The Lawletter Vol 41 No 8
Over the last 30 years or so, American companies have sought to reduce their U.S. federal income tax liability by employing the tactic known as the "tax inversion." Typically, in an inversion transaction, one or more of the corporation'’s shareholders transfer stock to a controlled foreign corporate subsidiary in exchange for stock in the subsidiary. The goal is to shift corporate revenue from the United States to the jurisdiction to which the subsidiary is subject, presumably a country with favorable rates of corporate income taxation.
It has recently come to light that corporate tax avoidance issues can arise in connection with a tax inversion transaction that are in addition to any question as to the validity of the inversion transaction itself. In proceedings involving Facebook'’s inversion transaction shifting a large portion of its tax base to Ireland, the Internal Revenue Service ("IRS") is seeking the production of books and records from Facebook with the object of determining whether Facebook improperly avoided U.S. income tax on its royalty by undervaluing the assets transferred to its Irish subsidiary as part of its inversion transaction. Facebook's inversion consisted of a corporate restructuring in 2009-2010 by which the corporation, under the "2010 Agreement," transferred to its Irish subsidiary the rights associated with its worldwide business outside of North America. That is, Facebook transferred its U.S. user base outside the United States and Canada to its Irish subsidiary, thereby shifting its online platform to the subsidiary.
As one of the multinational corporations that has carried out inversion tax avoidance transactions and has thereby attracted the IRS's scrutiny (Amazon and Microsoft are also under investigation as to their transfer pricing), Facebook now faces the allegation that its tax adviser, Ernst & Young, undervalued by billions of dollars the intangibles that it transferred to its Irish subsidiary. Facebook's return for 2010 reported royalty income resulting from its transfers of intangible assets to a controlled foreign corporation, Facebook Ireland Holdings Unlimited. In valuing these transfers for income tax purposes, Ernst & Young proceeded on the theory that each category of intangible assets (user base, online platform, and marketing intangibles) could be valued on a stand-alone basis. The IRS finds this approach to be problematic in that the categories are interrelated, and is conducting its examination under the authority of § 482 of the Internal Revenue Code of 1986, which permits the IRS to allocate income and deductions among commonly controlled business entities as necessary to prevent tax avoidance.
The IRS informed Facebook that it was considering the retention of experts to assist in its examination but claimed that, due to budgetary constraints, it could not begin the process until after October 1, 2015; the IRS requested Facebook to agree to extend the time for the running of the statute of limitations, but Facebook refused. The IRS then issued three Information Document Requests ("IDRs"), but Facebook's response was minimal (Facebook explained that under its narrow construction of the IDRs, the documents subject to the requests were limited to those reviewed by both Facebook U.S. and Facebook Ireland; Facebook also informed the IRS that if it wanted a more comprehensive response, it would have to start over with a new set of IDRs). In order to comply with the statute of limitations, the IRS served Facebook with a summons, seeking the information that Facebook had failed to supply. On April 7, 2016, the IRS issued ten additional IDRs. Facebook failed to provide any of the requested documents and records. With the statute of limitations due to expire on July 31, 2016, the IRS issued six additional summonses seeking the information that had not been supplied. These summonses were personally served on June 1, 2016, on David Wehner, Facebook's chief financial officer, with a due date of June 17. Facebook failed to comply with the summonses, and Mr. Wehner stated, "Facebook complies with all applicable rules and regulations in the countries where we operate."
On July 6, 2016, the IRS filed a petition in the U.S. District Court for the Northern District of California, United States v. Facebook, Inc., No. 3:16-cv-03777 (N.D. Cal. petition filed July 6, 2016), asking the court to enforce the summonses. With the preliminary sparring over, this soap opera appears to be headed for a showdown.