Originally published on Forbes.com.
As I tried to sort out the way Facebook is using Ireland to lower its tax bills, I was beginning to think that it involved leprechauns I mean it makes sense. Leprechauns have these hidden pots of gold. So if you have a magic formula to weave straw into gold – which is what Facebook really has as they somehow turn the cat pictures of regular people into billions of dollars – why not give your magic formula to a leprechaun who can hide most of the gold for you? The leprechaun will find a really safe spot, probably not actually in Ireland, maybe someplace in the Caribbean.
How It Works
The leprechaun story makes about as much sense as what actually goes on. I found a pretty good explanation in this Guardian story .
UK advertisers would pay Facebook Ireland Ltd., which would kick back a bit to Facebook UK for “support” and much more in “royalty fees” to ]Facebook Ireland Holdings, which is in the Cayman Islands. Yes, that is the magical spot where the leprechaun put the pot for the gold.
Under a new arrangement, the UK advertisers will pay Facebook UK Ltd which will then make its own royalty payments to the Cayman company. Apparently, the expectation is that something will be left for the UK to tax.
Who Audits Facebook?
Now according to its 10-K, there are really only two countries that scare Facebook when it comes to tax audits.
The material jurisdictions in which we are subject to potential examination include the United States and Ireland.
It is in the US that the audit is going on though. And that is what has been in the news this week.
We are under examination by the Internal Revenue Service (IRS) for our 2008 through 2010 tax years. We believe that adequate amounts have been reserved for any adjustments that may ultimately result from these examinations, and we do not anticipate a significant impact to our gross unrecognized tax benefits within the next 12 months related to these years.
Until this month even a close follower of the news might be hard-pressed to name more than two people famous for having worked for the IRS. Of course, John Koskinen and Lois Lerner have been made famous by Congressional investigation rather than from doing their jobs. Now there is a third. Nina Wu Stone is a Revenue Agent for the Large Business and International Division of the IRS. And it is her declaration that is attached to the summonses to Facebook filed by the United States in the District Court for the Northern District of California.
When They Say Purporting Look Out
The summonses (there are six)are in conjunction with an IRS examination of Facebook’s 2010 return (one of the returns mentioned in the 10-K). Part of the examination concerns:
…matters arising under certain agreements between Facebook In. and Facebook Ireland Holdings Limited purporting to transfer rights associated with Facebook’s worldwide business (Emphasis added)
If you have read has many Tax Court decisions as I have you would realize that “purporting” means “Liar, liar, pants on fire”.
Ms. Stone had served summonses on Facebook to appear on June 17 2016 at 55 South Market Street in San Jose. The building is aptly for this case known as the “Gold Building”. Nobody from Facebook showed up. With the attachments, the summonses are nearly two hundred pages although a lot of it is repetitive boilerplate.
The Wizards Of Ernst & Young
As best I can understand the issue, the long-range plan of having the leprechaun hide your gold requires you to charge the leprechaun a fair price for your magic formula. Because now it will be the leprechaun’s formula. To figure out the fair price you need a team of wizards. Facebook] decided to use Ernst & Young
Facebook retained Ernst & Young to value these transfers E&Y selected different methodologies to value these intangibles, on the theory that the user base, online platform, and marketing intangibles could be reliably measured on a stand-alone basis.
The IRS agents on the case started gathering information and heard from Facebook employees that the user base, online platform and marketing intangibles were interdependent and would be difficult to isolate from one another. They wanted to bring in an expert, but that had to wait until the new federal fiscal year due to budget constraints.
The summonses are looking for various sets of documents that will shed light on this issue. For example, there is a request for:
All Documents constituting, reflection, or referring to communications by or between any of Taxpayer’s business executives or managers regarding Taxpayer’s decision to make Dublin, Ireland or other countries or locations abroad the headquarters for its business operations outside of the United States and Canada.
The request that I found most intriguing is this one:
All Documents constituting, reflecting, or referring to internal communications by or between any of Taxpayer;s business executives and managers related to the announcement by Taxpayers on January 21, 2011 that it raised $1.5 billion at a valuation of approximately $50 billion.
That’s the approach that I’d be taken. Hey Facebook[, you transferred half your goodwill to the leprechaun, let’s call it $25 billion and be done with it.
Audit Hardball
Of course, that would probably not fly well in Tax Court which is why the audit team asked for all this additional data. According to the IRS Facebook[ was less than forthcoming which is why we now have summonses rather than requests. And there is the matter of the statute of limitations, which Facebook has refused to extend without conditions the IRS will not accept.
That is the aspect of this matter that I find of practical interest. The general wisdom I have always heard is to be cooperative with the IRS in extending the statute. Given the weakened state of the IRS, I think it is possible that that might no longer be the percentage move. One reading of this drama is that the Facebook tax team senses weakness on the other side and is exploiting it.
It will be interesting to see how this plays out.
Other Coverage
There has been a lot of other coverage of this including on forbes.com. My general rule is to not jump into these frenzies without having something to add. Besides the leprechaun connection, which is little remarked, I don’t think too many other commentators dug into the 10-K. I didn’t manage to work all my observations into this piece. The most intriguing part of the analysis is how little Facebook actually pays in income taxes compared to the amount that hits reported income as a provision for income taxes.
The amount actually paid is disclosed in the statement of cash flows. For 2015 the provision is over $3 billion, while the amount paid is $276 million (And that is not atypical). If you dig into it, you will find that the largest part of the difference comes from the way the company’s tax benefits for stock-based compensation are accounted for. If you want to get a good understanding of it, your best bet might be to find a bright young lad or lass studying for the CPA exam. I took the exam in 1980 and if I remember it rightly we only had debits back then.