UNITED STATES TAX COURT F ACEBOOK, INC. & SUBSIDIARIES,_ Petitioner, V. ) ) ) ) ) COMMISSIONER OF INTERNAL REVENUE, Respondent. ) ) ) ) Docket No. 21959-16 Judge Pugh Filed Electronically RESPONDENT'S STATEMENT OF POSITION THE RESPONDENT, pursuant to the Court's Order dated September 5, 2019, providing that the "parties shall file a brief statement of position, outlining the legal issues and a brief statement of the parties' respective legal positions," respectfully submits the following Statement of Position. I. ISSUE Whether additional income should be allocated under section 482 to petitioner ("Facebook") from its newly-formed foreign subsidiary, Facebook Ireland Holdings Unlimited (formerly Facebook Ireland Holdings Limited) ("FIH"), for the 2010 taxable year in connection with a cost sharing arrangement having a stated effective date of September 15, 2010. II. BACKGROUND FACTS Facebook developed and operated a social networking site, allowing persons, including without limitation, users, advertisers, and developers, to interact Docket No. 21959-16 -2- with each other on the Facebook site. Facebook had the resources, capabilities, and rights, including ownership of substantially all the technology and other intangibles, to operate Facebook's social networking business worldwide on (and well before) September 15, 2010. According to Facebook, by January 2008, more than 60 percent of Facebook's worldwide user base was outside the United States. As early as September 2008, Facebook was considered the leading social networking service provider worldwide. By December 2008, the Facebook site was available in more than 35 languages with more than 60 additional languages in development. Facebook's business involved, among other things, the development of the "social graph" - a digital mapping of people's real-world meaningful connections among themselves, their friends, and interests. Facebook developed technologies to facilitate the sharing of information among its users through the social graph. To attract new users and promote positive experiences and engagement for existing users, Facebook developed technology to create and improve website features and products, as well as to improve its underlying site infrastructure. Facebook also leveraged developer-created applications through its product, Facebook Platform. Similarly, its product, Facebook Connect, expanded the users' social graph beyond the Facebook site, which encouraged user growth and engagement. Docket No. 21959-16 -3- The resources, capabilities, and rights that Facebook employed in its business operations included technology, user base, and marketing intangibles, which were complementary and interrelated with each other. For example: Facebook tested new technologies and features by, among other things, collecting data and observations from its worldwide user base, adve1iisers, and developers, creating feedback loops that were critical to the development of its technology. Facebook exploited its intangibles to drive user growth and engagement. Facebook utilized its user base and marketing intangibles to attract engineering talent, which further contributed to the development of Facebook's technology. Facebook's technology and user base growth, in turn, contributed to the development and value of Facebook's marketing intangibles. These are only a few examples of how these intangibles assets, combined with other resources, capabilities, and rights, are necessarily and inextricably linked. Operating together, they generate value and utility to Facebook and its various user communities. One of Facebook's key strategies was to expand its worldwide user base (i.e., to connect the world). Advertisers and developers were attracted to Facebook's large and engaged user base. Facebook prioritized product quality and long-term user growth over short-term monetization objectives. Facebook earned revenue primarily by selling online advertisements to advertisers, including Docket No. 21959-16 -4- developers. To a lesser extent, Facebook ean1ed revenue by receiving a share of revenues from Facebook Credits ("FBC"), a virtual currency for Facebook users to make virtual and digital goods purchases. A. Facebook Ireland Limited and Facebook Ireland Holdings Facebook's subsidiary, Facebook Ireland Limited ("FIL"), was incorporated in Ireland on October 6, 2008. At that time, other than one foreign subsidiary, 1 Facebook's worldwide operations were based in the United States. Facebook's subsidiary FIH was incorporated in Ireland on January 19, 2009, with its stated place of management and control in the Cayman Islands. FIL became a disregarded entity of FIH for Federal income tax purposes as of September 1, 2010. While FIL had employees principally involved in user operations and sales functions during the 2009 and 2010 taxable years, FIH had no employees. FIH had no access to financial or accounting systems until September 1, 2010, at the earliest. FIH was not capitalized until August 31, 2009, at the earliest. B. 2010 Agreements Facebook and FIH entered into the following agreements, having a stated 1 Facebook UK Limited ("Facebook UK") was incorporated under the laws of England and Wales on August 1, 2007. During the 2009 and 2010 taxable years, Facebook UK's employees were principally involved in sales and marketing functions and included Facebook's vice president of Europe, Middle East and Africa. Docket No. 21959-16 -5- effective date of September 15, 2010: the "Online Platfom1 Intangible Property Buy-In License Agreement" ("PCT Agreement"), the "User Base Transfer and Marketing Intangibles License Agreement" ("UBMI Agreement"), and the "Agreement To Share Costs And Risks Of Online Platfonn Intangible Property Development" ("Cost Sharing Agreement"). Facebook and FIH, respectively, entered into other agreements 2 having a stated effective date of September 15, 2010 with related entities. Among other agreements, FIH and FIL entered into an "Operating License Agreement." 1. PCT Agreement Under the terms of the PCT Agreement, Facebook granted FIH a license to "Facebook US PCT Property and Confidential Information" in all countries worldwide, excluding the United States and Canada ("ROW Territory"). 3 "Facebook US PCT Property" was defined, among other things, as "all Intangible Property, including computer software, relating to the Facebook Online Platform existing and owned or licensed by [Facebook] as of the Effective Date. "4 Under the terms of the PCT Agreement, the definition of "Intangible Property" excluded 2 Respondent's Statement of Position uses the term "agreement" to reference documents labeled as agreements but does not necessarily agree to the legal effect of the documents as agreements for Federal income tax purposes. 3 PCT Agreement, §§ 1.8, 2.1. 4 PCT Agreement, § 1.6. Docket No. 21959-16 -6- the "User Base and Marketing Intangibles" defined in the UBMI Agreement. 5 2. UBMI Agreement Under the terms of the UBMI Agreement, Facebook transfe1Ted all rights to the User Base in the ROW Territory to FIH and granted FIH a license to the Marketing Intangibles in the ROW Territory. 6 "User Base" was defined as "the contracts and other relationships with persons comprising the various user communities developed and maintained by [Facebook and FIH], information about such users, and networks developed by users on the various Facebook sites." 7 3. Cost Sharing Agreement Under the terms of the Cost Sharing Agreement, Facebook and FIH agreed to share the costs of intangible development ("IDC") with respect to developing technology for the Facebook Online Platform based on each party's share of reasonably anticipated benefits ("RAB") to be derived by the parties from the "Cost Shared Intangibles. "8 Under the Cost Sharing Agreement, "Cost Shared 5 PCT Agreement,§ 1.3. Under the UBMI, "Marketing Intangibles" meant and included "any and all trademarks, service marks, trade names, ... marketing strategies, customer lists, ... and other similar marketing intangible property." UBMI, § 1.2. 6 UBMI Agreement,§§ 2.1, 2.2. 7 UBMI Agreement,§ 1.6. 8 Cost Sharing Agreement,§ 7.2. Docket No. 21959-16 -7- Intangibles" meant and included "any Intangible Property developed as a result of the Intangible Development Activity. "9 Under the Cost Sharing Agreement, the definition of "Intangible Property" excluded the "User Base and Marketing Intangibles" defined in the UBMI Agreement. 10 C. Facebook's 2010 Reporting Position 1. PCT and Royalty Income For the 2010 taxable year, Facebook included in income $100 million under the PCT and UBMI Agreements. Specifically, Facebook included in income $59,561,111 based on a $1,685 million net present value ("NPV") ofFacebook US PCT Property and Confidential Information payments; $37,626,671 based on a $4,078 million NPV of User Base license payments; and $2,812,217 based on an annual contingent royalty of one percent of FIH's revenue for the licensed Marketing Intangibles. 11 According to Facebook, FIH paid $5 million upon signing the PCT and UBMI Agreements in November 2010 and signed an 9 Cost Sharing Agreement, § 1.5. "Intangible Development Activity" was defined, among other things, as the activity performed under the Cost Sharing Agreement of "developing or attempting to develop reasonably anticipated Intangible Property" in specified categories and classes related to the Facebook Online Platfonn. Id. §§ 1.8, 3, Ex. B. °Cost Sharing Agreement,§ 1.10. 1 11 See Ernst & Young ("EY") report titled "U.S. Internal Revenue Code Section 6662 transfer pricing documentation for FY2010, Intercompany PCT and license payments" dated September 15, 2011 ("EY PCT Report"), pp. 5, 107 (Fig. 22). Docket No. 21959-16 -8- intercompany note for $95 million payable to Facebook, effective December 31, 2010. 12 The payment amounts under the PCT and UBMI Agreements were based on EY reports prepared for Facebook to satisfy section 6662 documentation requirements. To determine an arm's length price for Facebook's so-called "rights to the pre-existing technology intangibles" in the ROW Territory under the PCT Agreement, the EY PCT Report determined that the income method under Treas. Reg.§ 1.482-7T(g)(4) (2009) was the best method. 13 The EY PCT Report acknowledged that "[Facebook] held resources, capabilities or rights which it had developed outside of the CSA that the participants reasonably anticipated would contribute to the development of cost shared intangibles." 14 In pricing the so-called "rights to the pre-existing user base" in the ROW Territory under the UBMI Agreement, the EY PCT Report selected the comparable profits method ("CPM") under Treas. Reg. § 1.482-5 as the best method. 15 In EY's view, applying a "CPM analysis to the stream of profit projected to derive from the pre-existing international user base is equivalent to an income method 12 EY PCT Report, p. 5 n.3. 13 EY PCT Report, pp. 1, 73, 75. 14 EY PCT Report, pp. 72-73. 15 EY PCT Report, pp. 1, 96-97. Docket No. 21959-16 -9- application." 16 The EY PCT Report acknowledged that "[Facebook] owns a significant portion of the IP related to the existing international user base as of 15 September 2010, which is the subject asset in the valuation." 17 Similarly, EY considered, but rejected, the residual profit split method as the best method, in part, because "FBUS owns most all valuable user IP as of 15 September 2010." 18 In applying the income method and CPM, EY created projected income statements attributable to the ROW Territory that, in general, allocated 70 percent of income items to technology intangibles and 30 percent of income items to User Base intangibles ("70/30"). This allocation was based on Facebook agreements with third-party developers in which Facebook took a 30 percent fee on payments related to virtual and digital goods purchases by users with Facebook Credits. 19 16 EY PCT Report, p. 98. 17 EY PCT Report, p. 97. 18 EY PCT Report, p. 98. Respondent notes that this conclusion, which informed Facebook's selection of the transfer pricing method it used to prepare its 2010 Form 1120 stands in contrast to Facebook's allegation in the Petition that FIR, in the period leading up to the cost sharing arrangement, developed valuable assets that require compensation as part of the transfer pricing analysis. Facebook has not substantiated its allegation on this point, and if Facebook advances this theory at trial, respondent will present evidence demonstrating that Facebook's position is not supported by facts, legal authorities, or economic principles. 19 EY PCT Report, p. 89. Docket No. 21959-16 - 10 - Finally, to price the "rights to marketing intangibles" in the ROW Territory under the UBMI Agreement, the EY PCT Report selected the comparable uncontrolled transaction ("CUT") method under Treas. Reg. § 1.482-4(c) as the best method. 20 2. IDC Deductions According to the Petition, Facebook's RAB share was 57 percent and FIH's RAB share was 43 percent under the Cost Sharing Agreement, resulting in a cost sharing payment by FIH to Facebook in the amount of $44 million, based on total IDCs of $102 million.21 The EY CSA Report determined the RAB share by using less than three years of Facebook's and FIH's present-valued gross profit 20 EY PCT Report, pp. 1, 102-3. Petition, ,r 5.b.7., 8. Respondent believes that the RAB share percentages and total IDCs alleged in the Petition are erroneous. Figure 13 on page 88 in the EY PCT Report shows the total projected R&D expenses as $102 million for the 2010 taxable year. Page 88 of the EY PCT Report states that "R&D Expenses were allocated based on the RAB share calculation, as described in the Online Platfonn Cost Sharing Agreement." However, Exhibit 10 of page 42 in E& Y's report titled "U.S. Treasury Regulation§§ 1.482-7T(k)(2) and 1.6662-6(d) transfer pricing documentation for tax year ended 2010" dated September 15, 2011 ("EY CSA Report"), shows the total cost sharing pool as $49,001,311; FIH's RAB share as 44 percent; FIH's cost sharing payment as $21,560,577; and FIH's net cost sharing payment as $21,160,536 (after deducting $400,041 of FIH's directly incurred costs) for the 2010 taxable year. Facebook appeared to have deducted $27,440,734 ($49,001,311 x 56%) in IDCs and reported $21,160,536 of cost sharing payments on its 2010 retmn. On August 16, 2019, respondent requested clarification from Facebook on this issue but Facebook has not provided a response to respondent's mqmry. 21 Docket No. 21959-16 - 11 - projections and by calculating forecasted international revenue using "the latest projected international share data. "22 III. RESPONDENT'S POSITION Facebook's income must be increased to (1) reflect additional amounts due from FIH for Facebook's platform contributions in connection with the Cost Sharing Agreement and (2) disallow Facebook's IDC deductions that exceed its RAB share. Respondent's position on these issues is as follows. A. PCT Income The best method rule must be utilized for evaluating the arm's length compensation from FIH for Facebook's platform contributions in connection with the Cost Sharing Agreement. Treas. Reg.§§ 1.482-l(c)(l),23 1.482-7T(g)(2)(i). In the context of a cost sharing arrangement, the 2009 section 482 temporary regulations provide supplemental guidance on the application of the best method rule by reference to the investor model, realistic alternatives, and aggregation principles, among others. Id. § 1.482-7T(g)(2)(ii)-(iv). Facebook's methods do not 22 23 EY CSA Report, p. 40. The best method is the method that provides the most reliable measure of an arm's length result (i.e., the results of a controlled transaction are consistent with the results that would be realized if uncontrolled taxpayers had engaged in the same transaction under the same circumstances). Treas. Reg. § 1.482-1 (b )(1 ), (c)(l). Docket No. 21959-16 - 12 - result in PCT and royalty payments that fully compensate Facebook under the best method rule. To begin with, Facebook counterfactually valued its technology separate from its user base and marketing intangibles, disregarding that these items are complementary and inten-elated and only deliver value to Facebook and its various user communities as an integrated whole. Furthermore, Facebook treated technology intangibles as a platform contribution under Treas. Reg. § 1.482-7T but treated its user base and marketing intangibles as intangible property transactions under Treas. Reg. § 1.482-4. By doing so, Facebook wholly ignores the entirety of Facebook's resources, capabilities, and rights that are reasonably anticipated to contribute to developing the Cost Shared Intangibles, which include Facebook's user base and marketing intangibles. Respondent contends that the income method under Treas. Reg. § 1.4827T(g)(4) is the best method in this case - in particular, a discounted cash flow method that compares the future expected cash flows Facebook would be projected to receive in connection with the Cost Sharing Agreement to the projected cash flows under its best realistic alternative. Furthermore, as the evidence at trial will make abundantly clear, Facebook's technology, user base, and marketing intangibles are highly inten-elated and, in addition to other related resources, capabilities, or rights, are reasonably anticipated to contribute to developing the Docket No. 2 1959-16 - 13 - Cost Shared Intangibles. To apply the best method, the income method must be applied to these platform contributions on an aggregate basis under Treas. Reg. § 1.482-7T(g)(2)(iv). Based on respondent's preliminary analysis, an appropriate application of the income method yields an aim's length NPV result of approximately $20 billion. 24 24 After the notice of deficiency was issued, Facebook produced over 2 million pages of documents pursuant to previously issued summonses (see United States v. Facebook Inc. & Subs., case no. 3:16-cv-03777-LB (N.D. Cal.)(filed Jul. 6, 2016)), as well as information in response to infonnal and formal discovery. The parties are in the process of stipulating to documents and facts drawn from these productions. Respondent is also in the process of conducting depositions, which will lead to additional stipulations and further educate his experts. Respondent intends to supp01i his valuation with testimony from experts in the fields of economics, industry practice, valuation, and intellectual property, among others, who will opine on a number of relevant questions and provide the Court with a variety of relevant perspectives. Respondent intends this testimony to assist the Court in gaining a better understanding of the evidence presented and the various positions of the parties. Depending upon the evidence developed in this case and presented at trial, respondent may present additional evidence, including alternative methodologies, to address or rebut assertions advanced by Facebook. Moreover, depending upon the ultimate findings of the Court, the differential, if any, between the $13.9 billion NPV determined in the notice of deficiency and the potential range of arm's length results that respondent intends to present at trial could result in an increase in the deficiency for the 2010 taxable year. Accordingly, to the extent the Court's redetermination of respondent's adjustments in the notice of deficiency result in an increased deficiency, respondent will file an appropriate motion. See, e.g., Tax Court Rule 41. Docket No. 21959-16 B. - 14 - IDC Deductions A controlled participant's RAB share is equal to its reasonably anticipated benefits divided by the sum of the reasonably anticipated benefits of all the controlled participants. Treas. Reg. § 1.482-7T(e)(1 )(i). Reasonably anticipated benefits must be estimated over the entire period, past and future, of exploitation of the cost shared intangibles. Id. The reliability of an estimate of RAB shares depends, in part, upon the reliability of projections used in making the estimate. Id. § 1.482-7T(e )(2)(iii). In determining Facebook's and FIH's RAB shares, among other errors, Facebook inappropriately limited the period over which the cost shared intangibles would be exploited and understated the projected share of revenue growth in the ROW Territory. Respondent contends that the entire period of exploitation of the Cost Shared Intangibles is indefinite. Facebook's own income projections in the ROW Territory indicate higher growth than in the projections used in the EY CSA Report. Facebook's IDC deductions should therefore be reduced by the amount of additional cost sharing payments due from FIH based on Facebook's and FIH's correct RAB shares. Docket No. 21959-16 - 15 - RESPECTFULLY SUBMITTED, MICHAEL J. DESMOND Chief Counsel Internal Revenue Service Date: October 18, 2019 By: (signed) Justin L. Campolieta JUSTIN L. CAMPOLIETA Special Trial Attorney (LB&I) Tax Court Bar No. CJ1671 1600 Stewart Ave., Ste. 601 Westbury, NY 11590 Telephone: (516) 688-1754 justin.l.campolieta@irscounsel.treas.gov By: (signed) Huong T. Bailie HUONG T. BAILIE Special Trial Attorney (LB&I) Tax Court Bar No. DH0267 300 E. 8th St., Ste. 601 Austin, TX 78701 Telephone: (512) 499-5759 huong. t. bailie@irscounsel.treas.gov OF COUNSEL: ROBIN L. GREENHOUSE Division Counsel (Large Business & International) MICHAEL P. CORRADO Area Counsel JOHN M. ALTMAN Senior Level Counsel (SL)