Veritas Software Corporation & Subsidiaries, Symantec Corporation (Successor in Interest to Veritas Software Corporation & Subsidiaries.) v. Commissioner , 133 T.C. No. 14 ( 2009 )

133 T.C. No. 14UNITED STATES TAX COURT
VERITAS SOFTWARE CORPORATION & SUBSIDIARIES, SYMANTEC CORPORATION
(SUCCESSOR IN INTEREST TO VERITAS SOFTWARE CORPORATION &
SUBSIDIARIES), Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 12075-06. Filed December 10, 2009.
P entered into a cost-sharing arrangement with S,
its foreign subsidiary, to develop and manufacture
storage management software products. Pursuant to the
cost-sharing arrangement, P granted S the right to use
certain preexisting intangibles in Europe, the Middle
East, Africa, and Asia. As consideration for the
transfer of preexisting intangibles, S made a $166
million buy-in payment to P. P employed the comparable
uncontrolled transaction method to calculate the
payment. In a notice of deficiency issued to P, R
employed an income method and determined a requisite
buy-in payment of $2.5 billion and made an income
allocation to P of that amount. In an amendment to
answer, R reduced the allocation from $2.5 to $1.675
billion. R further determined that the requisite buy-
in payment must take into account access to P’s
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research and development team; access to P’s marketing
team; and P’s distribution channels, customer lists,
trademarks, trade names, brand names, and sales
agreements. P contends that R’s determinations are
arbitrary, capricious, and unreasonable and the comparable
uncontrolled transaction method is the best method to
calculate the requisite buy-in payment.
1. Held: R’s determinations are arbitrary,
capricious, and unreasonable.
2. Held, further, P’s comparable uncontrolled
transaction method, with appropriate adjustments, is
the best method to determine the requisite buy-in
payment.
Mark A. Oates, Scott Frewing, Andrew P. Crousore, James M.
O’Brien, Catlin A. Urban, Erika S. Schechter, Paul E. Schick,
Jaclyn Pampel, Jenny A. Austin, Mark T. Roche, Erika L. Andersen,
John M. Peterson, Jr., and Kristen B. Proschold, for petitioner.
Lloyd Silberzweig, James P. Thurston, Kimberley Peterson,
David Rakonitz, Stephanie Profitt, Margaret Burow, and John
Strate, for respondent.
CONTENTS
Background.................................................... 4
I. Storage Management Software Products.................... 6
II. Product Distribution Channels........................... 10
III. Intensely Competitive Market............................ 11
IV. Product Lifecycles and Useful Lives..................... 15
V. Geographic Expansion.................................... 16
VI. The Cost-Sharing Arrangement............................ 17
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VII. VERITAS Ireland’s Operations............................ 21
VIII. Procedural History...................................... 23
Discussion.................................................... 30
I. Applicable Statute and Regulations...................... 33
II. Respondent’s Buy-in Payment Allocation Is Arbitrary,
Capricious, and Unreasonable............................ 35
A. Respondent’s Notice Determination Is Arbitrary,
Capricious, and Unreasonable........................ 37
B. Respondent’s Determination in Amendment to Amended
Answer Is Arbitrary, Capricious, and Unreasonable... 39
1. Respondent’s “Akin” to a Sale Theory Is Specious. 39
2. Respondent’s Allocation Took into Account Items
Not Transferred or of Insignificant Value........ 41
3. Respondent’s Allocation Took Into Account
Subsequently Developed Intangibles............... 44
4. Respondent Employed the Wrong Useful Life,
Discount Rate, and Growth Rate................... 45
III. Petitioner’s CUT Analysis, With Some Adjustments, Is the
Best Method............................................. 50
A. Comparability of OEM Agreements..................... 54
B. Unbundled OEM Agreements Were Comparable to the
Controlled Transaction.............................. 56
IV. Requisite Adjustments to Petitioner’s CUT Analysis...... 64
A. The Appropriate Starting Royalty Rate............... 65
B. The Appropriate Useful Life and Royalty Degradation
Rate................................................ 66
C. Value of Trademark Intangibles and Sales Agreements. 67
D. The Appropriate Discount Rate....................... 69
V. Conclusion............................................... 71
OPINION
FOLEY, Judge: On November 3, 1999, VERITAS Software Corp.
(VERITAS US) and VERITAS Ireland entered into a cost-sharing
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arrangement (CSA), which consisted of a research and development
agreement and a technology license agreement.1 Also on November
3, 1999, VERITAS US, pursuant to the CSA, transferred preexisting
intangible property to VERITAS Ireland and VERITAS Ireland made a
buy-in payment to VERITAS US as consideration for the preexisting
intangible property. After concessions, the issue for decision
is whether, pursuant to section 482,2 the buy-in payment was
arm’s length.
Background
On August 22, 2007, the Court issued a protective order to
prevent disclosure of petitioner’s proprietary and confidential
information. The facts and opinion have been adapted
accordingly, and any information set forth herein is not
proprietary or confidential. VERITAS US is a Delaware
corporation with its principal place of business in Cupertino,
California. During 1999, 2000, and 2001 (years in issue) VERITAS
US was the parent of a group of affiliated subsidiaries.
1
See infra, Background, sec. VI, The Cost-Sharing
Arrangement, for detailed discussion of the research and
development agreement and technology license agreement.
2
Unless otherwise indicated, all section references are to
the Internal Revenue Code of 1986, as amended and in effect for
the years in issue, and all Rule references are to the Tax Court
Rules of Practice and Procedure.
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VERITAS US is in the business of developing, manufacturing,
marketing, and selling advanced storage management software
products. VERITAS US’ products protect against data loss and
file corruption, provide rapid recovery after disk or system
failure, process large files efficiently, manage and back up
systems without user interruption, and provide performance
improvement and reliability enhancement features that are
critical for many commercial applications.
In the mid to late 1990s VERITAS US expanded its business
through corporate acquisitions and the establishment of foreign
subsidiaries. On April 25, 1997, VERITAS US acquired and merged
with OpenVision Technologies, Inc. (OpenVision). With the
acquisition of OpenVision, VERITAS US obtained NetBackup;3 offices
in the United Kingdom, Germany, and France; an engineering team;
and skilled sales and marketing executives. By the end of 1997
VERITAS US had sales subsidiaries in Canada, Japan, the United
Kingdom, Germany, France, Sweden, and the Netherlands. VERITAS
US, on May 28, 1999, acquired Seagate Software Network and
Storage Management Group, Inc. (NSMG). As a result of this
acquisition, VERITAS US became the largest storage software
3
See infra, Background, sec. I, Storage Management Software
Products, for a discussion of NetBackup.
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company in the industry and obtained Backup Exec;4 a distribution
channel in Europe, the Middle East, and Africa (EMEA); and a
sales force that sold Backup Exec to customers in Europe. On
July 2, 2005, VERITAS US was purchased by Symantec Corp.
(Symantec) and became one of Symantec’s wholly owned
subsidiaries. References to petitioner are to VERITAS US, its
subsidiaries, and Symantec (successor in interest to VERITAS US
and subsidiaries).
I. Storage Management Software Products
All computer operating systems have “backup” and “restore”
capabilities.5 Storage management software replaces the portion
of a computer’s operating system that organizes files and manages
data storage devices. Stored data is preserved and protected
against loss or corruption by the use of backup applications that
copy, on secondary storage, the data, its organizational
structure, and its ownership information. Secondary storage
devices may be attached directly to a computer or accessed
through a network server.
4
See infra, Background, sec. I, Storage Management Software
Products, for a discussion of Backup Exec.
5
“Backup” is simply making a copy and moving it to a safe
location. “Restore” takes the copy from the safe location and
makes it available to the end-user.
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Prior to 1999 only one application could access a data file
at any given time. Thus, to back up data on secondary storage,
it was first necessary to shut down all applications using the
data. Most secondary storage was on magnetic tape and directly
attached to a single server. After the CSA, there were important
technological advances relating to the data storage software
industry. In response to 24-hour Web sites, backup technology
advanced significantly, enabling backups to run at any time. In
addition, exponential increases in file size and data volume and
the plummeting cost of disk storage spurred the use of disks as
secondary storage. The switch to disks as the primary backup
medium required the source code6 of backup products to be
rewritten. The advent of storage area networks allowed storage
to be shared by numerous computers, allowed more than one server
to access a particular piece of data, and enabled applications to
run continuously without interruption. Other technological
advances dramatically increased storage capacity and also
facilitated disaster recovery by allowing storage resources to be
replicated several times in different data centers. These
6
Source code is the human readable statement used to write
computer programs and is commonly organized into files, which are
composed of individual lines of code. Complex software, such as
storage management software, often requires thousands of source
code files and hundreds of thousands or millions of lines of
code.
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advances reduced the cost of physical storage and made it
possible for many systems to share storage devices.
During the years in issue, VERITAS US had one primary
commercial product (i.e., a product with a low price point and
high-volume sales), Backup Exec, and five primary enterprise
products (i.e., products with a high price point and low-volume
sales): NetBackup, Volume Manager, File System, Cluster Server,
and Foundation Suite.
Backup Exec, which was targeted to small businesses, was a
data management product that provided backup, archive, and
restore capabilities for a network’s servers and workstations.
NetBackup, Volume Manager, File System, Cluster Server, and
Foundation Suite were purchased by businesses with large
sophisticated information technology systems. NetBackup provided
backup, archive, and restore capabilities for servers and
workstations using complex UNIX, Windows, Linux, and NetWare
operating systems. Volume Manager allowed an administrator to
manage volumes (i.e., physical disks or hard drives that stored
data) and also provided online disk storage management. File
System was a journaling system that provided a directory index of
files and made it easier to find and access files and data. File
System also enabled fast system recovery from operating system
failure or disruption. Cluster Server allowed multiple servers
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to be grouped together as a cluster and, if one server failed,
another server was automatically activated to perform the
functions of the failed server. Volume Manager had Cluster
Server functionality by 1999 and File System had such
functionality by 2000. Foundation Suite combined Volume Manager
and File System to deliver a complete solution for online disk
and file management functions. The consolidated product
facilitated quicker and more efficient data transmission,
storage, and backup. Foundation Suite was also sold in a high
availability version. This version combined Foundation Suite and
Cluster Server and ensured continuous uninterrupted operation in
the event of system failure.
Many of VERITAS US’ products were deemed “sticky” because
after employing them it was difficult, costly, and time consuming
for the user to change to a competing product. These products
communicated with and controlled parts of the computer and its
attached devices without support from standard application
program interfaces (API)7 or device drivers. Consequently, the
software code in these products included code inextricably tied
to the most basic part of an operating system. In 1999 VERITAS
7
APIs, which provide software vendors with access to the
operating system’s features, allow an application written for one
type of operating system to run on a different type of operating
system.
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US software products could run on systems and applications
manufactured by Sun Microsystems, Inc. (Sun); Hewlett-Packard Co.
(HP); Microsoft Corp. (Microsoft); International Business
Machines Corp. (IBM); Red Hat, Inc.; Apple Inc.; Novell, Inc.
(Novell); Oracle Corp. (Oracle); SAP AG; Sybase, Inc.; and
VMware, Inc. After the CSA, VERITAS US released numerous
versions of its aforementioned products. Each version contained
new features. When new features were added to a product, the
source code relating to these features was either added to
existing files or placed in newly created files. While no one
feature modification significantly altered the essential elements
of the code, the cumulative effect of modifying hundreds of
features typically resulted in significant code changes.
II. Product Distribution Channels
A product’s path to market is often referred to as a
distribution channel. In 1999 VERITAS US sold its products
directly to customers and through original equipment
manufacturers (OEMs), distributors, and resellers. From 1997 to
2006 VERITAS US entered into OEM agreements with several entities
including Sun, HP, Dell Products, L.P. (Dell), Compaq Computer
Corp. (Compaq), Ericsson Radio Systems AB (Ericsson), Hitachi,
Ltd. (Hitachi), NEC Corp. (NEC), Microsoft, NCR Corp. (NCR), and
Siemens Nixdorf Informationssysteme AG (Siemens). VERITAS US
provided the OEMs with the product and the OEMs sold the products
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either bundled with their operating systems or unbundled as an
option. Bundled products were installed with, and sold as a part
of, the operating system, while unbundled products were sold as
separate products for customers to install. During the term of
the license, OEMs generally received the current version of the
products plus updates, upgrades, and new versions. After selling
VERITAS US’ bundled products, the OEMs often provided technical,
engineering, and maintenance support. The OEMs’ willingness to
sell and support the bundled products was a tacit affirmation of
the products’ reliability and quality. VERITAS US benefited from
this arrangement because the OEMs had better name recognition and
more customers.
From November 1999 to 2006 OEM licensees paid VERITAS US
$1.327 billion in royalties.8 The calculation of royalties was
based on list price, revenues, or profits and the products were
often sold at a discount off list price. VERITAS US generally
received a one-time license fee upon entering into the agreement
and additional license fees each time the OEM sold VERITAS US
products bundled with an operating system. The royalty rates
8
From 1999 to 2006 Sun, VERITAS US’ largest and most
significant OEM partner, paid VERITAS US $657.4 million in
royalties. During this period VERITAS US also received $292.9
million from HP, $181.6 million from Dell, $23.9 million from
Hitachi, $7.9 million from NEC, and $780,000 from Compaq. In
addition, from 2000 to 2008 VERITAS US received $23.9 million in
royalties from Ericsson.
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relating to VERITAS US’ OEM licenses ranged from 10 to 40 percent
for bundled products and 5 to 48 percent for unbundled products.
Profit potential and sales volume were important factors in
determining royalty rates. VERITAS US could not accurately
predict the amount of its license revenue receipts attributable
to OEM agreements because VERITAS US had no control over delivery
dates or the number of VERITAS US products sold with OEM
operating systems. This uncertainty led VERITAS US to explore
other paths to market (i.e., distributors, resellers, and direct
sales) for its products .
VERITAS US sold Backup Exec through distributors and
resellers. The distributors sold Backup Exec to resellers and
the resellers sold it to customers. VERITAS US sold NetBackup,
Volume Manager, File System, Cluster Server, and Foundation Suite
directly to customers and through resellers. Between 1997 and
2005 VERITAS US entered into reseller agreements with operating
system, hardware, and database vendors including Compaq, Hitachi,
Fujitsu, Ericsson, Dell, HP, NCR, Bull S.A., and EMC Corp. (EMC).
The royalty rates relating to the reseller agreements ranged
between 32.5 and 70 percent.
III. Intensely Competitive Market
Prior to the CSA, VERITAS US products competed intensely
with products manufactured by numerous companies. ARCserve, a
backup product manufactured by Computer Associates, was Backup
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Exec’s major competitor. NetBackup’s primary competitors
included IBM’s Tivoli Storage Manager, EMC’s Legato NetWorker,
HP’s OmniBackup/Data Protector, and CommVault’s Galaxy.
Foundation Suite’s primary competitors were products manufactured
by operating system, hardware, and database vendors (i.e., Sun,
EMC, and Oracle).
VERITAS US products competed with both comparable and free
alternatives. The free alternatives included storage management
products readily accessible on the Internet and those bundled
with operating systems. Vendors sometimes incorporated storage
management capabilities into their operating systems. Some
customers preferred operating systems with built-in storage
management software (i.e., integrated stacks).9 These stacks were
less expensive and easier to deploy because purchasers were not
required to acquire or install costly individual components.
VERITAS US continuously sought to offer products that were faster
and more efficient than comparable products or free alternatives.
The performance advantages of VERITAS US products over free
products decreased, however, as competitors improved their
products’ functionality.
9
The operating system, the applications it supports, and the
software it uses to manage devices attached to the computer are
referred to as a “stack”.
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Between 1996 and 2006 the primary competition for VERITAS US
products was products sold by operating system, hardware, and
database vendors such as Sun and Oracle. Sun and Oracle had a
similar objective--remove VERITAS US from their respective stacks
and provide their respective customers with viable alternatives
to VERITAS US products.
Sun, an operating system manufacturer and distributor, was
one of VERITAS US’ main OEM contractors and competitors. The
relationship between VERITAS US and Sun evolved from a mutually
beneficial partnership in 1997 to mutual tolerance in 1999 and,
ultimately, to outright competition in 2006. Sun was committed
to capturing the funds that its customers were spending on
VERITAS US products. Sun upgraded its operating systems in an
attempt to replicate the functionality of VERITAS US products and
achieved this goal by adding to its operating system a
supplanting product that was provided to customers at no cost.
From 2000 through 2006 Sun released a series of operating systems
that included software products that offered progressively more
functionality. These products took market share from VERITAS US
and closed the technology gap between Sun and VERITAS US.
Oracle, a software manufacturer known for its databases and
applications, was as aggressive as Sun in competing with VERITAS
US. Oracle offered software to directly, and successfully,
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compete with File System, Volume Manager, and Cluster Server. In
an attempt to maximize revenues and customer loyalty, Oracle
embarked on a strategy to build a complete stack and compete not
just with VERITAS US, but also with operating system vendors.
Oracle started with basic level technology and continued to
innovate until it developed products similar, and ultimately,
equal to VERITAS US products.
IV. Product Lifecycles and Useful Lives
In the rapidly changing storage software industry, products
with state-of-the-art function lost value quickly as that
functionality was duplicated by competitors or supplanted by new
technology. Even with substantial ongoing research and
development (R&D), VERITAS US products had finite lifecycles.
Intense competition (i.e., from OEMs offering comparable
products) and the rapid pace of technological advances forced
VERITAS US to innovate constantly. By the time a new product
model became available for purchase, the next generation was
already in development.
At the time of the CSA, VERITAS US products, on average, had
a useful life of 4 years. In 2001 VERITAS US’ board of directors
realized that VERITAS US’ primary products were approaching the
end of their lifecycles and that the product pipeline was not
capable of sustaining business growth. In 2002 and 2003 the
board of directors recognized that revenues relating to Backup
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Exec and NetBackup had ceased to grow and that the revenues
relating to Volume Manager and File System were declining.
NetBackup’s useful life came to an end in 2005 when a major
overhaul was performed. Even as the products approached the end
of their useful lives, they did not lose all of their value.
VERITAS US typically updated its products but, on occasion,
an OEM would pay VERITAS US to build a custom item that would not
be further developed. In these instances, the related OEM
agreements contained a royalty degradation or technology aging
discount provision to account for obsolescence and decay. Some
agreements provided for the royalties to be decreased at a steady
rate while others required royalty rate reductions that increased
during the term of the agreement. Generally, the agreements did
not provide a royalty rate reduction of more than 75 percent over
a 4-year period.
V. Geographic Expansion
Prior to 2000 VERITAS US had limited presence in EMEA and
Asia Pacific and Japan (APJ). While VERITAS US had sales and
service offices and resellers in North America, Europe, Asia
Pacific, South America, and the Middle East, it had no
manufacturing operation in these countries and only small sales
subsidiaries in the United Kingdom, France, Germany, Sweden, the
Netherlands, Switzerland, Japan, and Australia. In 1999 VERITAS
US’ international sales force, excluding Canadian employees,
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consisted of 287 employees: 237 in Europe, 27 in Asia Pacific,
and 23 in Japan. VERITAS US had a total of 33 international
marketing employees: 28 in Europe, 4 in Japan, and 1 in Asia
Pacific.
In the EMEA storage management software market (i.e., in
which VERITAS US sold Foundation Suite, NetBackup, and Backup
Exec), VERITAS US’ market shares in 1998 and 1999 were 8.9
percent and 13.2 percent, respectively. Computer Associates’
ARCserve, Backup Exec’s primary competition, dominated the EMEA
market, holding more than 50 percent of the United Kingdom market
and more than 60 percent of the French, Italian, and Spanish
markets.
In 1999 the EMEA and APJ territories accounted for 92
percent of VERITAS US’ international revenues and 22 percent of
VERITAS US’ total revenues (i.e., EMEA revenue totaled $110
million and APJ revenue was de minimis). VERITAS US’ management
recognized that geographic expansion in EMEA and APJ presented an
opportunity to increase sales. After evaluating the cost of
labor, employment laws, quality of workforce, and tax
considerations, VERITAS US’ management decided to headquarter its
EMEA and APJ operations in Ireland.
VI. The Cost-Sharing Arrangement
In January 1999 VERITAS Software Holding, Ltd. (VSHL) was
incorporated as an Irish corporation. VSHL was a resident of
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Bermuda and a wholly owned subsidiary of VERITAS US. In August
1999 VERITAS Software International, Ltd. (VSIL) was incorporated
as a resident of Ireland and a wholly owned subsidiary of VSHL.
VERITAS Software, Ltd. (VERITAS UK) and VERITAS Software Asia
Pacific Trading PTE, Ltd. (VERITAS Singapore), disregarded
entities for U.S. income tax purposes, were also wholly owned by
VSHL. In 2000 and 2001 VSHL, VSIL, VERITAS UK, and VERITAS
Singapore (collectively, VERITAS Ireland) were subsidiaries of
VERITAS US.
Effective November 3, 1999, VERITAS US assigned to VERITAS
Ireland all of VERITAS US’ existing sales agreements with
European-based sales subsidiaries (i.e., VERITAS UK, VERITAS
Sweden, VERITAS Switzerland, VERITAS France, and VERITAS
Germany). Also effective on that date, VERITAS US, VERITAS
Operating Corp., NSMG, and VERITAS Ireland10 entered into the
Agreement for Sharing Research and Development Costs (RDA), and
VERITAS US and VERITAS Ireland11 entered into the Technology
License Agreement (TLA).12
10
With respect to the RDA, “VERITAS Ireland” refers to VSHL
and VSIL, the two parties who entered into the RDA with VERITAS
US.
11
With respect to the TLA, “VERITAS Ireland” refers to VSHL
and VSIL, the two parties who entered into the TLA with VERITAS
US.
12
As previously stated, the CSA consisted of these
(continued...)
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Pursuant to the RDA, the signatories agreed to pool their
respective resources and R&D efforts related to software products
and software manufacturing processes. They also agreed to share
the costs and risks of such R&D on a going-forward basis. The
RDA provided VERITAS Ireland with:
the exclusive and perpetual right to manufacture
Products utilizing, embodying or incorporating the
Covered Intangibles within VERITAS Ireland’s
Territory,[13] and the nonexclusive and perpetual right
to otherwise utilize the Covered Intangibles worldwide,
including in the marketing, sale, and licensing of
Products utilizing, embodying or incorporating the
Covered Intangibles, and in further research into
similar technology.
The RDA defined “Covered Intangibles” as:
any and all inventions, patents, copyrights, computer
programs (in source code and object code form), flow
charts, formulae, enhancements, updates, translations,
adaptations, information, specifications, designs,
process technology, manufacturing requirements, quality
control standards, and other intangible property rights
arising from or developed as a result of the Research
Program.[14]
Pursuant to the TLA, VERITAS US granted VERITAS Ireland the
right to use certain “Covered Intangibles”, as well as the right
12
(...continued)
agreements.
13
The RDA defined VERITAS Ireland’s Territory as “Europe,
Middle East, Africa, Asia, and the Asia Pacific.”
14
The RDA defined Research Program as “all software research
and development activity and process development activity”.
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to use VERITAS US’s trademarks, trade names, and service marks in
EMEA and APJ. The TLA defined “Covered Intangibles” as:
any and all inventions, patents, copyrights, computer
programs (in source code and object code form), flow
charts, formulae, enhancements, updates, translations,
adaptations, information, specifications, designs,
process technology, manufacturing requirements, quality
control standards, and other intangible property rights
arising in existence as of the Effective Date of this
Agreement, relating to the design, development,
manufacture, production, operation, maintenance and/or
repair of any or all of the Products.
In exchange for the rights granted by the TLA, VERITAS Ireland
agreed to pay VERITAS US royalties. The TLA, which was amended
on three occasions,15 specified the initial royalty rates, as well
as a prepayment amount (i.e., a lump-sum buy-in payment). The
TLA provided that the parties “shall adjust the royalty rate
prospectively or retrospectively as necessary so that the rate
will remain an arm’s-length rate.”
In 1999 VERITAS Ireland paid VERITAS US $6.3 million and
agreed to prepay VERITAS US, in 2000, the remaining consideration
relating to the preexisting intangibles. In 2000 VERITAS Ireland
made a $166 million lump-sum buy-in payment to VERITAS US, and in
2002 VERITAS Ireland and VERITAS US adjusted the payment to $118
million.
15
Amendment No. 1 was effective as of Nov. 3, 1999;
Amendment No. 2 was effective as of Aug. 1, 2001; and Amendment
No. 3 was effective as of July 1, 2002.
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VII. VERITAS Ireland’s Operations
Prior to the establishment of VERITAS Ireland, VERITAS US’
supply chain and distribution channels to the EMEA and APJ
markets were weak and inefficient. NetBackup, Volume Manager,
File System, Cluster Server, and Foundation Suite were
manufactured in Pleasanton, California, and Backup Exec was
manufactured by a contractor in Lisle, France (Lisle contractor).
In 1999 VERITAS Ireland began codeveloping, manufacturing, and
selling VERITAS US products in the EMEA and APJ markets. VERITAS
Ireland’s facility, in Shannon, County Clare, Ireland,
manufactured NetBackup, File System, Volume Manager, Cluster
Server, and Foundation Suite.16 The Ireland location had a
production line, quality control stations, and a CD replication
tower. VERITAS Ireland controlled all aspects of production,
planning, shipping, and logistics. It also processed purchase
orders and bore contractual, credit, and collection risks
relating to transactions in the EMEA and APJ markets. With
VERITAS Ireland in control of the manufacturing process and
managing the Lisle contractor, the supply chain became much more
efficient.
16
In 2001 VERITAS Ireland outsourced the manufacture of
Volume Manager, File System, Cluster Server, and Foundation
Suite.
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VERITAS Ireland developed the EMEA and APJ markets without
significant input from VERITAS US. In 1999 VERITAS US’ customer
base had little or no value because of its minimal market share
and limited presence in EMEA and APJ. At that time there were
two offices in the United Kingdom: One in Chertsey and one in
Reading. The Chertsey office was staffed by direct sales
employees. The Reading office was staffed by two small teams
(i.e., a distribution team and a reseller team) of inept workers.
VERITAS Ireland focused on the basics of building a more
extensive sales business and stronger distribution channels. In
2000 VERITAS Ireland hired a new distribution sales manager who
was responsible for expanding its products’ paths to market.
VERITAS Ireland’s new management totally changed the culture by
continually upgrading VERITAS Ireland’s sales resources;
examining distributor and reseller reports; finding new
customers; initiating interaction with the reseller base;
providing sales incentives for distributors; training and
educating the distributors’ presales teams; and firing
underperforming salesmen, distributors, and resellers. To
further expand its sales presence, VERITAS Ireland accessed and
leveraged its distribution partners’ sales organizations and
customer contacts.
VERITAS Ireland’s operations and its presence in the EMEA
territory grew substantially from 2000 to 2006. By 2001 the
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Ireland facility had increased from 12,000 to 40,000 square feet
and the number of VERITAS Ireland employees had increased from 20
to more than 100. By 2002 VERITAS Ireland had over 25 new
offices and subsidiaries in 19 countries, and by 2004 VERITAS
Ireland had more than 1,500 employees in more than 30 countries.
From 1999 to 2006 VERITAS Ireland spent $1.374 billion on sales
and marketing expenses, $676 million on cost-sharing payments,
$456 million on customer service expenses, $146 million on
administrative expenses, and $124 million on buy-in payments. In
2000 VERITAS Ireland’s first full year of operation, revenues
were approximately $200 million. By 2003 VERITAS Ireland’s
license revenues had doubled, and by 2004 its annual revenues
were five times higher than VERITAS US’ 1999 revenues
attributable to EMEA and APJ.
VIII. Procedural History
VERITAS US timely filed Federal income tax returns for 2000
and 2001. On its 2000 return VERITAS US reported a $166 million
lump-sum buy-in payment from VERITAS Ireland. In response to
VERITAS Ireland’s updated sales figures and forecasts, VERITAS
US, on December 17, 2002, amended the 2000 return reducing the
lump-sum buy-in payment to $118 million.
Respondent examined VERITAS US’ 2000 and 2001 returns and
concluded that the cost-sharing allocations reported did not
clearly reflect VERITAS US’ income. On March 29, 2006,
- 24 -
respondent issued petitioner a notice of deficiency based on a
report prepared by Brian Becker (Becker). In the notice,
respondent stated:
In accordance with Section 482 of the Internal
Revenue Code, to clearly reflect the income of the
entities, we have allocated income and deductions
as a result of the transfer and/or license of pre-
existing intangible property in connection with the
cost sharing arrangement and technology license
agreement, both effective November 3, 1999.
Becker employed the forgone profits method, the market
capitalization method, and an analysis of VERITAS US’ arm’s-
length acquisitions to arrive at a series of values, ranging from
$1.9 billion to $4 billion, for the lump-sum buy-in payment. He
ultimately decided that a $2.5 billion buy-in payment was
appropriate. In accordance with Becker’s calculations,
respondent, in the notice to petitioner, made a $2.5 billion
allocation of income to VERITAS US and determined deficiencies of
$704 million and $54 million, and section 6662 penalties of $281
million and $22 million, relating to 2000 and 2001, respectively.
On June 26, 2006, petitioner timely filed its petition with
the Court seeking redetermination of the deficiencies and
penalties set forth in the notice. On August 25, 2006, the Court
filed respondent’s answer, and on August 31, 2006, the Court
filed respondent’s amended answer. Respondent, in his statement
of position filed September 6, 2007, stated: “In view of the
fact that information is still being collected and analyzed,
- 25 -
Respondent cannot state which transfer pricing method(s) he
intends to utilize at trial.” On October 11, 2007, respondent,
in a supplement to his statement of position, notified the Court
and petitioner that he was going to employ the forgone profits
method, but was not going to rely on the market capitalization
method or call Becker as a witness. Respondent, in the October
11, 2007, statement also stated:
Respondent will use the actual income figures and
projections extrapolated from those figures to
determine the value of the intangibles and,
consequently, the total compensation due Petitioner
from VERITAS Ireland for the intangibles. Based on a
preliminary analysis of Petitioner’s actual income
figures, which are less than Petitioner’s projections
relied upon by Dr. Becker, Respondent anticipates that
the resulting value will be less than the amount used
in the notice of deficiency. In that case, Respondent
will not contend that the value is greater than the
amount determined by his experts at trial.
On April 10, 2007, the Court filed the parties’ stipulation
of settled issues relating to stock-based compensation, technical
support services, and section 6662 penalties.17 On May 24, 2007,
the Court filed the parties’ stipulation of settled issues
relating to the RDA. Pursuant to the May 24, 2007, stipulation,
17
The parties stipulated the stock-based compensation costs
at issue and agreed that the determination of whether such costs
must be included in the cost-sharing pool would be “controlled by
the final decision, within the meaning of section 7481 of the
Internal Revenue Code (the ‘Code’), in Xilinx, Inc. and
Subsidiaries v. Commissioner, 125 T.C. 37 (2005), appeals
docketed, No. 06-74246 and 06-74269 (9th Cir., Aug. 30 and Sept.
29, 2006).” In addition, respondent conceded adjustments
relating to technical support services.
- 26 -
the parties established the 2000 and 2001 arm’s-length values of
VERITAS Ireland’s proportional shares of the cost-sharing
payments.18
On January 11, 2008, the Court filed petitioner’s motion for
partial summary judgment. In the motion, petitioner contended
that respondent had abandoned the $2.5 billion allocation and the
methodologies set forth in the notice; the notice was
fundamentally defective; and respondent’s determination was
arbitrary, capricious, and unreasonable. Petitioner further
contended that, pursuant to precedent governing the Court of
Appeals for the Ninth Circuit (Ninth Circuit), the burden of
proof shifts to respondent. The Court, on February 6, 2008,
filed respondent’s notice of objection to petitioner’s motion for
partial summary judgment.
On March 7, 2008, respondent submitted to the Court an
expert report prepared by John Hatch (Hatch). Hatch, employing a
discounted cashflow analysis, concluded that the requisite lump-
sum buy-in payment was $1.675 billion, and calculated, as an
alternative, a 22.2-percent perpetual annual royalty. In
determining the best method to calculate the buy-in payment,
18
VERITAS Ireland’s shares of reasonably anticipated
benefits, pursuant to section 1.482-7(f)(3), Income Tax Regs.,
were 23.04 percent relating to 2000 and 28.47 percent relating to
2001.
- 27 -
Hatch rejected the comparable uncontrolled transaction method
(CUT method)19 and the profit split method20. He contended that
prior to November 3, 1999, VERITAS US had made several
acquisitions of software companies that offered complementary,
and in some cases, competing products. Hatch opined that those
acquisitions were comparable to the CSA because VERITAS US
received rights pursuant to the acquisitions that were similar to
those which VERITAS Ireland received pursuant to the CSA. On the
basis of his findings, Hatch characterized the CSA as “akin” to a
sale or geographic spinoff (“akin” to a sale theory) and employed
the income method to determine the requisite buy-in payment.
Hatch defined the buy-in payment as “the present value of
royalty obligations expected to be paid under arm’s length
royalty terms applicable to the rights conferred on a go-forward
basis.” He did not individually value any of the specific items
that were allegedly transferred to VERITAS Ireland. Instead, he
employed an “aggregate” valuation approach that was based on a
three-step analysis. First, Hatch estimated the arm’s-length
royalty amounts that would be due in each period (i.e., each
19
See sec. 1.482-4(c)(1), Income Tax Regs. See also infra,
Discussion, sec. III, Petitioner’s CUT Analysis, With Some
Adjustments, Is the Best Method, for a fuller discussion of the
CUT method.
20
See sec. 1.482-6, Income Tax Regs., for a discussion of
the profit split method.
- 28 -
calendar year or portion thereof after November 3, 1999) of the
CSA. Second, Hatch chose a discount rate to convert estimated
future royalty payments into November 1999 dollars. Third, Hatch
calculated the buy-in payment as equal to the present value of
the royalty payments estimated in step 1, discounted at the rate
determined in step 2. Hatch concluded that the requisite buy-in
payment was $1.675 billion and that a 22.2-percent perpetual
annual royalty was economically equivalent to the requisite
$1.675 billion payment. In calculating the requisite buy-in
payment, Hatch assumed that the preexisting intangibles have a
perpetual useful life. In addition, he concluded that 13.7
percent was the appropriate discount rate and 17.91 percent was
the appropriate compound annual growth rate.
On March 21, 2008, the Court filed respondent’s motion for
leave to file amendment to amended answer and lodged respondent’s
amendment to amended answer. In the proposed amendment,
respondent alleged that the requisite buy-in payment was $1.675
billion, payable as either a lump-sum payment or a 22.2-percent
perpetual royalty. In paragraph 9.f of the proposed amendment,
respondent asserted an adjustment relating to a transfer of
“certain other intangible rights.” Respondent specifically
alleged a transfer of access to VERITAS US’ marketing team;
access to VERITAS US’ R&D team; and VERITAS US’ trademarks, trade
names, customer base, customer lists, distribution channels, and
- 29 -
sales agreements (collectively, paragraph 9.f items).
Petitioner, in its notice of objection to respondent’s motion for
leave to file amendment to amended answer filed April 10, 2008,
contended that respondent’s assertion of the paragraph 9.f items
raised a new matter because the issue was not described in the
notice of deficiency and required the presentation of new
evidence.
On May 2, 2008, the Court held a hearing (May 2 hearing)
relating to the aforementioned motions. In an order issued June
13, 2008 (June 13 order), we denied petitioner’s motion for
partial summary judgment and concluded that there was a genuine
issue with respect to whether respondent had abandoned the theory
and methodology set forth in the notice, petitioner had failed to
establish that the notice was fundamentally defective, and
petitioner had therefore failed to establish that the
determination was arbitrary, capricious, or unreasonable. With
respect to whether the burden of proof shifts to respondent, we
concluded that it was premature to rule on the issue. We also
granted respondent’s motion for leave to file amendment to
amended answer and concluded that the notice of deficiency was
sufficiently broad to include the paragraph 9.f items and,
therefore, respondent’s amendment to amended answer did not raise
a new matter. We stated:
- 30 -
if, after an evaluation of expert and fact witnesses,
we determine that an adjustment relating to such items
is not appropriate, that such items were not in fact
transferred, or that such items are not intangibles
pursuant to section 482, we may conclude that the
notice of deficiency is arbitrary, capricious, or
unreasonable. * * *
On July 1, 2008, the trial commenced.
Discussion
We must determine whether VERITAS Ireland made an arm’s-
length buy-in payment to VERITAS US as consideration for
intangible property transferred to VERITAS Ireland in connection
with the CSA. In addition, we must determine whether
respondent’s allocation is arbitrary, capricious, or
unreasonable.
In essence, respondent’s determination began to unravel with
the parties’ pretrial stipulations of settled issues. After the
parties’ settlement relating to the arm’s-length value of the
RDA, as a practical and legal matter respondent was forced to
justify the $1.675 billion allocation by reference only to the
preexisting intangibles. As discussed herein, he simply could
not. Respondent, in a futile attempt to escape this dilemma,
ignored the parties’ settlement relating to the RDA and
disregarded section 1.482-7(g)(2), Income Tax Regs., which limits
the buy-in payment to preexisting intangibles. In addition,
respondent inflated the determination by valuing short-lived
intangibles as if they have a perpetual useful life and taking
- 31 -
into account income relating to future products created pursuant
to the RDA.
After an extensive stipulation process, a lengthy trial, the
receipt of more than 1,400 exhibits, and the testimony of a
myriad of witnesses, our analysis of whether respondent’s $1.675
billion allocation is arbitrary, capricious, or unreasonable
hinges primarily on the testimony of Hatch. Put bluntly, his
testimony was unsupported, unreliable, and thoroughly
unconvincing. Indeed, the credible elements of his testimony
were the numerous concessions and capitulations.
Respondent’s predicament was primarily attributable to the
implausibility of respondent’s flimsy determination. In
calculating the $1.675 billion allocation, Hatch used the wrong
useful life for the products and the wrong discount rate and
admittedly did not know precisely which items were valued.
Furthermore, respondent’s trial position reflected sections
1.482-1T through 1.482-9T, Temporary Income Tax Regs., 74 Fed.
Reg. 349 (Jan. 5, 2009)--regulations that were promulgated 10
years after the transaction and 5 months after trial.21 These
regulations include specific examples involving “assembled
21
These regulations, promulgated in December 2008, are
effective for transactions entered into on or after Jan. 5, 2009.
See infra, Discussion, sec. III(A), Comparability of OEM
Agreements, for a more in-depth discussion.
- 32 -
workforce”22 and prescribe the income method as a specified
method. In fact, after amending his amended answer, respondent
began referring to the intangibles subject to the buy-in payment
as “platform contribution” intangibles (i.e., the term used in
sections 1.482-1T through 1.482-9T, Temporary Income Tax Regs.,
supra) rather than “pre-existing intangibles”23 (i.e., the term
used in the applicable regulations). We further note that the
Administration, in 2009, proposed to change the law, expanding
the section 482 definition of intangibles to include “workforce
in place”,24 goodwill, and going-concern value.25 See Department
of the Treasury, General Explanations of the Administration’s
Fiscal Year 2010 Revenue Proposals 32 (May 2009). For the years
in issue, however, there was no explicit authorization of
respondent’s “akin” to a sale theory or its inclusion of
22
During the May 2 hearing, respondent referred to “access
to R&D team” and “access to marketing team” as “assembled
workforce”.
23
The term “pre-existing intangibles” is not used in secs.
1.482-1T through 1.482-9T, Temporary Income Tax Regs., 74 Fed.
Reg. 349 (Jan. 5, 2009).
24
During trial and on brief, respondent referred to “access
to R&D team” and “access to marketing team” as “workforce in
place”.
25
The Administration stated that the proposed change in law
was simply a “clarification” yet estimated that this change, when
combined with other “clarifications”, would raise nearly $3
billion dollars over 10 years. See Department of the Treasury,
General Explanations of the Administration’s Fiscal Year 2010
Revenue Proposals, Table 1 (May 2009).
- 33 -
workforce in place, goodwill, or going-concern value. Taxpayers
are merely required to be compliant, not prescient.
Pursuant to the law in effect at the time of the CSA,
respondent’s determination is arbitrary, capricious, and
unreasonable, and VERITAS US’ CUT method, with some adjustments,
is the best method to determine the requisite buy-in payment.
I. Applicable Statute and Regulations
Section 482 was enacted to prevent tax evasion and ensure
that taxpayers clearly reflect income relating to transactions
between controlled entities. This section authorizes the
Commissioner to distribute, apportion, or allocate gross income,
deductions, credits, or allowances between or among controlled
entities if he determines that such distribution, apportionment,
or allocation is necessary to prevent evasion of taxes or to
clearly reflect the income of such entities. Id. In determining
the true taxable income, “the standard to be applied in every
case is that of a taxpayer dealing at arm’s length with an
uncontrolled taxpayer.” Sec. 1.482-1(b)(1), Income Tax Regs.
Section 482 provides that in the case of any transfer of
intangible property the income with respect to the transfer shall
be commensurate with the income attributable to the intangible.
In a qualified cost-sharing arrangement, controlled participants
share the cost of developing one or more items of intangible
property. See sec. 1.482-7(a)(1), Income Tax Regs. When a
- 34 -
controlled participant makes preexisting intangible property
available to a qualified cost-sharing arrangement, that
participant is deemed to have transferred interests in the
property to the other participant and the other participant must
make a buy-in payment as consideration for the transferred
intangibles. Sec. 1.482-7(g)(1) and (2), Income Tax Regs. The
buy-in payment, which can be made in the form of a lump-sum
payment, installment payments, or royalties, is the arm’s-length
charge for the use of the transferred intangibles. Sec. 1.482-
7(g)(2), (7), Income Tax Regs.
Section 1.482-7(g)(2), Income Tax Regs., requires buy-in
payments to be determined in accordance with sections 1.482-1 and
1.482-4 through 1.482-6, Income Tax Regs. Section 1.482-4(a),
Income Tax Regs., provides:
(a) In general. The arm’s length amount charged
in a controlled transfer of intangible property must be
determined under one of the four methods listed in this
paragraph (a). Each of the methods must be applied in
accordance with all of the provisions of § 1.482-1,
including the best method rule of § 1.482-1(c), the
comparability analysis of § 1.482-1(d), and the arm’s
length range of § 1.482-1(e). The arm’s length
consideration for the transfer of an intangible
determined under this section must be commensurate with
the income attributable to the intangible. See § 1.482-
4(f)(2) (Periodic adjustments). The available methods
are--
(1) The comparable uncontrolled transaction
method, described in paragraph (c) of this
section;
(2) The comparable profits method, described in §
1.482-5;
- 35 -
(3) The profit split method, described in §
1.482-6; and
(4) Unspecified methods described in
paragraph (d) of this section.
If the recipient of the intangibles fails to make an arm’s-length
buy-in payment, the Commissioner is authorized to make
appropriate allocations to reflect an arm’s-length payment for
the transferred intangibles. Sec. 1.482-7(g)(1), Income Tax
Regs. The Commissioner’s authority to make section 482
allocations is limited to situations where it is necessary to
make each participant’s share of costs equal to its share of
reasonably anticipated benefits or situations where it is
necessary to ensure an arm’s-length buy-in payment for
transferred preexisting intangibles. Sec. 1.482-7(a)(2), Income
Tax Regs.
II. Respondent’s Buy-in Payment Allocation Is Arbitrary,
Capricious, and Unreasonable
Respondent’s section 482 allocation must be sustained absent
a showing of abuse of discretion. Sundstrand Corp. & Subs. v.
Commissioner, 96 T.C. 226, 353 (1991); Bausch & Lomb, Inc. v.
Commissioner, 92 T.C. 525, 582 (1989), affd. 933 F.2d 1084 (2d
Cir. 1991). Thus, to prevail petitioner first must show that
respondent’s section 482 allocation is arbitrary, capricious, or
unreasonable. Sundstrand Corp. & Subs. v. Commissioner, supra at
353-354 (citing G.D. Searle & Co. v. Commissioner, 88 T.C. 252,
- 36 -
359 (1987), and Eli Lilly & Co. v. Commissioner, 84 T.C. 996,
1131 (1985), affd. in part, revd. in part and remanded 856 F.2d
855 (7th Cir. 1988)). If petitioner proves that respondent’s
allocation is arbitrary, capricious, or unreasonable but fails to
prove that the allocation it proposes meets the arm’s-length
standard, the Court must determine the proper allocation for the
buy-in payment. See Sundstrand Corp. & Subs. v. Commissioner,
supra at 354.
Respondent’s determination as set forth in the notice of
deficiency is presumptively correct. Id. at 353. Respondent
made two determinations with respect to the requisite buy-in
payment, one set forth in the notice of deficiency and one set
forth in the amendment to amended answer. Because we found in
the June 13 order that the amendment to amended answer did not
raise a new matter, the presumption of correctness that attached
to the determination set forth in the notice carried forward to
the revised determination set forth in the amendment to amended
answer. See Shea v. Commissioner, 112 T.C. 183 (1999). Thus, we
look to both the notice determination and the revised
determination in the amendment to amended answer to decide
whether respondent’s section 482 allocation is arbitrary,
capricious, or unreasonable.
- 37 -
A. Respondent’s Notice Determination Is Arbitrary,
Capricious, and Unreasonable
In the notice, respondent determined, using Becker’s
valuation, that the requisite buy-in payment was $2.5 billion.
During trial respondent did not call Becker as a witness, place
Becker’s report in evidence, or present any evidence to support
Becker’s findings. Respondent, relying solely on the report
prepared by Hatch, did not address Becker’s $2.5 billion buy-in
valuation but instead asserted a $1.675 billion buy-in valuation.
The $825 million decrease in value with little explanation is
just one of the factors we consider in evaluating the
reasonableness of respondent’s determination. There are other
factors that collectively and convincingly establish that the
notice determination was not only unreasonable but was also
arbitrary and capricious. Using an income method, Becker and
Hatch, respectively, employed a 12.8- and a 13.7-percent discount
rate to calculate the requisite buy-in payment. Beta, a key
component in the formula used to calculate the discount rate, is
a measure of the tendency of a security’s price to respond to
swings in the market.26 In calculating their discount rates,
26
A beta of 1 indicates that the security’s price has tended
to move in step with the market (i.e., a 1-percent increase in
the market has led to a 1-percent increase for the security), a
beta of less than 1 implies that the security is less volatile
than the market, and a beta greater than 1 indicates that the
security is more volatile than the market. See infra,
(continued...)
- 38 -
Becker and Hatch used essentially the same beta, 1.4 and 1.42,
respectively. Petitioner’s finance expert established that 1.935
was the correct beta. See infra, Discussion, sec. IV(D), The
Appropriate Discount Rate. Hatch ultimately conceded that a 1.42
beta “could not, to a reasonable degree of economic certainty, be
the correct beta.” See infra, Discussion, sec. II(B)(4),
Respondent Employed the Wrong Useful Life, Discount Rate, and
Growth Rate. In essence, Hatch admitted that both he and Becker
employed the wrong beta. Indeed, the beta Becker employed was
even further removed from the correct beta.
In sum, respondent, without meaningful explanation, conceded
$825 million of the buy-in amount set forth in the notice and at
trial failed to offer even a token defense in response to
petitioner’s critique of Becker’s conclusions. Moreover,
respondent cannot convincingly contend that the notice
allocations are reasonable while adopting the opinion of an
expert who admits that a critical factor relating to the
calculation of the allocation is incorrect. Accordingly,
respondent’s notice determination is arbitrary, capricious, and
unreasonable.
26
(...continued)
Discussion, sec. II(B)(4), Respondent Employed the Wrong Useful
Life, Discount Rate, and Growth Rate, for formula using beta.
- 39 -
B. Respondent’s Determination in Amendment to Amended
Answer Is Arbitrary, Capricious, and Unreasonable
Respondent’s amendment to amended answer set forth a revised
determination of the requisite buy-in payment. The revised
determination, which is based on Hatch’s report, takes into
account certain items (i.e., the paragraph 9.f. items) that
respondent alleges were intangibles transferred to VERITAS
Ireland. Hatch’s valuation was based on the theory that the
collective effect of the RDA, TLA, and conduct of the parties was
“akin” to a sale of VERITAS US’ business. Respondent’s
determination is erroneous for several reasons.
1. Respondent’s “Akin” to a Sale Theory Is Specious
Respondent contends that VERITAS US’ transfer of preexisting
intangibles was “akin” to a sale and should be evaluated as such.
Respondent further contends that because “th[e] assets
collectively possess synergies that imbue the whole with greater
value than each asset standing alone”, it is appropriate to apply
the “akin” to a sale theory and aggregate the controlled
transactions, rather than value each asset. Hatch was certainly
in a position to know whether his valuation method took into
account the collective assets’ “synergies”, yet his defense, of
respondent’s “akin” to a sale theory was akin to a surrender. On
redirect examination, Hatch testified:
Q [Counsel for respondent] Do you believe your
valuation methodology captured synergistic value?
- 40 -
A [Hatch] I really don’t have an opinion. It
may have. It may not have.
At trial the Court asked respondent’s counsel: “if [we] reject
Dr. Hatch’s approach that [we] should look at this in the
aggregate and he hasn’t valued any of the intangibles separately,
where does that leave the Court?” Respondent’s counsel replied:
“That leaves the Court absolutely nowhere”, and that is precisely
where respondent is with this theory--absolutely nowhere.
Petitioner astutely suggests that “The reason that respondent is
placing an all or nothing bet on his aggregation theory is
simple: software does not last forever, but Respondent’s
valuation approach does.” Indeed, respondent’s assertion of the
“akin” to a sale theory and its assumption that the preexisting
intangibles have a perpetual life are an unsuccessful attempt to
justify respondent’s determination.
Respondent contends that pursuant to section 1.482-
1(f)(2)(i)(A), Income Tax Regs., he was authorized to aggregate
the transactions and treat them as a sale. Transactions may be
aggregated if an aggregated approach produces the “most reliable
means of determining the arm’s length consideration for the
controlled transactions”. Id. (emphasis added). Respondent’s
“akin” to a sale theory (i.e., a theory which encompasses short-
- 41 -
lived intangibles valued as if they have a perpetual life27 and
takes into account intangibles that were subsequently developed
rather than preexisting)28 certainly does not produce the most
reliable result. Thus, pursuant to section 1.482-1(f)(2)(i)(A),
Income Tax Regs., respondent was not authorized to aggregate the
transactions and treat them as a sale.29
2. Respondent’s Allocation Took Into Account Items
Not Transferred or of Insignificant Value
The parties agree that, on November 3, 1999, certain product
intangibles (i.e., NetBackup, Backup Exec, Volume Manager, File
System, Cluster Server, and Foundation Suite) were transferred
from VERITAS US to VERITAS Ireland but disagree about the
transfer of the nonproduct items alleged by respondent. With the
exception of the trademarks, trade names, brand names, and sales
27
See infra, Discussion, sec. II(B)(4), Respondent Employed
the Wrong Useful Life, Discount Rate, and Growth Rate.
28
See infra, Discussion, sec. II(B)(3), Respondent’s
Allocation Took Into Account Subsequently Developed Intangibles.
29
Even if respondent, pursuant to section 1.482-
1(f)(2)(i)(A), Income Tax Regs., were authorized to aggregate the
transactions, the “akin” to a sale theory may violate section
1.482-1(f)(2)(ii)(A), Income Tax Regs. This regulation provides
that “The district director will evaluate the results of a
transaction as actually structured by the taxpayer unless its
structure lacks economic substance.” The transaction at issue,
which certainly had economic substance, was structured as a
license of preexisting intangibles, not a sale of a business.
- 42 -
agreements,30 the nonproduct items either were not transferred or
had insignificant value.
With respect to distribution channels, VERITAS US had
relationships with distributors and resellers prior to the CSA,
but those relationships were weak and had little value. In fact,
it was not until VERITAS Ireland hired the channel manager from
Computer Associates that the distribution channels were
strengthened and maximized. Thus, to the extent VERITAS US’
distribution channels were transferred to VERITAS Ireland, they
had insignificant value. With respect to customer lists and
customer base, Hatch agreed that, prior to the CSA, VERITAS US
lacked the data systems needed to generate accurate and
meaningful customer lists and that VERITAS US’ customer base had
no value given VERITAS US’ marginal market share and limited
presence in EMEA and APJ. Thus, to the extent VERITAS US’
customer lists and customer base were transferred to VERITAS
Ireland, they had insignificant value. With respect to “access
to research and development team”, Hatch testified that his
valuation of the buy-in payment did not include access to R&D
team and that access to R&D team “just was not on [his] radar
screen or anything that [he] thought of.” In addition, Hatch
30
The sales agreements were transferred, but the parties
made no attempt to value them. See infra, Discussion, sec.
IV(C), Value of Trademark Intangibles and Sales Agreements.
- 43 -
conceded that if he assumed that the agreement relating to the
share of R&D expenses was arm’s length, a fact that the parties
stipulated, then access to the R&D team would have zero value.
With respect to “access to marketing team”, Hatch testified that
he did not value VERITAS US’ marketing team, did not know whether
marketing support was provided by VERITAS US, and had no idea
whether the alleged marketing intangibles existed or had been
transferred. Hatch further testified:
if those marketing intangibles did exist -- and
sometimes they don’t, and they just have clauses in
there, I don’t know. But if they did exist, they were
conferred when these related party seller contracts
were assigned. Now did they have any value? I don't
have any opinion on that. I have no idea. [Emphasis
added.]
In short, there is insufficient evidence that access to VERITAS
US’ R&D and marketing teams was transferred to VERITAS Ireland or
had value.31
31
Even if such evidence existed, these items would not be
taken into account in calculating the requisite buy-in payment
because they do not have “substantial value independent of the
services of any individual” and thus do not meet the requirements
of sec. 936(h)(3)(B) or sec. 1.482-4(b), Income Tax Regs.
“Access to research and development team” and “access to
marketing team” are not set forth in sec. 936(h)(3)(B) or sec.
1.482-4(b), Income Tax Regs. Therefore, to be considered
intangible property for sec. 482 purposes, each item must meet
the definition of a “similar item” and have “substantial value
independent of the services of any individual”. Sec.
936(h)(3)(B); sec. 1.482-4(b), Income Tax Regs. The value, if
any, of access to VERITAS US’ R&D and marketing teams is based
primarily on the services of individuals (i.e., the work,
(continued...)
- 44 -
3. Respondent’s Allocation Took Into Account
Subsequently Developed Intangibles
Hatch’s calculations of the requisite buy-in payment took
into account rights to future codeveloped intangibles transferred
pursuant to the RDA. Petitioner contends that respondent’s buy-
in payment allocation relating to subsequently developed products
violates section 1.482-7(g)(2), Income Tax Regs. We agree.
Section 1.482-7(g)(2), Income Tax Regs., the regulatory
authority requiring a buy-in payment, states:
(2) Pre-existing intangibles. If a controlled
participant makes pre-existing intangible property in
which it owns an interest available to other
controlled participants for purposes of research in
the intangible development area under a qualified cost
sharing arrangement, then each such other controlled
participant must make a buy-in payment to the owner.
* * * [Emphasis added.]
31
(...continued)
knowledge, and skills of team members). Nevertheless, respondent
in support of his contention cites Newark Morning Ledger Co. v.
United States, 507 U.S. 546 (1993), and Ithaca Indus., Inc. v.
Commissioner, 97 T.C. 253 (1991), affd. 17 F.3d 684 (4th Cir.
1994). These cases, however, do not suggest that access to an
R&D or marketing team has substantial value independent of the
services of an individual, do not define intangibles for sec. 482
purposes, and do not even reference sec. 482. We note that in
December 2008, the Secretary promulgated temporary regulations
(i.e., secs. 1.482-1T through 1.482-9T, Temporary Income Tax
Regs., supra) which reference “assembled workforce”. In
addition, the Administration, in 2009, proposed to change the law
to include “workforce in place” in the sec. 482 definition of
intangible.
- 45 -
The regulation unequivocally requires a buy-in payment to be made
with respect to transfers of “pre-existing intangible property”.
No buy-in payment is required for subsequently developed
intangibles. Yet Hatch unabashedly took such items into account
in calculating the requisite buy-in payment rather than limiting
the valuation to preexisting intangibles as prescribed by section
1.482-7(g)(2), Income Tax Regs. In fact, respondent readily and
repeatedly acknowledged that his valuation took into account
income relating to items other than the preexisting intangibles.
Accordingly, respondent’s allocation violates section 1.482-
7(g)(2), Income Tax Regs.
4. Respondent Employed the Wrong Useful Life,
Discount Rate, and Growth Rate
Respondent, relying on Hatch’s report, employed the wrong
useful life, the wrong discount rate, and an unrealistic growth
rate to calculate the requisite buy-in payment.
In calculating his valuation of the buy-in payment, Hatch
assumed a perpetual useful life for the transferred intangibles,
yet acknowledged that “if you had 1999 products that you left
untouched, that technology would age and eventually become
obsolete” and that the preexisting product intangibles would
“wither on the vine” within 2 to 4 years without ongoing R&D.
The useful life of the preexisting product intangibles was, on
average, 4 years, and certainly was not perpetual. Petitioner
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established that something, however, was perpetual--VERITAS US
was in a perpetual mode of innovation. Before and after the CSA
VERITAS US released numerous versions of its products. Even with
substantial ongoing R&D, VERITAS US products had finite
lifecycles. By the time a new product became available for
purchase, the next generation was already in development.
In determining the discount rate32 for the buy-in payment,
Hatch used a weighted average cost of capital (WACC)33 derived
under the capital asset pricing model (CAPM).34 Employing the
CAPM,35 Hatch used, as the risk-free rate, the yield on 20-year
32
The discount rate (i.e., the cost of capital) is an
adjustment to a determined value to take into account the rate of
inflation, the time value of money, and any attendant risk.
33
The WACC provides the expected rate of return for a
company on the basis of the average portion of debt and equity in
the company’s capital structure, the current required return on
equity (i.e., cost of equity), and the company’s cost of debt.
The equation for calculating the WACC is: WACC = E(re) +
D(rd)(1-T), where D represents the company’s average portion of
debt, E represents the company’s average portion of equity, re
represents the company’s cost of equity, rd represents the
company’s cost of debt, and T represents the company’s marginal
tax rate.
34
Estimating the WACC for a company requires estimating the
company’s cost of equity (re). The CAPM, which seeks to
determine the rate of return for a specific security, is commonly
used to estimate a company’s cost of equity.
35
The CAPM model uses the following equation to determine
the cost of equity: re = rf + $*(rm - rf), where $ (beta) is a
measure of the volatility, or systematic risk, of a security or
portfolio in comparison to the market as a whole, rf is the yield
to maturity for a U.S. Treasury bond (often referred to as the
(continued...)
- 47 -
U.S. Treasury bonds as of March 31, 2000, without adjustments,
and determined an equity risk premium of 5 percent. The equity
risk premium is the expected long-term yield for the stock market
less the risk-free rate. Hatch applied the 5-percent equity risk
premium and an industry beta of 1.4236 to calculate the
applicable discount rate, which he concluded was 13.7 percent.
Petitioner contends that respondent employed the wrong beta,
the wrong equity risk premium, and therefore the wrong discount
rate. Hatch employed an industry beta to calculate the discount
rate. He opined that using an industry, rather than a company
specific, beta was preferred because, with respect to an
individual company, a beta relating to an earlier period is a
very poor predictor of the beta for subsequent periods. Hatch
ultimately admitted, however, that “to a reasonable degree of
economic certainty, the beta he used could not have been the
correct beta for VERITAS US as of November 3, 1999.”
Hatch’s 5-percent equity risk premium was much lower than
the 1926 through 1999 historic average of 8.1 percent which Hatch
stated was reported by Ibbotson Associates (i.e., the recognized
35
(...continued)
risk-free rate), and rm is the expected long-term yield for the
U.S. stock market as a whole.
36
See supra note 26 for a more detailed discussion of beta.
- 48 -
industry standard of historical capital markets data).37 There
are several problems with Hatch’s analysis. First, in
determining the equity risk premium, Hatch contended that
employing the Ibbotson Associates’ historic average equity risk
premium, which was based on the expected long-term yield for the
U.S. stock market, was not appropriate because the rights
licensed to VERITAS Ireland were exploited in markets outside the
United States. Rights licensed to VERITAS Ireland were indeed
exploited outside the United States, but Hatch erroneously
assumed that the long-term yield for the U.S. market was higher
than the long-term yield for foreign markets. In fact, the
literature upon which Hatch relied establishes that there was no
difference between the observed risk premium in the U.S. market
and the risk premium in foreign markets. See Brealey & Myers,
Principles of Corporate Finance 159 (7th ed. 2003). Hatch’s
erroneous assumptions led to an underestimate of the appropriate
equity risk premium relating to the buy-in payment.
Second, in determining the equity risk premium, Hatch
applied the 20-year U.S. Treasury bond yield as the risk-free
rate. Petitioner contends that the classic formulation of CAPM
uses the 30-day U.S. Treasury bill rate as the risk-free rate,
37
A lower equity risk premium results in a lower cost of
equity, lower WACC (i.e., discount rate), and larger buy-in
payment.
- 49 -
not the bond rate, and that if the bond rate is used, duration
risk has to be taken into account. Ibbotson Associates’ Cost of
Capital 2000 Yearbook 34 states: “In all of the beta
regressions, the total returns of the S&P 500 are used as the
proxy for the market returns. The series used as a proxy for the
risk-free asset is the yield on the 30-day T-bill.” Furthermore,
the text Hatch cites as support for his use of the U.S. Treasury
bond rate states that “The risk-free rate could be defined as a
long-term Treasury bond yield. If you do this, however, you
should subtract the risk premium of Treasury bonds over bills”.
See Brealey & Myers, supra at 226 n. 8. Hatch, however, did not
reduce the U.S. Treasury bond rate and, on cross-examination,
acknowledged that he used the wrong risk-free rate. In sum,
Hatch employed the wrong beta, the wrong equity risk premium, and
thus the wrong discount rate to calculate the requisite buy-in
payment.
Hatch also employed large and unrealistic growth rates into
perpetuity. Hatch determined that from 2001 through 2005 VERITAS
Ireland’s compound annual growth rate was 17.91 percent. He
projected that VERITAS Ireland’s revenues would increase 13
percent each year from 2007 through 2010 and beginning January 1,
2011, would increase 7 percent each year into perpetuity.
VERITAS Ireland’s actual growth rate between 2004 and 2006 was
3.75 percent, 14.16 percentage points lower than the 17.91-
- 50 -
percent growth rate Hatch employed for the same period. In
calculating the buy-in payment, Hatch used VERITAS Ireland’s
actual income relating to 2004 through 2006 but opted not to use
actual growth rates relating to those years. Moreover, he could
not provide a plausible explanation for the growth rate he
employed. Further, petitioner notes that a buy-in payment based
on Hatch’s growth rate would require VERITAS Ireland to allocate
a buy-in payment equal to 100 percent of its actual and projected
operating income to VERITAS US through 2009, resulting in $1.9
billion in losses over that period. Simply put, the growth rate
Hatch employed was unreasonable.
In sum, VERITAS Ireland prospered, not because VERITAS US
simply spun off a portion of an established business and
transferred valuable intangibles, but because VERITAS Ireland
employed aggressive salesmanship and savvy marketing,
successfully developed the EMEA and APJ markets, and codeveloped
new products that performed well in those markets. For the
foregoing reasons, we conclude that respondent’s allocations set
forth in the amendment to amended answer and at trial are
arbitrary, capricious, and unreasonable.
III. Petitioner’s CUT Analysis, With Some Adjustments, Is the
Best Method
Petitioner used the CUT method to calculate the buy-in
payment. The best method rule seeks the most reliable measure of
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an arm’s-length result. Sec. 1.482-1(c), Income Tax Regs.
“[T]here is no strict priority of methods, and no method will
invariably be considered to be more reliable than others.” Id.
Respondent’s income method, riddled with legal and factual
miscalculations, is certainly not the best or most reliable
method. Therefore, we must determine the propriety of
petitioner’s CUT analysis. If petitioner’s CUT analysis does not
meet the arm’s-length standard, we must determine the requisite
buy-in payment. See Sundstrand Corp. & Subs. v. Commissioner, 96
T.C. at 354; see also Eli Lilly & Co. v. Commissioner, 856 F.2d
at 860 (and cases cited thereat).
The CUT method evaluates whether the amount charged for a
controlled transfer of intangible property is arm’s length by
referencing the amount charged in comparable uncontrolled
transactions. If an uncontrolled transaction involves a transfer
of the same intangible under the same, or substantially the same,
circumstances as a controlled transaction, the results derived
from applying the CUT method will generally be the most reliable
measure of the arm’s-length result. Sec. 1.482-4(c)(2)(ii),
Income Tax Regs. If, however, uncontrolled transactions
involving the same intangible under the same circumstances cannot
be identified, uncontrolled transactions that involve the
transfer of “comparable intangibles under comparable
- 52 -
circumstances” may be used to apply the CUT method, but the
reliability of the results is reduced. Id.Respondent contends that the CUT method is not the best
method and that petitioner has not presented comparable
uncontrolled transactions to prove that its buy-in payment is
arm’s length. Specifically, respondent asserts that the rights
licensed under agreements between VERITAS US and unrelated
parties are not comparable because they involved either rights
that are not comparable to those licensed under the CSA or
licensees who are not comparable to VERITAS Ireland. Petitioner
contends that the CUT method is appropriate and that the value
determined by its expert, William Baumol (Baumol), was arm’s
length.
Baumol calculated, using the CUT method, a range of
estimates for the value of the transferred intangibles and
concluded that the lump-sum buy-in payment was within or exceeded
the arm’s-length range. Baumol used four parameters to estimate
a value for the buy-in payment: The expected economic life of
the intangibles, the annual rate at which the value of the
intangibles declines as a function of time and new software
replacements (i.e., the rate of obsolescence), the parameter
value selected to determine the value of the licenses (e.g.,
- 53 -
royalty rates as a percent of revenues, list price, or profits),
and the appropriate discount rate.38
Baumol chose particular agreements (i.e., some involving
bundled products and some involving unbundled products) between
VERITAS US and seven OEMs (i.e., Sun, HP, Dell, Hitachi, NEC,
Compaq, and Ericsson) to determine the appropriate starting
royalty rate for the buy-in payment. Most of the product
licenses that Baumol selected provide royalties as a percentage
of list price (e.g., global list price, international list price,
or U.S. list price). Based on his findings, Baumol derived a
range of starting royalty rates of 20 to 25 percent of list price
and opined that the low end of the range, 20 percent, was the
appropriate starting royalty rate for the buy-in payment.
Baumol determined that the preexisting product intangibles
had a useful life ranging from 2 to 4 years. Having determined
both the starting royalty rate and the useful life, Baumol
adjusted the royalty rate by ramping down (i.e., incrementally
38
Using a value for the intangible license expressed in
terms of revenues, Baumol employed the following formula to
determine the requisite buy-in payment: V=Et=0AC(1-B)t(1-D)tPt,
where A is the expected economic life of the intangibles, B is
the rate of obsolescence, C is the value of the parameter
representing the ratio between the list price and the appropriate
intangible license fee (i.e., the arm’s-length license fee for
the intangibles as a percent of revenue), D is the discount rate,
and P is the revenue for products sold during the product’s
useful life, with the payment for the initial year being C(1-
B)(1-D)P1.
- 54 -
reducing) the rate over the buy-in period. Baumol analyzed
royalty degradation and technology aging provisions in third-
party agreements as evidence of the appropriate ramp-down rates.
To confirm his ramp-down conclusions, Baumol relied on
petitioner’s source code expert, who opined that new lines of
code noticeably increased after 1999 while the amounts of
unchanged functional 1999 source code and files were virtually
nonexistent within a period of 3 to 4 years.
Using the aforementioned findings, Baumol calculated a
valuation range of $94 million to $315 million for the buy-in
payment and concluded that “the preponderance of the values” fell
between $100 million and $200 million.
A. Comparability of OEM Agreements
Use of the CUT method requires that the controlled and
uncontrolled transactions involve the same or comparable
intangible property. Sec. 1.482-4(c)(2)(iii)(A), Income Tax
Regs. In order for intangibles involved in controlled and
uncontrolled transactions to be comparable, “both intangibles
must--(i) Be used in connection with similar products or
processes within the same general industry or market; and (ii)
Have similar profit potential.” Sec. 1.482-4(c)(2)(iii)(B)(1),
Income Tax Regs.
In his CUT valuation, Baumol referenced, as comparables,
agreements between VERITAS US and certain OEMs (i.e., Sun, HP,
- 55 -
Dell, Hitachi, NEC, Compaq, and Ericsson). Respondent contends
that the CSA involves the transfer of “platform contribution”
intangibles and broad “make-sell rights”39 with respect to
VERITAS US’ full range of products, while the OEM agreements did
not. We note that the term “platform contribution intangibles”
does not appear in the regulations applicable to the CSA but is
set forth in section 1.482-7T, Temporary Income Tax Regs., 74
Fed. Reg. 352 (Jan. 5, 2009)--regulations effective for
transactions entered into on or after January 5, 2009. Thus,
respondent’s litigating position appears to mirror transfer
pricing regulations promulgated 10 years after VERITAS US and
VERITAS Ireland signed the CSA.40 In essence, respondent
39
Make-sell rights are the licensed rights to manufacture
and sell existing intangible property.
40
Secs. 1.482-1T through 1.482-9T, Temporary Income Tax
Regs., supra, provide “further guidance and clarification
regarding methods under section 482 to determine taxable income
in connection with a cost sharing arrangement in order to address
issues that have arisen in administering the current
regulations.” 74 Fed. Reg. 340 (Jan. 5, 2009). These
regulations include the income method and the price acquisition
method and provide guidance on applying these methods for
purposes of evaluating the arm’s-length amount for platform
contribution transactions (i.e., formerly referred to as
transactions involving preexisting intangibles). The temporary
regulations list the following specified methods: The CUT
method, the income method, the price acquisition method, the
market capitalization method, and the residual profit split
method. The CUT method and the profit split method are the only
two “specified methods” in the temporary regulations that were
listed as “specified methods” in the regulations applicable to
VERITAS US’ transaction.
- 56 -
contends that, pursuant to section 1.482-4(c)(2)(iii)(A), Income
Tax Regs., the CUT method is not appropriate because the OEM
agreements involve substantially different intangibles. We
disagree.
VERITAS Ireland, pursuant to the TLA, received broad rights
for the full range of VERITAS US products. The rights licensed
under the OEM agreements referenced by Baumol involved Backup
Exec, NetBackup, Volume Manager, File System, Cluster Sever, and
Foundation Suite. While none of the individual OEM agreements
evaluated by Baumol included a license for the full range of
VERITAS US’ product line, collectively the agreements did involve
essentially the same intangibles that were transferred from
VERITAS US to VERITAS Ireland. The OEM agreements Baumol
selected do not, however, provide the most reliable measure for
calculating the requisite buy-in payment.
B. Unbundled OEM Agreements Were Comparable to the
Controlled Transaction
VERITAS US entered into numerous OEM agreements prior to and
during the CSA. Baumol chose to use only a select few of those
OEM agreements (i.e., some involving bundled products and some
involving unbundled products) to calculate the requisite buy-in
payment. His justification for rejecting particular agreements
was simply: “I didn’t find the numbers that I could use.”
Respondent contends that the OEM agreements Baumol selected are
- 57 -
not comparable to the controlled transaction because the
circumstances surrounding the selected OEM agreements and the
circumstances surrounding the controlled transaction are
different. We conclude that, collectively, the more than 90
unbundled OEM agreements the parties stipulated are sufficiently
comparable to the controlled transaction.
When OEMs sold VERITAS US products bundled with the OEMs’
operating systems, VERITAS US gained credibility and improved
brand identity. The OEMs actively marketed the bundled products;
listed the products on their Web sites; and provided equipment,
technical support, and engineering assistance for those products.
Because of these factors, OEMs paid a lower royalty rate with
respect to bundled products. VERITAS Ireland, on the other hand,
did not have a trade name as widely recognized as the trade names
of the OEMs, guaranteed sales like the OEMs, or an operating
system with which to bundle VERITAS US products. Therefore,
VERITAS Ireland would not be entitled to similar royalty rates.
In contrast to bundled products, unbundled products were not
directly associated with the OEMs’ products and the OEMs did not
provide the same level of assistance (i.e., technical and
engineering support). Thus, customers did not perceive unbundled
products to be more reliable or of greater quality than other
comparable products. The OEMs merely listed the unbundled
- 58 -
products as an option (i.e., customers could purchase VERITAS US
products or other products). Because such agreements are more
comparable to the transaction between VERITAS US and VERITAS
Ireland, use of the OEM agreements involving unbundled products
provides a more reliable arm’s-length result. Thus, we compare
VERITAS US’ unbundled OEM agreements with the controlled
transaction.
The degree of comparability between controlled and
uncontrolled transactions is determined by applying the
comparability standards set forth in section 1.482-1(d), Income
Tax Regs. Sec. 1.482-4(c)(2)(iii), Income Tax Regs. Section
1.482-1(d)(1), Income Tax Regs., provides that the following
factors shall be considered in determining comparability between
controlled and uncontrolled transactions: Functions, contractual
terms, risks, economic conditions, and property or services. An
analysis employing these factors confirms that VERITAS US’
unbundled OEM agreements are sufficiently comparable to the
controlled transaction.
The first factor, functional analysis, compares the
economically significant activities undertaken, or to be
undertaken, in the controlled transactions with the economically
significant activities undertaken, or to be undertaken, in the
uncontrolled transactions. Sec. 1.482-1(d)(3)(i), Income Tax
Regs. VERITAS Ireland and the OEMs undertook similar activities
- 59 -
(e.g., manufacturing and production, marketing and distribution,
transportation and warehousing, etc.) and employed similar
resources in conjunction with such activities. See section
1.482-1(d)(3)(i), Income Tax Regs., for a list of functional
analysis comparability factors. Respondent contends, however,
that the OEM agreements and the controlled transactions are not
functionally comparable because R&D is a particularly significant
function in the controlled transactions (i.e., VERITAS US and
VERITAS Ireland agreed to share in ongoing R&D costs relating to
the development of new software products), whereas the OEM
agreements did not involve ongoing R&D activities. Respondent
contends that the R&D function is important because VERITAS
Ireland “received ownership interests in future generations of
technology which germinated from the pre-existing technology.”
Respondent’s functional analysis is misguided. Respondent is
relying on rights involving subsequently developed intangibles to
support his assertion that the OEM agreements are not comparable
to the controlled transaction. As previously determined herein,
VERITAS Ireland was required to make a buy-in payment with
respect to the transfer of “pre-existing intangible property”,
not subsequently developed intangibles. See sec. 1.482-7(g)(2),
Income Tax Regs. Thus, the focus of the buy-in payment analysis
should be on transactions involving preexisting intangibles. For
- 60 -
the products in existence on November 3, 1999, there are no
significant differences in functionality.
The second factor is the comparability of contractual terms.
Determining the degree of comparability between the controlled
and uncontrolled transactions requires a comparison of the
significant contractual terms that could affect the results of
the transactions (e.g., the form of consideration; the sales
volume; the scope and terms of warranties; the right to updates,
revisions, or modifications; the duration of the agreement;
etc.). Sec. 1.482-1(d)(3)(ii)(A), Income Tax Regs. Respondent
contends that the contractual terms of the OEM agreements are not
comparable to the controlled transaction for two reasons. First,
respondent contends that the OEMs often provided VERITAS US with
APIs, source code, or information about their hardware so VERITAS
US could adapt VERITAS US products to the OEMs’ hardware and
operating systems, whereas VERITAS Ireland did not have an
operating system, APIs, or source code. Some of VERITAS US’
unbundled OEM agreements did contain contractual terms pursuant
to which OEMs provided APIs and source code information to
VERITAS US to assist with adaptation issues, but, unlike the
contractual terms set forth in section 1.482-1(d)(3)(ii)(A),
Income Tax Regs., the contractual terms relating to adaptability
were not significant terms that affected the results of the
transactions. The APIs and source code information did not
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change the essential functions of VERITAS US products but rather
enabled VERITAS US products to run on the OEM’s operating system.
Second, respondent contends that the OEMs provided engineering
assistance to VERITAS US in connection with the development of
VERITAS US bundled products, whereas there is no evidence that
VERITAS Ireland was in a position to provide engineering
assistance to VERITAS US. While it is true that some OEMs did
provide engineering support with respect to bundled products, the
provision of engineering support was not a standard contractual
term in OEM agreements relating to unbundled products. Indeed,
the provision of engineering support was not a significant factor
that affected the results of OEM agreements involving unbundled
products. Thus, there are no significant differences in
contractual terms.41
The third factor compares the significant risks borne by the
parties that could affect the prices charged or the profit earned
in the controlled and uncontrolled transactions. Sec. 1.482-
1(d)(3)(iii), Income Tax Regs. The parties to the controlled and
uncontrolled transactions bore similar market risks, similar
risks associated with R&D activities, similar risks associated
41
We recognize that one of the differences between the
controlled and uncontrolled transactions is that, unlike the
OEMs, VERITAS Ireland was not entitled to product updates,
revisions, or modifications. We have concluded, however, that it
was appropriate to make an adjustment to account for this
difference. See infra, Discussion, sec. IV(B), The Appropriate
Useful Life and Royalty Degradation Rate.
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with fluctuations in foreign currency exchange rates and interest
rates, similar credit and collection risks, and similar product
liability risks. See section 1.482-1(d)(3)(iii)(A), Income Tax
Regs., for a list of risk comparability factors. Respondent
contends, however, that the risks borne by VERITAS Ireland and
the risks borne by the OEMs are not comparable because the OEMs
were subject to the risk that the version of technology they
licensed would not do well in the market. VERITAS Ireland bore
the same risk as the OEMs. In short, there are no significant
differences in risks borne.
The fourth factor compares the significant economic
conditions that could affect prices or profit in the controlled
transaction to the significant economic conditions that could
affect prices or profit in the uncontrolled transactions. Sec.
1.482-1(d)(3)(iv), Income Tax Regs. Respondent contends that the
economic and market conditions affecting the OEM agreements are
not comparable to those affecting the transaction between VERITAS
US and VERITAS Ireland because, unlike VERITAS Ireland, the OEMs
occupied significant positions in the market. Respondent further
contends that the OEMs had established sales forces and
relationships with resellers and distributors, whereas on the
date of the transfer VERITAS Ireland was a startup with no
customer relationships or other assets. We agree with respondent
that the OEMs and VERITAS Ireland were at dramatically different
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stages of development and held different positions in the market.
We note, however, that both the OEMs and VERITAS Ireland competed
in similar geographic markets, incurred similar distribution
costs, marketed products that faced similar competition, and were
subject to similar economic conditions. See section 1.482-
1(d)(3)(iv), Income Tax. Regs., for a list of economic condition
comparability factors. While certain economic conditions (e.g.,
interest rate fluctuations, general vicissitudes of the market,
etc.) affect prices and profits for both startups and established
businesses, the impact on a particular business may certainly
depend on the business’ economic stability and market position.
Our analysis of this factor narrowly weighs against a finding of
comparability.
The fifth factor compares the property or services provided
in the controlled transaction to that provided in the
uncontrolled transactions. Sec. 1.482-1(d)(3)(v), Income Tax
Regs. Respondent contends that under the OEM agreements, VERITAS
US generally contracted to provide only the development work
necessary to ensure its products would work with the OEMs’
products, whereas under the CSA, VERITAS US provided make-sell
rights and preexisting intangibles for research to produce future
generations of technology. Specifically, respondent contends
that “VERITAS U.S. and VERITAS Ireland contracted to share all
the costs of future R&D on future software generations and for
- 64 -
each to hold separate exploitation rights. * * * Neither the
property nor services were comparable.” Once again, respondent’s
contention is misguided. Respondent is relying on rights
involving subsequently developed intangibles to support his
assertion that the OEM agreements are not comparable to the
controlled transaction. As previously determined herein,
pursuant to section 1.482-7(g)(2), Income Tax Regs., the
requisite buy-in payment need not take into account subsequently
developed intangibles. With respect to the controlled
transaction involving the transfer of preexisting intangibles and
the uncontrolled transactions involving VERITAS US’ unbundled OEM
agreements, there are no significant differences in property or
services provided.
Although VERITAS US’ unbundled OEM agreements are certainly
not identical to the controlled transaction, an analysis of the
comparability factors establishes that the unbundled OEM
agreements are sufficiently comparable to the controlled
transaction and that the CUT method is the best method to
determine the requisite buy-in payment. There are, however,
certain adjustments we must make to petitioner’s CUT analysis to
enhance its reliability.
IV. Requisite Adjustments to Petitioner’s CUT Analysis
Imperfect comparables serve “as a base from which to
determine the arm’s length consideration for the intangible
- 65 -
property involved in this case.” Sundstrand Corp. & Subs. v.
Commissioner, 96 T.C. at 383, 393. Section 1.482-1(e)(2)(ii),
Income Tax Regs., provides that
Uncontrolled comparables must be selected based upon
the comparability criteria relevant to the method
applied and must be sufficiently similar to the
controlled transaction that they provide a reliable
measure of an arm’s length result. If material
differences exist between the controlled and
uncontrolled transactions, adjustments must be made to
the results of the uncontrolled transaction if the
effect of such differences on price or profits can be
ascertained with sufficient accuracy to improve the
reliability of the results. * * *
A. The Appropriate Starting Royalty Rate
Respondent contends that if the OEM agreements are
comparable to the controlled transaction, petitioner’s
calculation of the starting royalty rate is nevertheless
erroneous. In determining the requisite buy-in payment, Baumol
used 20 percent as the starting royalty rate and acknowledged
that he did not use any “sophisticated calculation” or “higher
mathematics” to arrive at that rate. He based the 20-percent
royalty rate on rates found in select OEM agreements involving
bundled and unbundled products. As previously determined, OEM
agreements involving unbundled products are the appropriate
comparables. As petitioner did not use sufficiently comparable
transactions in determining the starting royalty rate to
calculate the requisite buy-in payment, and respondent has not
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provided a royalty rate other than one based on a perpetual
royalty, the Court must determine the appropriate royalty rate.
The parties provided the Court with the royalty rates for
more than 90 unbundled OEM agreements. Because each unbundled
OEM agreement standing alone does not involve the full range of
intangibles referenced in the TLA, the agreements must be looked
at collectively. The royalty rates relating to VERITAS US
unbundled products range between 25 and 40 percent. The mean
(i.e., the average) royalty rate for VERITAS US’ OEM agreements
involving unbundled products is 32 percent of list price. Thus,
we conclude that the starting royalty rate for the transferred
product intangibles is 32 percent of list price.
B. The Appropriate Useful Life and Royalty Degradation
Rate
The appropriate useful life of the preexisting product
intangibles is 4 years. Indeed, as previously discussed, VERITAS
US products, on average, had a useful life of that duration.42
Licensing parties often agree to ramp down royalty rates to
account for the gradual obsolescence of static technology.43
Petitioner contends that the royalty rates for the preexisting
42
See supra, Discussion, sec. II(B)(4), Respondent Employed
the Wrong Useful Life, Discount Rate, and Growth Rate, and supra,
Background, sec. IV, Product Lifecycles and Useful Lives.
43
While a static product may lose considerable value, the
value of the product need not be zero in the final year of the
product’s useful life.
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product intangibles should be ramped down over the lives of the
intangibles to account for obsolescence and decay of technology.
The majority of VERITAS US’ OEM agreements included provisions
for updates and new versions, but the preexisting product
intangibles transferred pursuant to the TLA did not. Thus, an
adjustment must be made to the starting royalty rate to account
for the static nature of the technology.44 Consistent with
VERITAS US’ other agreements involving static technology,45 the
royalty rates for VERITAS US’ preexisting product intangibles
must be ramped down, starting in year 2, at a rate of 33 percent
per year from the then-current percentage (i.e., 32 percent in
year 1; 21 percent in year 2; 14 percent in year 3; and 10
percent in year 4).46
C. Value of Trademark Intangibles and Sales Agreements
Petitioner contends that VERITAS US’ trademarks, trade
names, and brand names (trademark intangibles) lacked value
because in 1999 “VERITAS” was registered in only a few foreign
jurisdictions and was relatively unknown in the EMEA and APJ
markets. Regardless of the number of foreign jurisdictions in
44
In calculating ramp-down rates, Baumol relied on
petitioner’s source code expert. The source code expert’s
simplistic and mechanical analysis was not convincing.
45
See supra, Background, sec. IV, Product Lifecycles and
Useful Lives.
46
The rates are rounded to the nearest percentage.
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which the “VERITAS” trademark was registered, the “VERITAS”
trademark and the individual product names, especially
“NetBackup” and “Backup Exec”, were well known, respected, and
valuable. Thus, pursuant to section 1.482-7(g), Income Tax
Regs., VERITAS Ireland was required to pay VERITAS US a buy-in
payment as consideration for those trademark intangibles.
Petitioner’s trademark expert found that as of November 3,
1999, VERITAS US had trade names for Backup Exec, NetBackup,
Volume Manager, File System, Cluster Server, and Foundation
Suite, as well as certain other products. He believed that the
value of the trademark intangibles was zero but nevertheless
calculated another value for those intangibles. In calculating a
value petitioner’s trademark expert opined that the useful life
of the trademark intangibles in VERITAS Ireland’s territory
should be no more than 7 years, selected a range of royalty rates
from 0.5 to 1 percent of revenue, and concluded that before taxes
the value for the trademark intangibles was between $1.7 and $3.4
million. He assumed that VERITAS Ireland was entitled to
royalty-free use of the trademark intangibles for the duration of
the TLA and concluded that the TLA, which did not have a
termination date, had a term of November 1999 through October
2003. Thus, his initial valuation included a royalty for only 3
years (i.e., from November 2003 through the end of 2006). During
trial, in response to Hatch’s criticism of his findings
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petitioner’s trademark expert revised his calculations to include
a royalty that covered the entire 7-year useful life that he
projected. He ultimately concluded that the revised upper-end
value for the trademark intangibles was $9.6 million.
Petitioner’s trademark expert was not convincing and when he
was questioned regarding the calculation of his lower range of
values, his response was incoherent. Respondent failed to
estimate a value for these intangibles, and the paucity of
credible evidence relating to this issue is disconcerting.
Nevertheless, we conclude that petitioner’s trademark expert’s
upper-end value of $9.6 million is the best available
approximation of, and thus, the arm’s-length value of the
trademark intangibles.
The buy-in payment must also be adjusted to take into
account the value of the sales agreements transferred from
VERITAS US to VERITAS Ireland. We do not, however, have
sufficient evidence to determine the value of those agreements.
Thus, this matter must be addressed in the parties’ Rule 155
computations.
D. The Appropriate Discount Rate
Petitioner’s financial markets expert Burton Malkiel
(Malkiel) applied the CAPM and concluded that 20.47 percent was a
reasonable estimate of VERITAS US’ WACC. There are two
differences between Hatch’s and Malkiel’s applications of CAPM:
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The estimate of the beta and the equity risk premium. Malkiel,
unlike Hatch, used reliable data to calculate both variables.
Malkiel had two reasons for employing a 1.935 company-
specific beta, rather than a 1.42 industry beta, to calculate
VERITAS US’ WACC. First, the industry beta for VERITAS US’
Standard Industrial Classification (SIC) code47 was skewed
because of the presence and size of Microsoft.48 Microsoft
dominated the personal computer operating system software market
and had a stronger and more established business than VERITAS US.
Thus, the risk level for VERITAS US’ industry SIC group did not
present a portfolio of comparable risk. Second, while betas for
individual companies tend to be unstable, VERITAS US’ betas were
quite stable. Moreover, Malkiel used the historic average risk
premium from 1926 to 1999 as reported by Ibbotson Associates
(i.e., the best available data) to estimate the equity risk
47
The SIC is a U.S. Government statistical classification
system that uses a four-digit numerical code to group businesses
according to industry and subindustry groups. Businesses are
grouped according to their primary economic activity (e.g.,
agriculture, fishing, manufacturing, transportation,
communications, wholesale trade, etc.).
48
Betas relating to industry portfolios typically reflect
the capital structure of the companies included in the particular
industry. Companies that have large market values (i.e.,
determined by multiplying the number of the company’s shares of
stock outstanding by the price of the shares) carry greater
weight in the SIC group’s portfolio.
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premium for 1999. See Brealey & Myers, supra at 157, 179.
Accordingly, the appropriate discount rate is 20.47 percent.
V. Conclusion
With the aforementioned adjustments, the CUT method is the
best method for determining the requisite buy-in payment relating
to VERITAS Ireland’s transfer of intangibles to VERITAS US.
Contentions we have not addressed are irrelevant, moot, or
meritless.
To reflect the foregoing,
Decision will be entered
under Rule 155.