Originally published on Forbes.com.
The Tax Court, showing no consideration for tax bloggers who have returns to prepare, finally released its decision in Amazon’s long battle with the IRS on March 23. The decision is a door stopper and if you read the whole thing you will learn more that you want to know about Amazon’s European business and technical difficulties. For example:
The transition from Obidos to Gurupa was an architectural shift from a monolithic to a distributed system and involved rewriting software in different programming languages. Amazon decided to abandon catsubst for building web-pages and shifted to a programming language known as Perl and a templating language known as Mason (the duo was called “Perl/Mason”). Amazon could reuse very little of the Obidos software when it moved to Gurupa.
There has been plenty of coverage of the decision, which by tax blogging standards is now ancient history, so normally I would pass on it having let it go this long. There are some aspects, little remarked, that I find of interest, so I will focus on that. Overall I find the Amazon case a good illustration of Reilly’s Third Law of Tax Practice – Any reasonably complex tax matter involving significant dollars, regardless of whatever else it might be, is a white-collar jobs program.
Some Background
For 2016, according to its 10-K Amazon had pretax income of $3.892 million. In computing net income Amazon used an income tax provision of $1.425 billion. Total amount of income tax paid net of refund was $412 million. Almost all of the large difference between the amount paid and the amount provided is explained by the tax benefits derived by Amazon from employees exercising stock options. The exercise of some stock options can generate a tax deduction. Since under GAAP you cannot increase your income by dealing in your own stock, the benefit of that deduction, $829 million in 2016, is recorded as a capital contribution. I mention in this in passing, because you will often read that this or that public company is “paying” X % in income taxes. The numerator used in computing that percentage is usually the GAAP income tax provision, which, as we see, can be only vaguely related to what is actually paid. Sometimes it is due to timing differences like depreciation, but the tax benefit of the option exercises is a permanent difference.
The litigation, however, is about a different wrinkle that is another permanent difference. You can see in the notes:
Undistributed earnings of foreign subsidiaries that are indefinitely invested outside of the U.S. were $2.8 billion as of December 31, 2016. Determination of the unrecognized deferred tax liability that would be incurred if such amounts were repatriated is not practicable.
If Amazon were to change its mind and decide that it wanted to bring those earnings to the US, they would have to figure out what that deferred tax liability was and of course if Amazon repatriated it would have to actually pay on it.
The Problem
If Amazon were ever to decide to have its foreign subsidiaries cough up that $2.8 billion, it would be entitled to a foreign tax credit for the amount that the subsidiaries paid other countries. The presumption is that that was a lot less than the US rate otherwise there would not be all this need to worry about whether the profits were “indefinitely invested outside the U.S.”. The problem is that the parent company and the subsidiaries have transactions among themselves that can move the profits from this country to that. Those transactions get eliminated in consolidated financial statements, something you need to learn how to do if you want to pass the CPA exam. Or at least you did back in the day when I took it. And they would be eliminated if a consolidated tax return were filed.
So the parent company is providing services to the subsidiary. Income to the parent and deduction to the subsidiary. The transaction is eliminated in consolidation. Doesn’t affect reported earnings. Who cares? The IRS cares because the tax return is not consolidated and what is paid for those services affects whether the profits are taxed by the United States or, say, Luxembourg. That’s why we have Code Section 482, which as codes section go is pretty short. So here it is.
In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B) ), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible.
That is what the case is about – particularly that last part “In the case of any transfer (or license) of intangible property”. In order to get the ball rolling, on keeping overseas profits overseas, Amazon sold intellectual property to its subsidiary. How much the subsidiary should pay was the big dollar contention in the case. Amazon Europe Holding Technologies SCS, which is in Luxembourg, paid its parent $254.5 million for preexisting intangible assets. That is less than 10% of the $3.468 billion that the IRS maintained was the correct number. There was also dispute about how ongoing expenses related to intangibles should be shared between US and Luxembourg.
The reality is that it is very unlikely that a company would actually do something like this with an unrelated company. So the determination of the right price becomes a matter for contention among experts about hypothetical transactions. And of course, all that intracompany stuff must keep people busy tracking things. As a Great Depression echo baby, there is part of me that wants to cheer. Whatever else you might think about this, it gives people work.
How It Came Out?
Overall Amazon won. There is a ton of coverage on the case, some of it a little off, but for a quick summary you can go to the Journal of Accountancy.
The 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 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 best comment in the rest of the coverage came from Lew Taishoff, who declined to dig in deep to the case.
If you think I’m going to digest this, when I’ve sworn off drink for the rest of the month, try again.
So that’s how it turned out. The main purpose of this post is to share with you the good bits that didn’t get featured in the rest of the coverage.
Why Luxembourg?
Why does what promises to be the world’s greatest retailer choose to headquarter a substantial part of its operations in a landlocked country roughly the size of Rhode Island with about half the Ocean State’s population? That was what Project Goldcrest was about.
In broad outline, Amazon’s plan was to transfer from Amazon US to the Luxembourg headquarters affiliate all of the intangible assets required to operate the European website businesses; to continue using the European Subsidiaries as service companies earning a nominal rate of return; and to have the vast bulk of the income from Amazon’s European businesses taxed in Luxembourg at a very low rate. In pursuit of the latter goal, Amazon successfully negotiated an advance tax agreement with the Government of Luxembourg. After the restructuring, the Luxembourg entity would function as the operational and administrative headquarters for the European businesses and own virtually all of the intangible assets required to operate those businesses.
So it wasn’t just US income taxes Amazon is dodging
Problems With Amazon Website? Here’s Why
Amazon’s software engineers, computer scientists, and management team focused on continuous innovation to provide easy-to-use functionality, rich web-site content, fast and reliable fulfillment, timely customer service, and a trusted transactional environment. Amazon regularly launched software on a test basis, fully conscious of the need for further improvements; its software and website content often changed multiple times the same day. Amazon’s software development process “leveraged the future”: By building a piece of software quickly, Amazon incurred the risk that it would not be adaptable to future needs. By repeatedly choosing “the expedient path” over “the right path,”Amazon built up “technical debt” that inheres in software with a relatively short useful life.
Give It To The New Guy
Here are some amusing observations about the type of thinking that goes into arguments about transactions that have no real-world arms-length analogs.
Given the unpredictability of eCommerce revenue growth, Amazon for internal budgeting purposes did not make financial projections more than 12 or 18 months out. It assigned its tax department the task of creating longer term projections for this occasion.
Talk about made up numbers.
Then there is this.
We find several flaws in Dr. Higinbotham’s approach. The “goodwill impairment” model on which he relied was developed by a new employee in Amazon’s accounting department. This employee testified that he was then in his orientation period; that he was given the prior year’s model and told to “mark it up” ; and that he spent his first few weeks at Amazon learning how the model worked by plugging in different variables. There is no indication that this spreadsheet presented reliable projections of Amazon’s future revenue.
Here Is An Idea
Perhaps the simplest thing would be to tax public companies based on their reported earnings. The foreign tax credit prevents double taxation. By taxing the companies on their reported earning instead of having one set of accountants scheming how to inflate earnings to help stock prices and another set of accountants over in the tax department scheming on how to reduce taxable income, the pressure would be to tell a consistent story. The IRS could to a significant extent ride on the work of the independent auditors and tax provisions would be comprehensible to more than a few hundred people in the country. On the other hand, a plan like that would probably be a job killer for accountants, so maybe it is good to keep things as they are. At least it gives people clean jobs with no heavy lifting.