United States Seeks Compelled Production by Federal District Court Order Against Facebook, Inc. With Respect to “Billions of Dollars” of Undervalued Intangibles Transferred Offshore

By: Jerald David August

Summons Enforcement Action Against Facebook Filed In Federal District Court

The government recently filed a summons enforcement proceeding on July 6 in The United States District Court for the Northern District of California against Facebook Inc., 16-cv-o3777.[1] The enforcement action taken by the government became necessary since the taxpayer recently refused to turn over summoned tax and business records related to Facebook’s transfer of its global rights of many of its intangible assets, situated outside the United States and Canada (but not within the United States and Canada), to a subsidiary (Facebook Ireland Holdings Limited or “Facebook Ireland”) situated in Ireland, which has a corporate tax rate approximately 1/3 (12.5%) of the U.S. corporate income tax rate (35%). The relevant audit year at present is 2010 which is alleged to expire on August 1, 2016. Other years are presumably under review as well, including the years after 2010. 

Facebook’s Failure to Respond to Recent Summons Pertaining to Transfer of Valuable Intangibles to Irish Subsidiary

The IRS audit group summoned Facebook representatives to appear on June 17 to deliver the requested records but Facebook decided to stonewall the request and did not appear. Facebook’s refusal to turn over what the government may consider to be key information on the valuation of the transferred intangibles for purposes of Section 482 and other related provisions comes at a time when the statute of limitations for 2010 is due to expire this month, i.e., July 31, 2016. Facebook perhaps is playing a high stakes and a risky game against the Commissioner indeed given the potential magnitude of the case and the fact that other years are still open with the same underlying issues present. [1]

In general, the bundle of rights in issue pertain to the company’s online platform, which permits users to communicate with each other and allows advertisers to reach such users. It has been reported in the business press that for U.S. income tax purposes, Facebook understated the value of the transferred intangibles by billions of dollars. More specifically, the IRS wants to see the specific transfer pricing studies and cost sharing arrangement documentation with respect to the outbound transfers.

Revenue Agent’s Stone’s Affidavit In Support of the Motion to Compel Production

The Revenue Agent, Ms. Stone, issued six (6) IRS summonses on June 1, 2016, for Facebook to produce described books, records, and other documents. In a supporting affidavit to the Complaint filed with the Federal District Court, the Revenue Agent stated, in relevant part:

15. The 2010 examination was opened in January 2013 and added to the already-open examination cycle for the 2008 and 2009 tax years.

16. Facebook's tax return for 2010 reported royalty income that I learned came from transfers of intangible property to a controlled foreign corporation, Facebook Ireland Holdings Unlimited. Facebook Ireland Holdings Unlimited was previously known (as of September 15, 2010) as Facebook Ireland Holdings Limited ("Facebook Ireland").

17. According to documents obtained during the examination, Facebook, Inc. ("Facebook U.S.") entered into the following agreements with Facebook Ireland effective September 15, 2010 (collectively, the "2010 Agreements"):

a. User Base Transfer and Marketing Intangibles License Agreement;

b. Online Platform Intangible Property Buy-In License Agreement;

c. Agreement to Share Costs and Risks of Online Platform Intangible Property Development.

18. The IRS is examining matters arising under the 2010 Agreements, which, among other things, purported to transfer the rights associated with Facebook's worldwide business to Facebook Ireland, with the exception of the United States and Canada, i.e., the “rest-of-world” rights or ROW rights. Specifically, the 2010 Agreements purported to transfer Facebook's ROW rights user base to Facebook, Ireland. The 2010 Agreements also purported to transfer rights to the intangible property constituting Facebook's "online platform." The online platform allowed users to communicate, allowed Facebook to store user information and allowed advertiser/developers to reach those users. The 2010 Agreements also purported to license rights in "marketing intangibles" to Facebook Ireland. Finally, under the 2010 Agreements, Facebook U.S. and Facebook Ireland purported to share future costs to jointly develop the Facebook online platform.

19. Facebook retained Ernst & Young (E&Y) to value these transfers for income tax purposes including for transfer pricing purposes. In carrying out this assignment, E&Y selected different methodologies to value those intangibles, on the theory that the user base, online platform, and marketing intangibles could be reliably measured on a stand-alone basis. Comment: Perhaps this is the gravamen of any resulting case which presumably will follow.

21. During 2013 and 2014, the IRS gathered information from Facebook in order to understand the 2010 Agreements, E&Y's valuation, and the functions performed by U.S. and foreign entities. The IRS issued a number of information document requests ("IDRs"), reviewed numerous public documents, and conducted interviews of certain Facebook employees. Several of those employees indicated that the user base, online platform, and marketing intangibles were interdependent and it would be difficult to isolate one from the other.  But that approach presumably was not adopted by E&Y. The information gathered suggested to the IRS examination team that the E&Y approach to valuing Facebook's transferred intangibles on a stand-alone basis was problematic.

22. On April 17, 2015, the IRS examination team presented its preliminary examination position to Facebook.

23. On May 27, 2015, Facebook responded to the IRS team's presentation with a presentation of its own.

24. In its May 27, 2015 presentation, Facebook rejected the IRS team's preliminary position and provided additional arguments and insights regarding the transfers.

25. Following the May 27, 2015 presentation, the IRS examination team gave careful consideration to the matters that Facebook raised and determined it needed a better understanding of the nature and value of Facebook's user base, distinctions Facebook was drawing between its online platform and its user base, suggestions made by Facebook that Facebook Ireland had developed its own user-based intangibles prior to the 2010 Agreements, risks associated with competitive threats to Facebook's business, and the role of mobile access to the Facebook platform.

26. Within a month of Facebook's May 27, 2015 presentation, the IRS examination team informed Facebook that it was considering retaining experts to assist with its understanding of the transfers. The IRS examination team's preliminary positions suggested that the E&Y valuations of the transferred intangibles were understated by billions of dollars. (emphasis added)

27. Due to budgetary constraints, the IRS team could not commence the lengthy expert retention process until after October 1, 2015. Because of this, the IRS team asked Facebook to extend the statute of limitations, to afford the team time to confer with experts and follow up with any additional requests for information to Facebook. Facebook, however, refused to afford the IRS team any further extensions of time, unless the IRS agreed to unacceptable conditions. (emphasis added)

28. On January 13, 2016, the IRS issued IDRs one set of which specifically requested documents considered or reviewed by Facebook U.S. and Facebook Ireland regarding 2010 intercompany agreements. The documents were needed, among other reasons, to provide insight into the nature of the transferred user base and the distinction between user-based intangibles and online platform intangibles. Facebook responded by producing only three e-mails with attachments. In March 2016, Facebook explained that it had narrowly construed this IDR request to be limited to documents reviewed by both Facebook U.S. and Facebook Ireland, resulting in minimal document production. Facebook indicated that the IRS would have to start over with issuance of a new set of IDRs if the IRS wanted a more comprehensive response. Could this be construed as “stalling” and pushing the audit out to close to the statute of limitations for 2010? Given the limited time remaining before the statute of limitations would expire, the IRS issued a summons seeking similar information it needed that was not provided by Facebook because of its narrow interpretation of the IDRs.  See summons, Exhibit 1.

30. On April 7, 2016, the IRS issued additional IDRs to obtain business information from Facebook that may be relevant to valuing the ROW transferred intangibles. Key topics addressed by these IDRs included:(i) documents regarding business risks associated with Facebook's competitors; (ii) documents regarding company and budget goals, and Facebook's decision to make Dublin, Ireland its international headquarters; (iii) documents regarding growth in the user base and how to measure that growth;(iv) documents used by advertisers to target users; (v) documents regarding features built into the online platform; (vi) documents regarding hiring of international employees to expand user growth; (vii) documents regarding international sales offices; (viii) documents regarding products built for advertisers; (ix) documents regarding developers who build user applications; and (x) documents regarding support services for the user base. The Affidavit further stated Facebook has not provided any documents to the IRS examination team in response to the recent set of IDRs 178-187 (shown in this 30 as (i)-(x)). Although Facebook proposed search terms (to search for electronically stored information of individual custodians), Facebook predicated any production on obtaining an agreement under Federal Rule of Evidence 502. This approach was summarily rejected by the Service.

32. Given the July 31, 2016 expiration of the statute of limitations, the IRS also issued additional summonses (Exhibits 2-6) to Facebook demanding the documents sought by IDRs 178-187.

33. The documents requested by the summons attached as Exhibit 2 primarily seek the information requested in IDRs 178-179. The documents sought by the requests in this summons may be relevant to understanding the risks associated with competitive threats to Facebook's business and Facebook executives' internal views regarding the transferred intangibles, and thus may be relevant to determining the value of the transferred intangibles.

Other recent IDRs issued by the Service with respect to the transfer of intangibles were similarly listed, identified and acknowledged as not complied with by Facebook.

The summonses were served on the CFO, Mr. Wehner. Facebook was to appear on June 17, failed to appear and did not produce the records requested. In its summons enforcement pleading, the IRS set forth the necessary predicates for the enforcement order to be issued by the Court.  

It will be quite interesting to see what the government does with respect to the July 31, the statute of limitations for 2010 which will expire on July 31. Perhaps it will issue a notice of deficiency based on its 2015 status report to Facebook and further take the opportunity to allege the “stall” so to speak in additional document production. Facebook’s tax counsel may respond that the audit has been unduly prolonged and that the government needs to determine just what it will do for 2010 now.  Section 6503(j), however, provides an extension of the statute of limitations with respect to certain “designated summons” issued to a corporation with respect to which the corporation is being examined in accordance with its terms. [2]

What’s At Stake?

In mid-2015, the IRS explained to Facebook that its preliminary findings indicated that the outside accounting firm had substantially undervalued the transferred assets and as further reflected in the three licensing agreements between Facebook and Facebook Ireland.  By “substantially undervalued” the government commented that such was in the billions of dollars. This could translate into substantial underreporting of taxable income for example, under Section 367(d), or greatly reduce the amount of license payments that would be required by the licensees of the transferred ROW rights.  

The additional information requests made by the Service was to further understand the taxpayer’s position in segregating out the user base, online platform, and marketing intangibles on a stand-alone basis. Among the documents the IRS wants agency are internal communications between executives and managers about the need for the formation of these divisions, and records that show the countries or geographical regions of the users whom the operations divisions supported. This suggests that the IRS may be investigating where the work actually took place, in order to determine where the related income was earned.  As an aside, the government admitted it did not work up the case earlier as it had suffered from budgetary constraints and could not begin the process of hiring an expert until October 2015. 

Well, what did Facebook say to its investors or potential investors in its SEC filings? Indeed in its most recent 10-K filed with the SEC, Facebook reported that the tax years 2008 to 2013 are under audit. Its tax reserves jumped from $1.19 billion as of December 31, 2014 to $2.46 billion as of December 31, 2015.  There was little explanatory information for the increase.

The government’s expected line of attack is the accounting firm’s methodology in valuing the transferred ROW intangibles for 2010 (and subsequent years). The Ernst & Young valuation used different methods “on the theory that the user base, online platform, and marketing intangibles could be reliably measured on a stand-alone basis”.

There has been some commentary that the government’s seeking judicial enforcement of the summons issued in this case marks a shift in enforcement tactics against MNEs.

There will undoubtedly be more to report about with respect to this case.

[1] See 26 U.S.C. §§6420(e)(2), 6421(g)(2), 6427(j)(2), 7210.

[2] The term “designated summons” is defined under §6503(j)(2)(A). 

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