Veritas case challenges IRS position on transfer pricing valuations

Veritas Software Corp. v. Commissioner, 2009 WL 4723602 (U.S. Tax Court)(Dec. 10, 2009)

After aggressively expanding in the 1990s, Veritas Software Corporation became the largest manufacturer of advanced storage management software, holding distribution agreements with leading original equipment manufacturers (OEMs), including Microsoft and HP. Typically, the OEMs bundled the Veritas software into their operating systems or offered it as a standalone option (unbundled).

As local competition increased, the software’s useful life declined to about four years. To boost overseas sales, Veritas entered a cost-sharing arrangement (CSA) with a wholly-owned Irish subsidiary, transferring all rights to European markets along with certain pre-existing intangibles (patents, inventions, etc.). The subsidiary paid $166 million for the buy-in in 2000, adjusted the following year to $118 million, which Veritas reported on its federal income tax returns.

The IRS claimed the parent’s income was closer to $2.5 billion, based on its expert’s calculations. It assessed an additional $758 million in taxes plus $300 million in penalties. The company appealed to the U.S. Tax Court, claiming that the IRS notice was unreasonable and capricious.

IRS shifts experts in mid-stream. Prior to trial, the IRS disclosed that it would not use its original expert or his report. Instead, it retained a new expert, who believed the buy-in was comparable to the acquisitions that Veritas U.S. made during the 1990s. Rather than value the individual intangibles, he estimated their aggregate value based on arm’s length royalty rates and the assumption of a perpetual useful life. He also applied a fairly high growth rate (17.9%) and discount rate (13.7%) to conclude the buy-in was worth $1.675 billion, or the equivalent of a 22.2% perpetual annual royalty rate.

The court was highly critical of this approach—in particular, its attempt to apply the most recent (2009) transfer pricing proposals to the 2000 transaction. There was no statutory authority for the IRS’s comparable sale theory, the court held, or its inclusion of intangibles such as workforce-in-place and goodwill. “Taxpayers are merely required to be compliant, not prescient.” The IRS also failed to address the $825 million decrease in value from its notice of deficiency—“just one of the factors we consider in evaluating [its] reasonableness,” the court said. Its expert valuation at trial was another factor. “Put bluntly,” the court said, “his testimony was unsupported, unreliable, and thoroughly unconvincing.” Indeed, the expert’s only credibility consisted of his “numerous concessions and capitulations.”

What went so wrong. In calculating the $1.675 billion allocation, the IRS expert used “the wrong useful life for the products and the wrong discount rate,” the court said. He also used the wrong growth rate and the wrong risk-free rate and equity risk premium in deriving a weighted cost of capital. Further, his aggregate approach failed to identify the value of specific intangibles, but included items (such as distribution channels and customer lists) which the expert later conceded had little or no value. The IRS’s valuation theory was “riddled with legal and factual miscalculations,” the court held, and found its notice of deficiency arbitrary and capricious.

By contrast, the taxpayer’s expert used the CUT method (comparable uncontrolled transactions) to calculate the buy-in payment. He chose seven agreements between Veritas U.S. and OEMs, covering bundled and unbundled products; he also assumed the preexisting intangibles had a useful life of two to four years. Based on these observations and his applied discount rates, he concluded an appropriate range for the buy-in was between $100 million and $200 million.

The IRS objected, claiming that the selected OEM agreements were not sufficiently comparable to the CSA. The court disagreed, adopting the expert’s discount rate but adjusting his comparables to use only the unbundled agreements and their average royalty rate. It also added a value for trademarks, and ordered the parties to recalculate the appropriate buy-in payment using its adjusted variables plus a value for related sales agreements.