Amazon.com, Inc. & Subsidiaries, TC Memo 2014-149
The Tax Court has denied an online retail corporation’s motion for summary judgment, finding that IRS didn’t abuse its discretion in allocating 100% of certain costs to intangible development costs (IDCs). The Court found that the taxpayer, which had entered a cost-sharing agreement (CSA) with an affiliate in respect to IDCs, first had to show that the costs at issue were “mixed” – i.e., allocable in part to IDCs and in part to general operating costs – before applying an allocation formula to them. Click here for the Opinion of the Court.
Background. A cost-sharing agreement (CSA) is defined by Reg. § 1.482-7(a)(1) as an agreement under which the parties “agree to share the costs of development of one or more intangibles in proportion to their shares of reasonably anticipated benefits from their individual exploitation of the interests in the intangibles assigned to them under the arrangement.” Under Reg. § 1.482-7(b)(2) and Reg. § 1.482-7(f)(1), a participant must calculate its share of IDCs on the basis of factors that can reasonably be expected to reflect that participant’s share of anticipated benefits. A participant’s costs of developing intangibles, in turn, means “all of the costs incurred…related to the intangible development area,” and “[i]f a particular cost contributes to the intangible development area and other areas or other business activities, the cost must be allocated between the intangible development area and the other areas or business activities on a reasonable basis.” (Reg. § 1.482-7(d)(1))
Facts. Amazon.com, Inc. (Amazon) is a Seattle-based online retailer that, with its U.S. affiliates, executed a CSA with a European affiliate. In the CSA, which was intended to comply with Reg. § 1.482-7(b), the parties agreed to share IDCs.
Amazon’s cost accounting system during 2005-06 did not specifically segregate IDCs from other operating costs. It instead developed a formula and applied it to allocate to IDCs a portion of the costs accumulated in various “cost centers” (essentially, accounting classifications to manage and measure operating expenses) under its method of accounting. The main issue in this case concerns the “Technology and Content” (T&C) call center. According to Amazon’s 2005 SEC Form 10-K, the T&C category expenses consisted “principally of payroll and related expenses for employees involved in research and development, including application development, editorial content, merchandising selection, systems and telecommunications support, and costs associated with the systems and telecommunications infrastructure.” The T&C category was a “rollup” of numerous individual cost centers, and for some calendar quarters, more than 200 individual cost centers were included within it.
Amazon took the position that a portion of the costs accumulated in the T&C category were allocable to IDCs using an allocation formula it developed. IRS disputed this allocation (and made other adjustments not at issue in this case) and determined that 100% of T&C category costs constitute IDCs. As a result of this and the other adjustments, it determined under Code Sec. 482 substantial deficiencies in Amazon’s income tax for 2005 and 2006 and issued a notice of deficiency.
On June 13, 2014, IRS filed a motion to compel production of documents relating to Amazon’s cost allocations under Reg. § 1.482-7(d)(1), to which Amazon objected as unduly burdensome. On July 2, 2014, the Tax Court denied IRS’s motion in its then-current form, but stated in its order that IRS “is entitled to discovery as to the facts underlying petitioner’s cost allocations, as to whether costs within the T&C category are “mixed” as petitioner contends, and as to the appropriateness of the formula petitioner has used to allocate T&C category costs to IDC.”
Amazon filed a motion for partial summary judgment, contending that it is entitled to judgment as a matter of law on the issues of (i) whether IRS abused its discretion by allocating 100% of the T&C costs to IDCs under Reg. § 1.482-7(d)(1), and (ii) whether Amazon is entitled to apply an allocation method to determine IDCs under the governing regs. Amazon argued that, by simply including 100% of the T&C costs, IRS violated Reg. § 1.482-7(d)(1)’s mandate to not take into account “[c]osts that do not contribute to the intangible development area.” IRS, in turn, responded that Amazon failed to establish that any of the T&C category costs contributed to business activities other than intangibles development.
Summary judgment denied. On the issue of whether IRS erred in allocating 100% of certain costs to IDCs, the Tax Court easily concluded that there were genuine disputes of material fact precluding partial summary judgment. It found that Amazon had failed to establish that a “nontrivial” amount of the T&C category costs should be categorized as other than IDCs, that IRS had sought and was continuing to seek discovery on the issue, and that until Amazon made such a showing, the Court could not rule as to whether IRS abused its discretion.
Amazon argued that it wasn’t required under the regs to show that the T&C costs were mixed before applying an allocation formula, and that it only had to prove that the formula it developed and applied was reasonable. However, the Court found that Reg. § 1.482-7(d)(1) essentially operated under the assumption that the status of costs was mixed, as demonstrated by its language allowing costs to be allocated only if a “particular cost” contributes to the intangible development area.
With respect to the second issue, the Tax Court found that its holding above precluded summary judgment as to whether Amazon was entitled to apply an allocation method. The Court stated that Amazon would have to first show that the T&C costs were mixed before it could justifiably use an allocation method to determine IDCs under Reg. § 1.482-7(d)(1). Accordingly, the Court denied Amazon’s motion for partial summary judgment on both issues.