Perhaps it was just a matter of time until the Internal Revenue Service decided to “outsource” its tax audit and litigation function to a private entity, i.e., a law firm. As reported in the December 8th issue of Tax Notes, the Service has hired the law firm of Quinn Emanuel Urquhart & Sullivan LLP, at a cost of more than $2 million, to assist in the transfer pricing audit of Microsoft Corp., signaling a resolve to aggressively litigate disputes over buy-in payments in cost-sharing agreements (CSAs), and raising the prospect of Quinn Emanuel lawyers participating in summons interviews of Microsoft executives. Does that work delegation to render legal advice to the Service sound appropriate, or even legal? For those of you who are not quite familiar with Quinn Emanuel the litigation-only global law firm is rumored to have the second highest profits per equity partner of any law firm in the world. The firm is headquartered in Los Angeles, California and currently employs 650 attorneys throughout eleven locations around the world, with its largest office located in New York City.
So What’s The Cost to the Taxpayer? Two Million One Hundred Eighty Five Thousand Dollars
Certainly Microsoft wanted to know. It filed a complaint on November 24 in the U.S. District Court for the District of Columbia under FOIA for the IRS to produce “all documents representing proposals” and “all documents representing agreements for the performance of services to be rendered by Quinn Emanuel.” Attached to the complaint as an exhibit is “what purports to be a copy of a[n] excised portion” of the IRS’s contract with Quinn Emanuel, which the Service gave to Microsoft on September 10 . Quinn Emanuel, such contract provides, will “assist with the evaluation, analysis, presentation and defense of claims or adjustments related to the issues under examination,” including “transfer pricing issues relating to the license of intangible property rights in association with a cost sharing arrangement and related transactions.”
According to a website maintained by the Office of Management and Budget, the contract was signed May 19, 2014, with a completion date of December 31, 2016, and a payment obligation of $2,185,500. The website categorizes the service to be supplied by Quinn Emanuel as “Support-Professional: Expert Witness,” suggesting that the law firm’s services may be limited to identifying and supporting expert witnesses. It is speculated that Quinn Emanuel’s involvement could also extend to be involved in the trial preparation phase. The contract further reveals, according to Tax Notes, that Quinn Emanuel will be closely associated with the IRS examination team during the audit phase, stating that the “Contractor will work collaboratively with the Service to support the examination.” Particularly, the law firm is tasked with reviewing all “the key documents (including reports, position papers, IDR responses, etc., prepared by or on behalf of the Taxpayer or the Service) and all relevant legal authorities to build a thorough understanding of the factual and legal issues and the record to date.” Among the various transfer pricing issues that the audit may involve includes a cost-sharing agreement with respect to the sufficiency of buy-in payments by an offshore affiliate of Microsoft’s in exchange for licensing intangibles.
According to the disclosed portions of the contract, Microsoft’s case spans two examination periods: tax years ended June 30, 2004, through June 30, 2006, and those ended June 30, 2007, through June 30, 2009. The Service alleges that in July, 2005 Microsoft licensed to its foreign affiliate rights to ‘technology intangibles’. in certain software products sold by Microsoft to third-parties in the Americas geographic region.” In exchange, the foreign affiliate made a buy-in payment to compensate Microsoft “for the value of the rights that it received and assumed responsibility for funding future research and development associated with the technology intangibles.” Finally, Microsoft and the affiliate established a transfer price “to determine how to share revenues that are collected, after licensing of the technology intangibles to the foreign affiliate, on future sales of the software products in question to third parties.”
Well, presumably the Service thinks the buy-in payment was far too low based on the standards contained in the regulations at that time. The new regulations apply to transactions entered into or after January 5, 2009. The current regulations value intangibles contributed to a CSA not just to “make or sell rights” for products incorporating the preexisting intangible, but also to a “platform” or foundation for developing new intangibles to be used in future products. That approach inserts an investor model for quantifying an arm’s-length buy-in payment under which an affiliate entity contributing only cash to a CSA is treated as making a low-risk investment and is therefore required to make a proportionately larger buy-in payment. The same additional platform argument was made in the Veritas case which the Tax Court flatly rejected. It criticized the IRS for making an argument as to “platform contribution intangibles,” a phrase that does “not appear in the regulations applicable to the CSA” but was introduced in the then-temporary regulations issued in 2009. The Tax Court opined that thus, the IRS’s “litigating position appears to mirror transfer pricing regulations promulgated 10 years after Veritas U.S. and Veritas Ireland signed their CSA.” Dismissing the notion that the contributed intangibles had ongoing value, the court limited itself to the intangibles’ make or sell rights, holding that a comparable uncontrolled transaction, and not a discounted cash flow, was the appropriate mode of analysis.
After its defeat in Veritas the Service reportedly re-examined its litigation position as to pre-2009 revised (final) regulations. But the Service would continue in proceeding against Amazon again over the buy-in payment notion. Now, in another pre-2009 case, the Service is willing to fork over $2 million for outside legal assistance in auditing Microsoft’s CSA and buy-in payments. Will Microsoft “flinch” into a more favorable settlement for the IRS just because Quinn Emanuel is on board?
The Quinn Emanuel contract and its price tag also suggest how high the stakes may be in the IRS’s dispute with Microsoft. Regardless of its outcome, the dispute, just like the Veritas and Amazon cases, will have limited precedential value on the jurisprudence of CSAs and buy-in payments, since they involve regulations that have been superceded. Still the potential deficiencies in tax are substantial. The determined deficiencies in Veritas and Amazon were $758 million and $234 million, respectively. No doubt the Microsoft case will be in the same range if not higher; why else go outside the government’s trial lawyers?
Cost Sharing Agreements Involving Intangibles In a Cross-Border Context
A typical CSA in the U.S. multinational context involves a sequence consisting of three parts: (i) a U.S. taxpayer licenses preexisting technology to a foreign affiliate; (ii) the foreign affiliate makes a buy-in payment and proceeds to further develop (or co-develop) the intangibles; and (iii) the U.S. taxpayer and foreign affiliate agree to share rights to, and revenue from, exploiting the developed intangibles. The U.S. taxpayer seeks to shift as much value and future profits over to the foreign affiliate(s) with a low buy-in payment. Obviously the Service will disagree where it believes a “stranger” would pay a much great value or make a much higher buy-in payment. Based again on the potential range of values that could be given to intangibles already in place, the stakes to the litigation that might ensue become quite high to both parties.
The arm’s length pricing analysis under section 482 begins with the factual and functional analysis of the actual transaction or transactions among the controlled taxpayers. In the context of a CSA, the controlled participants make economic contributions of two types, (i) mutual commitments to prospectively share intangible development costs in proportion to their reasonably anticipated benefits from exploitation of the cost shared intangibles (cost contributions) and (ii) provide any existing resources, capabilities, or rights that are reasonably anticipated to contribute to developing cost shared intangibles (platform contributions). CSAs may also involve economic contributions by the controlled participants of other existing resources, capabilities, or rights related to the exploitation of cost shared intangibles (operating contributions). The concepts of platform and operating contributions are intended to encompass any existing inputs that are reasonably anticipated to facilitate developing or exploiting cost shared intangibles at any time, including resources, capabilities, or rights, such as expertise in decision-making concerning research and product development, manufacturing or marketing intangibles or services, and management oversight and direction. The regulations provide guidance for determining the arm’s length charge for all such contributions to clearly reflect the incomes of the controlled participants.
Delegation of Power to Question A Taxpayer By Another Taxpayer Acting Under Authority of A Governmental Agency
The author of the Tax Notes report on the hiring of Quinn Emanuel, Ajay Gupta, comments that “[m]uch more significant than the money that will be paid under the contract to Quinn Emanuel, however, is the power that will be conferred on the law firm. The contract states that the contractor may “as necessary for the performance of his or her duties under this Contract, be given access to confidential tax returns and return information, as those terms are defined in section 6103(b)(I) and (2), respectively.” Quinn Emanuel is thus described in section 6103(n) and reg. section 301.6103(n)-1(a) as a person to which the IRS is authorized to disclose returns and return information “for purposes of tax administration . . . in connection with a written contract or agreement” for services.”
More particularly new temporary and proposed regulations issued in 2014 provides that “persons described in section 6103(n) and reg. section 301.6103(n)-1(a) with whom the IRS or Chief Counsel contracts for services may receive books, papers, records, or other data summoned by the IRS and take testimony of a person who the IRS has summoned as a witness to provide testimony under oath.” The temporary regulations were issued one month after the contract with Quinn Emanuel was inked. The temporary regulations apply to “to summons interviews conducted on or after June 18, 2014.” So, the regulations will permit Quinn Emanuel lawyers to participate in interviewing Microsoft employees and tax return preparers and others, and under statutory penalty of perjury. Can this be right? Can a private contractor be granted the legal authority to examine a witness for the IRS? Take a look at sections 7602, 7701(a)(11) and 7701(a)(12)(A) and after looking at the statutory language, you might think the answer is “no”! If the answer is yes, then the outsourced law firm effectively steps into the shoes an an “agency of the Treasury Department” under section 7602.
As Mr. Gupta points out, the Service’s calling a private law firm to help fight Microsoft may be admitting too much. While the idea of hiring an expert is not unusual or even suspect, the hiring of outside legal counsel to participate in an audit and perhaps more is close to if not a direct admission. Moreover, as mentioned it may be improper. Another noteworthy item is that Quinn Emanuel does not hold itself out as a specialist in transfer pricing or even tax controversy. The firm’s website doesn’t list those or any related fields among its more than two dozen categories of practice specialties. Its contract with the IRS describes the firm’s lawyers as “highly skilled commercial litigation attorneys with extensive complex litigation experience evaluating, preparing and presenting cases dealing with multifaceted facts, complex economics and multiple legal issues.”
So perhaps Microsoft’s CSA is not the only item of public interest….indeed using taxpayer money to have an outside law firm help in trying a tax case which firm is the second most profitable in the world is indeed going to attract attention. In other words, the IRS is contracting with Quinn Emanuel to obtain general commercial litigation expertise, which implies that that kind of expertise is unavailable among the tens of thousands of government attorneys who litigate civil, criminal, and administrative actions day in and day out at the dozens of federal agencies.
So, let’s see if the Department of Justice and Chief Counsel can leverage its litigation position through the help of a multinational and prestigious litigation law firm. After the Service’s loss in Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009) nonacq. AOD 2010-005 and its current case against Amazon, No. 31197-12 (T.C. 2014) perhaps the Service felt there’s nothing wrong with getting a little help from a “new” friend. Microsoft is not only seeking to understand Quinn Emanuel’s role in the case by having filed the motion referred to above, but predictably will want this or another federal court to rule that it may not participate as co-counsel on behalf of the Treasury of the United States or its delegate.