Facebook Faces Billion-Dollar IRS Audit Over Irish Restructuring

The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.

By Dolores W. Gregory

July 7 — The IRS suspects that Facebook Inc. understated by billions of dollars the value of intangibles transferred to an Irish subsidiary as part of a 2010 restructuring, filings in federal district court reveal ( United States v. Facebook, Inc., N.D. Cal., No. 3:16-cv-03777, petition filed 7/6/16 ).

The Internal Revenue Service filed a petition July 6 to the U.S. District Court for the Northern District of California, asking it to enforce summonses that directed company officials to produce books, records and other data as part of an audit of the company's intercompany pricing.

The audit team summoned Facebook officials to a June 17 meeting in San Jose to deliver the requested records, but the company didn't show up, according to court filings. The IRS then filed another petition to seek enforcement of the summonses.

Facebook is the latest U.S. multinational to fall under IRS scrutiny for shifting assets to low-income or no-income jurisdictions offshore. The transfer of high-value intangibles to a subsidiary in places like Ireland and the Cayman Islands is regarded as a potential mechanism for tax avoidance when the subsidiary pays far less than the assets are worth.

A company spokesman declined to respond to specific questions, but said that “Facebook complies with all applicable rules and regulations in the countries where we operate.”

Restructuring Under Scrutiny

The IRS audit is looking closely at a 2009-10 restructuring that granted Facebook's Irish subsidiary the rights associated with the parent's worldwide business outside of North America. The deal transferred the U.S. parent's user base outside the U.S. and Canada to the Irish subsidiary and transferred the rights to the intangible property that constitutes Facebook's “online platform.”

The IRS thinks Facebook's tax adviser, Ernst & Young LLP, severely undervalued the intangibles involved in the restructuring, according to court documents.

The agency is seeking more information to clarify the distinctions between user-based intangibles and online platform intangibles. It also seeks business information that may be relevant in valuing the transferred intangibles, including documents related to:

  •  business risks associated with competitors,
  •  growth in the user base,
  •  advertising to target users,
  •  features built into the online platform,
  •  hiring of international employees to expand user growth,
  •  developers who build user applications, and
  •  support services for the user base.

Value of Intangibles

Facebook is an $18 billion company with worldwide operations; if the IRS prevails, Facebook could face a massive bill for back taxes—not just for the tax year under audit, but for subsequent years as well.

In previous filings to the Securities and Exchange Commission, most recently on April 28, Facebook reported that its 2008 to 2013 tax years are under examination by the IRS. The company also reported that its uncertain tax positions—reserves the company is required to record for tax positions it thinks it may not be able to maintain if challenged—doubled in 2015, from $1.19 billion as of Dec. 31, 2014, to $2.46 billion as of Dec. 31, 2015. The company didn't say why it increased those positions, or what tax areas they involved.

However, the court filings show that in mid-2015, the IRS presented Facebook with its preliminary findings, indicating that EY had undervalued the transferred intangibles.

A declaration filed by an examining IRS agent states that the transactions at issue are covered by a cost-sharing agreement. The agent, Nina Wu Stone, said the transactions came to light when the IRS examined the company's 2010 tax return and found royalty income from transfers of intangibles to Facebook Ireland Holdings Unlimited, a controlled foreign corporation, that hadn't been reported earlier.

Documents obtained by the IRS show that on Sept. 15, 2010, Facebook entered into three agreements with Facebook Ireland:

  •  a user base transfer and marketing intangibles licensing agreement,
  •  an online platform intangible property buy-in-licensing agreement, and
  •  an agreement to share costs and risks of online platform intangible property development.

EY Method Under Scrutiny

In valuing the transferred intangibles, Stone said, EY selected different methods “on the theory that the user base, online platform, and marketing intangibles could be reliably measured on a stand-alone basis.”

During the audit, the IRS gathered information from Facebook to understand the 2010 agreements, EY's valuation and the functions performed by the U.S. and foreign entities. Several employees interviewed by the agency indicated that it would be difficult to isolate the user base, online platform and marketing intangibles from one another.

The examiners concluded that EY's approach to valuing Facebook's intangibles on a stand-alone basis was problematic. In April 2015, the exam team presented Facebook with its conclusions that the intangibles had been undervalued by “billions of dollars.”

In May 2015, Facebook rejected the IRS's position and provided additional arguments. The IRS then determined that it needed more information from Facebook in order to understand the distinctions the company was drawing between its online platform and its user base, as well as to make sense of Facebook's suggestion that its Irish subsidiary had developed its own user-based intangibles before the 2010 agreements.

The agency also needed to better understand the risks associated with competitive threats to Facebook and the role of mobile access to the company's platform, Stone said.

The examiners informed the company that the IRS intended to retain experts to assist it with understanding the transfers, but because of budgetary constraints, the agency couldn't begin this process of expert retention until October 2015.

The agency asked Facebook to extend the statute of limitations, which expires on July 31, but the company refused unless the IRS agreed to certain conditions that the agency deemed unacceptable.

Irish Subsidiary

According to court documents, Facebook formed its Irish subsidiary in 2009 “to centralize in Ireland the operation of the Facebook business outside North America.” Effective Sept. 15, 2010, Facebook U.S. granted Facebook Ireland the rights to intangible property related to its online platform, online marketing intangibles and online communities of social networking users, advertisers and developers.

An operating license agreement with the Irish subsidiary granted it the right to develop the online platform as a social networking website, to maximize the number of users, advertisers and developers, as well as to increase the volume and amount of advertising sold—and to maximize profits—outside the U.S. and Canada.

The restructuring apparently also involved the transfer of support services provided to users and developers, who are third parties that use Facebook's platforms or application interfaces to build games or applications.

In 2006, Facebook—which is based in Menlo Park, Calif.—had a division known as community operations, or user operations, whose employees provide support by answering questions, testing online products and preparing “bug” reports for product managers and engineers, documents show.

By 2009, the company established a user operations division in Dublin and in 2010, it established similar operations in Texas and India.

Among the documents the agency seeks 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. Such details suggest the IRS may be investigating where the work actually took place, in order to determine where the related income was earned.

With assistance from Alex M. Parker in Washington.

To contact the reporter on this story: Dolores W. Gregory in Washington at dgregory@bna.com

To contact the editor responsible for this story: Molly Moses at mmoses@bna.com

For More Information

Text of the IRS petition is at http://src.bna.com/gBA.

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