# United States Tax Court > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3Aed056fbcb2711b00 ## Record - **Collection:** Agency decision - **Document type:** Agency decision ## Text United States Tax Court 164 T.C. No. 9 FACEBOOK, INC. & SUBSIDIARIES, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent ————— Filed May 22, 2025. Docket No. 21959-16. 1 ————— On September 15, 2010, P entered into a cost sharing arrangement (CSA) under Temp. Treas. Reg. § 1.482-7T with S, its Irish subsidiary. The CSA required P and S to engage in a platform contribution transaction (PCT), compensating each other for the value of any “platform contributions” made. See Temp. Treas. Reg. § 1.482-7T(a)(2), (b)(1)(ii), (c)(1). Pursuant to the PCT, P and S granted each other the right to use any existing online platform technology in their respective territories: the United States and Canada for P and the rest of the world (ROW territory) for S. In a separate agreement, P granted S all rights relating to P’s existing users, advertisers, and third-party application developers in the ROW territory, including their data. P also granted S the right to use its marketing intangibles in the ROW territory. S made payments to P for 2010 on the basis of P’s valuation of these agreements at a September 2010 net present value (NPV) of $6.3 billion. In addition to a PCT payment to compensate P for its upfront PCT contributions, S also was required by the regulations to make (and commit to making annually) cost 1 Petitioner has a related case at Docket No. 12738-18 in which tax years 2011 and 2013 are at issue. Served 05/22/25 2 sharing transaction (CST) payments to compensate P for ongoing intangible development costs (IDCs) in proportion to its share of reasonably anticipated benefits (RAB share) from exploiting cost shared intangibles. See id. para. (b)(1)(i). S made a CST payment for 2010. R’s valuation expert selected the income method as the best method for valuing contributions to the CSA, see id. para. (g)(4), and opined that the NPV of the assets P contributed to the CSA was $19.945 billion. Because this valuation increased S’s required PCT payment, R made a PCT allocation for 2010. R also increased S’s RAB share used to determine S’s CST payment for 2010. P contends that the income method cannot apply because both P and S made “nonroutine platform contributions.” See id. subdiv. (i)(D). P also argues that R selected the wrong values for three key inputs to the income method: revenue projections for the ROW territory, the appropriate discount rate for those projected revenues, and S’s best realistic alternative to cost sharing. P argues that once those inputs are corrected, R’s income method produces a result consistent with P’s valuation. See Treas. Reg. § 1.482-1(e). P simultaneously maintains that the income method cannot be the best method because it cannot produce an arm’s-length result and that the regulations are invalid because they limit the expected return on IDCs to a discount rate reflecting marketcorrelated risks. P also challenges R’s adjustments to P’s and S’s RAB shares. 1. Held: Only one CSA participant—P—made a nonroutine platform contribution and therefore the income method in Temp. Treas. Reg. § 1.482-7T(g)(4) can apply. 2. Held, further, R implemented the income method unreasonably, by selecting the wrong inputs, and therefore abused his discretion under I.R.C. § 482 by reallocating income to P with respect to the PCT payment to the extent of the wrong inputs. 3 3. Held, further, with reliable inputs, the income method is the best method and produces an arm’s-length PCT payment value. 4. Held, further, Temp. Treas. Reg. § 1.482-7T reasonably implements I.R.C. § 482 and is not invalid. 5. Held, further, Temp. Treas. Reg. § 1.482-7T(i)(6) does not operate as a safe harbor and therefore does not preclude R from making a PCT allocation under paragraph (i)(3). 6. Held, further, R did not abuse his discretion under I.R.C. § 482 by adjusting P’s and S’s RAB shares to determine the required CST payment. 7. Held, further, R’s method for calculating RAB shares is consistent with Temp. Treas. Reg. § 1.482-7T and provides the most reliable estimate of reasonably anticipated benefits, using corrected inputs. ————— Andrew P. Crousore, Scott H. Frewing, Mark A. Oates, Susan E. Ryba, George M. Clarke III, Mark T. Roche, Robert C. Hammill, Cameron C. Reilly, Courtland L. Roberts, Amanda T. Kottke, Julia T. Chiao, Yea-Jin A. Chang, Parisa Manteghi Griess, Ashley H. Zepeda, Eric M. Biscopink, Don Crawford, Gregory G. Garre, Miriam Louise Fisher, Melissa A. Sherry, Eric J. Konopka, Shannon C. Fiedler, Robert S. Walton, and Ronald Gee Ming Dong, for petitioner. Justin L. Campolieta, Michael S. Coravos, Ronald S. Collins, Jr., Victor W. Zhao, Laurie A. Humphreys, Timothy L. Smith, Eli Hoory, Christine S. Irwin, Elizabeth C. Turnbull, John M. Altman, Kathryn F. Patterson, Richard L. Wooldridge, Travis Vance, Henry C. Bonney, Huong T. Bailie, Katelynn M. Winkler, and Meenu Kapai, for respondent. 4 TABLE OF CONTENTS FINDINGS OF FACT ............................................................................ 13 I. Facebook’s social networking platform .......................................... 15 A. B. Users ........................................................................................ 16 1. Product development ....................................................... 17 2. User growth ..................................................................... 17 3. User operations and privacy ........................................... 18 Monetization............................................................................ 18 1. Digital advertising ........................................................... 19 a. Ads Manager ............................................................ 19 b. International playbook ............................................ 22 c. 2. II. i. Ad sales team .................................................... 23 ii. Resellers ............................................................ 23 Advertising agencies ................................................ 25 Nonadvertising revenue .................................................. 25 C. Facebook’s brand and other marketing intangibles .............. 27 D. Business strategy challenges.................................................. 27 Pre-CSA agreements ...................................................................... 30 A. 2009 Agreements..................................................................... 30 B. Sales and Marketing Service Agreements ............................. 32 C. Statement of Rights and Responsibilities .............................. 33 D. Octazen acquisition ................................................................. 33 5 III. CSA agreements ............................................................................. 34 A. The CSA................................................................................... 34 B. FOP technology license and UBMI license ............................ 36 IV. Financial projections ...................................................................... 38 A. LRP financial projections........................................................ 38 1. LRP development............................................................. 40 2. Key projections in the final LRP Base Case ................... 41 a. User growth .............................................................. 41 b. Financial projections ................................................ 42 i. Ads and Credits Revenue ................................. 42 ii. Other Revenue .................................................. 43 iii. Discount rates ................................................... 44 iv. Projected expenses ............................................ 44 3. V. Internal use of the LRP ................................................... 45 B. Investment bank’s equity investment .................................... 45 C. Financial results ..................................................................... 47 Transfer pricing documentation and payments ............................ 47 VI. Respondent’s allocations ................................................................ 49 A. Notice ....................................................................................... 49 B. Amended Answer .................................................................... 50 6 OPINION................................................................................................ 50 I. Burden of proof ............................................................................... 51 II. Posttransaction evidence................................................................ 53 III. Scope and standard of review ........................................................ 54 IV. 2009 cost sharing regulations generally ........................................ 56 A. Classification of contributions ................................................ 58 1. 2. 3. B. a. Platform contributions ............................................. 59 b. Operating contributions........................................... 59 Contributions internal to the CSA.................................. 60 a. Cost contributions .................................................... 60 b. Operating cost contributions ................................... 60 Summary.......................................................................... 60 PCT Payment valuation methods........................................... 61 1. V. Contributions external to the CSA ................................. 59 Income method................................................................. 62 a. Mechanics of the income method............................. 63 b. When the income method is preferred .................... 64 2. Residual profit split method............................................ 65 3. Unspecified method ......................................................... 65 PCT Payment .................................................................................. 65 A. Respondent’s PCT Payment determination ........................... 66 1. Dr. Newlon’s key economic considerations ..................... 66 2. Dr. Newlon’s method ....................................................... 67 7 B. Application of 2009 cost sharing regulations ......................... 71 1. Method selection .............................................................. 71 a. Classifying initial contributions .............................. 71 b. Octazen technology .................................................. 73 c. Facebook Ireland’s contributions ............................ 74 2. Aggregation ...................................................................... 76 3. Income-method inputs ..................................................... 77 a. Financial projections ................................................ 77 i. ii. b. Other Revenue .................................................. 77 a) The Base Case was not a probabilityweighted average forecast. ....................... 78 b) Projections excluding Other Revenue more reliably reflect Facebook US’s platform and operating contributions. ..... 82 Acquisition expenditures .................................. 85 Discount rate ............................................................ 87 i. Market-correlated risk ..................................... 88 ii. Beta ................................................................... 90 iii. Dr. Newlon’s discount rate(s) ........................... 91 iv. Petitioner’s proposed beta ................................ 94 v. c. Our discount rate options ................................. 96 Best realistic alternative ....................................... 101 i. Dr. Newlon’s cost-plus markup for Facebook Ireland’s ad sales and marketing contribution ......................................................................... 102 ii. Dr. Unni’s 21.3% Reseller commission .......... 105 8 4. C. D. d. Respondent’s corroboration test ............................ 108 e. Conclusion: arm’s-length result............................. 109 Dr. Unni’s unspecified method and Dr. Reichert’s RPSM ............................................................................. 111 Validity of the 2009 cost sharing regulations ...................... 116 1. Origin of the arm’s-length standard ............................. 117 2. The arm’s-length standard and economic profits ......... 120 Other legal challenges to the 2009 cost sharing regulations............................................................................. 123 1. Major questions doctrine ............................................... 123 2. Nondelegation doctrine ................................................. 124 3. Intangible property under section 936(h)(3)(B) ........... 124 4. “Ex post” adjustments ................................................... 124 5. Commensurate with income “range” ............................ 124 VI. CST Payments .............................................................................. 127 APPENDIX A: EXPERT WITNESSES ............................................... 131 APPENDIX B: DEFINED TERMS...................................................... 140 PUGH, Judge: The Internal Revenue Service (IRS or respondent) determined a deficiency in petitioner’s federal income tax for 2010 in a Notice of Deficiency dated July 26, 2016 (Notice). This deficiency arose because respondent reallocated income between petitioner’s domestic and foreign affiliates under section 482 2 in connection with intercompany agreements they entered into, effective September 15, 2 Unless otherwise indicated, statutory references are to the Internal Revenue Code, Title 26 U.S.C., in effect at all relevant times, regulation references are to the Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant times, and Rule references are to the Tax Court Rules of Practice and Procedure. We round monetary amounts and percentages as appropriate. 9 2010 (transaction date). 3 Effective that date, Facebook, Inc. (Facebook US), 4 entered into a cost sharing arrangement (CSA) and two related license agreements with its Irish subsidiary, Facebook Ireland Holdings Unlimited (FIH). 5 We refer to FIH and its wholly owned Irish subsidiary, Facebook Ireland Limited (FIL), together as “Facebook Ireland.” We refer to Facebook, Inc., and subsidiaries together as Facebook or petitioner, and the CSA and associated licenses as the “transaction.” Petitioner timely challenged respondent’s determination. We begin, as we always must, with the statute. Section 482 in effect for 2010 provides in full: In any case of two or more organizations, trades, or businesses (whether or not incorporated, whether or not organized in the United States, and whether or not affiliated) owned or controlled directly or indirectly by the same interests, the Secretary may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if he determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses. In the case of any transfer (or license) of intangible property (within the meaning of section 936(h)(3)(B)), the income with respect to such transfer or license shall be commensurate with the income attributable to the intangible. The regulations promulgated under section 482 authorize commonly controlled entities to enter into a CSA. 6 Facebook US and Facebook Ireland entered into the CSA pursuant to the cost sharing regulations in effect for 2010. See Temp. Treas. Reg. § 1.482-7T. We refer 3 Because of the number of defined terms and acronyms we must use, we have included in Appendix B a glossary to aid the reader. 4 Facebook US originally was incorporated under the name “TheFacebook, Inc.” It later changed its name to “Meta Platforms, Inc.” We use “Facebook” to refer to the worldwide affiliated group, to be consistent with the trial record. 5 The CSA was executed on November 12, 2010. 6 The regulations under section 482 commonly are referred to as the “transfer pricing regulations.” Section -7 of the transfer pricing regulations commonly is referred to as the “cost sharing regulations.” 10 to these regulations as the “2009 cost sharing regulations.” 7 This is the first time we apply them. 8 In a CSA, controlled (i.e., related) participants commit to bear the ongoing costs of developing certain intangibles in proportion to their respective shares of reasonably anticipated benefits from exploiting those cost shared intangibles (RAB shares). Temp. Treas. Reg. § 1.4827T(a)(1), (b)(1)(i). By bearing its RAB share of the ongoing intangible development costs (IDCs) going forward, a controlled participant in a CSA comes to own, in its designated territory, the “cost shared intangibles” that it helps develop through that shared funding. Id. para. (b)(1)(iii), (4)(i). In addition to the annual “cost sharing transaction” payments (CST Payments) during the CSA, controlled participants must compensate each other for the value of any upfront noncash contributions in proportion to their RAB shares. Id. paras. (a)(2), (b)(1)(ii). The 2009 cost sharing regulations label the upfront transaction in which CSA participants make contributions a “platform contribution transaction” (PCT), the noncash contribution a “platform contribution,” and the payment for the upfront noncash contribution a “PCT Payment.” See id. paras. (a)(2), (b)(1)(ii), (c)(1). In the CSA, Facebook US and Facebook Ireland agreed to codevelop future versions of the hardware and software systems underlying Facebook’s Online Platform (FOP technology). 9 They divided The 2009 cost sharing regulations were effective January 5, 2009, as temporary regulations. See T.D. 9441, 74 Fed. Reg. 340 (Jan. 5, 2009), 2009-7 I.R.B. 460. Initially proposed in 2005, see Prop. Treas. Reg. § 1.482-7, 70 Fed. Reg. 51,116 (Aug. 29, 2005), they were made final effective December 16, 2011, see T.D. 9568, 76 Fed. Reg. 80,082 (Dec. 22, 2011), 2012-12 I.R.B. 499. 7 8 The 2009 cost sharing regulations replaced the 1995 cost sharing regulations and redesignated them Treasury Regulation § 1.482-7A (Treas. Reg.). See 74 Fed. Reg. 352. The 1995 cost sharing regulations were at issue in Amazon.com, Inc. & Subs. v. Commissioner (Amazon I), 148 T.C. 108 (2017), aff’d, Amazon.com, Inc. & Subs. v. Commissioner (Amazon II), 934 F.3d 976 (9th Cir. 2019), and Veritas Software Corp. & Subs. v. Commissioner, 133 T.C. 297 (2009). The 2009 cost sharing regulations replaced the term “buy-in payment” (in Treas. Reg. § 1.482-7A(g)) used in those cases with “PCT Payment.” As in many cases we must use, and take care using, terminology. For example, the term “platform” has four meanings in this case that we must keep distinct in our discussion: 9 11 all interests in the cost shared intangibles into two nonoverlapping geographical territories; the U.S. and Canada (domestic territory) was assigned to Facebook US, and the rest of the world (ROW territory) was assigned to Facebook Ireland. See id. para. (b)(1)(iii), (4)(i). Facebook Ireland also committed to bear its RAB share of IDCs through CST Payments. In connection with the CSA, Facebook US and Facebook Ireland licensed to each other their existing rights in the FOP technology for use in their respective territories. Additionally, Facebook US licensed to Facebook Ireland the rights associated with Facebook US’s existing user, advertiser, and developer relationships (user community rights) and its marketing intangibles, including trademarks, in the ROW territory. The transfer pricing documentation provided that Facebook Ireland would make contingent annual payments to Facebook US (over a period of years) for the existing FOP technology, user community rights, and marketing intangibles that Facebook US contributed to the CSA. The documentation used the value of Facebook US’s upfront contributions as the starting point for computing the contingent annual payments made by Facebook Ireland. The Petition challenges the adjustment respondent made in the Notice to the total contingent annual payments Facebook Ireland made for 2010 (calling them gross royalties). 10 (1) the 2009 cost sharing regulations’ definition of assets contributed to a CSA—“platform contributions”—that must be compensated through a PCT, see Temp. Treas. Reg. § 1.482-7T(c)(1); (2) the technology stack that Facebook operates—the “FOP technology” for purposes of our analysis—that enables communication by users, advertising by advertisers, and software application (app) development by third-party app developers, which was transferred in connection with and was to be developed further under the CSA; (3) an economic description of a business—a “platform business”—that facilitates interactions between or among participants and often exhibits network effects; and (4) the product name—“Facebook Platform” (capital P)—for Facebook’s set of application programing interfaces (APIs) that allows third-party developers to build apps and offer them to Facebook users. 10 Respondent does not challenge the form of payment (contingent and annual) adopted in the transfer pricing documentation. 12 The parties use various terms to refer to the value of Facebook US’s upfront contributions and Facebook Ireland’s contingent annual payments computed on the basis of that value. Petitioner sometimes refers to the value of the “PCT and other intangibles” and also “PCT and royalty.” Respondent often uses the defined term in the regulations, “PCT Payment.” Consistent with the regulations, we adopt the term PCT Payment to mean the value of Facebook US’s upfront contributions to the CSA, which in turn is the value to be used for computing the amount of the contingent annual payments owed by Facebook Ireland for 2010 and subsequent years. This PCT Payment value is the main dispute between the parties that we must resolve. Facebook used an estimated net present value (NPV) of $6.3 billion. 11 Respondent contends that the NPV is $19.945 billion. The parties disagree over the best method for valuing the PCT Payment under the 2009 cost sharing regulations. See Temp. Treas. Reg. § 1.482-7T(g). The parties also disagree over the inputs to be used in whatever method we adopt. 12 Respondent’s transfer pricing valuation expert, T. Scott Newlon, 13 selected the income method in paragraph (g)(4) as the best method. Petitioner argues that the income method is not appropriate and urges us to adopt an unspecified method under paragraph (g)(8) offered by its primary valuation expert, Sanjay Unni. Dr. Unni’s unspecified method is an amalgam of the income method and a method he derived from cases applying prior regulations. Petitioner also offers an alternative valuation by another of its valuation experts, Timothy Reichert, using the residual profit split method (RPSM) in paragraph (g)(7). Petitioner also contends that Dr. Newlon used the 11 Although petitioner states that the NPV was $6.3 billion, the transfer pricing documentation did not include a total (it listed a percentage for the marketing intangibles, not a value). Respondent’s Notice stated that Facebook determined an NPV of $6.7 billion. We need not resolve this curious discrepancy as the initial valuation Facebook used does not affect our ultimate holding, but to avoid confusion we will use the $6.3 billion figure. 12 A third issue involves the interaction between the provisions in the 2009 cost sharing regulations governing respondent’s adjustments to the value of the PCT Payment, under Temporary Treasury Regulation § 1.482-7T(i)(3) (Temp. Treas. Reg.), and the rules governing periodic adjustments that respondent adopted to implement the commensurate with income standard of section 482, in paragraph (i)(6). Petitioner argues that these rules provide an implicit safe harbor protecting it from respondent’s proposed adjustments under paragraph (i)(3). 13 Appendix A to this Opinion includes thumbnail sketches of the experts who testified in this case. We discuss their testimony only to the extent it is relevant to our analysis. 13 wrong values for three key inputs needed for the income method (and Dr. Unni’s unspecified method): revenue projections for the ROW territory, the appropriate discount rate for those projected revenues, and Facebook Ireland’s best realistic alternative to cost sharing. These are the key factual disputes we must resolve. At the same time, petitioner argues that the income method and the other methods specified in the 2009 cost sharing regulations are invalid insofar as they mandate valuation methods that do not produce an arm’s-length result. We take up petitioner’s three challenges (to Dr. Newlon’s method, Dr. Newlon’s key inputs, and the regulations themselves) in turn. The parties also disagree over how to estimate Facebook Ireland’s RAB shares for purposes of computing its CST Payments. Petitioner reported an RAB share of 44% for Facebook Ireland for 2010; 14 respondent contends that it should be 53.5%. We therefore must determine how to estimate Facebook Ireland’s RAB shares as well. In deciding these issues, our focus is on what was reasonably anticipated as of the transaction date. Unless otherwise specified, the facts we find are as of the transaction date. To put the valuation inputs used by the experts into context and to evaluate their reliability we will go back further in time. We do not need to dwell on Facebook’s origins. But we do need to understand its business model, products, and international growth leading up to the transaction. FINDINGS OF FACT Some of the facts have been stipulated and are so found. Facebook US is the U.S. parent of a group of affiliated corporations that joined in the filing of a consolidated federal income tax return for 2010. Incorporated in Delaware in 2004, Facebook US maintains its principal place of business in Menlo Park, California. 15 Facebook operates an online social networking platform and makes money primarily by selling advertisements shown to its users. 16 14 For simplicity we use the RAB share identified in petitioner’s posttrial brief but note that the Petition stated that the percentage reported was 43%. 15 Absent stipulation to the contrary, this case is appealable to the U.S. Court of Appeals for the Ninth Circuit. See § 7482(b)(1)(B). 16 The Court issued protective orders adopting procedures to protect certain confidential information, including trade secrets and proprietary technology, during the pretrial, trial, and posttrial phases of this case. We have determined that the facts 14 As of the transaction date, Facebook was a privately held, venture capital (VC)-backed company. It received funding by issuing stock to private investors in financing rounds that took place in 2004, 2005, 2007, and 2009. It completed an initial public offering (IPO) of its common stock in May 2012. Before the IPO, its stock could be traded on secondary markets only. Facebook formed its first international entity, an advertising sales office, in the United Kingdom in August 2007. This was its only foreign subsidiary as of June 2008 when it started considering locations for its international headquarters. In October 2008 Facebook announced that it planned to open its international headquarters in Dublin, Ireland. Among other reasons—including access to a talented labor force and proximity to markets it wanted to develop—it chose Ireland to help reduce its global effective tax rate. FIL was incorporated as an Irish corporation resident in Ireland in October 2008. FIH was incorporated as an Irish corporation with a registered address in Ireland and its stated place of management and control in the Cayman Islands in January 2009. FIH was a holding company and did not have any employees. As noted above, we refer to FIH and FIL together as Facebook Ireland. Both were wholly owned subsidiaries of Facebook US, with FIH wholly owning FIL. Facebook first capitalized FIH with a $10 million contribution in August 2009, made an additional contribution of nearly $4 million later in 2009, and another, of $20 million, in August 2010. Effective September 1, 2010, FIL elected to be treated as a disregarded entity for U.S. federal income tax purposes pursuant to Treas. Reg. § 301.7701-3, after which it no longer was a separate entity for U.S. federal income tax purposes. In December 2009 Facebook US and Facebook Ireland executed a series of intercompany agreements (2009 Agreements), in which Facebook Ireland obligated itself to perform certain functions, and certain market development expenses were allocated to it by Facebook US. Although Facebook Ireland had nearly 200 employees by the transaction date, it lacked the financial and accounting systems necessary to record third-party revenue before September 1, 2010. Facebook US therefore booked all revenue before the transaction. we find in this Opinion do not constitute confidential information warranting protection. 15 Facebook Ireland did not record any intangible property leading up to the transaction; it recorded only cash and intercompany receivables. Facebook Ireland established the necessary financial and accounting systems on September 1, 2010 (the day FIL elected disregarded entity status), that allowed it to begin recording revenue. Two weeks later, in connection with the CSA, the ROW territory became Facebook Ireland’s territory and Facebook Ireland began funding its RAB share of the IDCs. The main factual disagreements between the parties relate to their valuation experts’ choices of valuation methods and key valuation inputs. To evaluate Facebook’s revenue projections, we need to understand its idiosyncratic business opportunities and risks. To select an appropriate discount rate for those projected revenues, we need to consider the market-correlated risks for similar companies. And to determine Facebook Ireland’s best realistic alternative to cost sharing, we need to understand the role of Facebook’s ad sales team and compare it to the third-party ad resellers (Resellers) and advertising agencies used by the valuation experts as comparables. Finally, Facebook’s preCSA international activities and the 2009 Agreements are relevant to the parties’ dispute over what each controlled participant brought to the CSA, which in turn dictates which valuation method is appropriate and how it applies. I. Facebook’s social networking platform Facebook’s stated mission is 17 to “[g]ive people the power to share and make the world more open and connected.” Its technology enables individuals to create a user profile (Profile), through which they can share information, establish connections with other users (friends), 18 communicate with those users, and view and post content. It also enables businesses and other organizations to create public profiles (Pages). Its third-party developer platform, Facebook Platform, allows developers to integrate their apps into the site and interact with users. We generally use the present tense for factual descriptions that are not specific to a time period and the past tense for facts that are specific to a particular period; however, our findings are as of the transaction date unless we otherwise specify. 17 18 It has become common to use the noun “friend” as a verb, abandoning the previously useful verb “befriend”; thus at trial witnesses referred to befriending someone on Facebook as “friending.” 16 Facebook collects data on its users. It collects demographic data (age, gender, location, interests, etc.) as well as contextual data (how users interact with content on its site). Facebook’s goal in collecting this data is to map digitally the “social graph.” The social graph is a conceptual representation of the real-world connections between people and their friends and interests. Facebook uses this data in developing and improving products, and targeting ads for users. Facebook’s business strategy is first to grow, retain, and engage users on its site and then to monetize them (that is, earn revenue). Facebook measures its success in each part of this strategy with different metrics. For user growth and engagement, it generally uses monthly active users (MAUs) and daily active users (DAUs). 19 To measure its ability to monetize the users, it uses average revenue per user (ARPU). Facebook operates a platform business because it facilitates interactions between, and among, users, advertisers, and app developers. Platform businesses often exhibit network effects. Network effects are positive when the value of the platform to one user is enhanced by the presence of other users of the platform. Positive network effects can accelerate the growth of a platform. Negative network effects can accelerate the decline of a platform. Facebook was exhibiting positive network effects as of the transaction date. These positive network effects provided a “tailwind” for user growth and gave Facebook a competitive advantage. Facebook’s positive network effects did not insulate it from competition, however, because users could switch to another platform or use multiple platforms at once. We now turn to a description of the platform business and participants, along with the tailwinds, then address the perceived headwinds (the market risks and challenges) as of the transaction date. A. Users Leading up to the transaction date, Facebook was succeeding on the first part of its business strategy, growing an engaged user community. Users grew rapidly after Mark Zuckerberg launched 19 MAUs reflect the number of people who have logged in and visited the Facebook site, or have taken an action to share content or activities with their connections through integrated third-party websites in the last 30 days of the date of measurement. DAUs are measured the same way as MAUs but look to activity in the last 24 hours of the date of measurement. 17 Facebook in February 2004. Initially restricted to students at a few colleges, by the end of 2006 registration was open to anyone with a valid email address who was at least 13 years old. By the transaction date, Facebook had over 500 million global MAUs. Approximately 384 million MAUs were located outside the United States and Canada (growing from 94 million in January 2009). 1. Product development Facebook’s user growth reflects the popularity of its core user products, launched early in its history. Profile, launched in 2004, enables users to create an online identity. Photos, launched in 2005, allows users to upload and share photos and to “tag” the people shown in them. News Feed, launched in 2006, is the user “landing page” and displays content including user stories, photos, videos, and status updates from friends, groups, and followed Pages. Facebook’s products are developed, maintained, and improved by its software engineers, often using user data to inform their work. In addition to observing user behavior as they develop products, Facebook’s engineers sometimes build products that solicit user input. For example, in late 2007 and early 2008, Facebook translated the site’s user interface elements into different languages. Facebook’s engineers accomplished this by developing a translation tool that used crowdsourced responses about how to translate. Through this translation tool, users could submit translations of words from Facebook’s user interface into other languages and rank (vote on) translations submitted by other users. Like any consumer data, Facebook’s user data can be used to identify problems and opportunities, but in isolation does not provide technical solutions or designs for a new or improved product. User data are inputs Facebook uses to build products and make decisions. 2. User growth Facebook understood that two of its biggest levers for user growth were its scalable products and network of users. Facebook aimed for its user products to be “scalable” (that is, expand automatically to fit demand as demand grows). Its site was, for the most part, a uniform global product that could scale anywhere it was not blocked. Facebook also understood the importance of “product-market fit” (i.e., having a product that people find valuable and want to continue using). From 2008 through 2010, a cross-functional group of employees, the “Growth Team,” focused on building a scalable product to grow users. 18 One product that the Growth Team used to grow users was People You May Know (PYMK). PYMK recommended potential new friends to Facebook users. It relied on user data, including the user’s existing friends, demographic data, and prior interactions with PYMK. Facebook saw PYMK as its number one lever for growth. “Contact importer” technology enabled users to transfer their contacts from email and instant messaging services into their Facebook accounts, which PYMK then used to recommend other users to “friend.” Facebook also used scalable technologies (e.g., Groups, Pages, and Facebook Platform) to provide content to users specific to their location. Through these technologies, users could create groups for local events, local businesses and organizations could communicate with users, and developers could create apps that appealed to local users. Many users’ friends were local, and their News Feed content was inherently local because it was personalized to them. This product-driven “scalable localization” was more cost efficient than nonscalable “custom localization.” In a few markets (such as Japan) Facebook needed, and devoted resources including local employees to provide, a more localized approach. 3. User operations and privacy As the number of users grew, so too did the need for a user operations team that could moderate the content users posted and provide technical support. As Facebook collected user data, the need for, and importance of, a data controller that could comply with any countryand region-specific regulations also grew. So too did the need to address data privacy concerns. B. Monetization Leading up to the transaction date, Facebook also made strides on the second part of its business strategy: monetization. Facebook monetized its users primarily by displaying targeted ads to them on its site. It also generated non-ad revenue by charging a fee when users redeemed its virtual currency, Facebook Credits (Credits), on an app using the Facebook Platform. In 2010 Facebook generated 95% of its revenue (approximately $1.9 billion) from selling online digital advertising. 20 Credits accounted for the other 5% of Facebook’s 2010 20 By contrast, offline, or traditional, advertising includes print (newspaper, direct mail, magazines), broadcast (television, radio), and outdoor (billboards). 19 revenue. We go through Facebook’s ad sales team functions in some detail for two reasons. First, ad revenue made up the bulk of the projected revenue that the valuation experts used to value the PCT Payment. Second, the experts disputed the appropriate comparable for this function (as Facebook Ireland’s hypothetical “best realistic alternative”) when applying the income method. Facebook’s ad sales team was divided into a Direct Sales Organization (DSO), Inside Sales Organization (ISO), and Online Sales Operations Organization (OSO). The DSO provided high-touch services to the largest advertisers. The ISO serviced mid-tier (small- and midsize) business advertisers with a “lighter touch” than the DSO. ISO representatives generally engaged with clients through emails, phone calls, and video conferences, with occasional marketing trips to meet in person. The OSO mainly provided customer support services to advertisers that used Facebook’s “self-service” ad platform, called Ads Manager. 1. Digital advertising Early on, Facebook’s ad sales team sold ads through insertion orders (IOs). An IO is a contract, signed by an advertiser and Facebook, that specifies the details of the advertiser’s campaign. The DSO sold IOs to large brand advertisers. Generally, IOs are used for ad “impressions” (the times an ad is shown to a user), specifying the number to be purchased. To place an IO, the advertiser typically must spend above a minimum threshold and is guaranteed the number of ad impressions it purchases. Ad impressions generally are associated with brand advertising—ads used to promote awareness of a brand. 21 a. Ads Manager In 2007 Facebook launched two products that transformed its advertising business. One, Facebook Pages, allowed organizations and businesses to create Profiles and engage with users, who could become “fans” of their Pages. The other, Ads Manager, was an online platform that allowed prospective advertisers to purchase and manage ad campaigns on Facebook without having to interact with a salesperson; for this reason it also was referred to as the “self-service” ad platform. 21 Digital ads also could be priced on a “cost per click” basis; most of the ads sold through Ads Manager were priced on that basis. 20 Ads Manager did not require an advertiser to spend a minimum amount and did not require an IO. It was priced through an online auction system. Ads Manager made advertising on Facebook more accessible globally. Any advertiser anywhere in the world with an internet connection (where Facebook was not blocked) could use Ads Manager to run an ad campaign on the site. Advertisers who were managed by Facebook’s ad sales team could and did use Ads Manager. And advertisers could run ad campaigns using Ads Manager without ever interacting with a Facebook salesperson. Ads Manager also made advertising on Facebook accessible to small and mid-sized businesses who would not meet the minimum threshold for purchasing ads through IOs. Ads Manger made Facebook’s advertising business more efficient. First, advertisers using Ads Manager required less sales and marketing support. Before it was launched, a Facebook employee had to communicate with prospective advertisers about whether they wanted to run an ad campaign. After it was launched, Facebook could promote Ads Manager in its own internet-based marketing, including on-site merchandising (i.e., marketing on its own site), search engine marketing, search engine optimization (e.g., ensuring Facebook was listed as a top search result on search engine sites), email marketing, and paid ads on other websites. And advertisers could use those links to place ads on their own. Ads Manager advertisers also generally required less operational support from Facebook’s ad sales team. Before it was launched, a Facebook employee had to execute an IO reflecting the terms of an ad campaign. After it was launched, advertisers could select and adjust the terms of their ad campaigns on Ads Manager. Facebook’s ad sales team could focus on helping them manage and optimize their accounts and addressing any issues they had. These services helped Facebook retain advertisers and reduce churn. The ISO steered advertisers towards Ads Manager and the OSO supported advertisers using Ads Manager through the Ticket Processing System, an email-based response support system, as well as through one-to-many support systems, such as webinars and FAQ. Some advertisers were not managed by a member of Facebook’s ad sales team at any point in their advertising lifecycle. Revenue from 21 these advertisers was assigned to the OSO. In the third quarter of 2010, 29% of Facebook’s total ad revenue was completely unmanaged. From 2008 through 2010 revenue from Ads Manager increased relative to total ad revenue, growing from 35.3% ($96 million) of Facebook’s total ad revenue in 2008, to 45.5% ($353.8 million) in 2009, to 66.9% ($1.253 billion) in 2010. 22 As of the transaction date, Facebook expected the percentage of revenue from Ads Manager to continue growing. It anticipated that all ads eventually would be purchased on Ads Manager because its auction pricing system provided a marketplace with fair prices. From January through September 2010 Facebook’s approximately $1.2 billion in ad revenues was distributed across the DSO, ISO, and OSO, and between Ads Manager and IOs as follows: Organization Revenue (millions) and percentage of total ad revenue Percentage of revenue from Ads Manager Percentage of revenue from IOs DSO $464.3 (38%) 20% 80% ISO 212.2 (18%) 90% 10% OSO 532.0 (44%) 100% 0% In the third quarter of 2010, 71% ($329 million) of Facebook’s total ad revenue was from managed accounts. These were the advertisers that had at any point been assigned a dedicated account manager from the DSO, ISO, or OSO. The “managed revenue” included purchases via Ads Manager ($187 million) and by IOs ($142 million). The advertisers that accounted for the managed revenue received varying levels of support depending upon how actively they were managed. The following chart summarizes “Facebook ad revenue by purchase tool and sales and marketing involvement” in the third quarter of 2010: 23 22 It is unclear from the record whether this computation of total ad revenue includes revenue from Resellers; we assume it does not for purposes of our analysis and note that the small Reseller volume would not affect the numbers materially. 23 rebuttal. Anja Lambrecht, one of petitioner’s experts, included the chart in her 22 b. International playbook Facebook had an “international playbook” for selling and marketing ads in the ROW territory, summarized in a September 2010 presentation titled “International Sales Prioritization.” The international playbook took a “market coverage approach.” It assigned one of four levels of sales coverage to a country by considering whether that country met certain criteria. The table below, from a slide titled “International Playbook - Minimum Target Criteria,” details the four coverage levels and associated criteria. These criteria—the ratio of MAUs to total internet users within a country, the number of active users, the amount of revenue generated from Ads Manager, ARPU, and the size of the online ad market—reflect how monetizable Facebook projected a given market to be. More monetizable markets received greater coverage, and therefore a greater commitment of resources from Facebook’s ad sales team. 23 i. Ad sales team By the transaction date, Facebook had nine international sales offices located in highly monetizable markets, where it wanted its ad sales team physically located in the markets of the advertisers and ad agencies with whom they worked: London (Facebook UK), Paris (Facebook France), Milan (Facebook Italy), Hamburg (Facebook Germany), Madrid (Facebook Spain), Stockholm (Facebook Sweden), Sydney (Facebook Australia), Auckland (Facebook New Zealand), and Singapore (Facebook Singapore). 24 These offices were staffed by members of Facebook’s DSO. We refer to these offices collectively as the “FB Foreign Sales Affiliates.” The DSO provided ad sales and account management services for the largest advertisers in the international markets, as in the domestic ad market. In countries that met the criteria for the second-highest monetization level, Facebook’s ad sales team serviced advertisers through a nearby office functioning as a regional hub. Before the transaction date, for example, Facebook Sweden employees covered Norway, Denmark, and Finland, and Facebook Germany employees covered Switzerland and Austria. As for the remaining markets that did not warrant coverage from an in-country team or from a regional hub, Facebook used both the ISO and the OSO to provide customer service support. Facebook Ireland “housed” the international members of the ISO and OSO ad sales teams. ii. Resellers In the lower priority markets, Facebook also contracted with Resellers to “resell” ads. Its general goal was that after two or three years of coverage by a Reseller, a market would be ready to graduate to coverage by a regional hub. An in-country office required more resources than a regional hub, which in turn required more resources than contracting with a Reseller. Facebook entered into Network Affiliate Agreements (NAAs) with Resellers. 25 Resellers took a revenue-based commission specified by the 24 The record is unclear as to whether the Auckland, New Zealand, office was open as of the transaction date. 25 The NAAs predating the transaction were between Resellers and “Facebook, Inc., a Delaware corporation.” They were assigned to Facebook Ireland as part of the 24 applicable NAA. NAAs covered the following countries (with specific commissions noted in parentheses): South Africa, Nigeria, Kenya, and Ghana (30%); Czech Republic (20%); Poland (20%); Saudia Arabia, United Arab Emirates, Bahrain, Oman, Qatar, Kuwait, Yemen, Lebanon, Jordan, Egypt, Tunisia, and Morocco (30%); Mexico, Central America, South America, and the Caribbean (30%); Singapore, Malaysia, Indonesia, Taiwan, Philippines, Thailand, Vietnam, South Korea, Japan, Cambodia, Myanmar, East Timor, Brunei, and Laos (25% originally, 30% as amended); and Israel (30%). In 2010 Facebook’s ARPU in the Resellers’ countries ranged from $0.03 to $0.73, with a median ARPU of $0.10. By comparison, its ARPU for all international markets was $2.38. Resellers were limited to selling in their designated markets. Under some NAAs, Facebook reserved the right to remove countries from a Reseller’s “territory” upon written notice. Under others, Facebook and the Reseller could agree to add countries to the Reseller’s territory. Resellers had to deliver to Facebook an executed IO that was subject to Facebook’s prior review and approval. Additionally, each IO had to meet a monthly minimum sales threshold unless Facebook approved an exception in writing. These thresholds ranged from $4,350 to $10,000 in net monthly sales. Resellers could make these IO sales only to a select group of advertisers, a dedicated list controlled by Facebook. The Resellers’ limited sales role reflects the third-tier status of their markets in Facebook’s international playbook. Under the NAAs, Facebook was not restricted from selling ads in the Resellers’ markets. It could, and did, cover these markets concurrently with Ads Manager, serviced by the ISO and the OSO, reflecting Ads Manager’s global accessibility. Facebook paid Resellers a commission only for sales made through IOs. Facebook did not compensate Resellers for any of the ads sold through Ads Manager even if the Resellers were involved in the sales. The NAAs varied in duration, but they generally were short term (one year) and could be terminated by either party for any or no reason upon 30 days’ prior written notice. This reflected the Resellers’ temporary role in Facebook’s expansion in international markets. transaction. The Assignment Agreement was undated, but we assume it was signed around the same time as the CSA (on November 12, 2010). The NAAs have different effective dates, but those details are not relevant to our analysis. 25 Reseller activities accounted for less than 3% of Facebook’s 2010 total ad revenue in the ROW territory. 26 c. Advertising agencies Advertising agencies also purchase ads for advertisers, working as intermediaries between the media owner (here, Facebook) and advertisers. They work with the advertiser to plan the proper advertisement, channel, and budget. Facebook built long-term relationships with global advertising agencies. It preferred working with large agencies because they matched its scale. 2. Nonadvertising revenue Facebook generated almost all of its non-ad revenue (approximately 5% of total revenue) from a 30% fee on redemptions of Credits. “Credits” refers to Facebook’s virtual currency that allowed Facebook users to use a single form of payment across apps on Facebook Platform. Launched in May 2007, Facebook Platform, is a collection of external APIs and tools that enable third-party developers to develop apps that link to and operate with or within the Facebook site. Developer apps accessible through Facebook Platform contributed to user engagement on Facebook. Some of the most popular developer apps on Facebook were for social games, such as FarmVille and Tiki Resort (depicted below). 26 Petitioner’s valuation expert, Dr. Unni, estimated the amount to be $22 million (2.7%) and respondent’s internet advertising expert, Ian Maude, estimated it to be $21 million (2.6%). Either way it was a small fraction of the total revenue. 26 Facebook gave developers access to certain user data, and required developers to comply with the terms and conditions set forth in Facebook’s Platform Policy. Facebook did not charge developers any fees for access to Facebook Platform. Both Facebook and the developers could earn revenue by serving ads to Facebook Platform users. Facebook could display ads on the side bar, and developers could display ads on Facebook’s framed Canvas page that shows the developers’ content (the part that displays the game in the screenshot above). Facebook also sought to monetize Facebook Platform through Credits. Users bought Credits from Facebook that they then could use to purchase virtual goods in-app. Facebook retained a 30% fee when a user paid with Credits. The third-party developer that created the app received the remaining 70%. Facebook settled on this revenue split after reviewing what competing platforms (e.g., the Google Play and Apple iTunes stores) charged. Facebook believed this familiar model was the simplest for developers to accept. 27 Facebook began rolling Credits out to certain developers’ apps in May 2009, two years after it launched Facebook Platform. As of the transaction date, Credits were not available to all developers, and their use was not mandatory. C. Facebook’s brand and other marketing intangibles Facebook expected its marketing intangibles, including its trademark and brand, to contribute to its growth. Facebook developed its brand around connecting and sharing, openness, and “authentic identity” (that users provide their real names and are who they say they are). Facebook’s users and its marketing intangibles strengthened each other—users enhanced the brand and the brand contributed to Facebook’s ability to attract more users. Facebook’s branding also extended to employee recruiting; there its brand championed aspects of working for Facebook, including hacking, innovation, and impact. In this context, “hacking” refers to an engineer’s freedom to develop products and technology. Facebook showcased its distinct technical challenges and innovation capabilities by, for example, open sourcing its code (making it available to the public for free). Facebook emphasized that its engineers could make changes to the product soon after starting, and could have an impact (because of the comparatively small engineering team and large user base). Facebook anticipated that this recruitment brand would attract engineers. D. Business strategy challenges Notwithstanding its success growing and monetizing users, Facebook was worried that it would become a fad—that users might engage less on Facebook in favor of trendy new social or technological platforms. This was how Facebook displaced MySpace.com, a competing social networking site, around 2008 to 2009. Facebook faced competition from other social networking sites both in the United States and globally in growing its user base and keeping users engaged. It also faced competition for users’ attention from traditional and online media. Facebook subscribed to the mantra that “only the paranoid survive.” For example, Facebook held a “lockdown” in July 2010 to address the introduction of another social media product, Google+. Facebook’s ability to attract, retain, and serve its users depended upon the attractiveness and reliability of its products and the quality of their underlying technical infrastructure. The rapid pace of change in 28 technology forced Facebook to adapt to maintain and grow its user community and to keep users engaged. During 2010 Facebook’s user base grew rapidly from approximately 350 million to 600 million MAUs, causing scaling challenges. Storing and making use of exponentially expanding user data strained Facebook’s software and hardware infrastructure, requiring it to innovate constantly. Facebook’s global hardware and software infrastructure as of the transaction date were inadequate to support the number of MAUs it was projecting—its infrastructure would not be able to handle the increase in data from more users and the richer content they were sharing (such as videos). 27 Facebook knew its infrastructure would need to improve to support the growing number of users and to avoid disruptions in site performance. Another opportunity for (and risk to) Facebook’s achieving its user projections was the “platform shift” from desktop to mobile. At the time Facebook still was primarily a desktop destination. Facebook’s 2010 mobile offerings included a text-only (no photos) site, a mobile browser site, and rudimentary web-based mobile apps. These offerings were popular with users; more than 190 million MAUs accessed Facebook through mobile products, including nearly 160 million MAUs in the ROW territory. But these mobile products provided significantly fewer features than its desktop product, and the diminished experience was not a viable long-term mobile solution to attract and retain users. Developing an engaging mobile product would require Facebook to adapt its infrastructure, development process, and workforce. As of the transaction date, Facebook’s infrastructure almost exclusively supported desktop services, and the existing developer tools and product release process did not facilitate mobile development. Most of Facebook’s 574 engineers did not know mobile-specific programming languages such as Objective-C or Java. Facebook’s first attempt to build an engaging mobile app at scale, Faceweb, launched in fall 2010, failed. In late 2011 Facebook began hiring new engineers and retraining existing engineers to develop a native mobile product that did not depend on the desktop site. It finally launched true native mobile products in 2012. 27 The risk of managing growing demand is familiar. See Amazon I, 148 T.C. at 126–27 (noting need to increase scale was a driving factor in Amazon’s need for technological innovation and discussing scale limitations of its technology). 29 Facebook also faced pressure to further develop artificial intelligence and machine learning (AI/ML) capabilities to curate content for users (including ads they would find engaging) and to protect users from spam or inappropriate content as the universe of potential content continued to expand. Facebook’s AI/ML capabilities were insufficient to address the challenges it anticipated. The rise of rich media, such as photos and videos, heightened the challenges and risks. In the following years, Facebook rewrote or replaced much of the AI/ML technologies it possessed as of the transaction date. As with users, Facebook’s ability to attract, retain, and serve advertisers depended upon the attractiveness and reliability of the Facebook ad products and their underlying technical infrastructure. To achieve its ad revenue projections, Facebook anticipated that it would need to innovate its advertising technology. Advertisers were intrigued by the size of Facebook’s user community (its “reach”) and its demographic data on those users (its ability to target people based on their authentic identity). But advertisers remained skeptical of the effectiveness of advertising on the Facebook site because social media was still new and because Facebook at the time lacked the ability to show advertisers the metric they cared most about: their return on investment (the money spent advertising on the site). At the time of the transaction, Facebook had not developed an effective ads conversion tracking tool that could follow users after they left the Facebook site to determine whether the ad shown to them induced the action desired by the advertiser. In 2010 Facebook sold desktop advertising exclusively; it did not display ads on its mobile website or its then-existing mobile apps. Until Facebook started monetizing mobile users, it faced the risk that its mobile user growth would “cannibalize” its desktop revenue—that increasing unmonetized mobile use would consume its monetizable desktop business. To display mobile ads, Facebook also would need a place to put them. But the screen on mobile devices was smaller and Facebook’s mobile site did not have a side bar, unlike the desktop site. That left News Feed as the only option. Facebook had tried ads in News Feed in 2006 through an ad product, Sponsored Stories, that it later abandoned. And with the shift to mobile, the ability to track users’ activity after they left Facebook’s site (or mobile app) could become more difficult and therefore posed an additional risk to Facebook’s ad business. 30 II. Pre-CSA agreements The fight over how to value the platform contributions hinges, in part, on what Facebook Ireland contributed to the CSA. We discuss next what Facebook Ireland was doing before the CSA. We then discuss the CSA and related agreements. As of the transaction date, Facebook Ireland had 171 Dublin employees in the following cost centers: 28 A. Cost center Employees User Operations 54 OSO 37 Advertising Operations 19 ISO 17 Finance 9 Risk Operations 8 Recruiting 6 Platform Ops 6 Other 15 Total 171 2009 Agreements The 2009 Agreements included: the “Intangible Property License Agreement” (IPLA), the “Growth and Development Services Agreement” (GDSA), the “General and Administrative Services Agreement” (GASA), the “Expense Reimbursement Agreement” (ERA), and the “Sales Costs Reimbursement Agreement” (SCRA). FIH and FIL were parties to the 28 These figures are petitioner’s; respondent’s opening brief stated that 329 people were employed by FIL or the FB Foreign Sales Affiliates. In any event, the precise numbers are not critical to our analysis. 31 ERA. The other 2009 Agreements were between FIH and Facebook US. The 2009 Agreements were executed in December 2009 but generally had a stated effective date in January 2009. Petitioner has not taken the position that it intended the 2009 Agreements to constitute a CSA. Nor did Facebook prepare transfer pricing documentation for any transactions between Facebook US and Facebook Ireland for tax year 2009. The 2009 Agreements called for various written reports to be prepared. None were. They terminated as of the transaction date. Under the IPLA, Facebook US granted Facebook Ireland a nonexclusive license to use the Facebook System, Marks, 29 and Confidential Information (as those terms were defined) “to develop, promote, expand and maintain online social networking communities of users, advertisers and developers” outside the United States and Canada (the ROW territory). 30 The IPLA provided that Facebook US was “the owner, or authorized licensee, of all rights, title and interests in and to all of the Facebook System, Marks and . . . Confidential Information” and that Facebook Ireland “shall acquire no rights whatsoever” to the licensed rights “except as specifically provided” in the IPLA. With limited exceptions, immediately upon termination (which either party could do without cause upon 90 days’ prior written notice), Facebook Ireland had to “cease all use of the Facebook System, Marks and . . . Confidential Information.” The IPLA stated that Facebook Ireland would pay Facebook US royalties of 25% of Facebook Ireland’s net revenues. Facebook Ireland did not pay Facebook US any royalties pursuant to the IPLA. And because Facebook US recorded all revenue from international markets for the duration of the IPLA, Facebook Ireland did not owe royalties to Facebook US. Through two other agreements—the GDSA and the GASA— Facebook US agreed to perform certain development and general and administrative (G&A) services for Facebook Ireland, for which Facebook Ireland agreed to reimburse Facebook US. Facebook US did not submit names. 29 The term “Marks” generally included trademarks, service marks, and trade 30 Facebook generally used the term “international territory” for this; we will use ROW territory to avoid implying that the 2009 Agreements and the CSA covered different territories. 32 written reports or invoices to Facebook Ireland pursuant to the these agreements, or upon their termination. B. Sales and Marketing Service Agreements Under the Sales and Marketing Service Agreements (SMSAs), Facebook Ireland contracted with certain FB Foreign Sales Affiliates for their in-country ad sales services, agreeing to pay an 8% markup on costs. The FB Foreign Sales Affiliates with whom Facebook Ireland had SMSAs included: Facebook UK, Facebook Australia, 31 Facebook Sweden, Facebook Italy, Facebook Spain, Facebook Germany, and Facebook Singapore. Because before September 2010, Facebook Ireland lacked the accounting systems to book revenue, through a separate agreement, Facebook US agreed to bear the expense of paying the FB Foreign Sales Affiliates for their ad sales services. 32 31 The Australian Tax Office (ATO) audited Facebook Australia for tax years 2009 through 2013. At issue was whether consideration received by Facebook Australia for providing certain sales, marketing, and other support services to related parties (Facebook US and Facebook Ireland) was arm’s length. From May 1, 2009, to January 1, 2010, Facebook US compensated Facebook Australia at cost plus 10% for those services. From January 1, 2010, through the transaction date, Facebook Ireland compensated Facebook Australia on a cost-plus-8% basis. Facebook represented to the ATO “that a mark-up on costs of 8% is arm’s length.” 32 Under the ERA between FIH and FIL, FIL and FIH intended that Facebook US would bear the “Direct Sales Expenses” related to current revenue generation by reimbursing FIL directly or indirectly (reimbursing FIH after it reimbursed FIL), and FIH would bear “Market Development Expenses” related to future revenue generation in the “Territory” (defined as the international market). To the extent that FIL’s reimbursements under the SMSAs were Market Development Expenses, FIH agreed to bear those costs. The ERA defined Market Development Expenses as costs incurred by [FIL] in connection with activities performed by [FIL] or by an Affiliate related to market development of the Territory, including . . . marketing and demonstrating the Facebook website, advertising system, developer platform, community features and procedures; providing market and strategic analysis; and other similar activities which are intended to develop or support future revenues to advertisers . . . in the Territory. Under the SCRA between Facebook US and FIH, Facebook US, in turn, agreed to reimburse FIH for the Direct Sales Expenses FIH was incurring (or rather, was being allocated). The SCRA defined Direct Sales Expenses as selling costs, including commissions paid to sales employees for advertising sales and that portion of commissions or fees paid to an Affiliate, which are incurred by [FIH] but which are directly allocable 33 C. Statement of Rights and Responsibilities Before the transaction date, Facebook had in place terms and policies that governed its relationship with users, advertisers, and developers; by early 2009, these were contained in Facebook’s Statement of Rights and Responsibilities (SRR). The SRR included by reference Facebook’s Platform Policies, which applied to developers, and Facebook’s Advertising Guidelines, which applied to advertisers. For a time, the SRR also included by reference Facebook’s Privacy Policy; the Privacy Policy later became a stand-alone document. Every person who registered for and used Facebook agreed to comply with its terms and policies. As of August 2010, the agreement was with Facebook US if the user was in the United States or Canada, and with Facebook Ireland if the user was in the ROW territory. D. Octazen acquisition In February 2010 Facebook acquired Octazen Solutions (Octazen). Octazen had developed technology that could import contacts from various email domains (Octazen technology). Acquiring the Octazen technology (and the engineers who developed it) significantly improved Facebook’s contact importing capabilities. Facebook US acquired Octazen through a stock purchase, by its U.S. subsidiary Facebook Global Holdings II, LLC, of Bonus Energy Sdn Bhd (the company that owned Octazen in February 2010) for $375,000 and three milestone payments in the future. 33 In February 2010 Facebook US recorded an intangible asset purchase for $375,000 under the description “Octazen acquisition.” 34 Facebook Ireland had not recorded any entries on its books and records relating to the Octazen acquisition as of the transaction date. In December 2010 FIL and Facebook Malaysia executed two agreements with a March 2010 effective date (approximately six months before FIL elected disregarded entity status in September 2010). In one, Facebook to the external gross revenue derived from advertising sales to advertisers with invoicing or billing addresses in the Territory which is recognized by [Facebook US]. 33 In June 2010 Bonus Energy Sdn Bhd changed its name to Facebook Malaysia Sdn Bhd (Facebook Malaysia). 34 The financial accounting experts, Michelle Hanlon (for respondent) and Robert Wentland (for petitioner), both noted issues with this entry, namely, that it reflects an asset purchase rather than a stock purchase and it does not say to whom the $375,000 cash was paid. 34 Malaysia agreed to assign rights in intangible property to FIL. In the other, FIL retained Facebook Malaysia as an intangible property developer. Accounting entries for FIL and Facebook Malaysia dated December 31, 2010, appear intended to record these agreements, but on that same date the recorded entries were then reversed. In October 2011 FIL recorded the Octazen intangible property for financial accounting purposes. 35 III. CSA agreements A. The CSA The CSA was embodied in the “Agreement to Share Costs and Risks of Online Platform Intangible Property Development.” Under the CSA, Facebook US and Facebook Ireland agreed to share IDCs in proportion to their respective RAB shares. 36 They divided all interest in cost shared intangibles into two nonoverlapping territories—Facebook US’s domestic territory and Facebook Ireland’s ROW territory—and assigned the perpetual and exclusive right to exploit the cost shared intangibles accordingly. 37 Cost shared intangibles were defined to include the following intangible property reasonably anticipated to be developed under the CSA: “[i]mprovements, updates, adaptations, or other modifications to, or a complete replacement of, the [FOP technology],” and related intangible property. 38 The FOP technology was defined, in part, as 35 Facebook Malaysia was still named Bonus Energy Sdn Bhd as of the March 2010 effective date. It changed its name three months later, in June 2010. Thus, it was named Facebook Malaysia as of the December 2010 execution date. 36 See Temp. Treas. Reg. § 1.482-7T(b) (“A cost sharing arrangement is an arrangement by which controlled participants share the costs and risks of developing cost shared intangibles in proportion to their RAB shares.”). 37 See id. subparas. (1)(iii) (“Each controlled participant must receive a non- overlapping interest in the cost shared intangibles without further obligation to compensate another controlled participant for such interest.”), (4)(ii) (permitting and providing method for territory-based divisional interests). 38 See id. paras. (j)(1)(i) (“Cost shared intangible means any intangible, within the meaning of § 1.482-4(b), that is developed by the IDA, including any portion of such intangible that reflects a platform contribution.”), (k)(1)(ii)(B) (requiring a CSA to “[d]escribe the scope of the IDA to be undertaken and each reasonably anticipated cost shared intangible or class of reasonably anticipated cost shared intangibles”). 35 the hardware and software system, . . . in existence on [the transaction date], . . . that facilitates the sharing of data between users for social networking purposes, sales of credits and virtual items, development of applications by developers, delivery of targeted advertisements to user pages, and any related processes or technology that relates to facilitating communication and social networking among users and serving advertisements. The CSA’s definition of cost shared intangibles explicitly excluded the user community rights and marketing intangibles transferred in the “User Base Transfer and Marketing Intangibles License Agreement” (UBMI license). The CSA specified the functions and risks that Facebook US and Facebook Ireland would undertake in their respective territories. 39 In connection with the CSA, Facebook Ireland would pay its RAB share of IDCs for each year by making CST Payments, and would bear the risk associated with making those payments. Facebook US and Facebook Ireland committed to share “Aggregate Allocable IDCs.” The Aggregate Allocable IDCs did not include “Territory Specific IDCs,” which were individually borne by a participant and pertained solely to the territory that participant exploited. The CSA provided a method for calculating RAB shares for purposes of sharing the Aggregate Allocable IDCs. RAB shares were measured by “the ratio of the [NPV] of the aggregate gross profit of [one p]arty divided by the [NPV] of the aggregate total gross profit of both [p]arties.” In this context, the gross profit amounts were the gross profits in the current fiscal year plus projected gross profits for the following two fiscal years. 40 Facebook US and Facebook Ireland agreed to “review the actual and projected financial data” from the use of the cost shared intangibles “[f]rom time to time.” They also agreed to “amend the cost sharing methodology as necessary on a prospective basis to reflect changes in” 39 See id. para. (k)(1)(ii)(C) (requiring a CSA to “[s]pecify the functions and risks that each controlled participant will undertake in connection with the CSA”). 40 See id. subdiv. (ii)(E) (requiring a CSA to “[p]rovide a method to calculate the controlled participants’ RAB shares, based on factors that can reasonably be expected to reflect the participants’ shares of anticipated benefits, and require that such RAB shares must be updated, as described in paragraph (e)(1) of this section”). 36 their RAB shares “and/or the reliability of the measure provided [under the CSA] as the most reliable estimate of those benefits.” Facebook Ireland agreed to perform certain functions in the ROW territory, including to: “develop and manage the user, application developer, and advertiser communities”; “perform marketing activities”; “perform administrative functions such as facilities management, information services activities, human resource management, and tax and legal department activities”; “perform all operational functions that enable and maintain the performance of” the FOP technology, including ad operations, user operations, support, and user growth and optimization; “select, hire, and supervise employees . . . to perform” these functions; and “operate or manage data centers as necessary.” Facebook Ireland also agreed to bear risks in the ROW territory, including: “[m]arket risks”; “[l]egal and regulatory risks associated with operating an on-line business”; “[i]ntellectual property protection risks and . . . infringement risks”; “[b]usiness risks relating to [the ROW territory] including . . . credit risk, collections risk, market risk, and asset risks”; and “[r]isk associated with political unrest and foreign exchange rate fluctuation.” The CSA had an initial term of five years. It automatically renewed for successive one-year terms thereafter unless terminated. B. FOP technology license and UBMI license In connection with the CSA, Facebook US and Facebook Ireland concurrently entered into two additional agreements that conveyed resources or rights to Facebook Ireland: the “Online Platform Intangible Property Buy-In License Agreement” (FOP technology license) 41 and the UBMI license. In the FOP technology license, Facebook US granted Facebook Ireland the existing rights to the FOP technology through an exclusive, perpetual, irrevocable license in the ROW territory. Specifically, it licensed to Facebook Ireland the “Facebook US PCT Property,” defined as “all Intangible Property [(as defined in Treas. Reg. § 1.482-4(b), excluding the user community rights and marketing intangibles)], including computer software, relating to the [FOP technology] existing 41 See id. para. (b)(3) (“The controlled participants must enter into a PCT as of the earliest date on or after the CSA is entered into on which a platform contribution is reasonably anticipated to contribute to developing cost shared intangibles.”). 37 and owned or licensed by Facebook US,” in the ROW territory as of the transaction date. Facebook Ireland then could develop the FOP technology as part of the CSA and otherwise use and exploit it commercially, “in particular by providing services to users, application developers, and advertisers located in” the ROW territory. The FOP technology license also required that Facebook Ireland transfer to Facebook US any “Facebook Ireland PCT Property” (defined the same way as Facebook US PCT Property, but belonging to Facebook Ireland). As consideration for the rights and licenses granted to it under the FOP technology license, Facebook Ireland agreed to pay Facebook US “such arm’s length amounts as required by Treas. Reg. § 1.482-4 and Temp. Treas. Reg. § 1.482-7T” in the form of contingent annual payments. Those payments were to be net of any amount due from Facebook US to Facebook Ireland relating to the Facebook Ireland PCT Property. In the UBMI license, Facebook US granted to Facebook Ireland the rights to the existing Facebook “User Base” and “Marketing Intangibles” in the ROW territory. User Base was defined as “the contracts and other relationships with persons comprising the various user communities developed and maintained by the [p]arties, information about such users, and networks developed by users on the various Facebook sites.” “User communities” here appears to refer to the user, advertiser, and developer communities together. We use the term “user community rights” to distinguish the rights covered by the UBMI from “users” or the “user base” (which frequently appeared to mean only the individuals using the site to connect and share, not the advertisers or developers). Marketing Intangibles were defined as trademarks, service marks, trade names, trade dress, domain names, business marks, designs, packaging, marketing strategies, customer lists, other marketing information, registrations, pending registrations and copyrights to logos or pictorial depictions, any intangible property associated with any such marks (such as marketing intangibles and brand name quality control standards), and other similar marketing intangible property. (We similarly adopt the term “marketing intangibles.”) Facebook US also “contribute[d] to Facebook Ireland all goodwill and going concern 38 value associated with the User Base and Marketing Intangibles” in the ROW territory. As consideration for the user community rights and marketing intangibles licensed to Facebook Ireland under the UBMI license, Facebook Ireland agreed to pay Facebook US “such arm’s length amounts as required by Treas. Reg. § 1.482-4” in the form of contingent annual payments. In addition to the core agreements, the parties executed ancillary agreements, including a “Data Hosting Services Agreement” (DHSA), in which Facebook Ireland agreed to reimburse Facebook US for data hosting services at cost-plus-10%. We refer to all of the agreements executed as part of the transaction together as the “CSA agreements.” The parties also entered into an “Assignment Agreement” effective September 15, 2010, transferring Facebook US’s rights and obligations under certain NAAs to Facebook Ireland. 42 IV. Financial projections Both parties’ valuation experts value the upfront contributions to the CSA, and the PCT Payment required in exchange, by projecting relevant financial items (cashflow or operating income and expenses) for Facebook Ireland’s ROW territory and then discounting them back to present value at a rate intended to reflect the market-correlated risks of participating in the CSA. But they dispute which inputs—including which financial projections and which discount rate—should be used. Both parties use Facebook’s Long Range Plan (LRP), Facebook management’s three-year-projections for September 2010 through the end of 2013, as a starting point for their financial projections. We too use the LRP as our starting point for evaluating Facebook’s opportunities and risks as of the transaction date and the inputs the valuation experts chose. A. LRP financial projections The LRP is a 110-slide deck that Facebook management presented to its board of directors (Board) in August 2010. A slide titled 42 We assume the assignment is part of the transaction but do not group it with the CSA agreements. We note that an amendment to an NAA between Facebook US and one Reseller, Fox Latin American Channel, Inc., was executed (and made effective) after the transaction date but before the date the CSA was executed. 39 “3-Year Financial Plan: Why Do This?” listed the reasons for creating it: to “[i]dentify financial goals,” “[p]rovide context to guide certain decisions (e.g. facilities needs, financing needs, hiring plans) and enable alignment across the company,” and to “[o]btain Board feedback and identify areas for additional consideration.” This slide also stated that Facebook sought to “[m]inimize resources invested in putting the plan together (primarily a top-down exercise)” and to “[r]espect [the] impossibility of predicting the future with anything resembling precision.” The LRP presented multiple financial scenarios, each with an associated set of financial projections. The parties dispute which set of projections contained in the LRP “reflect[s] the best estimates of the items projected (normally reflecting a probability weighted average of possible outcomes)” for 2010 through 2013. See Temp. Treas. Reg. § 1.482-7T(g)(2)(vi). They do not dispute how the projections divided revenue between the domestic and ROW territories. Respondent, through Dr. Newlon, adopts the projections for the “Base Case” financial scenario. The Base Case projected revenue from Facebook’s then-existing sources—digital advertising (Ads Revenue) and redemptions of Credits on Facebook Platform (Credits Revenue)— and from Other Revenue (revenue not attributed to a known source). For 2013, Ads Revenue and Credits Revenue amounted to approximately $8.1 billion and Other Revenue made up the remaining $1.9 billion, for a total of $10 billion. Other Revenue thus “plugged” the gap between the revenue Facebook projected from existing sources and the $10 billion total revenue forecast for 2013. Petitioner adopts the “Downside, Excl. ‘Other’ Revenue” financial scenario that, as its title indicates, excluded Other Revenue from projected revenue (this is the only way in which it differs from the Base Case). Because we must decide which set of financial projections in the LRP should be used to estimate the value of the upfront contributions and the PCT Payment required to compensate for those contributions, we detail how the LRP was developed, how it reflected the opportunities and risks that Facebook perceived at the time, how Facebook used the Base Case internally, and how an investment bank treated the Base Case when conducting due diligence for a potential equity investment in Facebook. 40 1. LRP development Facebook’s finance team, led by its chief financial officer, David Ebersman, started working on the LRP in early 2010. It began by hosting a “hackathon” to brainstorm what the LRP would include. In the following months, members of Facebook’s management team (referred to as the “M team”) provided input on various items projected in the LRP, including users, revenue, and operating costs (namely, capital expenditures and headcount). Susan Li, one of the finance team’s analysts responsible for preparing revenue projections, developed a detailed forecast for 2011 through 2013. This involved projecting revenue from advertising, Credits, and an “other” category containing virtual gifts and other miscellaneous, de minimis revenue streams (amounting to approximately $13 million each year). The finance team strove to produce a 50/50 forecast, in which Facebook would exceed or miss the forecast equal parts of the time. As of June 2010 this bottoms-up forecast projected just over $8 billion in worldwide revenue for 2013. Facebook’s chief operating officer, Sheryl Sandberg, expressed hesitancy over Facebook’s ability meet these targets. In a June 2010 email exchange that included Mr. Ebersman, she stated: “My gut—and this is pure gut— tells me that our current trajectory is to hit $1.9 [billion] or less this year and then grow by 50% next year and less in 2012.” In mid-June 2010 Mr. Ebersman provided a draft of the LRP to Mr. Zuckerberg, Facebook’s founder, chairman, chief executive officer, and controlling shareholder, in anticipation of meeting with him to discuss it. He told Mr. Zuckerberg that the plan was to build around the medium revenue case in the draft, which reflected the bottoms-up forecast of just over $8 billion in worldwide revenue in 2013. Mr. Zuckerberg set the 2013 revenue forecast at $10 billion, instructing Facebook’s finance team to add Other Revenue to the Base Case forecast to produce that number. Mr. Zuckerberg’s decision to increase the 2013 revenue target was contentious internally. But Mr. Zuckerberg generally viewed Board meetings as an “open conversation”—an opportunity to discuss Facebook’s biggest issues, both opportunities and challenges, even if he did not yet have a solution. Mr. Zuckerberg understood that the finance team was forecasting how Facebook’s existing products were going to perform. He also acknowledged that the finance team’s revenue projections had been 41 accurate in the past and thought that their projection here may have been a little optimistic. Nonetheless, he thought that Facebook should perform better. He wanted to challenge the M team and other Facebook employees to do better. And he wanted to avoid the tendency to forecast just the things that existed. He believed Facebook “could create new things, and over a multi-year period, they could ramp up to be something meaningful” and ultimately deliver a better result. Drafts of the LRP after Mr. Zuckerberg’s mid-June 2010 input projected $10 billion in revenue in 2013 as a top-down estimate. In the breakout of revenue by segment, the “Other” category was increased from a de minimis revenue stream ($13 million in 2013) to an amount that represented the difference between the bottoms-up (approximately $8 billion) and top-down ($10 billion) forecasts. At least one of these drafts asked whether Facebook was “comfortable with a ~$2Bn ‘tbd’ plug for the 2013 revenue forecast?” and listed “$2bn ‘other’ revenue” as an item for followup. In the final LRP presented to the Board in August 2010 the “Base Case” scenario included an Other Revenue “plug” amount of zero for 2011, approximately $100 million for 2012, and approximately $1.9 billion for 2013. The final LRP also retained questions about the $10 billion revenue forecast for 2013, as we detail below. In addition to the Base Case, the final LRP included three other scenarios. The downside scenario labeled “Excl. ‘Other’ Revenue” simply excluded Other Revenue (as its label implies). It forecast $3.5 billion, $5.9 billion, and $8.1 billion for 2011, 2012, and 2013, respectively. The scenario labeled “Excl. ‘Other’ & Credits Rev.” excluded both Other Revenue and Credits Revenue. The scenario labeled “Upside” adopted revenue figures of $5 billion, $10 billion, and $15 billion for 2011, 2012, and 2013, respectively. 2. Key projections in the final LRP Base Case a. User growth The LRP projected that Facebook’s global MAUs would grow from 519 million in September 2010 to 600 million by the end of 2010, 834 million by 2011, 1.025 billion by 2012, and 1.195 billion by 2013. This reflected Facebook’s strong position in the social media industry in 2010; it was the largest social network in the world. Overall Facebook was in a dominant position in its industry because it possessed the largest user community and its user community was rapidly growing. But the LRP 42 also identified risks to user growth and engagement including “[s]aturation points in key countries,” “[d]ecreased engagement,” and “[c]ompetition.” The LRP reflected Facebook’s concern about user churn, which hurt user growth. Churned users were those who became “stale” (users whose last action was over 30 days ago) or “deactivated” (users who deactivated, but did not delete, their accounts). The LRP noted that, despite increasing user churn, Facebook added 30 million MAUs in July 2010 and mobile growth “reaccelerated.” It stated that Facebook’s team was “focused on reducing churn, better engaging new and low-activity users, and combatting fake accounts/spam across the site.” The LRP also mentioned the risks of site reliability, user discomfort with sharing personal information, and safety concerns as challenges to maintaining and growing its user base. To achieve its user growth projections in the LRP, Facebook anticipated that it would need to surmount various risks through innovations to the FOP technology. The LRP made assumptions and projections regarding Facebook’s users. It stated: “Mobile helps drives [sic] adoption around the world.” It assumed that global internet growth would continue each year through 2013 to more than 2.5 billion users. And that the “plan ends 2013 with 1.2B users (compared to ~900M for Google and ~600M for Yahoo today).” It also “assume[d] average user engagement (ad opportunities per user) [would] stay[] relatively flat.” b. Financial projections i. Ads and Credits Revenue For 2013 the LRP projected revenue from two existing sources, Ads and Credits. Together, Ads Revenue and Credits Revenue were projected to grow from approximately $1.9 billion in 2010 to approximately $8.1 billion by 2013. Ads Revenue was projected by taking the product of the user projections and ARPU. It was projected to grow from approximately $1.8 billion in 2010 to approximately $6.7 billion in 2013, for a compound annual growth rate (CAGR) of 55%. The LRP projected Credits Revenue to grow from under $100 million in 2010 to approximately $1.4 billion in 2013, reflecting a CAGR of 148%. It also listed the ability to ramp up Credits Revenue at this rate as a risk. The LRP indicated that Facebook’s ads business would grow significantly. It stated that “[o]verall online ads spend should continue 43 to grow at a healthy pace.” It noted that while Facebook then only accounted for “3% of online ad spend (vs. ~$50% for Google and 15% for Y[ahoo]!),” it anticipated that by 2013 it would grow its share to 7%. The LRP stated that Facebook predicted its ads revenue growth would be driven in equal parts by user growth and ads ARPU growth. It also stated that in the future Facebook planned to monetize its mobile platform, framing the shift to mobile as a “key strategic area.” The LRP also listed “[a]dvertiser [return on investment], particularly in the direct response business” as a risk. The LRP noted that in monetization Facebook still lagged behind competitors, especially those in the search advertising business. It noted, as an example, that in August 2010, Facebook had roughly the same number of active users as Google and Yahoo! had had three years earlier, but Google and Yahoo! were three to six times more effective at monetizing them. And it included a slide titled “Churn analysis for advertisers” which highlighted increased net churn even as total accounts grew. ii. Other Revenue Other Revenue was the third source of revenue in the Base Case. The LRP framed the Other Revenue target as aspirational. “Achieve $10B in annual revenue in 2013” was listed as a “proposed financial goal[].” The first bullet point on the slide titled “Key questions for discussion” asked: “Are we comfortable planning towards a $10B business?” It noted that this would require “~$3B from Credits and Other sources” to supplement “~$7B in ads.” Like the ability to ramp up Credits, the ability to ramp up Other Revenue was listed as a risk. In describing the Base Case revenue forecast, the LRP stated that Other Revenue “reflects the expectation that we will identify additional revenue opportunities over the coming years” and that it “[c]ould come from expanding [Facebook’s] existing Ads or Credits strategies and/or from new sources.” “Begin considering ideas for $2B in ‘other’ revenue by 2013” was listed on the “[f]ollow-up items and next steps” slide. These caveats were included because Mr. Ebersman wanted to ensure the Board understood that Other Revenue was a meaningful portion of the forecast for 2013 but Facebook did not have a plan for achieving it. Facebook had identified neither a product to generate Other Revenue nor a market in which it would earn Other Revenue. The need to explain these caveats was the most memorable part of the August 2010 presentation for Mr. Ebersman. 44 iii. Discount rates The LRP offered discount rates of 12.5%, 15%, and 17.5% on slides titled “Illustrative valuation ranges ($ per share),” “DCF valuation comparison ($ per share),” and “Illustrative valuation range detail ($ per share).” It used these discount rates as part of its discounted cashflow (DCF) analysis in computing an estimate for the (then) current value of Facebook’s stock. It listed Baidu, Tencent, and Google as comparables. iv. Projected expenses The two primary drivers of Facebook’s projected expenses in the LRP were capital expenditures and employee headcount. The LRP projected that Facebook’s capital expenditures would grow from $709 million in 2010 to $1.294 billion in 2013. It projected an increase in headcount from approximately 2,140 employees in 2010 to approximately 7,760 employees in 2013. The LRP also included among its key assumptions “M&A and Other Contingency” of $50 million, $250 million, and $750 million, for 2011 to 2013, respectively. A cashflow statement included these business acquisition expenses together with capital expenditures for purposes of computing cashflows from investing activities; neither was included in the computation of cashflows from operating activities. Facebook did not associate material projected expenses with Other Revenue. The LRP stated that 2013 free cashflow “could be overstated if the ‘other’ revenue is not generated from Ads or Credits” because Facebook “ha[d] not aggressively planned for significant increased expenses (beyond ~250 heads) to support an entirely new revenue stream.” Mr. Ebersman and the finance team thought that planning for expenses attributable to Other Revenue would be a more useful exercise once Facebook figured out what Other Revenue was going to be. Comparing the Base Case and the Downside Excluding Other Revenue indicates that the operating margin for Other Revenue would have been 94% (92% when accounting for the costs of 250 additional full-time employees). 45 3. Internal use of the LRP Soon after Facebook’s M team presented the LRP to the Board, 43 Facebook used it for internal decision-making purposes, and shared it with employees. Facebook also provided the Base Case to an accounting firm, KPMG LLP (KPMG), to value its common stock for compensation purposes under section 409A. KPMG produced a section 409A valuation report for the third quarter of 2010 and for quarters thereafter. In these reports KPMG employed various valuation methods—DCF method, secondary market transaction method, guideline public company method—to establish the FMV of Facebook’s common stock. In the section 409A valuation report for the quarter ending September 30, 2010, it employed a DCF method that incorporated the Base Case projections. KPMG viewed the Base Case projections as projecting significant growth that Facebook might not be able to realize. Accordingly, it added a “[c]ompany specific risk premium” of 6% to the discount rate it used to convert cashflows to present value, resulting in a weighted average cost of capital (WACC) of 17%. 44 It employed the secondary market transaction method as a corroboration method. B. Investment bank’s equity investment In December 2010, Goldman Sachs (investment bank or bank) considered an investment in Facebook’s common stock. 45 As part of its 43 It is unclear from the record whether formal Board approval was sought or required. 44 “The WACC provides the expected rate of return for a company on the basis of the average portion of debt and equity in the company’s capital structure, the current required return on equity (i.e., cost of equity), and the company’s cost of debt.” Amazon I, 148 T.C. at 184 n.35 (quoting Veritas, 133 T.C. at 324 n.33). At trial, the details of the bank’s process for evaluating the prospective investment was sealed but its identity was not. The investments made by the bank, its affiliates, and its clients, through a vehicle the bank managed, in December 2010 and January 2011, significantly exceeded $1 billion. They were disclosed in the Form S–1, Registration Statement Under the Securities Act of 1933, for Facebook’s IPO. We have concluded that the high-level details relevant to our analysis need not be sealed given the age of the transaction and what already is public. 45 We use the term “investment bank” to focus on what is relevant to the analysis: Roughly contemporaneously to the transaction, an unrelated potential investor evaluated an investment in Facebook for itself, and for its clients, on the basis of information provided by Facebook along with its own knowledge, experience, and expertise. 46 due diligence before making the investment, the bank met with members of the M team. It reviewed updated Base Case projections shared by Facebook, historical financials, and business strategy and prepared a confidential memorandum for its investment committee summarizing its analysis. 46 The investment bank conducted an analysis of its required returns for making an investment considering comparable companies and how those companies traded publicly, and contemplating Facebook’s future earning potential at selected future points. The investment bank selected two points—early 2012 (assuming that an IPO was most likely in this timeframe) and late 2014. It anticipated that Facebook would be more comparable to some of its publicly traded peers at those future dates. In its returns analysis the investment bank used Facebook’s projections as a starting point to create its own base case. For its base case the investment bank reduced the revenue projections in Facebook’s Base Case for each year: by $696 million (18.56%) in 2011, $1.667 billion (27.78%) in 2012, and $3.235 billion (32.35%) in 2013. The investment bank applied this haircut to Facebook’s projected Base Case revenue for two reasons, explained at trial by a former vice president in the bank’s technology, media, and telecom investment banking group, involved in evaluating the Facebook investment. First, the bank thought Facebook’s projections for its current and identifiable revenue streams (Ads and Credits Revenue) were aggressive. It thought Facebook took an “optimistic” view of the Facebook Credits business and was generally “bullish” on the growth of its advertising business. Second, it was uncomfortable with Facebook’s projections because there was no plan for generating Other Revenue. The investment bank therefore scaled back total revenue to produce a more “middle-of-the-road” case for which it would be willing to invest. The bank concluded that an internal rate of return (IRR) in the range of the “high teens to mid-20s” was necessary for the risk it was taking by investing in Facebook in 2010. An IRR can generally be viewed as a “hurdle rate,” or the return an investor aims to achieve. It used a 46 Facebook’s December 2010 presentation to the bank increased its revenue projections for 2011 to $3.75 billion to reflect increased ads revenue from Ads Manager but left the revenue projections for 2012 and 2013 unchanged. 47 20% discount rate to compute an NPV of $47B, as of December 2010, of Facebook’s “[i]mplied” market cap in 2014 of $97B. 47 C. Financial results Facebook’s actual revenue, as reported in its Forms 10–K, Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934, for subsequent years, was $3.711 billion for 2011, $5.089 billion for 2012, and $7.872 billion for 2013. The actual revenue thus exceeded the investment bank’s projections but fell short of Facebook’s LRP projections for 2012 and 2013, even after excluding Other Revenue in those years. Facebook’s actual revenue did exceed the $10 billion in 2014; Facebook reported revenue of $12.466 billion for that year. This 58% revenue increase from 2013 to 2014 is slightly more than the 55% increase from 2012 to 2013. The table below compares the revenue projections in the LRP Base Case, the LRP Downside Excluding Other Revenue, the investment bank’s base case, and Facebook’s actual revenue (expressed in billions). V. Year LRP Base Case LRP Downside Excluding Other Revenue Investment bank’s base case Facebook’s actual revenue 2011 $3.5 $3.5 $3.054 $3.711 2012 6 5.9 4.333 5.089 2013 10 8.1 6.765 7.872 Transfer pricing documentation and payments Facebook, with the help of Ernst & Young LLP (EY), prepared transfer pricing documentation for the transaction, which was finalized in September 2011. 48 This transfer pricing documentation consisted of Respondent points to other projections by the investment bank: a DCF analysis to arrive at an intrinsic equity value and a public companies comparables analysis to compute Facebook’s average implied equity value. 47 48 To prepare transfer pricing documentation, EY extended the 2010 LRP projections through 2020. EY projected operating margins to decrease by 0.5% each year after 2013 and determined a long-term growth rate of 3% for the terminal value of Facebook’s expected future cashflows. The parties’ valuation experts cited these assumptions in preparing their own analyses. 48 three separate reports: a CSA report, an intercompany PCT and license payments report, and an intercompany service transactions report. For 2010 Facebook Ireland paid Facebook US (and Facebook US included in income) total royalties of roughly $100 million. This figure comprised approximately $60 million for the FOP technology, $38 million for the user community rights, and $3 million for the marketing intangibles. (The UBMI license did not specify separate royalties for the user community rights and the marketing intangibles; rather this appears to be the product of EY’s transfer pricing analysis.) Of the $100 million, Facebook Ireland paid $5 million cash and a $95 million intercompany note. The royalty amounts were based on the following NPVs for each category (expressed in millions): License NPV FOP technology $1,685 User community rights 4,078 Marketing intangibles (1%) 49 Total 545 $6,308 In preparing its valuation analysis for the required PCT Payment, EY included Other Revenue but used a lower operating margin based on the LRP Downside Excluding Other Revenue scenario. EY applied the income method to compute the NPV for the rights transferred by Facebook US to Facebook Ireland under the FOP technology license using a discount rate of 17.7%, which it derived by adding a 0.7% international risk premium to KPMG’s 17% WACC for Facebook. Facebook and EY concluded that Facebook Ireland would pay the FOP technology license royalties over four additional years (2011 through 2014), and royalties for user community rights over six additional years (2011 through 2016). Facebook Ireland made these 49 The transfer pricing documentation prepared by EY states, in part, that “FIH has agreed to pay FBUS 1% of total international revenue for rights to the Facebook marketing intangibles under the User and Marketing IP Agreement, which is within the arm’s length range of results from the CUT search described” in that documentation. We infer that EY’s reference to the “User and Marketing IP Agreement” is to the UBMI license which it attached as an appendix. The UBMI license does not specify a 1% royalty for the marketing intangibles but broadly states that “Facebook Ireland shall pay to Facebook US such arm’s length amounts as required by Treas. Reg. § 1.482-4.” 49 payments. Facebook Ireland also was expected to pay the 1% trademark license royalty in perpetuity (and did pay it throughout the period covered by the record). 50 EY concluded that Facebook Ireland’s 2010 RAB share was 44% (and Facebook US’s was therefore 56%). Following the method specified in the CSA, EY computed this percentage by dividing the NPV of current and projected gross profit in the ROW territory into worldwide gross profit. To compute the NPV it again used KPMG’s estimated WACC of 17% for Facebook. In 2010 Facebook’s total cost sharing pool (i.e., the total amount of aggregate allocable IDCs paid by both Facebook US and Facebook Ireland) totaled approximately $49 million. Facebook Ireland bore its stated RAB share of these costs. After deducting some IDCs that it had directly incurred, Facebook Ireland made a net CST Payment to Facebook US of approximately $21 million for 2010. In October 2013, during the IRS’s examination for Facebook’s 2010 tax year, Facebook responded to an information discovery request from the IRS broadly describing the Base Case projections in the LRP as “the most likely scenario to occur.” VI. Respondent’s allocations A. Notice The Notice, issued in July 2016, reallocated income on the basis of respondent’s determination that the NPV of the assets transferred— the FOP technology, user community rights, and marketing intangibles—and therefore the NPV of the PCT Payment was $13.88 billion, not the $6.3 billion that Facebook used for computing its 2010 royalties. This reallocation resulted in an increase of approximately $85 million in Facebook US’s gross royalty income for 2010. The Notice did not separate the adjustment into the three royalties FIH paid Facebook US pursuant to EY’s documentation. The Notice also determined that Facebook Ireland’s RAB share should be increased (and Facebook US’s decreased) which in turn increased Facebook Ireland’s required CST Payment and reduced 50 It is unclear how Facebook Ireland made these payments (i.e., whether through a note or cash), but respondent does not dispute that Facebook Ireland paid some royalties or that it paid the 1% trademark license royalty. 50 Facebook US’s by a corresponding amount. The Notice therefore decreased Facebook US’s deductions for IDCs by $5.39 million for 2010. 51 Petitioner timely petitioned for redetermination. B. Amended Answer A month before trial respondent filed a First Amendment to Answer (Amended Answer), 52 increasing his asserted NPV for the PCT Payment from $13.88 billion to $21.15 billion, on the basis of Dr. Newlon’s opening expert report. This assertion in turn increased petitioner’s 2010 deficiency by approximately $2.4 million. The $21.15 billion NPV is the top of the range that Dr. Newlon opined would be arm’s length in his opening expert report. In his posttrial opening brief respondent argues that a PCT Payment of $19.945 billion is appropriate. 53 Respondent also has adopted Dr. Newlon’s calculation of Facebook Ireland’s RAB share for 2010 (53.5%), which is slightly lower than the RAB share respondent determined for Facebook Ireland in the Notice. This adjustment resulted in a decrease of $4.66 million (rather than the $5.39 million in the Notice) to Facebook US’s deductions for IDCs for 2010, resulting in a reduced deficiency of $735,020 attributable to this item. OPINION Before we tackle the parties’ legal arguments we address threshold evidentiary and procedural matters. We first address petitioner’s contention that respondent raised a “new matter” under This $13.88 billion NPV determination also resulted in collateral computational adjustments to Facebook’s net operating loss, a domestic production activities deduction, and general business credits. 51 52 Two months earlier, we gave respondent a deadline to move for leave to file an amended answer if he planned to seek an increased deficiency for 2010. This came after respondent indicated that he might be seeking an increased deficiency on the basis of what he “intend[ed] to present at trial.” Respondent then filed a Motion for Leave to File First Amendment to Answer. In our Order granting respondent’s Motion, we stated that we would allow petitioner to identify any prejudice during the course of trial and we deferred ruling on the effect of respondent’s amendment on the burden of proof. 53 Dr. Newlon presents this as the median result falling within a range from $18.757 billion to $21.147 billion that he determined under his method; respondent argues that a PCT Payment falling within Dr. Newlon’s range is reasonable and chose the midpoint. 51 Rule 142(a), shifting the burden of proof to respondent. We then discuss the extent to which we will consider posttransaction evidence. Finally, we address the scope and standard of review under section 482. I. Burden of proof The taxpayer generally bears the burden of proving that the Commissioner’s determinations in a Notice of Deficiency are erroneous. See Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). The Commissioner bears the burden of proof with respect to “any new matter, increases in deficiency, and affirmative defenses[] pleaded in the answer.” Rule 142(a)(1). The Commissioner raises a new matter when “a notice of deficiency fails to describe the basis on which the Commissioner relies to support a deficiency determination and that basis requires the presentation of evidence that is different than that which would be necessary to resolve the determinations that were described in the notice of deficiency.” Shea v. Commissioner, 112 T.C. 183, 197 (1999). In his Amended Answer, respondent asserted an increased deficiency for 2010 on the basis of Dr. Newlon’s opening expert report. The parties agree that respondent bears the burden of proof with respect to the increase. But petitioner contends that respondent’s Amended Answer also raised a new matter and he therefore has the burden of proof as to the entire deficiency. The Amended Answer did not change the statutory basis for respondent’s (now-increased) deficiency determination. See Abatti v. Commissioner, 644 F.2d 1385, 1390 (9th Cir. 1981), rev’g T.C. Memo. 1978-392. In the Notice, respondent invoked section 482 to reallocate income in connection with the transaction. In his Amended Answer, he also relies on section 482, now reallocating a greater amount of income. The main issues—the arm’s-length PCT and CST Payments— remain the same. Respondent now supports his determination with a different valuation methodology. For reallocations under section 482, “[t]he fact that the Commissioner relies on alternative theories at trial, supported by methodology different from that used in the notice of deficiency, does not necessarily place the burden on the Commissioner.” Altama Delta Corp. v. Commissioner, 104 T.C. 424, 458 (1995) (citing Sundstrand Corp. & Subs. v. Commissioner, 96 T.C. 226, 354–55 (1991)); see also Stewart v. Commissioner, 714 F.2d 977, 990 (9th Cir. 1983) (“It is well settled that the assertion of a new theory that merely 52 clarifies the original determination, without requiring the presentation of different evidence, does not shift the burden of proof.” (citing Achiro v. Commissioner, 77 T.C. 881, 890 (1981))), aff’g T.C. Memo. 1982-209. In a posttrial hearing we asked petitioner what different evidence it would have presented had respondent not amended his Answer. Petitioner confirmed that it would not have selected a different best method for estimating the arm’s-length PCT Payment in its case-inchief. Petitioner did note that its experts had to respond, on rebuttal, to a different method (Dr. Newlon’s income method) that applied different inputs (financial projections, discount rate, best realistic alternative) from the method and inputs underlying the Notice. But a rebuttal expert report should respond to the other side’s case-in-chief expert witness and the arguments made and evidence presented at trial by the other side through their expert(s). 54 We have treated a party’s reliance on new expert witness methodologies in a transfer pricing case as analogous to pursuing alternative legal theories. See Altama Delta Corp., 104 T.C. at 458. Changes to expert witness methodologies do not “necessarily” shift the burden of proof to the Commissioner. See id. (ruling that the Commissioner’s revisions at trial to the section 482 reallocations in the Notice of Deficiency did not warrant shifting the burden of proof). Raising a new statutory provision (e.g., dropping an economic substance challenge in favor of section 482), by contrast, would shift the burden of proof. See Achiro, 77 T.C. at 891. Here, petitioner had sufficient notice of the basis of respondent’s deficiency determination (a section 482 reallocation in connection with the transaction). Shifting the burden of proof with respect to the entire deficiency therefore is inappropriate. We conclude that petitioner retains the burden of proof for the deficiency determined in the Notice and respondent bears that burden for the increase to that amount in the Amended Answer. Regardless, the record before us allows us to resolve all issues on a preponderance of the evidence. The assignment of the burden of proof is not dispositive. 54 Respondent moved to exclude some of petitioner’s rebuttal experts’ reports as containing “untimely opening opinions.” We denied respondent’s Motion because the changes that petitioner’s experts made to their valuation methodology and inputs directly or indirectly challenge respondent’s opening expert reports on the same subject matter—generally, the arm’s-length amount charged in a PCT. 53 II. Posttransaction evidence In resolving the issues before us our focus is on the transaction date and what was “reasonably anticipated” as of that date. See Temp. Treas. Reg. § 1.482-7T(c)(1), (j)(1)(i) (defining compensable contributions by whether they are “reasonably anticipated to contribute to” either development of cost shared intangibles or exploitation of them). 55 For example, the regulations direct the parties to use financial projections that reflect a “probability weighted average of possible outcomes,” and a discount rate that reflects “the market-correlated risks of activities or transactions . . . based on all the information potentially available at the time for which the present value calculation is to be performed.” Id. para. (g)(2)(v) and (vi). Likewise, estimating RAB shares requires selecting reliable projections to measure the reasonably anticipated benefits. Id. para. (e)(1). Evidence from after the transaction date can help us evaluate what was reasonably anticipated or expected then. To that extent, therefore, posttransaction evidence may be relevant. Fed. R. Evid. 401 and 402. We have looked to posttransaction evidence for this purpose in valuation cases. See, e.g., Estate of Gilford v. Commissioner, 88 T.C. 38, 52 (1987) (permitting consideration of posttransaction date events “for the ‘limited purpose’ of establishing what the willing buyer and seller’s expectations were on the valuation date and whether these expectations were ‘reasonable and intelligent’” (quoting Estate of Jephson v. Commissioner, 81 T.C. 999, 1002 (1983))). We have considered posttransaction evidence for this purpose in prior cost sharing cases. See Amazon I, 148 T.C. at 168 (noting “ex post data” of a contract amendment that postdated the CSA transaction by 18 months “may provide a reference point or sanity check”); Veritas, 133 T.C. at 326–27 (comparing Veritas Ireland’s actual growth rate with the growth rate employed by the Commissioner’s valuation expert during a period following the tax years in issue and looking to its role in the international markets during the CSA). Throughout the trial, respondent objected to petitioner’s questions about posttransaction events as irrelevant. We overruled this objection but observed that posttransaction evidence has its limits 55 See also Treas. Reg. § 1.482-1(f)(2)(iii)(A and B) (explaining that “results of a controlled transaction ordinarily will be compared with the results of uncontrolled comparables occurring in the taxable year under review” but in certain circumstances multiyear data may be considered). 54 (affecting weight more than admissibility). 56 Respondent expressed concern about petitioner’s using posttransaction evidence to highlight the risks Facebook anticipated as of the transaction date (e.g., the shift from desktop to mobile) and downplay the corresponding opportunities (e.g., growing number of mobile users), reminding us that Facebook encountered these “supposed hiccups” on its way to becoming one of the world’s most valuable companies. Petitioner contends that posttransaction evidence is relevant precisely because respondent disputes testimony from Facebook’s management and employees about the risks they saw as of the transaction date. For example, petitioner points to its struggle to develop a native mobile app, such as the Faceweb failure, to demonstrate that Facebook was reasonable to view the shift to mobile as a risk in 2010. At trial, both parties focused on what was reasonably anticipated or expected as of the transaction date. They agree that we may look to what happened after the transaction date to assess the reasonableness of Facebook’s expectations at the time. Both parties also introduced evidence and elicited fact-witness testimony about events after the transaction date as part of their cases-in-chief. And both adopt the opinions of experts who relied on information from after the transaction date. The parties’ fight shows how posttransaction evidence may be helpful to our evaluation of the parties’ divergent views on Facebook’s prospects when it entered into the CSA, even as it also illustrates the limits to its usefulness. We consider posttransaction evidence within those limits. III. Scope and standard of review We now turn to the scope and standard of review, and a bit of semantics. The parties agree that we review deficiencies resulting from the Commissioner’s section 482 allocations de novo, under section 6213. Instead their focus is on the standard of review; they disagree over the deference we should afford respondent’s determination. 56 At trial we permitted testimony about posttransaction developments but cautioned the parties that the more distant the development was the less relevant it would be. 55 The Commissioner has broad discretion under section 482, and an allocation will be set [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Atax-court%3Aed056fbcb2711b00. Public record. Not legal advice.