Facebook, the IRS, and the Commensurate With Income Standard

Abstract

The IRS in 2016 issued a notice of deficiency and a penalty assessment to Facebook Inc. for undervaluing its 2010 cost sharing arrangement (CSA) buy-in payment by more than $7 billion (later increased in October 2019 to $13 billion), and recharacterized the entire buy-in payment as a platform contribution transaction. Facebook has challenged this adjustment in tax court, and told investors the taxes at issue could be as much as $9 billion, exclusive of penalties and interest. The IRS claimed that this adjustment was necessary in order to ensure compliance with the Commensurate with Income (CWI) standard that was added to Internal Revenue Code Section 482 by the Tax Reform Act of 1986. However, the IRS did not actually measure Facebook’s compliance with the CWI standard, as defined by the § 1.482-7(i)(6) periodic adjustment regulations which came into effect in 2009. This paper provides an overview of the CWI standard and related periodic adjustment regulations, and applies these regulations to Facebook’s cost sharing outcomes using available information through its 2019 fiscal year. The results suggest that Facebook’s buy-in payment was likely overpriced (and therefore likely compliant with the CWI standard) for the years at issue in the tax court proceedings. This is the opposite of the IRS examination result. However, extending these calculations to 2019 reveals that Facebook’s cost sharing results likely trigger a periodic adjustment in years subsequent to those at issue in this case. The paper examines the IRS reluctance to apply the periodic adjustment rules, and other applicable laws such as the economic substance doctrine, tax shelter and others to cost sharing arrangements – especially when the foreign cost sharing affiliate is a holding or shell company with little or no underlying substance. The paper also examines what appears to be a wide disparity between the IRS examination of Facebook’s cost sharing arrangement and that of a similar arrangement at Google Inc. a decade earlier, in which the IRS explicitly approved Google’s arrangement with an Advance Pricing Agreement, despite exhibiting much less substance and much greater offshore profit shifting than Facebook’s arrangement.

Keywords: Transfer Pricing, Auditing, Tax Compliance, Tax Enforcement

JEL Classification: F23, H26, H32, H83, K34, M42