valuation methodology captured synergistic value?

A: [Hatch] I really don’t have an opinion. It may have. It may not have.

At trial the Court asked respondent’s counsel: ’If [we] reject Dr. Hatch’s approach that [we] should look at this in the aggregate and he hasn’t valued any of the intangibles separately, where does that leave the Court?’ Respondent’s counsel replied: ‘That leave the Court absolutely nowhere’, and that is precisely where respondent is with this theory – absolutely nowhere.”

Sorry, I can’t make it to 10 such quotes, but there are many, many more in the case.

So let me turn serious for a moment.

A) The time period it takes to resolve these cases is too long. The years at issue are 1999 to 2001. It is now almost 2010 and if this case is appealed more years will go by. “Justice delayed is Justice denied”… and the uncertainty of the outcome is bad for the business community (except perhaps tax lawyers) and the IRS.

B) Rule of Law and Double Standard:

LARGE ERROR PERCENTAGE

The IRS audit determination was $2.5B of additional income. Note, the taxpayer and the IRS spent significant time, money and effort in the audit process to that point in time. Before they even got into court, they dropped it to $1.67B. The IRS lost the case, and for now, the taxpayer’s reported income of $118 million stands. The IRS original determination had an error factor of 20 times the original reported income. That’s an error of 2,000%. ($2.5B - $118M = ~ an error of $2.4 B / $118M = 20 or a 2,000% error). The reduced $1.67B was only an error of 1,300%

If I prepared and signed a tax return with such an error, and if the error was identified by the IRS, there would be fines, penalties, and possible loss of my CPA license and/or my right to practice.

Why can the IRS walk into a court room and make a representation, backed by all the assessment and collection powers of the Internal Revenue Service, which is off by 1,300%? If they lose, there are no consequences to the IRS for their lack of a good-faith argument.

May I propose that when the IRS is found to be “Arbitrary, Capricious and Unreasonable” by an informed, experienced Tax Court Judge, then, their actions are malicious. The IRS should pay the Court a fine of $1M plus reimburse the taxpayer’s court and legal fees. Then, perhaps, the IRS will be more cautious in their audit findings and litigating positions. They would be more apt to pursue reasonable out-of-court settlements.

Yes, some taxpayers cheat. We completely support the IRS in pursuing such taxpayers. Nothing about the Veritas case, as far as I can tell, was remotely about cheating. It, at worst, was an honest difference of opinion well within the taxpayer’s legitimate rights to interpret complex rules.

THE RULE OF LAW

The Rule of Law, in the area of taxation, is to prevent the nasty habit of Kings confiscating their citizen’s property at will. May I suggest, the $2.5 Billion and reduced $1.67 Billion IRS taxable allocation was nothing more than a malicious attempt to confiscate the taxpayers property.

To support this, I provide from the Court’s opinion: “Further, petitioner notes that a buy-in payment based on Hatch’s growth rate would require Veritas Ireland to allocate a buy-in payment equal to 100 percent of its actual and projected operating income to Veritas US through 2009, resulting in $1.9 billion in losses over that period. Simply put, the growth rate Hatch employed was unreasonable.”

That is, the IRS computed a payment due to Veritas US equal to 100% of Veritas Ireland’s (VI) operating income for the years projected and used by the IRS to determine the value of the IP. Without the income statement information, it is hard to confirm this result, but since the Judge accepts that impact of the related debits and credits, so will I. Transfer pricing is supposed to allocate profits between countries. It is not supposed to create offshore losses over the long-term span of years.

The above computational effort by Dr. Hatch (supervised, reviewed, overseen and acknowledged as the IRS’s expert in a highly public case) sounds to me like the “King” trying to confiscate and tax all of VI’s profits. The IRS is trying to tax the legally earned profits of a duly incorporated legal entity of a separate sovereign country.

Is that “malicious” intent on the part of the IRS? When they are off by 1,300%, it sounds like a better argument than any of the IRS contentions in this case.

The IRS is quick to point out taxpayer’s have “due process” rights and access to the courts as justification for wild determinations without merit. Sadly, I also see this often with individual tax audits. The IRS should be held accountable for meritless determinations and held to a higher standard as public servants. More sadly, perhaps, I’m just naïve.

C) Tax Court Judge Foley in this case also presided over a landmark case between the IRS and semiconductor maker Xilinx Inc.

For the complete story on the Xilinx case, see:
http://www.groco.com/readingroom/intl_xilinx_recent_legal.aspx

Xilinx originally won its case in Tax Court, with similar holdings against the IRS (arbitrary & capricious) but was later found by the 9th Circuit appeals court to owe over $100 million in back taxes, stemming from a cost-sharing arrangement with an Irish subsidiary. That appeals court decision, issued in May, had a widespread effect on the way other technology companies, such as Cisco Systems Inc., account for Cost Sharing Arrangements under FAS 109 and FIN 48 (GAAP rules).

The Silicon Valley tax community was flabbergasted by the appeals court ruling in Xilinx which is currently, last I heard, under review by the full Appeals court (an “en banc” review). Public companies adjusted their books (if they had a similar issue) because an appeal and subsequent hearing of the Xilinx case at the U.S. Supreme Court level is very unlikely. Tax cases rarely are allowed a hearing in the U.S. Supreme Court.

How can it be that the court system finds the IRS “arbitrary and capricious” at the tax court level, yet reverses and supports the IRS at a higher level? That implies the tax courts are highly “conflicted.” This leads to uncertainty for taxpayers and the IRS, and more litigation.

My point is that these are not minor difference in opinion on fine points in the law. These are strong disagreements between the courts on the basic principles of Cost Sharing and Transfer pricing.

For example, the Xilinx appeal called into question the use of the “arm’s-length” standard…an accepted principle, internationally in use and embedded in tax treaties throughout the world.

We hope the courts will resolve this confusion soon.

I’ve written on several occasions that perhaps, the tax laws in the international area, and most certainly in the areas of transfer pricing and Cost Sharing are too complex for even honest-minded Judges to decipher. Where, oh where, does that leave taxpayers who must to file, each year, on time and correctly?

In closing: As a self-proclaimed blogger who attempts to keep up with international tax law developments, the irony of the reality of the Veritas court ruling and recent comments by IRS Commissioner Doug Shulman seem appropriate to note highlight here:

Remarks of IRS Commissioner Doug Shulman Before
the Organization For Economic Co-Operation And Development
Washington, DC, June 2, 2009:

“First, for too many years, the IRS was in the position of not having the resources to go toe-to-toe with taxpayers operating in the international markets. They had deep pockets and could hire a cadre of legal and tax experts. Some observers said, “We were outmanned and outgunned.”

To meet this challenge, we must keep existing personnel current on emerging techniques and hire top examiners, lawyers, economists, special agents and financial specialists who can unravel the sophisticated and complex world of international tax issues.”

Given the holding and testimony in the Veritas case, I assume the Commissioner is still building his team.