Friday, October 14, 2016

Facebook responds to IRS court filings

Back in July we briefly looked at court filings the IRS had made into Facebook’s 2010 tax return in the US.  At the time Facebook had yet to respond; but they have now.

Earlier this week Facebook filed their own petition and there is a useful summary here.

Although the additional tax claimed by the IRS for 2010, $1.7 million, is relatively small there are a number of offsetting factors that give rise to the net figure.  Central to the case is the transfer of economics rights of  intellectual property owned by Facebook Inc. to Facebook Ireland Holdings in September 2010 after which date the two companies entered a cost-sharing agreement (CSA) for the continued development and licensing of Facebook’s technology.

As a result of the transfer and the cost-sharing agreement Facebook Ireland Holdings is granted the license to use Facebook’s technology outside of North America.  The IRS make some minor quibbles about the treatment of payments under the CSA but their major issue is the valuation of the IP that existed at the time the CSA for future developments was entered into.

Facebook Inc. put a net present value of $6.7 billion on the intangibles and calculated royalty payments on the basis of that.  The IRS meanwhile have assessed that the intangibles had an NPV of $13.9 billion at the time.  There is quite a substantial gap. In a separate filing related to discovery Facebook claim that their answer was “overly generous”:

Facebook explained that once the IRS errors were corrected, the IRS economic model yielded essentially the same value that Facebook used to prepare its tax returns, or even that Facebook’s tax return position was overly generous to the IRS.

The rights to the intangibles were transferred to Facebook Ireland Holdings on September 15, 2010 and the IRS estimate that an additional royalty payment based on their valuation of $85 million should have been made to Facebook Inc. for the remainder of the year.  Over a full year this would equate to additional payments of around $300 million, assuming payments on a straight-line basis.

So the IRS have revised up Facebook Inc.’s gross royalty income for 2010 by this $85 million (and will likely seek upward revisions of $300 million for a number of years after if the case is upheld).  One would expect that this would have led to a larger tax bill for Facebook Inc. for 2010 of around $30 million (assuming the 35% US CIT rate applies) but the IRS made a number of other adjustments.

Most of these were minor but the biggest of them was that the IRS increased Facebook Inc.’s deduction for Net Operating Loss by around $700 million.  The use of this deduction almost fully offset the additional tax due on the increased royalties.

The IRS adjustments mean that Facebook Inc. will not have the Net Operating Loss deductions applied to 2010 available for future periods and will face higher tax in the US due to the increased royalties that Facebook Ireland Holdings will have to pay. And this latter point highlights the key aspect of many of the global tax strategies used by US MNCs - getting the economic rights to IP developed in the US into entities outside the US (or at least considered ‘offshore’ for US tax purposes).  In this instance ‘offshore’ seems to be Grand Cayman but mentions of that in all the filings to date: nil.

Anyway, if the IRS require much larger payments to Facebook Inc. for the technology developed in the US then Facebook will have much larger US tax payments.  As the company itself says:

On July 27, 2016, we received a Statutory Notice of Deficiency (Notice) from the IRS relating to transfer pricing with our foreign subsidiaries in conjunction with the examination of the 2010 tax year. While the Notice applies only to the 2010 tax year, the IRS states that it will also apply its position for tax years subsequent to 2010, which, if the IRS prevails in its position, could result in an additional federal tax liability of an estimated aggregate amount of approximately $3.0 - $5.0 billion, plus interest and any penalties asserted. We do not agree with the position of the IRS and will file a petition in the United States Tax Court challenging the Notice. If the IRS prevails in the assessment of additional tax due based on its position, the assessed tax, interest and penalties, if any, could have a material adverse impact on our financial position, results of operations or cash flows.

In theory, of course, this is tax that Facebook would have to pay anyway.  But it has set up a structure, as many other companies have, to defer the tax due on earnings made outside the U.S. until those earnings are “repatriated” to a U.S.-registered entity in the company.  Facebook does not make a provision for this deferred tax in its accounts (one reason being that it does not intend to repatriate the profits) so actually paying this tax will have a “material adverse impact” on its operations.