Firms Beef Up Tax Practices in Silicon Valley as IRS Increases Scrutiny of IP Assets

Amy Miller

The Recorder

If there was any doubt about the value of patents to high-tech companies, Apple Inc.'s recent $1 billion victory over Samsung Electronics erased it.

Now the Internal Revenue Service wants a share of the action. The agency is beefing up staff, both nationally and in the San Francisco Bay Area, to look more closely than ever at how high-tech companies price intellectual property transactions involving their overseas subsidiaries.

And it's cracking down on tech companies in Silicon Valley that it suspects are dodging taxes on the profits their IP generates. Companies, however, aren't opening their wallets. They're fighting back, creating a lot more work for both tax planners and litigators. Tax lawyers say they're trying to help clients stay out of tax trouble, advising them to either work with the IRS before there's a dispute, or make sure they have their facts ready when the tax man arrives.

The IRS has made no secret of the fact that it's increasingly focused on what's called transfer pricing, or how a multinational company allocates income and expenses among itself and its foreign subsidiaries for tax purposes. Companies have long used transfer pricing to shift assets to countries with lower corporate tax rates, such as Ireland.

"There's been a substantial increase in controversy work, not just in Silicon Valley, but nationwide," said Kenneth Clark, who chairs Fenwick & West's tax litigation group and successfully defended Xilinx Inc. in one of the biggest transfer pricing cases in recent years. "We're not only seeing more cases, but also a greater degree of intensity in questioning by the IRS. From the taxpayers' perspective, that can mean a tremendous amount of additional work."

Now in addition to manufactured goods, the IRS is homing in on the transfer pricing of what it calls "intangible" intellectual property. Taxing an intangible asset like a patent, however, is no easy task, lawyers said.

There's much room for subjective interpretation about issues such as a patent's actual market value, and who generates more profit from the patent: the parent company in the U.S. where the idea was patented, or the factory in a foreign country that actually makes the products that the parent company sells?

"You end up having a battle over who is adding value," said John Ryan, a partner at Bingham McCutchen in Palo Alto who focuses on tax planning and audit defense. "And reasonable minds differ."

Several IP-heavy tech companies in Silicon Valley recently disclosed transfer pricing disputes with the IRS in their Securities and Exchange Commission filings, including Hewlett-Packard Co., Adobe Systems Inc., Cadence Design Systems Inc., Juniper Networks Inc. and Yahoo Inc., and the potential liabilities are substantial.

Last year, the IRS told Juniper Networks that it owes nearly $900 million in additional taxes based on cost-sharing arrangements related to the licensing of "intangibles," after auditing the company's 2004 to 2006 tax returns. The Sunnyvale, Calif.-based maker of network infrastructure equipment is fighting the tax bill and said in a recent SEC filing that the IRS' position is "inconsistent with applicable tax laws, judicial precedent and existing Treasury regulations."

TAXING TIMES

All these disputes are creating opportunities for law firms looking to expand their tax practices in Silicon Valley. Earlier this month Skadden, Arps, Slate, Meagher & Flom relocated two tax partners from Washington, D.C., to Palo Alto. The firm also hired Matthew Kramer, a former attorney with the IRS, as counsel. Focusing on the semiconductor and technology industries, he negotiated transfer pricing matters between foreign governments and multinational corporations and the IRS.

"We didn't have a [tax] presence in Silicon Valley, and some of our clients here had asked us why we didn't," said Skadden partner Julia Kazaks, who represents both corporate clients and individuals.

Last year, Bingham McCutchen, which acquired a top national tax practice when it merged with McKee Nelson in 2009, cherry-picked three partners from different firms to set up its Silicon Valley tax practice, including Ryan, formerly a partner at McDermott Will & Emery, and Robert Kirschenbaum, who had helped Washington, D.C.-based Miller & Chevalier, which specializes in tax planning and controversy work, open a Palo Alto office two years ago.

"To be able to compete in the marketplace, you have to have talent that is readily accessible," said Kirschenbaum, a former team leader for the IRS' Advance Pricing Agreement Program. "Clients expect on-the-ground resources."

LOOKING FOR REDEMPTION

The IRS has something to prove, lawyers such as Kirschenbaum said. It wants to make companies believe that if they're too aggressive when filing their tax returns, they'll face stiff consequences, and not just a painful audit.

The IRS is actively looking for the next big transfer pricing case it can take to court to redeem the agency after losing two major cases in court in the past few years, lawyers said.

In December 2009, the IRS lost a case it had lodged against software maker Veritas Software Corp., which had been acquired by rival Symantec Corp. in 2005. Veritas had licensed some of its IP to an offshore affiliate in Ireland back in 1999 under a cost-sharing agreement. The IRS said the deal understated the market value of the royalties involved by $2.4 billion and told the company it owed more than $1 billion in taxes, penalties and interest. The U.S. Tax Court ruled in favor of Symantec, calling the IRS' calculations "arbitrary, capricious and unreasonable."

A few months later, the IRS lost its transfer pricing case against semiconductor manufacturer Xilinx. Clark and fellow Fenwick tax attorneys Ronald Schrotenboer and Tyler Baker persuaded the U.S. Court of Appeals for the Ninth Circuit to affirm a U.S. Tax Court decision -- a year after the same panel had voted to reverse it. The 2-1 decision concluded the IRS erred in assessing penalties for improperly accounting for the cost of stock options as part of an international tax arrangement.

Although the IRS called the Ninth Circuit's opinion "erroneous," it said it accepted the result, while rejecting the court's reasoning.

Clark said he and other tax attorneys are worried that the IRS is trying to rewrite the "arms length" standards that govern transfer pricing and replace them with a standard formula, instead of looking at the individual facts of each case.

"The IRS, from our point of view, is disagreeing with court decisions that are determined by real-world evidence," Clark said. "And that is a great concern."

The IRS now needs to win a case "to show taxpayers that they are willing and able to go the mat if they need to," said Craig Sharon, former director of the IRS' Advance Pricing Agreement Program who is now a tax partner at Bingham McCutchen in Washington, D.C. "But that threat isn't very credible if they can't win in court."

So the agency has more than doubled its staff of transfer pricing specialists, both nationally and in the Bay Area, Sharon said. And IRS officials have told lawyers, including both Clark and David Forst, head of Fenwick's tax practice, to expect even more hires on the West Coast soon.

Officials at the IRS did not respond to requests for comment.

Clark and other tax lawyers say they're already seeing bigger IRS teams at audit reviews and dispute resolutions involving high-tech companies. Cooley's Stephen Gardner, head of the firm's tax controversy practice, and tax litigator Kathleen Pakenham, both based in New York, recently resolved two tax disputes for Silicon Valley companies. And at every meeting, they said, the IRS would show up with about 15 people.

"And all of them had some say in how the cases would be resolved," Pakenham said. "That contributed mightily to the time it took to resolve the case. The system has gotten tremendously bogged down, and it now takes a much longer time to take a case from inception to conclusion."

Tax controversy lawyers say they're often brought in early now, in an effort to head off trouble. They'll prepare submissions to the IRS' Advance Pricing and Mutual Agreement Program and other foreign governments to explain what their transactions are and how they're valued. The APMA Program lets U.S. multinationals request approval for their transfer pricing methodology before issues arise during an audit.

But some companies still aren't convinced that's a viable option, Ryan said. For example, Veritas' problems with the IRS began when it approached the agency on its own to approve its transfer pricing methodology. Instead of getting approval, discussions fell apart, and the case ended up in court.

"That's caused some hesitation," Ryan said. "Veritas was ultimately victorious, but only after years of litigation."

Companies that don't want to ask the IRS for approval ahead of an audit are advised to get their defenses ready. Companies need to coordinate their documentation of pricing in every country where they operate and hire economists and tax experts to document and analyze their transfer pricing method well in advance of an audit.

"As you can imagine, for multinational companies, that can be incredibly burdensome," Ryan said.