Amazon.Com Tax Court Opinion

148 T.C. No. 8

UNITED STATES TAX COURT

AMAZON.COM, INC. & SUBSIDIARIES, PetitionerPetitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 31197-12. Filed March 23,23, 2017.2017.

In 2005 P entered into a cost sharing arrangementarrangement (CSA)(CSA) withwith S, its LuxeLuxembourgmbourg subsidiary. Pursuant toto thethe CSA,CSA, PP grantedgranted SS thethe right to use certain pre-existing intangibleintangible assetsassets inin Europe,Europe, includingincluding the intangibles required toto operateoperate PP's’s EuropeanEuropean websitewebsite business.business. This arrangement required S to mmakeake an upfront “"buybuy-in-in paypayment"ment” to compensate P for the value of the intangible assetsassets thatthat werewere toto bebe transferred to S. See sec. 1.482-7(a)(2), (g)(2), IncomeIncome TaxTax Regs.Regs. Thereafter S was required to mmakeake annual costcost sharingsharing paymentspayments toto ccompensateompensate P fforor oongoingngoing intangibleintangible developmentdevelopment costscosts (IDCs), toto the extent those IDCs benefited S.S. SeeSee id.id. paras.paras. (a)(1),(a)(1), (d)(1).(d)(1). AsAs consideration for the transfer ofof pre-existingpre-existing intangibles,intangibles, SS mmadeade aa $254.5 mmillionillion buy-inbuy-in payment to P.

Applying a discounted cash-flowcash-flow (DCF) methodology toto thethe eexpectedxpected ccashash fflloowsws ffromrom tthehe EEuropeanuropean bbusiness,usiness, R R determined determined a a buybuy- in payment of $3.6 billion, later reduced toto $3.468$3.468 billion.billion. PP con-contends that RR's’s DCF methodology is substantially similar toto thatthat re-rejected by this Court in Veritas SoftwareSoftware Corp. v.v. CoCommissioner,mmissioner, 133133 - 2 -

T.C. 297 (2009). P contends that RR's’s determinations areare arbitrary,arbitrary, capricious, and unreasonable andand thatthat thethe comparablecomparable uncontrolleduncontrolled transaction (CUT) method is the best mmethodethod toto calculatecalculate thethe requisiterequisite buy- buyin payment.-in payment.

P used a multistep allocation system to allocate costscosts fromfrom its variousvarious ccostost centers to IDCs. See sec. 1.482-7(d)(1), IncomeIncome Tax Regs. (providing that costscosts “"mustmust be allocatedallocated betweenbetween thethe intangibleintangible development area and the other areaareass or business activitiesactivities onon aa rea-reasonable basis").basis”). While acceacceptingpting PP's’s allocation mmethodethod inin mmanyany re-respects, R determined that 100% of the costscosts capturedcaptured inin oneone importantimportant cost center (("Technology“Technology and ContentContent")”) must be allocatedallocated toto IDCs.IDCs. PP contends that RR's’s determination to allocateallocate toto IDCsIDCs 100%100% ofof thethe Technology and Content costs is inconsistentinconsistent withwith thethe regulations.regulations.

1. Held:Held: RR's’s determination with respect to the buy-inbuy-in payment isis arbitrary,arbitrary, ccapricious,apricious, aandnd uunreasonable.nreasonable. Veritas Software Corp. v. CommissionerCommissioner,, 133 T.C. 297, followed.

2. Held,Held, furtherfurther,, PP's’s CUT mmethod,ethod, with appropriate upward ad-adjustments in numerous respects, is the best mmethodethod toto determinedetermine thethe requisite buybuy-in-in payment.

3.3. Held,Held, further,further, R abusedabused hishis discretiondiscretion in determining that 100% of Technology and Content costscosts constituteconstitute IDCs.IDCs.

4.4. Held,Held, further,further, P'sP’s costcost-allocation-allocation mmethod,ethod, with certain adjustments, supplies a reasonable basis forfor allocatingallocating costscosts toto IDCs.IDCs.

JJohnohn BB.. MMagee,agee, SSanfordanford WW.. SStark,tark, BBryonryon AA.. CChristensen,hristensen, TTraceyracey X. X. Zheng Zheng,,

Robert S. KirschenbaumKirschenbaum,, Beth L. WilliamsWilliams,, John G. RyanRyan,, Saul MezeiMezei,, Julia

Kazaks,Kazaks, Rajiv MadanMadan,, John A. PolitoPolito,, Michael D.D. KummerKummer,, Christopher P.P. - 3 -

Murphy,Murphy, RRoyceoyce LL.. Tidwell,Tidwell, CCarlarl T.T. Ussing,Ussing, HansHans D.D. Gerling-Ritters,Gerling-Ritters, Nicholas A.

Zemil,Zemil, and Paul M. McLaughlinMcLaughlin,, for petitioner.

Jill A. FrischFrisch,, Anne OO'Brien’Brien HintermeisterHintermeister,, Melissa D. LangLang,, LloydLloyd T.

SilberzweigSilberzweig,, Shannon L. CohenCohen,, Melissa L.L. HiltyHilty,, ScottScott W.W. MentinkMentink,, DavidDavid A.A.

LeeLee,, My V. Vo,Vo, Jimeel R. Hamud,Hamud, Aaron T. Vaughan,Vaughan, and Mary E. WynneWynne,, for respondent.

CONTENTS

FINDINGSFINDINGS OOFF FFACTACT...... 10

I. Overview of AmazonAmazon's’s European Business ...... 12 A. Initial Expansion Into Europe ...... 12 B. Original Structure of European Business ...... 1166 C. "Project“Project GGoldcrest"oldcrest” ...... 202 . 0 1.1. Cost Sharing Arrangement ...... 23 2.2. LLicenseicense Agreement ...... 24 3.3. AssignmentAssignment Agreement ...... 24 4.4. European Subsidiary Contribution ...... 25 55.. European Business Contribution ...... 25 6.6. FourFour--PartyParty Agreement ...... 26 D. Life After Project Goldcrest ...... 26

II. Retail and Technological Environment ...... 28 A. Internet Retail Environment ...... 28 B. Evolution of AmazonAmazon's’s Website Architecture ...... 32 C. Evolution of AmazonAmazon's’s Software Applications ...... 38 1.1. CCustomerustomer Master Service ...... 38 2.2. OOrderrder Master Service ...... 39 3.3. DDynamoynamo ...... 40 4.4. PPaymentsayments ...... 41 55.. IItemtem MMasteraster ...... 42 - 4 -

6.6. Personalization ...... 43 77.. MMessagingessaging ...... 45 D. New Products and Services After JanuaryJanuary 1, 2005 ...... 46

III. Amazon'sAmazon’s ThirdThird-Party-Party Businesses ...... 47 A. Merchants.comMerchants.com ...... 47 B. Associates and Syndicated Stores ...... 49

IV.W. TheThe BBuyuy--InIn PPaymentayment ...... 51

V. Cost Sharing PayPaymentsments ...... 57

VI. Stock-BasedStock-Based Compensation ...... 65

OOPINIONPINION ...... 67

I. Cost Sharing Background ...... 69

II. RespondentRespondent's’s Determination of the Buy-InBuy-In PaymentPayment ...... 7373

III. PetitionerPetitioner's’s Determination of the Buy-InBuy-In PaymentPayment ...... 89 A. WebsiteWebsite Technology ...... 91 1.1. RRoyaltyoyalty RRateate ...... 95 2.2. Useful Life and Decay Curve ...... 102 a. UsefulUseful LLifeife ...... 103 b.b. DecayDecay CCurveurve ...... 107 c. "Tail"“Tail” PPerioderiod ...... 1117 17 3.3. RRevenueevenue Base ...... 121 4.4. DDiscountiscount Rate ...... 124 B. Marketing Intangibles ...... 127 1.1. RRoyaltyoyalty RRateate ...... 129 2.2. UsefulUseful LLifeife ...... 135 3.3. RRevenueevenue Base ...... 143 4.4. DDiscountiscount Rate ...... 146 55.. European Portfolio ...... 147 a. Ownership of the European Portfolio ...... 148148 b.b. Allocating Value to the European PortfolioPortfolio ...... 154154 - 5 -

C. CCustomerustomer Information ...... 162

IV.W. CCostost Sharing PayPaymentsments ...... 173 A. RespondentRespondent's’s Position ...... 174 B. PetitionerPetitioner's’s Position ...... 178 C. Stock-BasedStock-Based Compensation ...... 185

LAUBER, Judge:Judge: The Internal Revenue ServiceService (IRS oorr respondent)respondent) deter-determined, for 2005 and 2006 respectively, deficienciesdeficiencies inin petitionerpetitioner's’s FederalFederal incomeincome tax of $8,380,790 and $225,653,149.$225,653,149.11 TheseThese deficienciesdeficiencies arosearose frofromm aa seriesseries ofof transactions by which AAmazon.com,mazon.com, Inc., and its dodomesticmestic subsidiariessubsidiaries (collective-(collectively, AmazonAmazon US) transferred to Amazon Europe Holding TechnologiesTechnologies SCSSCS

(AEHT), a Luxembourg subsidiary, the intangible assets requiredrequired toto operateoperate pe-petitioner'stitioner’s European website business. InvokingInvoking sectionsection 482,482, thethe IRSIRS mademade substantial transfer-pricingtransfer-pricing adjustmentsadjustments reallocatingreallocating incomeincome toto AAmazonmazon USUS fromfrom

AEHT.

From its inception through 2005 AAmazonmazon USUS ownedowned thethe intellectualintellectual prop-property in question. In 2004 AAmazonmazon US andand AEHTAEHT enteredentered intointo aa “"costcost sharingsharing

1lUnless otherwise indicated, allall statutorystatutory referereferencesnces areare toto thethe InternalInternal Revenue Code in effect for the tax years at issue,issue, andand allall RuleRule referereferencesnces areare toto thethe Tax Court Rules of Practice and Procedure. WeWe roundround allall dollardollar amountsamounts toto thethe nearest dollar. - 6 - arrangement."arrangement.” See sec. 1.482-7(a)(1), (b)(1), IncomeIncome Tax Regs.Regs.22 This arrangement required AEHT to make an up-frontup-front "buy“buy-in-in paymentpayment"” to compensate Ama- zon US for the value of the intangible assetsassets thatthat werewere toto bebe transferredtransferred toto AEHT.AEHT.

See id. paras. (a)(2), (g)(2). Thereafter AEHT was required to mmakeake annualannual costcost sharing payments to compensate Amazon US for ongoing intangibleintangible developmentdevelopment costs (IDCs), to the extent those IDCsIDCs benefited AEHT.AEHT.

In a series of transactions inin 2005 andand 20062006 AAmazonmazon USUS transferredtransferred toto

AEHT three groups of intangible assets: (1)(1) thethe softwaresoftware andand otherother technologytechnology re-required to operate petitionerpetitioner's’s EuropeanEuropean websites,websites, fulfillmentfulfillment centers,centers, andand relatedrelated business activities; (2)(2) mmarketingarketing intangibles,intangibles, includingincluding trademarks,trademarks, tradenames,tradenames, and domain names relevant to the European business; andand (3)(3) customercustomer listslists andand other information relating to petitionerpetitioner's’s EuropeanEuropean clientele.clientele. AfterAfter concessions,concessions,33 this case requires the Court toto decidedecide twotwo mainmain issues:issues: thethe properproper amountamount ofof

AEHT'sAEHT’s buybuy-in-in obligation with respect to the assetsassets thusthus transferred;transferred; andand thethe vol-vol-

2Section 1.482-7, Income Tax Regs.,Regs., was redesignatedredesignated sectionsection 1.482-7A,1.482-7A, IncomeIncome TaxTax Regs.,Regs., withwith thethe promulgationpromulgation ooff new regulations effective January 5, 2009. See T.D. 9441, 2009-7 I.R.B. 460.

3On0n May 30, 2014, the parties filedfiled aa stipulation ofof settledsettled issuesissues reflectingreflecting theirtheir ssettlementettlement ooff aann iissuessue captionedcaptioned “"CostCost SharingSharing AcquiredAcquired Intangibles Intangibles Buy-In. Buy-In."” Petitioner conceded this issue inin fullfull andand agreedagreed thatthat itsits taxabletaxable incomeincome wouldwould accordingly be increased by $4,881,993 forfor 20052005 andand $2,548,165$2,548,165 forfor 2006.2006. - 7 - umeume ofof petitioner'spetitioner’s ccostsosts pproperlyroperly ttreatedreated asas IDCs (the larger the volume, the larger the cost sharing payments that AEHT mmustust mmake).ake).

On the first issue, petitioner originallyoriginally reportedreported aa buy-inbuy-in paymentpayment fromfrom

AEHTAEHT ooff $254.5 mmillion,illion, to be paid overover sevenseven years.years. InIn determiningdetermining thethe valuevalue ofof the transferred assets, petitioner assumedassumed thatthat eacheach groupgroup ofof assetsassets (website(website tech-technology, mmarketingarketing intangibles, andand customercustomer information)information) hadhad aa seven-yearseven-year usefuluseful life.

On examination of petitionerpetitioner's’s returns, the IRSIRS cconcludedoncluded thatthat thethe buy-inbuy-in paymentpayment hhadad nnotot bbeeneen ddeterminedetermined atat armarm's’s length.length. SeeSee sec.sec. 1.482-7(g)(2),1.482-7(g)(2), IncomeIncome

Tax Regs. In respondentrespondent's’s view, the transferred propertyproperty hadhad anan indeterminateindeterminate useful life, and it had to be valued, notnot asas threethree distinctdistinct groupsgroups ofof assets, assets, butbut asas in-integrated components of an operating business. ApplyingApplying aa discounteddiscounted cash-flowcash-flow

(DCF) methodology to the expected cash flowsflows fromfrom the EuropeanEuropean business, thethe

IRS determined a buybuy-in-in paypaymentment of $3.6 billion, laterlater reducedreduced toto $3.468$3.468 billion.billion.

Petitioner contends that respondentrespondent's’s DCFDCF methodologymethodology isis substantiallysubstantially similarsimilar to that rejected by this Court inin Veritas SoftwareSoftware Corp.Corp. v.v. CommissionerCommissioner,,

133133 TT.C..C. 229797 ((2009),2009), nonacqnonacq.,., 2010-492010-49 I.R.B.I.R.B. (2010).(2010). PetitionerPetitioner disputesdisputes the the con- con- ceptual soundness ofof that mmethodologyethodology asas appliedapplied here,here, contendingcontending thatthat itit treatstreats short-lived intangibles as if they had perpetual useful lives. The result, according short-lived intangibles as if they had perpetual- 8 - useful lives. The result, according to petitioner, is to inflate the buy-in payment by improperly including in it the value of subsequently developed intangible property. See sec. 1.482-7(g)(2), In-

come Tax Regs. (requiring that the buy-in payment reflect only pre-existing intangibles).

To value the pre-existing intangibles properly, petitioner contends that each group of transferred assets must be valued separately under the "comparable un-

controlled transaction" (CUT) method. On the basis of expert testimony at trial,4 petitioner contends that the website and related technology had a value when transferred between $117 million and $182 million; that the marketing intangibles had a value when transferred between $115 million and $165 million; and that the

customer information had a value when transferred between $52 million and $66 million. This would yield a buy-in payment ranging from $284 million to $413 million. Citing testimony by his trial experts, respondent urges substantially high-

er values for each group of assets in the event we reject his DCF method.

With respect to ongoing cost sharing payments, we must address two distinct issues. The first is essentially a tax accounting question, requiring that we determine "all of the costs incurred * * * related to the intangible development

4An alphabetical list of petitioner's and respondent's expert witnesses, together with a short resume of each, appears in the appendix to this Opinion. - 89 - area."to petitioner, Id. paras. is to (b)(2), inflate (d)(1), the buy-in (f)(1). payment Petitioner by improperlyused a multistep including allocation in it the system tovalue allocate of subsequently costs from itsdeveloped various costintangible centers property. to IDCs. SeeSee sec. id. para.1.482-7(g)(2), (d)(1) (pro- In- vidingcome Tax that Regs. costs (requiring"must be allocated that the buy-in between pay thement intangible reflect only development pre-existing area in- and thetangibles). other areas or business activities on a reasonable basis"). While accepting petitioner'sTo value allocation the pre-existing system in intangibles many respects, properly, the IRS petitioner determined contends that 100%that each of thegroup costs of transferredcaptured in assets one important must be valuedhigh-level separately cost center under ("Technology the “comparable and un-Con- tent")controlled must transaction be allocated” (CUT) to IDCs. method. The result On the of basisthis determination of expert testimony was to at increase trial,4 bypetitioner $23 million contends and $109.9that the millionwebsite the and cost related sharing technology payments had that a value AEHT when was re- quiredtransferred to make between in 2005 $117 and million 2006, and respectively. $182 million; Asserting that the that marketing this determination intangibles washad aarbitrary value when and transferredcapricious, betweenpetitioner $115 contends million that and only $165 about million; half ofand Tech- that the nologycustomer and information Content costs had shoulda value be when allocated transferred to IDCs. between $52 million and $66 million.The This second would question yield a involves buy-in payment section 1.482-7(d)(2),ranging from $284 Income million Tax toRegs., $413 whichmillion requires. Citing thattesti stockmony-based by his compensationtrial experts, respondent be included urges in the substantially IDC pool upon high- whicher values cost for sharing each group payments of assets are based. in the eventPetitioner we reject complied his DCF with method. this regulation in preparingWith respect its 2005-2006 to ongoing tax returns;cost sharing because payments, the vast we bulk must of address petitioner's two dis-stock- basedtinct is compensationsues. The first was is essentially paid to its adomestic tax accounting employees, question, the result requiring was tothat increase we accordinglydetermine “all the of cost the sharingcosts incurred payments * * required* related of to AEHT.the intangible Our treatment development of this issue is governed by the terms of the parties' cost sharing agreement, and in light

4An alphabetical list of petitioner’s and respondent’s expert witnesses, together with a short resume of each, appears in the appendix to this Opinion. -- 10 9 -- aofre oura.” decisionId. paras .in (b Altera)(2), ( dv.)( 1Commissioner,), (f)(1). Petitioner 145 T.C.used 91 a multistep (2015), which allocation invalidated system theto allocate regulation costs in fromquestion. its various cost centers to IDCs. See id. para. (d)(1) (providing that costs “must be allocatedFINDINGS between OF the FACT intangible development area and the otherAmazon.com, areas or business Inc. (ACI), activities is the on common a reasonable parent basis of a” ).group While of acceaffiliatedpting cor- porationspetitioner ’thats allocation join in the system filing in of m aany consolidated respects, the return IRS (Amazondetermined US) that and 100% of nu- of merousthe costs foreign captured subsidiaries in one important (collectively, high-level Amazon cost centeror petitioner). (“Technology ACI was and incor- Con- poratedtent”) must in 1994 be allocated in Washington to IDCs. and The was result reincorporated of this determination in 1996 in wasDelaware. to increase It beganby $23 operations million and in $109.9 1995 and million completed the cost an sharing initial publicpayments offering that AEHT of common was re- stockquired in to 1997. make Itsin 2005principal and 2006,place ofrespectively. business when Asserting it filed that the thispetition determination was in wasSeattle, arbitrary Washington. and capricious,5 petitioner contends that only about half of Tech- nologyAmazon and Content is an costsonline should retailer. be allocatedIt does not to haveIDCs. brick-and-mortar stores, but rather sellsThe second products question exclusively involves through section Amazon.com 1.482-7(d)(2), and Incorelatedme websites.Tax Regs., Ini- tiallywhich Amazon requires soldthat onlystock-based books, butcompensation by 2000 it hadbe included expanded in itsthe offerings IDC pool into upon manywhich other cost sproductharing p categories,ayments are including based. Pe music,tition ervideo, com pelectronics,lied with th toys,is reg software,ulation videoin preparing games, its cameras, 2005-2006 kitchen tax returns;items, tools/hardware, because the vast and bulk home/garden. of petitioner ’Amazons stock- based compensation was paid to its domestic employees, the result was to increase accordingly5The Court the cost issued sharing protective payments orders required adopting of AEHT. procedures Our treatmentto protect ofpetition- this er's trade secrets and proprietary technology (collectively confidential information)issue duringis governed the pre-trial, by the terms trial, ofand the post parties-trial’ phasescost sharing of this agreement, case. The andfacts in set light forth in this Opinion have been adapted accordingly. All information included herein has been determined by the Court not to constitute "trade secrets or other confidential information" within the meaning of section 7461(b). - 1110 - wouldof our didentifyecision unrelatedin Altera vproduct. Comm vendors;issioner, buy145 productsT.C. 91 (2015),from them; which manage invalidated inventorythe regulation and inprice question. the products; list the products for sale on Amazon.com; and ship the items to customers fromFINDINGS its warehouses. OF FACT

AmazonAmazon. ciso mcommitted, Inc. (AC toI), continuous is the common growth parent in the of numbera group ofand affiliated variety ofcor- productsporations it that offers join for in sale.the filing With of a a view consolidated to increasing return selection (Amazon further, US) and Amazon of nu- in

2000merous began foreign allowing subsidiaries third parties (collectively, to sell items Amazon on its or websites.petitioner). Amazon ACI was made incor- availableporated in a 1994 set of in eCommerce Washington platforms, and was reincorporated services, and tools in 1996 that in enabled Delaware. third It par- tiesbegan to operationslist their own in 1995products and andcompleted services an for initial sale publicon Amazon.com offering of and common related websites.stock in 1997. This Itsbranch principal of Amazon's place of business whenwas called it filed Marketplace. the petition wasThrough in

Marketplace,Seattle, Washington. third-party5 merchants set their own prices for their products and services, whichAmazon appeared is an online alongside retailer. the Itproducts does not that have Amazon brick-and-mortar itself sold. stores,Amazon but receivedrather sells commissions products exclusively on these third through-party A msalesazon.com and recorded and related the commission websites. Ini- amountstially Am (notazon the sold sale only prices) books, as butrevenue. by 2000 it had expanded its offerings into many oSomether p thirdrodu cpartiest categ odesiredries, in ctoluding use Amazon's music, video, technology electronics, but did toys, not software, wish to sellvideo their games, products cameras, on an kitchen Amazon items,-branded tools/hardware, website. To and meet home/garden. this demand, A Amazonmazon built and operated eCommerce websites, custom made for a particular merchant,

5 throughThe which Court that issued merchant protective could ordersmake onlineadopting sales procedures of its products to protect under petition- its own er’s trade secrets and proprietary technology (collectively confidential informa- brandtion) during name. theThis pre-trial, branch trial, of Amazon's and post-trial business phases was of called this case. Merchants.com The facts set or forth in this Opinion have been adapted accordingly. All information included M.com.herein has Whereas been determined Marketplace by theretailers Court sold not toitems constitute on Amazon's “trade secrets websites, or otherM.com confidential information” within the meaning of section 7461(b). - 1211 - retailerswould identify sold items unrelated on their product own brandedvendors; websites, buy products which from were them; built m byanage Amazon usinginventory the entireand price suite the of products; eCommerce list technologythe products that for ran sale Amazon's on Amazon.com; own websites. and

Althoughship the items Amazon to custo builtm erswebsites from itsfor warehouses. numerous customers, the most successful implementationAmazon is of com its M.committed to business continuous was growththe website in the it numberbuilt for and Target variety Corp., of whichproducts enabled it offers Target for sale. to sell With its retaila view products to increasing through selection Target.com. further, Amazon in

2000 beganSince allowingits founding third Amazon parties tohas sell committed items on itselfits websites. to the "three Amazon pillars" made of selection,available aprice, set of and eCommerce convenience. platforms, Under services, the selection and tools pillar that Amazon enabled aims third to par-offer itsties customers to list their the own widest products possible and selectionservices forby saleensuring on Amazon.com continuous growthand related in the numberwebsites. and This variety branch of productsof Amazon offered.’s business Under was the called price Marketplace. pillar Amazon Through endeavors toMarketplace, keep its prices third-party as low asm erchantspossible setat alltheir times. own Theprices convenience for their products pillar encom- and ser- passesvices, which a range appeare of goalsd alongside associated the with products improving that Athem azoncustomer itself experience,sold. Amazon in- receivedcluding: commissions(1) helping customers on these third-partyfind what they sales seek and asrecorded quickly the as commissionpossible; (2) de- liveringamounts to (not them the as sale quickly prices) and as accuratelyrevenue. as possible all items that they purchase; and (3)Some ensuring third that parties potential desired customers to use Amazon have all’s informationtechnology butuseful did innot making wish to purchasingsell their pr odecisions,ducts on a evenn Am ifazon-branded their initial decision website. is To not m toeet make this demand,a purchase. Am azon

I.built andOverview operated of eCommerce Amazon's European websites, Businesscustom m ade for a particular merchant, throughA. which Initial that merchantExpansion could Into Europemake online sales of its products under its own brand name.In April This 1998 branch Amazon of Amazon acquired’s Bookpages,business was Ltd., called an Merchants.comonline bookstore or in the

UK, and Telebook, Inc., an online bookstore in Germany. Later that year Amazon M.com. Whereas Marketplace retailers- sold13 - items on Amazon’s websites, M.com re-launched these websites under the respective domain names Amazon.co.uk and

Amazon.de. In August 2000 Amazon launched its French business organically rather than by acquisition, adopting the domain name Amazon.fr. At the outset,

Amazon.co.uk and Amazon.de offered only books; Amazon.fr offered books, music, and video products. During the tax years at issue, Germany, the UK, and

France were the only European countries in which Amazon operated.

By 1999 Amazon.co.uk, Amazon.de, and Amazon.com had become the three most popular online retail domains in Europe. By 2005 Amazon's share of total online retail spending approached or exceeded double digits in Germany and the UK, while lagging in France. In each country, however, Internet retailing was a small fraction of the overall retail market segment. By one account, Internet sales in 2005 represented only 2.4%, 5.6%, and 1.1% respectively of total retail spending in Germany, the UK, and France.

Although all three nations were EU members, the manner in which Amazon

operated its business in each country was in many respects local. A local country manager supervised a staff with responsibility for vendor and customer relationships, fulfillment, pricing, and financial management. Due to differing cultural preferences, retail traditions, and national regulations, the details of these opera- - 1412 - tions--andretailers sold the items technology on their required own branded to make websites, them happen which--often were built varied by fromAmazon coun- tryusing to country.the entire suite of eCommerce technology that ran Amazon’s own websites.

AlthoughAs ofAm Januaryazon built 1, 2005, websites vendors for numerous and the terms customers, on which the theymost sold successful goods to

Amazonimplementation differed of in its each M.co country.m business Local was Amazon the website employees it built in for each Target country Corp., iden- tifiedwhich and enabled recruited Target vendors; to sell itsthis retail recruitment products process through was Target.com. intensely personal and

could takeSince years. its founding For example, Amazon although has committed Canon is itself a multinational to the “three corporation pillars” of sell- ingsele ccamerastion, pr ithroughoutce, and con vtheen iworld,ence. Undereach of the Amazon's selection European pillar Amazon subsidiaries aims to had offer to negotiateits customers separately the widest with possible the Canon selection team in by its ensuring country, continuous and those Canongrowth teamsin the hadnumber distinct and organizations,variety of products pricing offered. policies, Under and thesources price of pillar supply. Amazon Similar endeavors varia- tionsto keep existed its prices in the as Marketplacelow as possible program: at all times. Local The teams convenience speaking the pillar local encom- lan- guagepasses identifieda range of and goals recruited associated prospective with improving Marketplace the customer sellers in experience, each country. in- As cluding:of January (1) 1, helping 2005, even customers the largest find ofwhat Amazon's they seek vendors as quickly and merchantsas possible; trans- (2) de- actedlivering with to themits European as quickly subsidiaries and accurately at the aslocal possible level, allrather items than that transacting they purchase; with

Amazonand (3) ensuring on a global that orpotential pan-European customers basis. have all information useful in making purchasingPricing decisions, in Europe even was if alsotheir local. initial Amazondecision endeavoredis not to make to offera purchase. the best val- ueI. for Overviewcustomers, of which Amazon meant’s European matching Business or beating local prices, both online and

offline.A. But prevailingInitial Expansion prices forInto a Europegiven item could vary considerably from country to countryIn April on 1998 account Amazon of such acquired factors Bookpages, as: (1) unique Ltd., localan online competitors bookstore and in the

UK,competitive and Telebook, environments; Inc., an (2)online different bookstore vendors in Germany. with different Later pricing that year policies; Amazon - 1513 - andre-la (3)unched local these laws websitesand regulations under the that respective restricted domain pricing names (e.g., by Am preventingazon.co.uk dis- and

Amazon.de.counting on books In August and other2000 items).Amazon In launched order to itsmatch French competitors' business organically prices, each ratherEuropean than subsidiary by acquisition, first had adopting to determine the dom whichain name companies Amazon.fr. it would At the treat outset, as competitors;Amazon.co.uk this was and a Alocalmazon.de decision offered because only the books; markets Am wereazon.fr all offereddifferent. books, Each m u- subsidiarysic, and video then products. sent teams During of local the employees tax years at to issue, check Germany, prices by thevisiting UK, andcom- petitors'France were stores. the only European countries in which Amazon operated.

ByLocal 1999 factors Amazon.co.uk, also affected A mtheazon.de, fulfillment and Aprocess,mazon.com that is,had the become mechanics the of preparingthree most an popular order foronline shipment retail domainsand effecting in Europe. timely By delivery 2005 Amazonto the customer.’s share ofAs totalof January online 1, retail 2005, spending each European approached subsidiary or exceeded filled doubleorders fromdigits an in inGermany-country and ful- thefillment UK, whilecenter; lagging if a French in France. warehouse In each was country, short of however, an item, deliveryInternet retailingcould be wasde- layeda small even fraction if UK of warehouses the overall retailhad ample market supply. segment. Amazon's By one UK account, and German Internet ful- salesfillment in 2005centers represented used a "buffer only 2.4%,rebin sortation5.6%, and process" 1.1% respectively that was built of totalindepen- retail dentlyspending in Europe;in Germany, it had the a fundamentallyUK, and France. different design from that used in Ama- zon's U.S.Although and French all three fulfillment nations were centers. EU members,Amazon's the transportation manner in which costs Aandmazon the speed,operated reliability, its business and in accuracy each country of its wasshipping in m anyalso respects varied because local. A of local local country reg- ulationsmanager andsupervised other economic a staff with factors responsibility in Germany, for thevendor UK, andand customerFrance. relationships, fulfillment,Surprisingly pricing, perhaps, and customers' financial paymentmanagem preferencesent. Due to alsodiffering differed cultural geo- graphically.preferences, retailGerman traditions, customers, and fornational example, regulations, used credit the cardsdetails less of thesefrequently opera- than customers in other countries. The German subsidiary thus had to build two - 1614 - uniquetions--a paymentnd the te csystemshnology for required use by to its m customers:ake them happen--often "direct debit," varied which from enabled coun- it totry deduct to country. purchase amounts from customers' bank accounts; and "pay by invoice," which Asprovided of January customers 1, 2005, a bill vendors along and with the their terms shipment. on which German they sold customers goods to wereAmaz alsoon d proneiffered to in regard each country. items as Localhaving A beenmazon purchased employees "on in approval" each country and iden-to returntified and items recruited with which vendors; they this were recruitment dissatisfied. process This requiredwas intensely the German personal subsid- and iarycoul dto t acreateke ye auniquers. For processes example, toalthough deal with Canon the highis a multinationalvolume of returns, corporation which sell- ingcould cameras range upthroughout to 50% on the certain world, items. each of Amazon’s European subsidiaries had to negotiateThe separately idiosyncrasies with theof local Canon markets team in tripped its country, up many and U.S. those retailers Canon seekingteams tohad expand distinct into organizations, Europe. Best pricing Buy failedpolicies, in the and UK, sources and Walmartof supply. failed Similar in Ger- varia- many.tions existed Amazon in the itself Marketplace came close program: to failing Local in France; teams in speaking the early the 2000s local the lan-

Frenchguage i dsubsidiaryentified an wasd recruited Amazon's prospective worst performing Marketplace business. sellers Thisin each led country. to a sub- As stantialof January downsizing 1, 2005, evenin 2004, the largestwhich requiredof Amazon the’ scompany vendors toand file m erchantswith French trans- au- thoritiesacted with a "socialits European plan" subsidiariesby which it communicatedat the local level, its ratherdownsizing than transacting plan and the with justificationAmazon on afor global it. or pan-European basis.

B.Pricing Original in Europe Structure was also of local. European Am azonBusiness endeavored to offer the best value for Beginningcustomers, inwhich 1999 meant and continuing matching orinto beating 2006, localthe German prices, retailboth online business and wasoffline. conducted But prevailing by Amazon.de prices forGmbH a given and item its subsidiary, could vary a considerably disregarded entityfrom coun- for

U.S.try to income country tax on purposes account of(Amazon such factors Germany). as: (1) Seeunique sec. local 301.7701-3(b)(2), competitors and Proced.

& Admin. Regs. Beginning in 2000 and continuing into 2006, the French retail competitive environments; (2) different- vendors17 - with different pricing policies; business was conducted by Amazon.fr Holdings SAS and its subsidiaries, which were likewise disregarded entities for U.S. income tax purposes (Amazon France).

The UK retail business was conducted primarily by Amazon.co.uk Ltd. (Amazon

UK). Collectively, we will refer to these entities as the European Subsidiaries.

The European Subsidiaries were wholly owned by Amazon US.6

Until April 30, 2006, Amazon US was the inventory owner and seller of rec-

ord for the European businesses. The European Subsidiaries provided services to

Amazon US in operating those businesses; in Germany, these services included setting up a commissionaire arrangement, whereby Amazon Germany held itself

out to customers as the retail seller for the benefit of Amazon US. The European

Subsidiaries provided Amazon US with retail support, storage facilities, fulfillment, back-office support, and local financial management services.

Until April 30, 2006, Amazon US also operated petitioner's "international third party" or "international 3PS" businesses. The international 3PS businesses included: (1) the European activities of Marketplace, which allowed third parties to offer products for sale on Amazon's websites; (2) the European activities of

6The consolidated group headed by ACI includes a bewildering array of subsidiaries. In an effort to reduce the alphabet-soup character of this Opinion, we will generally refrain from noting which particular domestic subsidiary does particular things unless it is material to the legal analysis. - 1815 -

M.com,and (3) local whereby laws Amazon and regulations used its thattechnology restricted to pricing build websites (e.g., by enabling preventing European dis- retailerscounting to on sell books their and products other items). through In their order own to mdomainatch competitors names and’ URLs;prices, andeach (3)

"SyndicatedEuropean su bStores,"sidiary f essentiallyirst had to dtheete rmineconverse which of Marketplace, companies it wherebywould treat Amazon as com- usedpetitors; its technologythis was a local to sell decision its own because products the through markets a Europeanwere all different. retailer's Eachwebsite.

Thesubsidiary European then Subsidiaries sent teams of provided local employees various services to check to prices Amazon by visitingUS in connection com- withpetitors the’ internationalstores. 3PS businesses, including website development and design, marketingLocal services, factors alsoand certainaffected commissionaire the fulfillment services.process, that is, the mechanics of preparingBefore an order April for 30, shipment 2006, Amazon and effecting US owned timely most delivery of the intellectualto the customer. property As requiredof January to 1,operate 2005, itseach European European businesses, subsidiary and filled it licensed orders from this intellectualan in-country prop- ful- fillmenterty to the center; European if a French Subsidiaries. warehouse This was intellectual short of an property item, delivery included could the under- be de- lyinglayed websiteeven if UKtechnology, warehouses all ofhad which ample had supply. been developed Amazon’s in UK the and United German States; ful- all fillmentof the European centers usedcustomer a “buffer information; rebin sortation and most process of the” thatmarketing was built intangibles, indepen- in- dentlycluding in trademarks Europe; it andhad domaina fundamentally names. Indifferent 1996, fordesign example, from Amazonthat used USin Ama- regis- teredzon’s theU.S. "Amazon" and French trademark fulfillment under centers. Nice classesAmazon 9,’s 37, transportation and 42 in an costs attempt and tothe protectspeed, reliability, that mark throughoutand accuracy the of EU. its shippingAs explained also varied more fullybecause below, of local some reg- of the trademarksulations and and other domain economic names factors used inby Germany, the European the UK,Subsidiaries and France. were titled in their respectiveSurprisingly names. perhaps, customers’ payment preferences also differed geo- graphiUnlikecally. Ger in thema nUnited custo mStates,ers, fo wherer exam Amazonple, used operated credit card uniforms less frequenretail websitestly serving a large geography with a large population, Amazon's retail business in than customers in other countries. The -German 19 - subsidiary thus had to build two

Europe had a siloed structure. Each European Subsidiary had a distinct website

employing its own national language. Each European Subsidiary had its own ful-

fillment centers, often processing country-specific inventory, and a distinct universe of customers residing chiefly within its own borders.

This siloed structure resulted in inefficient operations, lack of coordination among the European businesses, and barriers to pan-European expansion. The

European fulfillment centers had inventory management problems and were reaching their physical capacity. Unlike their U.S. counterparts, European fulfillment

centers could not freely transfer inventory and could not offload volume from one

center to another. The growth of the European business was also stressing Ama- zon's website technology: All website servers were in the United States, and increased website traffic exacerbated latency problems. ("Latency" refers to the speed with which a webpage loads; customers prefer faster speeds.)

Recognizing that serving European customers through poorly coordinated national silos was inefficient, Amazon during the early 2000s began to investigate

creation of a centralized European headquarters. One goal of this process was to

enhance customer experience by locating servers closer to customers, thus reducing website latency. Other goals were to place top managers in the same time zones as their customers; to standardize best practices for customer service, traffic - 2016 - generation,unique payment pricing, systems and vendor for use acquisition;by its customers: to increase “direct efficiency debit,” which by minimizing enabled it duplicativeto deduct pu individualrchase am ocountryunts fro costs;m cus tandome tors ’create bank accounts;a pan-European and “pay fulfillment by invoice, ” infrastructurewhich provided that customers would facilitate a bill along expansion with their into shipment. additional German EU countries. custom ers were alsoTax prone issues, to including regard items applicable as having tax been rates, purchased also loomed “on largeapproval in Amazon's” and to thinking.return items To with avoid which creating they a were U.S. dissatisfied. permanent establishment, This required Europeanthe German personnel subsid- iarycould to not create sign unique contracts processes or make to ultimatedeal with business the high decisions volume of on returns, behalf ofwhich Amazon

UScould within range Europe. up to 50% By onestablishing certain ite am Europeans. headquarters, Amazon could col- lect andThe remit idiosyncrasies value added of tax local (VAT) markets at a singletripped rate up minany a single U.S. jurisdictionretailers seeking (the locationto expand of into the Europe.seller), rather Best Buythan failedat multiple in the rates UK, inand multiple Walmart jurisdictions failed in Ger- (the locationsmany. A mofazon the buyers).itself came And close Amazon to failing was inquite France; aware in thatthe earlythe effective 2000s the marginal rateFrench of corporatesubsidiary income was A mtaxazon was’s (orworst could performing be negotiated business. to be) This significantly led to a sub- lower instantial certain downsizing EU member in 2004,states --specifically,which required Luxembourg the company and to fileIreland with--than French it wasau- in thethorities United a “ States.social plan” by which it communicated its downsizing plan and the justificationC. for"Project it. Goldcrest"

Amazon'sB. Original management Structure decided of European to establish Business a European headquarters and assignedBeginning its U.S. taxin 1999 department and continuing the task intoof developing 2006, the Germana tax-efficient retail businessstrategy for doingwas conducted this. It considered by Amazon.de several GmbH locations and its for subsidiary, the European a disregarded headquarters, entity includ- for ingU.S .Ireland incom eand tax Luxembourg, purposes (Am andazo neventually Germany )opted. See forsec .the 30 1.7701-3(b)(2),latter. Amazon Proced.repre- sentatives met with Luxembourg authorities, including Jean-Claude Juncker, & Admin. Regs. Beginning in 2000 and- 21continuing - into 2006, the French retail

Luxembourg's then prime minister, to discuss the potential for Amazon to locate its European headquarters there.

In broad outline, Amazon's plan was to transfer from Amazon US to the

Luxembourg headquarters affiliate all of the intangible assets required to operate the European website businesses; to continue using the European Subsidiaries as service companies earning a nominal rate of return; and to have the vast bulk of the income from Amazon's European businesses taxed in Luxembourg at a very low rate. In pursuit of the latter goal, Amazon successfully negotiated an advance tax agreement with the Government of Luxembourg. After the restructuring, the

Luxembourg entity would function as the operational and administrative headquarters for the European businesses and own virtually all of the intangible assets required to operate those businesses.

Beginning in 2004 Amazon undertook a series of transactions, dubbed "Pro- ject Goldcrest," to implement this plan. ("Goldcrest" refers to Luxembourg's national bird.) These transactions were complex; they involved many steps and many entities. But the basic outline can be stated fairly succinctly. Amazon US

formed AEHT, the Luxembourg headquarters entity that would serve as the holding company for all of the European businesses. AEHT elected to be treated as a

corporation for U.S. income tax purposes from the date of its formation. See sec. - 2217 -

301.7701-3(c),business was conducted Proced. & by Admin. Amazon.fr Regs. Holdings Underneath SAS AEHTand its numeroussubsidiaries, subsidiaries which were likewisecreated (collectively, disregarded entitiesAmazon for Luxembourg) U.S. income totax perform purposes various (Amazon functions France).

Theessential UK retailto operation business of was the conductedEuropean businesses.primarily by These Amazon.co.uk functions Ltd. included (Amazon hold- ingUK). title C otoll ectheti vinventoryely, we w soldill refer in Europe, to these licensing entities a Amazon'ss the Euro pintellectualean Subsid iproperty,aries. housingThe European the servers, Subsidiaries and maintaining were wholly call owned centers. by AmazonAmazon Germany,US.6 Amazon

UK, andUntil Amazon April 30,France 2006, thereafter Amazon supplied US was tothe Amazon inventory Luxembourg owner and theseller same of rec- typesord for of the customer European-related, businesses. fulfillment, The Europeanand support Subsidiaries services that provided they had services previous- to lyAmazon furnished US toin Amazonoperating US. those businesses; in Germany, these services included settingAfter up a coformingmmissionaire Amazon arra Luxembourg,ngement, whereby Amazon A effectedmazon Germany the restructuring held itself by outcompleting to customers six related as the transactions:retail seller for (1) the the benefit Cost Sharingof Amazon Arrangement;' US. The European (2) the

SubsidiariesLicense Agreement provided For A mPreexistingazon US with Intellectual retail support, Property storage (License facilities, Agreement); fulfill- (3) thement, Assignment back-office Agreement support, and For local Preexisting financial Intellectual management Property services. (Assignment

Agreement);Until April (4) the 30, European 2006, Amazon Subsidiary US also Contribution; operated petitioner (5) the European’s “international Business thirdContribution, party” or and “international (6) the Four 3PS-Party” businesses. Agreement. The These international agreements 3PS may businesses be sum- marizedincluded: as (1) follows: the European activities of Marketplace, which allowed third parties to offer products for sale on Amazon’s websites; (2) the European activities of 'The Cost Sharing Arrangement actually involved two successive agreements. In December 2004 Amazon US and AEHT entered into an "Agreement to Share Costs and Risks of Intangible Development" with a stated effective date of June 7,6The 2004. consolidated On January group 11, 2005, headed Amazon by ACI US includes and AEHT a bewildering entered into array an of "Amendedsubsidiaries and. In Restatedan effort Agreementto reduce the to alphabet-soupShare Costs and character Risks of of Intangible this Opinion, Devel- we willopment" generally with arefrain stated from effective noting date which of January particular 1, 2005. domestic We subsidiary will generally does use par- the termticular "Cost things Sharing unless Arrangement" it is material to or the "CSA" legal toanalysis. refer to the latter. -23- 18 -

M.com, wher1.eb y ACostmazo Sharingn used it Arrangements technology to build websites enabling European retailersThe to Costsell their Sharing products Arrangement through their(CSA) own was do intendedmain names to be and a "qualified URLs; and cost (3) sharing“Syndicated arrangement" Stores,” essentially within the themeaning converse of section of Marketplace, 1.482-7(a)(1), whereby Income Am azonTax usedRegs. its Through technology the Licenseto sell its and own Assignment products through Agreements a European (described retailer more’s website. fully below),The European AEHT Subsidiaries obtained access provided to pre-existing various services intangible to A propertymazon US of in Amazon connection US, referredwith the tointernational as "the Amazon 3PS businesses, Intellectual including Property." website Through development the CSA, andthe partiesdesign, agreedmarketing to share services, the costsand certain of further commissionaire "research, development, services. marketing, and other activitiesBefore relating April to 30, * * 2006, * maintaining, Amazon US improving, owned m enhancing,ost of the intellectual or extending property the

Amazonrequired toIntellectual operate its Property." European businesses, and it licensed this intellectual property toThrough the European its participation Subsidiaries. in theThis CSA, intellectual AEHT wouldproperty assist, included by way the ofunder- finan- lcialyin gcontribution website tec honly,nolo giny, the all ongoingof which development had been developed of technology in the United required States; to op- all oferate the the European European customer websites information; and related and activities. most of Thethe marketingCSA required intangibles, the parties in- to determinecluding trademarks "Aggregate and Allocable domain names. Development In 1996, Costs," for example, which would Amazon then US be regis- allo- teredcated theto the “Amazon parties” according trademark to under the ratio Nice of classes benefits 9, each37, and was 42 projected in an attempt to derive to protectfrom ongoing that m arkdevelopment. throughout Basically,the EU. As this explained meant that more Amazon fully below, Luxembourg some of the wouldtrademarks pay Amazon and domain US fornames its ratableused by share the European of subsequently Subsidiaries incurred were intangible titled in developmenttheir respective costs names. (IDCs).

Unlike in the United States, where Amazon operated uniform retail websites serving a large geography with a large population, Amazon’s retail business in -24-- 19 -

Europe had a2. siloed License structure. Agreement Each European Subsidiary had a distinct website employingOn January its own 1, national 2005, Amazonlanguage. US Each and EuropeanAEHT entered Subsidiary into the had License its own Agree- ful- mentfillment with centers, a stated often effective processing date of country-specific January 1, 2005. inventory, Amazon and US a thereby distinct granted uni-

AEHTverse of the customers rights to residinguse "Amazon chiefly Intellectual within its ownProperty," borders. defined to exclude the marketingThis intangibles siloed structure covered resulted by the in Assignment inefficient operations, Agreement. lack The of property coordination cov- amongered by the the European License Agreement businesses, related and barriers to Amazon's to pan-European website technology. expansion. Under The theEur oLicensepean fu Agreement,lfillment cen AEHTters ha dagreed inven ttoor ymake man agement buy-in paymentproblems for and the were website reach - technologying their physical in the capacity.aggregate Unlikeamount their of $226,520,000, U.S. counterparts, to be Europeanpaid in installments fulfillment duringcenters thecould seven-year not freely period transfer beginning inventory in and2005 could and endingnot offload in 2011. volume from one center to another.3. TheAssignment growth of Agreement the European business was also stressing Ama- zon’s websiteIn July 2005technology: Amazon All US website and AEHT servers executed were in the the Assignment United States, Agreement. and

Amazonincreased US website thereby traffic granted exacerbated AEHT the latency rights problems. to use Amazon (“Latency Intellectual” refers Propertyto the notspeed covered with which by the a Licensewebpage Agreement, loads; custo namely,mers prefer customer faster data speeds.) and previously developedRecognizing marketing that intangibles serving European including customers trademarks, through trade names,poorly coordinatedwebsite content,national and silos domain was names inefficient, relating Am toazon the duringEuropean the business.early 2000s Though began statedto investigate to be creationeffective of as a of centralized January 1, European 2005, the headquarters. Assignment Agreement One goal of remained this process executory was to untilenhance the customer"Business experience Transfer Date," by locating which servers was May closer 1, 2006. to custo Undermers, the thus Assign- reduc- menting website Agreement, latency. AEHT Other agreed goals to were make to aplace buy-in top payment managers for in the the marketing same time in- zones as their customers; to standardize- best25 - practices for customer service, traffic tangibles and customer data in the aggregate amount of $27,991,000, to be paid in installments during the six-year period beginning in 2006 and ending in 2011.

4. European Subsidiary Contribution

In February 2006 Amazon Luxembourg acquired all of the stock of the

European Subsidiaries via tax-free reorganizations under section 368(a)(1)(D).

The reorganizations were accomplished by ACI's transfer of the stock of the Euro- pean Subsidiaries (valued at approximately $196 million in toto) to AEHT in ex-

change for AEHT stock and cash, immediately followed by each of the European

Subsidiaries' electing to be disregarded as separate from their owner for U.S. tax purposes. Amazon Luxembourg thus became the ultimate owner of all of the

European Subsidiaries' property and the ultimate employer of their employees.

See sec. 301.7701-3(b)(2), Proced. & Admin. Regs.

5. European Business Contribution

In a series of transactions between April 7 and May 1, 2006, Amazon US transferred to Amazon Luxembourg, in a section 351 exchange for stock, various assets (other than intellectual property) required to operate the European businesses. These assets included inventory, accounts receivable/payable, vendor contracts, transportation/delivery contracts, "associates agreements," licenses from third parties, and service contracts. Amazon US concurrently terminated the prior - 2620 - agreementsgeneration, pricing,whereby and the vendorEuropean acquisition; Subsidiaries to increase had provided efficiency services by minimizing to and li- duplicativecensed intellectual individual property country from costs; it. and to create a pan-European fulfillment infrastructure6. that wouldFour-Party facilitate Agreement expansion into additional EU countries.

UnderTax issues, the Four including-Party applicableAgreement, tax effective rates, also April loomed 30, 2006, large the in AEuropeanmazon’s thinking.Subsidiaries To assigned avoid creating or licensed a U.S. exclusively permanent toestablishment, AEHT certain European intellectual personnel prop- coulderty titled not signin their contracts names. or Before make ultimate 2005 the business European decisions Subsidiaries on behalf procured of Amazon pro- tectionUS within for, Europe. and registered By establishing in their own a European names, certain headquarters, trademarks Am azonand domain could col- nameslect and deployed remit value in Europe. added tax In (VAT)exchange at a for single these rate assets in a AEHTsingle jurisdictionpaid in the aggre-(the gatelocation about of $5the million. seller), rather than at multiple rates in multiple jurisdictions (the locatioD.ns of tLifehe buyers). After Project And A Goldcrestmazon was quite aware that the effective marginal rate ofAfter corporate April income 30, 2006, tax Amazonwas (or couldLuxembourg be negotiated reported, to be) for significantly U.S. tax purposes, lower allin cofer ttheain incomeEU mem andber expenses states--sp connectedecifically, withLuxe thembourg European and Ireland--than businesses. itIt wasen- in teredthe United into agreements States. with the European Subsidiaries whereby they provided it with certainC. fulfillment“Project Goldcrest services,” customer and merchant services, and support servicesAmazon within’ stheir manage respectivement decided territories; to establish the European a European Subsidiaries headquarters were paid and a assignedcost-plus itsfee U.S. for thesetax department services. Inthe May task 2006of developing AEHT's Irisha tax-efficient subsidiary strategy constructed for adoing facility this. with It considerednumerous serversseveral thatlocations provided for thedata European storage and headquarters, hosting services includ- ingfor theIreland European and Luxembourg, businesses; itand received eventually a cost-plus opted for fee the for latter. doing Amazonthis. repre- sentatives met with Luxembourg authorities,- 27 - including Jean-Claude Juncker,

Amazon Luxembourg was by no means a shell company. Beginning in May

2006 it played a meaningful role in expanding Amazon's existing business in Ger- many, the UK, and France and extending Amazon's reach elsewhere in Europe.

From 2006 through 2013 AEHT launched 11 new product categories through its

UK and German websites, including apparel/accessories, sports/outdoors, jewelry/ watches, health/personal care, shoes/accessories, auto parts, groceries, and baby products. It launched 15 new product categories through its French website, in-

cluding most of the preceding categories and some others. And it launched new website operations in Italy (Amazon.it) and Spain (Amazon.es). Amazon's Euro- pean revenues grew very rapidly during this period.

The Luxembourg headquarters also played a nontrivial part in rolling out new technology--the European Fulfillment Network (EFN)--that implemented standardized and improved fulfillment operations across Europe. The software underlying EFN was developed in the United States by Amazon US after 2005. It addressed the problem of multiple websites with country-specific fulfillment centers located in multiple countries.

The EFN technology successfully converted a three-country silo structure into a network, leveraging AEHT's status as Amazon's single seller of record throughout Europe, which simplified the sharing and pooling of inventory. The - 2821 -

LEFNuxe mtechnologybourg’s th enableden prime customers minister, tshoppingo discuss onthe one potential national for website Amazon to to view locate in- ventoryits European and acquire headquarters products there. housed in fulfillment centers located in other countries. ImplementationIn broad outline, of Amazon this technology’s plan was significantly to transfer reducedfrom Am theazon time US that to the cus- tomersLuxem bourgwaited headquarters to receive products, affiliate reducedall of the shipment intangible costs, assets lowered required product to operate prices,the European and dramatically website businesses; increased to selection. continue using the European Subsidiaries as

II.ser viceRetail companies and Technological earning a nominal Environment rate of return; and to have the vast bulk of the incomeA. froInternetm Am azonRetail’s EnvironmentEuropean businesses taxed in Luxembourg at a very low rate.Internet In pursuit technology of the lattermakes goal, retailing Amazon a more successfully competitive negotiated business an than advance it used totax be. agreement The World with Wide the Government Web enables of consumers Luxembourg. to compare After the prices restructuring, in real time the and buyLuxe atm thebourg lowest entity price would offered function on multiple as the operational websites. andThe administrativeInternet makes head- consum- quartersers' costs for of the searching European for businessesa product virtuallyand own disappear virtually alland of allows the intangible them to assetsswitch requiredfrom one to retailer operate to thoseanother businesses. by clicking a mouse. A theory called "stickiness" posits Beginningthat a consumer in 2004 usually Amazon will undertook not switch a to series a competitor of transactions, after a singledubbed bad “Pro- jectexperience Goldcrest, on ”a toparticular implement site. this But plan. Amazon (“Goldcrest adopted” referas a guidings to Luxembourg principle ’thats na-

"competitiontional bird.) These is literally transactions one click were away." complex; they involved many steps and many entities.The price But transparency the basic outline associated can bewith stated online fairly retailing succinctly. leads toA mlowerazon salesUS margins,formed AEHT, one factor the Luxembourg that makes online headquarters retailing entity so competitive. that would serveDuring as the the last hold- 20 years,ing co minnumerablepany for all onlineof the retailersEuropean have businesses. gone out AEHT of business elected or tolost be significant treated as a value; even today, online retail remains a small fraction of the total retail market corporation for U.S. income tax purposes- 29 fro -m the date of its formation. See sec. segment. Because of this competitive environment, constant innovation is

essential to ensure survival. Technological failure damages profitability; a late delivery or damaged product may also alienate a customer permanently.

Innovative technology underlies every aspect of Amazon's retail business.

It is integral to creating and managing the catalog, displaying items in the catalog to potential customers, conveying the look and feel of the websites, convincing a potential customer to buy an item, completing transactions, processing payments, packaging an item, shipping it to the customer, and preventing fraud. To continue to deliver on its promises, Amazon in the mid-2000s made massive investments to

ensure a rapid pace of technological innovation. Respondent's principal valuation

expert, Daniel J. Frisch, agreed that Amazon operated in a "highly competitive, rapidly changing industry" that "requires substantial innovation all the time."

Respondent's technology expert, Edward Felten, noted that "Amazon's entire

existence has been characterized by the challenges of innovating due to running into unexpected walls and growing so fast that the entire structure seems in danger

of failure at any moment."

Amazon's software engineers, computer scientists, and management team

focused on continuous innovation to provide easy-to-use functionality, rich website content, fast and reliable fulfillment, timely customer service, and a trusted - 3022 - transactional301.7701-3(c )environment., Proced. & A dAmazonmin. Re gregularlys. Underneath launched AEHT software numerous on a testsubsidiaries basis, werefully consciouscreated (collectively, of the need A form azonfurther Luxembourg) improvements; to perform its software various and functions website essentialcontent often to operation changed of multiple the European times thebusinesses. same day. These Amazon's functions software included develop- hold- menting title process to the "leveraged inventory soldthe future":in Europe, By licensing building Aa mpieceazon of’s softwareintellectual quickly, property,

Amazonhousing tincurredhe server thes, a risknd m thatain titai nwoulding ca notll ce bent eradaptables. Amazon to future Germ aneeds.ny, A mByazon re- peatedlyUK, and Achoosingmazon France "the expedient thereafter path" supplied over to"the Am rightazon path," Luxembourg Amazon the built same up

"technicaltypes of custo debt"mer-related, that inheres fulfillment, in software and with support a relatively services short that usefulthey had life. previously furnishedAmazon's to A mneedazon to US. innovate was driven by multiple factors. Perhaps the most importantAfter forming factor Amazon was the Luxembourg,need to increase Am "scale."azon effec Oneted of the Amazon's restructuring early by businesscompleting goals six wasrelated to "get transactions: big fast"; (1)getting the Cost big fast Sharing meant Arrangement; adding customers,7 (2) the web - pageLicense views, Agreement vendors, For and Preexisting new products Intellectual at an extremely Property rapid (License pace. Agreement); Website tech- (3) nologythe Assignment by its nature Agreement is subject For to Preexisting scale limitations; Intellectual if the Property website (Assigncannot "scalement up" toAgreement); meet the demands (4) the European placed upon Subsidiary it, it will Contribution; crash. Rapid (5) technological the European innovation Business wasContribution, required toand overcome (6) the Four-Party the scale challenges Agreement. posed These by agreementsrapid growth. m ay be sum- marizedThese as follows: challenges were especially pronounced during Amazon's peak holiday seasons, when webpage views, transactions consummated, and products pack- 7The Cost Sharing Arrangement actually involved two successive agree- agedments. increased In December by 300% 2004 to A400%mazon over US nonpeak and AEHT periods. entered Holiday into an periods“Agreement stressed to Share Costs and Risks of Intangible Development” with a stated effective date of Juneevery 7, aspect 2004. of On Amazon's January system,11, 2005, and Am eachazon successive US and AEHT peak seasonentered entailed into an higher “Amended and Restated Agreement to Share Costs and Risks of Intangible Devel- opment” with a stated effective date of January 1, 2005. We will generally use the term “Cost Sharing Arrangement” or “CSA” to refer to the latter. -31- 23 - volumes and 1thus. greaterCost Sharing scale challenges. Arrangement Amazon risked system collapse if its technologyThe Cost could Sharing not scale Arrangement up to these (CSA) demands. was intended to be a “qualified cost sharingAmazon's arrangem engineersent” within testified the meaning that they of section spent the 1.482-7(a)(1), 1998, 2003, Income 2004, and Tax

2005Regs. holiday Through seasons the License "in crisis and mode." Assignment Although Agreements its website (described was available more fully to the publicbelow), 98% AEHT of the obtained time during access the to pre-existingfourth quarter intangible of 2004, property Amazon ofexperienced Amazon US, referreoutagesd duringto as “the critical Amazon holiday Intellectual periods thatProperty. impaired” Through customers' the CSA, ability the to parties browse andagreed shop. to shareThese the and costs other of outagesfurther “ duringresearch, 2004, development, which resulted marketing, in lost andrevenue other approachingactivities relating $130 to million, * * * m jeopardizedaintaining, iAmazon'smproving, relationshipsenhancing, or with extending retail custom-the

Amazoners and Marketplace Intellectual merchants.Property.” Determined to address these scale challenges,

AmazonThrough made 24-7its participation website availability in the CSA, its chief AEHT company would assist, goal for by 2005. way of financial contributionA related factor only, drivingin the ongoing innovation development was the need of technology to reduce "latency."required to Dur-op- ingerat ethe th eearly Euro 2000spean w Amazon'sebsites and software related architectureactivities. The was CSA built required in a siloed the fashionparties to thatdetermine required “Aggregate particular Allocable functions Development to "call" data Costs,from databases.” which would As website then be trafficallo- geometricallycated to the parties increased, according more to nanoseconds the ratio of benefitswere required each was to call projected these data, to derive caus- ingfrom webpages ongoing developto load morement. slowly Basically, and respondthis meant less that quickly Amazon to customer Luxembourg requests.

Amazonwould pay believed Amazon that US website for its ratablelatency share frustrated of subsequently customers, incurredleading them intangible to aban- dondevelop the mpageent theycosts were (IDCs). viewing or leave Amazon's site altogether.

Another factor driving innovation was the need to protect customer data and prevent fraud. Computer hackers and other bad actors posed increasing security - 3224 - risks through2 cyber-attacks. License Agreementof various kinds. After 2005 security became a major

focus ofOn investment January 1, for200 Amazon.5, Amazo nIt UdedicatedS and AE largeHT e teamsntered ofinto software the License engineers Agree- to mentcreate with innovative a stated security effective protocols date of January designed 1, to2005. repel A cyber-attacks,mazon US thereby keep itsgranted web- siteAEHT up, theprotect rights customer to use “ Amazoninformation, Intellectual and maintain Property, customer” defined trust. to exclude the marketingThe intangiblesadvent of new covered technologies, by the Assignment such as smartphones, Agreement. likewise The property propelled cov- innovation.ered by the LicenseSmartphones Agreement enabled related customers to Am azonto view’s website products technology. and make purchases Under throughthe License mobile Agreement, networks; AEHT younger agreed customers to make were a buy-in especially payment prone for tothe doing website this.

Antechnology online retailer in the aggregaterisked losing amount these of customers $226,520,000, if it did to notbe paid meet in their installments demands.

Becauseduring the the seven-year online retail period environment beginning was in 2005 changing and ending so rapidly, in 2011. Amazon believed it impossible3 to. anticipateAssignment technological Agreement advances more than three years away.

B.In JulyEvolution 2005 Amazon of Amazon's US and AEHTWebsite executed Architecture the Assignment Agreement.

AmazonIn USJanuary thereby 2005 granted Amazon AEHT knew the that rights many to componentsuse Amazon ofIntellectual its website Property archi- tecturenot covered would by not the meet License its long-term Agreement, needs. namely, Its engineers,customer datawho and never previously lacked self- developedconfidence, marketing believed thatintangibles they would including succeed trademarks, in meeting trade future names, challenges website as con- they appeared.tent, and domain But they names did notrelating know to how the Europeanthey would business. do this. Though stated to be effectiveWhen as of Amazon.com January 1, 2005, was launchedthe Assignment in 1995, Agreement its website remained ran on Obidos, executory a singleuntil the monolithic “Business application Transfer Date, atop” an which Oracle was database.' May 1, 2006. Its user Under interface the Assign- code, ment Agreement, AEHT agreed to make a buy-in payment for the marketing in- 'In software engineering, a monolithic application describes a single-tiered software application in which the user interface and the data access code are (continued...) - 3325 - databasetangibles connections,and custome rand data business in the aggregate logic were amount heavily of interdependent. $27,991,000, to Asbe trafficpaid in toinstallments Amazon's during website the increased, six-year periodit added beginning more and in more 2006 servers, and ending called in "onlines,"2011.

each running4 a. webEuropean server and Subsidiary an instance Contribution of the monolithic Obidos code.

TheIn February Obidos 2006application Amazon was Luxe writtenmbourg in "catsubst," acquired all an of arcane the stock programming of the languageEuropean thatSubsidiaries Amazon viacreated. tax-free Significant reorganizations engineering under effort section was 368(a)(1)(D). required to per-

Tformhe r eevenorga basicnizati otasks.ns we rThee ac cmanneromplis hine dwhich by A CObidosI’s transfer was writtenof the stock made of it thedifficult Euro- topean identify Subsidiaries "dependencies," (valued at i.e., approximately instances in $196 which million specific in toto)parts toof AEHT the code in de-ex- pendedchange foron specificAEHT stock other and parts cash, of the immediately code. Since followed any change by each to the of theObidos European code mightSubsidiaries affect ’many electing applications, to be disregarded a team desiringas separate to modify from their one owner application for U.S. had tax to getpurposes. input from Amazon multiple Luxe engineeringmbourg thus groups. became This the ultimatebecame aowner cumbersome of all of process. the

EuropeanObidos Sub swasidiar alsoies’ subjectproperty to a "deathnd the spirals."ultimate eUntilmployer 2000, of everytheir emp Obidosloyees. pro-

Seecess, sec. no matter301.7701-3(b)(2), how short lived, Proced. created & Admin. its own Regs. database connections by calling databases directly,5. withoutEuropean coordinating Business Contribution requests across the different onlines.

When Intoo a manyseries onlinesof transactions were seeking between the Aprilsame 7database and May resources, 1, 2006, Aerrormazon condi- US tionstransferred called to "timeouts" Amazon Luxembourg, would occur. inThe a section Obidos 351 process exchange would for then stock, throw various a fatal assetserror and (other restart, than creating intellectual new property) database requiredconnections to operate without the properly European releasing busi- the noldes sones.es. T hAsese database assets in cconnectionsluded inventory, piled accountsup, calls fromreceivable/payable, other Obidos processes vendor con- to tracts, transportation/delivery contracts, “associates agreements,” licenses from 8(...continued) combined into a single program from a single computer system or network. third parties, and service contracts. Am-azon 34 - US concurrently terminated the prior the databases would time out, throwing more fatal errors. When these "death spirals" occurred, the affected website could become unavailable for an hour or more.

As the number of Amazon's customers grew, such crashes became more common.

By 2002 Amazon had moved six services out of Obidos: By reducing the load on Obidos it was able to handle a higher volume of web traffic. Although

Amazon's chief technology officer declared in 2005 that the Obidos architecture had reached its "end of life" in 2001, 98% of Amazon's retail webpages still ran

on Obidos as of January 2005. By May of that year there was real concern that

Amazon's website would not be able to scale through the holiday season if it continued to run on Obidos. Great effort was expended to move a significant amount

of traffic off Obidos and onto a service-oriented architecture known as Gurupa.

Amazon transitioned rapidly away from Obidos during 2005 and ceased using it altogether on August 31, 2006.

Amazon began its shift toward a service-oriented architecture around 2002.

"Service-oriented architecture" describes software designed as a set of small, independent programs or "services"; the services work together to perform complex tasks. In this model, each service needs to understand how to interact only with those other functions with which it has actual contact. This differentiates it from a monolithic model, where each function must understand how to interact with - 3526 - aeverygreem otherents wfunctionhereby inth ea Elargeruropean program. Subsidiaries Amazon had did provided not invent services service to -orientedand li- architecture,censed intellectual which property was a well-known from it. concept in the computer industry.

Amazon6. builtFour-Party this new architecture Agreement on a Gurupa engine, which received requests Underfrom a the web Four-Party server, sent Agreement, the requests effective to services April or 30, applications, 2006, the European and re- turnedSubsidiaries responses assigned to the or web licensed server. exclusively The engine to AEHTdid not certain create webpageintellectual content; prop- instead,erty titled it insent their requests names. to Beforeapplications 2005 thethat, European in coordination Subsidiaries with services,procured created pro- andtection returned for, and webpage registered content in their to the own server. names, The certain role trademarksof the Gurupa and engine, domain in nameseffect, wasdeployed to stitch in Europe. together Indynamic exchange webpages. for these assets AEHT paid in the aggregate aboutThe transition$5 million. from Obidos to Gurupa was an architectural shift from a monolithicD. toLife a distributed After Project system Goldcrest and involved rewriting software in different programmingAfter April languages. 30, 2006, Amazon Amazon decided Luxembourg to abandon reported, catsubst for U.S.for building tax purposes, web- pagesall of theand income shifted and to a expenses programming connected language with known the European as Perl businesses.and a templating It en- lan- guagetered into known agreements as Mason with (the the duo European was called Subsidiaries "Perl/Mason"). whereby Amazon they provided could reuse it verywith littlecertain of fulfillment the Obidos services, software customer when it moved and m erchantto Gurupa. services, And andmany support concepts thatservices underlay within the their monolithic respective architecture territories; were the European not applicable Subsidiaries to a distributed were paid a system.cost-plu sAmazon fee for t hdisplayedese servic itses. first In May Perl/Mason 2006 AEHT page’ sin Irish August subsidiary 2005, but constructed very few aEuropean facility w webpagesith numer wereous s ergeneratedvers that usingprovi dPerl/Masoned data stora andge Gurupaand hos tuntiling s 2006.ervices for theProblems European with businesses; the new it architecture received a cost-plussoon emerged. fee for Webpagesdoing this. created in

Perl/Mason and rendered using the Gurupa engine took longer to appear in a - 3627 - user's Amazonbrowser thanLuxembourg comparable was Obidos by no m pages.eans a Gurupa'sshell company. throughput Beginning--the number in May

2006of webpages it played that a meaningful could be displayed role in expanding per second A--wasmazon less’s existing than a tenth business of Obidos' in Ger- inmany, August the 2005.UK, and One France reason and was extending that Gurupa Amazon at the’s reachtime did elsewhere not support in Europe. parallel renderingFrom 2006 or through "streaming." 2013 AEHT Rather launched than loading 11 new webpages product sequentially, categories through streaming its

UKenables and differentGerman websites,parts of a includingwebpage toapparel/accessories, be loaded simultaneously, sports/outdoors, permitting jewelry/ the watches,customer health/personalto view part of thecare, page shoes/accessories, while the rest is auto being parts, delivered groceries, to his and or baby her webproducts. browser. It launched Streaming 15 newcapabilities product were categories increasingly through prevalent its French on website, Amazon's in- cludingcompetitors' most websites,of the preceding and their categories absence andat Amazon some others. negatively And affectedit launched its new websitecustomers' operations shopping in experience.Italy (Amazon.it) and Spain (Amazon.es). Amazon’s Euro- pean revenuesAnother grewproblem very was rapidly that theduring services this period. called by the Gurupa engine were developedThe Luxembourgin "silos" rather headquarters than as an alsointegrated played system. a nontrivial In certain part in situations, rolling out thesenew technology--the services suffered European from "circular Fulfillment dependencies," Network (EFN)--that that is, links imple thatm eventuallyented standardizedconnect code andback improved to itself, fulfillmentwhich can causeoperations the software across Europe. to crash Theafter software a code underlyingchange. Because EFN was of lack developed of coordination in the United between States service by Amazon "silos," US code after was 2005. often It writtenaddressed that the duplicated problem ofexisting multiple functionality. websites with These country-specific structural problems fulfillment increased cen- asters Amazon located createdin multiple new countries. services and expanded its website capabilities.

BecauseThe EFN the technology Gurupa architecture successfully was converted a set of a disconnected three-country silos silo ratherstructure than ainto technology a network, platform, leveraging many AEHT of Amazon's’s status as engineers Amazon regarded’s single sellerit as "dramatically of record unreliable from the first day." Amazon found it increasingly difficult to hire pro- throughout Europe, which simplified the- 37 sharing - and pooling of inventory. The grammers eager to work in this environment: Typically trained in Java and C++, they came to regard Perl/Mason as a "dead language." In October 2009 Gurupa instances running the U.S. website were expected to crash with unacceptable frequency if not killed and restarted.

In September 2006 Amazon hired Brian Valentine to envision and lead the development of a new eCommerce platform. He regarded Gurupa as an unreliable application and put it on "life support" shortly after he arrived. He testified that his unit had to devote most of its efforts to "keeping the lights on"--that is, keeping Amazon's websites from crashing on Gurupa--rather than pursuing innovative projects. By 2012 Amazon had migrated most of its website platform from Gur- upa to Santana, but it was still using Gurupa for some applications as late as No- vember 2014.

Mr. Valentine's goal was to create a true technology platform, with a central and standardized set of services and a uniform interface for interacting with those services. A key feature of this platform was Santana, a Java-based web hosting service and rendering engine that addressed Gurupa's performance and stability problems. Santana was first deployed on an Amazon website in 2007; by 2008

Amazon had chosen Santana as its preferred architecture for future software devel-

opment projects. This shift to Santana required Amazon to rewrite virtually all of -38- 28 - itsEFN eCommerce technology services, enabled andcustomers the new shopping platform on thus one took national much website longer to buildview in-and implementventory and than acquire Amazon products had expected.housed in fulfillment centers located in other countries. ImTheplementation new platform of thiswas technology vastly superior significantly to its predecessor. reduced the Java time was that more cus- tefficientomers wa andite dperformance to receive p rorientedoducts, rethanduce Perl/Mason,d shipment andcos tits, waslowered a modern produ pro-ct grammingprices, and languagedramatically that increamade shiringed selection. easier. Java reduced the parallel rendering problemII. Retail that andhad Technologicalplagued Gurupa, Environment and it significantly reduced latency. Java was superiorA. for streamingInternet Retail digital Environment content and, in conjunction with Santana, it provided much betterInternet throughput. technology makes retailing a more competitive business than it used to be. C.Th e WEvolutionorld Wide of W Amazon'seb enables Softwareconsume rApplicationss to compare prices in real time and buy at Correspondingthe lowest price to offered these major on multiple shifts inwebsites. Amazon's The software Internet architecture, makes consum- the applicationsers’ costs of searchingor "services" for thata product performed virtually specific disappear business and functionsallows them underwent to switch fromconstant one change. retailer toThe another shift toby Santana clicking required a mouse. almost A theory everything called “fromstickiness Gurupa” to beposits rewritten that a consumeror thrown usuallyout. Representative will not switch examples to a competitor are discussed after a below. single bad experience on1. a particularCustomer site. Master But Amazon Service adopted as a guiding principle that

“competitionLaunched is literally around one2000, click Customer away.” Master Service (CMS) was the first service launchedThe price in transparencyAmazon's move associated toward with a service online-oriented retailing architecture. leads to lower CMS sales initiallymargins, had one limited factor thatambitions, makes onlinesimply retailing allowing so customers competitive. to change During their the userlast 20 namesyears, innumerableor passwords. online As a retailers result of have constant gone revision out of business its functionality or lost significant was vastly

expanded. CMS eventually functioned as a "broker" between the database storing value; even today, online retail remains- a39 small - fraction of the total retail market

Amazon's customer information and the various retail segments (e.g., service centers, fulfillment centers, and the website) that needed this customer information.

By fall 2004 CMS had grown very large, complex, and fragile as Amazon's

evolving business requirements necessitated constant changes to the software.

CMS became a bottleneck and experienced more than 50 hours of outages during the December 2004 holiday season. To address these problems, Amazon em- barked on a complete re-architecture of CMS during 2005 and 2006. At the time

of trial, CMS no longer existed, having been replaced by new software known as

Identity Service.

2. Order Master Service

"Ordering" includes the steps whereby a customer places an order, payment is authorized, a shipment request is prepared, and the order is handed off for ful-

fillment. This requires interactions with many other parts of Amazon's software, including the systems managing fraud prevention, payment, sales tax collection, and fulfillment. Amazon developed Order Master Service (OMS) around 2000 to handle key aspects of shopping carts, orders, shipments, and related business logic and messaging. Although it was built outside of Obidos, it resembled Obidos in being a large monolithic program that was difficult to support. - 4029 - segment.By springBecause 2004 of this OMS competitive was causing environ bottlenecksment, constant that generated innovation fatal is errors in

1%essential of all to customer ensure survival. sessions, Technologicalfrustrating customers failure damagesand generating profitability; other problems. a late

Amazon'sdelivery or engineersdamaged referredproduct mayto OMS also as alienate "the new a customer Obidos" permanently. because it "created long leadInnovative times for technology bug fixes andunderlies new features every aspect and needlessly of Amazon tied’s retail together business. unre- latedIt is integral product to launches." creating and Amazon managing concluded the catalog, that OMS displaying needed items to be in substantially the catalog rewrittento potential to customers,simplify it andconveying decouple the it look from and the feel software of the handlingwebsites, payments, convincing pro- a motion,potential shopping customer cart, to buy and an fulfillment. item, completing transactions, processing payments, packagingBeginning an item, in shipping2006 Amazon's it to the engineerscustomer, "refactored" and preventing OMS fraud. into Toseveral continue differentto deliver services.' on its promises, The software Amazon was in therewritten mid-2000s in a way made that massive allowed investments multiple to teamsensure of a rapidprogrammers--e.g., pace of technological those writing innovation. software Respondent for payments’s principal and sales valuation tax expert,collection Daniel--to workJ. Frisch, in parallel, agreed therebythat Am improvingazon operated efficiency in a “highly and avoiding competitive, time- rapidlyconsuming changing collaboration. industry ” Bythat January “requires 1, 2010,substantial there innovationwas virtually all nothingthe time. left” of theRespondent OMS software’s technology that existed expert, in Edward2005. Felten, noted that “Amazon’s entire existence has3. been characterizedDynamo by the challenges of innovating due to running into unAnexp importantected wal lscomponent and growing of Amazon'sso fast that ordering the entire technology structure seems is its much in danger- imitatedof failure "shopping at any moment. cart,"” which allows customers to save items they intend to purchaseAmazon in a single’s software location engineers, while they computer continue scientists, to shop. andAmazon management initially team stored focused on continuous innovation to provide easy-to-use functionality, rich web- 9"Refactoring" means changing the internal structure of source code to improve its efficiency--e.g., by removing dead code and unwanted dependencies-- without changing its essential function or external behavior. site content, fast and reliable fulfillment,- 41 timely - customer service, and a trusted shopping cart information in an Oracle database. By the end of 2004 Amazon's

overloaded shopping carts were driving the Oracle databases to operate beyond the limits of their capability, causing multi-day outages in 2004. In early 2005 Ama- zon's shopping cart had "low availability," which meant that customers could put items in their carts, experience a session crash, and return to find their carts empty.

During 2005-2006 Amazon's engineers developed a high-availability system

called "Dynamo" to replace the Oracle databases. Dynamo was fully implemented during 2007 and lasted about five years before it needed to be replaced.

4. Payments

Amazon's Payments software manages and secures payment transactions with both retail customers and merchants. By late 2004 this software was experi-

encing stress. To keep Payments running during the 2004 holiday season, Ama- zon's engineers had to work around the clock, sleeping in hotels close to its data-

centers so they could be available in the event of an emergency. By 2005, simply adding a new payment method required changing multiple services and consumed several months of an engineer's time. Amazon's engineers described the state of the Payments system as "pretty dire" in 2006, when slow transaction processing

caused it to lose a significant amount of revenues. Concluding that small-scale revisions would not do the trick, Amazon decided (in the words of Distinguished - 4230 - transactionalEngineer Vosshal) environment. to "declare Am bankruptcyazon regularly on Payments launched andsoftware just start on a over."test basis, The fullyengineering conscious team of completelythe need for rewrote further thisimprovements; software between its software 2006 and 2011,website re- placingcontent oftenall but changed "a few linesmultiple of code times that the may sam persiste day. inA mtheazon dark’s softwarecorners." development process5. “ leveragedItem Master the future ”: By building a piece of software quickly,

AmazonAmazon incurred stores the riskinformation that it would about not products be adaptable offered to on future its websites needs. Byin data- re- basespeatedly referred choosing to as “ the"the expedient catalog." path In 2001” over Amazon “the right began path, developing” Amazon builtsoftware up

“calledtechnical Item debt Master” that as inheres a single in repository software withfor product a relatively information. short useful This life. software allowedAmazon Merchants’s need and to suppliers innovate to was add driven items by to mAmazon'sultiple factors. catalog Perhaps and maintain the mostcurrent, important accurate factor descriptions was the ofneed these to increaseproducts “ andscale. their” One attributes. of Amazon ’s early busineItemss go aMasterls was wentto “get through big fast three”; getting major big revisions fast meant between adding 2001 customers, and 2010. web-

Bypage 2004 views, the vendors,software and(then new in itsproducts second at version) an extremely was encountering rapid pace. Websitescale limita- tech- tionsnology and by lacked its nature functionality is subject thatto scale Amazon's limitations; expanding if the websitebusiness cannot required. “scale For up ” toexample, meet the Item dem Masterands placed was unable upon it,to itidentify will crash. situations Rapid where technological items listed innovation by dif- wasferent required sellers towere overcome in fact thethe samescale item;challenges this damaged posed by the rapid customer growth. experience by returningThese multiple challenges search were results especially in response pronounced to a query during for aA singlemazon product.’s peak holi- To addressday seasons, these when and other webpage challenges, views, transactionsAmazon in 2006 consummated, began developing and products a third pack- versionaged increased of the software, by 300% Itemto 400% Master over v3. nonpeak Item Master periods. v3 Holidayrebuilt the periods process stressed for listingevery aspect and describing of Amazon items’s syste in them, catalogand each and successive entailed peaka substantial season entailed rewrite ofhigher - 4331 -

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Amazon6. ’s engineersPersonalization testified that they spent the 1998, 2003, 2004, and

2005 holidayAmazon's seasons personalization “in crisis mode. technology” Although includes its website "Recommendations" was available toand the

"Similarities."public 98% of theThe time "Recommendations" during the fourth quartersoftware of tracks 2004, informationAmazon experienced about a cus- tomeroutages and during suggests critical products holiday he periods or she mightthat im wishpaired to custobuy onmers the’ abilitybasis of to prior browse pur- andchases. shop. The These "Similarities" and other softwareoutages during suggests 2004, items which that resultedresemble in or lost are revenue compatible withapproaching an item $130for which million, the jeopardizedcustomer is shoppingAmazon’s (e.g., relationships "customers with who retail bought custom- this itemers and also Marketplace bought item merchants. X," or "this Determined item and Item to address Y are frequently these scale bought challenges, togeth-

Amazoner"). made 24-7 website availability its chief company goal for 2005.

APersonalization related factor posesdriving two innovation sets of problems. was the need One to set reduce involves “latency. the algorith-” Dur- micing the(or earlymathematical) 2000s Am challengesazon’s software posed arc byh aitecture constant was effort built to in refine a siloed the fashionaccuracy thatof items required suggested particular as "similar" functions or to "recommended." “call” data from Thedatabases. second As set website of problems traffic involvesgeometrically scaling: increased, As the mnumberore nanoseconds of customers, were prior required purchases, to call and these products data, caus- for saleing webpages grows geometrically, to load more the slowly number and of respond links between less quickly these to variables, customer and requests. the dataAmazon that believedmust be searchedthat website to make latency "recommendations" frustrated custom ers,and leadingpropose them "similarities," to aban- growsdon the almost page they exponentially. were viewing or leave Amazon’s site altogether.

AsAnother of January factor 2005, driving Amazon's innovation Similarities was the need software to protect was scalingcustomer very data poorly and andprevent faced fraud. significant Computer challenges hackers related and other to latency. bad actors The posed technology increasing could security not keep - 4432 - uprisks with through the rapid cyber-attacks growth of of available various data;kinds. as Afterit took 2005 longer security to update became data, a majorsimi- laritiesfocus of could investment not be fordetected Amazon. using It the dedicated most recent large data.teams This of software inability engineers to scale to reducedcreate innovative the technology's security value.protocols designed to repel cyber-attacks, keep its website up,During protect 2004-2005 customer information,Amazon tried and to mbuildaintain a new customer Similarities trust. engine with in-

creasedThe scaling advent capacity, of new buttechnologies, that effort suchfailed. as smartphones,During 2005-2006, likewise Amazon propelled built andinnovation. launched S ma thirdartphones Similarities enabled engine custom thaters engineersto view products described and as m "aake complete purchases rethinkingthrough mobile of the networks; problem" younger and "a total custo gamemers changer."were especially By employing prone to doing"vastly this. moreAn online efficient retailer algorithms," risked losing the newthese Similarities customers ifengine it did achievednot meet speedstheir demands. 40 times

Becaufaster thanse th eits o npredecessor's.line retail env irIto nsignificantlyment was ch reducedanging stheo rap timeidl y,needed Amaz toon assemble believed andit impossible update Similarities to anticipate data. technological advances more than three years away.

Amazon'sB. Evolution Recommendations of Amazon’s softwareWebsite Architecturelikewise faced algorithmic, scale, and latencyIn January challenges. 2005 A Becausemazon knew Amazon that mdidany not components know which of customers its website would archi- visittecture when, would the not software meet its had long-term to process needs. large Its volumes engineers, of data who very never rapidly lacked in self-real time.confidence, Its algorithms believed hadthat to they select would from succeed and account in meeting for a futurewide variety challenges of inputs as they in determiningappeared. But exactly they did which not itemsknow wouldhow they be recommended;would do this. for example, a purchase

of patioWhen furniture Amazon.com years ago was would launched not yield in 1995, useful its recommendations website ran on Obidos, for a cus- a tomersingle nowmonolithic shopping application for a computer. atop an OracleIn an effort database. to ameliorate8 Its user latencyinterface problems, code,

Amazon rewrote Recommendations between May 2005 and May 2006, reducing 8In software engineering, a monolithic application describes a single-tiered itssoftware 60,000 application lines of code in whichto fewer the than user 15,000 interface lines. and Thisthe data redesign access significantly code are (continued...) - 4533 - improveddatabase connections, performance. and Because business of logic "substantial were heavily changes interdependent. across every major As traffic component"to Amazon of ’thes website Personalization increased, technology, it added more Amazon's and more engineers servers, estimatedcalled “onlines, that the” eachcontribution running ofa webthat software,server and as an it instance existed inof Januarythe monolithic 2005, was Obidos "no longercode. material" withinThe Obidos six years. application was written in “catsubst,” an arcane programming language that7. A mazonMessaging created. Significant engineering effort was required to perform evenOnce basic Amazon tasks. moved The manner toward ina servicewhich -orientedObidos was architecture, written made it required it difficult

"messaging"to identify “dependencies, software to enable” i.e., instancesthe technological in which components specific parts underlying of the code its de- web - sitepended to communicate on specific other with parts each ofother the incode. a unified Since way. any changeIn 2003 to Amazon the Obidos was code using mightcommercially affect m availableany applications, publish-subscribe a team desiring (or "pub to m-sub")odify messaging one application software had sup-to pliedget input by TIBCO, from multiple a third engineering party. TIBCO's groups. messaging This became service a cumbersomeat the time was process. state-

of-the-art,Obidos but wasit was also being subject pushed to “ deathto its limitsspirals. by” theUntil uniquely 2000, every heavy Obidos performance pro- demandscess, no m thatatter Amazon how short was lived, placing created upon its it. own database connections by calling databasesDuring directly, the 2003 without holiday coordinating season, failures requests in across the TIBCO the differe messagingnt onlines. software

Whencaused too outages many that onlines could were last seeking hours at the a time. same Indatabase early 2004 resources, Amazon's error engineers condi- texpressedions calle dconcern “timeo uthatts” wintroductionould occur. of The new Obidos services process could would bring thendown throw Amazon's a fatal websiteerror an dbecause restart, ofcreating the problems new database associated connections with TIBCO without messaging properly software. releasing Cis-the oldco Systems, ones. As which database supplied connections Amazon piled with up, routers calls froandm other other networking Obidos processes equip- to ment, informed the company that its routers, in conjunction with the TIBCO soft-

8 ware, would(...continued) not support the "scaling up" required for the 2004 holiday season. combined into a single program from a single computer system or network. - 4634 - the databasesIn October would 2004 time Amazon out, throwing stopped m usingore fatal TIBCO errors. for Whenits "biggest these “usedeath cases." spi-

Itra lthens” o cexploredcurred, th developinge affected w itseb ownsite c pubould-sub become software unavailable to overcome for an TIBCO's hour or more. per-

Asformance the number and scaling of Amazon problems.’s customers Amazon grew, ultimately such crashes created became and deployed more common. the

AmazonBy Messaging 2002 Amazon Platform had m (AMP)oved six in serviceslate 2007. out of Obidos: By reducing the load onD. Obidos New it wasProducts able toand handle Services a higher After volu Januaryme of 1, web 2005 traffic. Although

AmazonMany’s chief Amazon technology products officer and servicesdeclared familiarin 2005 tothat consumers the Obidos today architecture did not hexistad r einached January its “ 2005.end of Theselife” in included 2001, 98% Kindle, of Amazon Amazon’s retailPrime, webpages the Fire smart still ran- phone,on Obidos Fire as TV, of JanuaryAmazon's 2005. digital By musicMay of and that video year offerings, there was cloudreal concern computing, that andAmazon cloud’s storagewebsite services. would not Though be able some to scale of thesethrough products the holiday and services season ifwere it con- in developmenttinued to run onduring Obidos. 2005, Great none effort generated was expendedrevenues untilto move later. a significant amount of trafficKindle, off Obidos Amazon's and ontoeBook a service-oriented reader, enables customersarchitecture to known view digital as Gurupa. books, newspapers,Amazon transitioned magazines, rapidly and blogsaway fromdirectly Obidos on the during device. 2005 Kindle and ceased was prototyped using it inaltogether May 2005 on andAugust launched 31, 2006. in the United States in November 2007. In October

2009, AEHTAmazon launched began its Kindle shift toward2, a subsequent a service-oriented version of architecture the device, aroundin France, 2002.

“Germany,Service-o andrien ttheed aUK.rchi tecture” describes software designed as a set of small, inde- pendentAmazon programs Prime or “ isservices a membership”; the services program work that together enables to customers perform complexto receive tasks.free one In-or this two-day model, shipping each service and discountedneeds to understand overnight how shipping to interact along only with with other benefits.those other Amazon functions introduced with which Prime it has in actualthe United contact. States This in 2005differentiates and in Europe it from a between 2007 and 2008. The Prime program required major changes to the tech- monolithic model, where each function- m 47ust - understand how to interact with nology used to operate Amazon's fulfillment centers, especially during peak shopping periods. Items destined for Prime customers had to be picked, sorted, pack- aged, and shipped in a different manner from other items in order to ensure the

expedited delivery that Amazon promised.

Amazon introduced Amazon Unbox, a digital video download service, in

September 2006, and it introduced Amazon MP3 in the United States in Septem- ber 2007. AEHT launched MP3 in Europe the following year. Digital media has become an increasingly important part of Amazon's business.

Amazon Web Services (AWS), the company's cloud-computing business, was largely developed after January 2005. It was launched in the United States in

2006. It has grown significantly in terms of employee headcount, number of servers required to operate the business, and revenues generated.

III. Amazon's Third-Party Businesses

A. Merchants.com

In its M.com business, Amazon used the technology that powered its own retail websites to build and operate eCommerce websites for other merchants.

Amazon's principal M.com clients were large retailers doing business in the

United States and abroad; there were no material differences between the technology "packages" that domestic and foreign clients received. Amazon's major -48- 35 - eclientsvery o includedther func tTargetion in ain l atherge Unitedr program. States, Am Marksazon did& Spencer not invent in theservice-oriented UK, Mother- architecture,care in the UK, which and wasSears a well-knownCanada. Amazon's concept contractin the computer with Target industry. went into effect in 2001Amazon and was built initially this newset to architecture expire in 2006; on a Gurupait was later engine, extended which several received times re- viaquests amendments. from a web Amazon server, sent eventually the requests decided to services to terminate or applications, the M.com andprogram re- andturned shut responses it down altogetherto the web afterserver. 2010. The engine did not create webpage content; instead,M.com it sent retailers requests sold to applications their own products that, in coordination on their own with branded services, websites; created the thirdand returned-party retailer webpage was content the seller to theof record server. and The owned role of all the the Gurupa inventory. engine, Although in

Amazoneffect, was built to stitchand operated together these dynamic sites, webpages. it remained "behind the scenes" as far as the retailer'sThe transition customers from were Obidos concerned. to Gurupa The was M.com an architectural sites employed shift the fro retailer'sm a webmonolithic address, to URL,a distributed trade name, system and and trademarks; involved rewritingM.com clients software had in no different right to use

Amazon'sprogramming marketing languages. intangibles Amazon and decided received to abandon no information catsubst about for building Amazon's web- pagesown retail and shiftedcustomers. to a programming language known as Perl and a templating language Theknown clients as Mason obtained, (the asduo part was of called the M.com “Perl/Mason "package,"”). Amazon the complete could suite reuse of

Amazon'svery little ofwebsite the Obidos technology, software including when it themoved customer to Gurupa. service, And fulfillment, many concepts and re- latedthat underlay software the that monolithic Amazon itselfarchitecture used. M.com were not clients applicable received to aall distributed of the software updatessystem. andAm aupgradeszon disp lthatayed benefited its first Perl/Mason Amazon's pageown websites.in August There2005, wasbut very no extra few

Europeancharge for webpages these upgrades; were generated they were using included Perl/Mason within the and basic Gurupa deal until structure 2006. re- gardlessProblems of whether with Amazon's the new architecture contract with soon the emerged. client included Webpages an explicit created "fea- in turePerl/Mason parity" clause.and rendered using the Gurupa engine took longer to appear in a - 4936 - user’s Forbrowser additional than comparable fees, M.com Obidos clients pages. could alsoGurupa arrange’s throughput--the to have Amazon number per- ofform webpages certain servicesthat could for be them, displayed using per Amazon's second--was own facilities.less than aThese tenth ofservices Obidos ’ incould August include 2005. fulfillment, One reason transportation, was that Gurupa customer at the service, time did payment not support processing, parallel renderingfraud prevention, or “streaming. and/or ”marketing. Rather than Not loading all M.com webpages clients sequentially, chose to avail streaming them- selvesenables of different these additional parts of aservices. webpage In to some be loaded cases simultaneously, Amazon agreed permitting to develop the for

M.comcustomer clients to view (again part forof theadditional page while fees) the specific rest is technologiesbeing delivered that to Amazon his or her did notweb use browser. in its own Streaming business. capabilities were increasingly prevalent on Amazon’s competitorsB. ’ Associateswebsites, and and their Syndicated absence Stores at Am azon negatively affected its customersThrough’ shopping the M.com experience. program, Amazon functioned essentially as a supplier

of technologyAnother to problem other retailers. was that Throughthe services the calledAssociates by the and Gurupa Syndicated engine Stores were programs,developed Amazonin “silos” entered rather thaninto asrelationships an integrated with system. third parties In certain with situations, the goal of en- hancingthese services its own suffered customer from base. “circular In both dependencies, of the latter ”programs, that is, links Amazon that eventually paid refer- ralconnect fees tocode the backthird toparty itself, when which its customerscan cause theor website software visitors to crash made after purchases a code change.from Amazon. Becau seBoth of lack programs of coordination were in operation between in service 2005-2006; “silos, ”only code the was Associ- often ateswrit tprogramen that d ucontinuesplicated existing to operate functionality. today. These structural problems increased as AmazonIn the created Associates new program,services and the expandedthird party its or website "associate" capabilities. includes on its own websiteBecause a link to the Amazon's Gurupa architecture site. When wasa visitor a set toof thedisconnected associate's silos website rather "clicks than through"a technology to Amazon platform, and m anymakes of Amazona purchase,’s engineers the associate regarded earns it a as referral “dramatically fee. As- sociates could be online retailers themselves, but more typically they maintain unreliable from the first day.” Amazon- found50 - it increasingly difficult to hire pro-

content-specific sites or blogs that offer product reviews or similar information.

Some have as their principal goal capturing web traffic and linking their viewers to Amazon and other sellers in order to earn commissions. Generally speaking, the associate earns a commission on any purchase the customer makes from Ama- zon within 24 hours of "clicking through" to Amazon's site.

Through Syndicated Stores, Amazon used its eCommerce technology to sell

Amazon products through a third-party retailer's website (called the "mirror site").

In this scenario Amazon was the merchant making the sale; it kept the associated retail markup and paid a referral fee to the Syndicated Stores partner. Although

Amazon derived benefits from Syndicated Stores apart from customer referral-- because the partner was usually a web retailer, the program eliminated some com- petition--the fees Amazon paid were essentially payments for customer referrals.

Notwithstanding their differences, petitioner viewed the Associates and

Syndicated Stores programs similarly: The primary purpose of both was to drive

customers to Amazon. It signed agreements with about 20 Syndicated Stores partners (including European partners) before discontinuing the program. Whereas these agreements were individually negotiated, agreements in the Associates program were not. The process by which an associate joined the program was sub- -51- 37 - stantiallygrammers automated eager to work and inthe this compensation environment: terms Typically were fixed trained and in largely Java and non- C++, negotiable.they came to regard Perl/Mason as a “dead language.” In October 2009 Gurupa instancesThe running stated commission the U.S. website rates wereunder expected both programs to crash depended with unacceptable on product fre- mix andquency sales if volumes.not killed andCommission restarted. rates generally ranged from 4% to 8% in the

AssociatesIn September program 2006and from Amazon 4% to hired 6% inBrian the SyndicatedValentine to Stores envision program. and lead Refer- the raldevelop fees mforent Syndicated of a new eCommerceStores partners platform. generally He hadregarded a per-unit Gurupa cap; as this an meantunreliable that theapp leffectiveication and commission put it on “ ratelife supportcould be” shortlylower than after the he nominalarrived. rate He testifiedreflected that in the hiscontract. unit had Amazon to devote expected most of that its mostefforts people to “keeping referred the to lights it under on ”these--that programs is, keep- woulding Am beazon converted’s websites into fro Amazonm crashing customers, on Gurupa--rather on whose subsequent than pursuing purchases innovative no referralprojects. fees By would 2012 A bem due.azon hadIt was migrated accordingly most ofwilling its website to pay platform relatively from high Gur- up- upafront to commissions Santana, but forit was customer still using referrals. Gurupa The for average some applications referral fee asAmazon late as actu-No- allyvember paid 2014. under the Associates and Syndicated Stores programs was approximately

5.9% ofMr. referred Valentine sales.’s 1°goal was to create a true technology platform, with a central andW. standardizedThe Buy-In set Payment of services and a uniform interface for interacting with those services.Petitioner A key featureknew that of thisit had platform a duty wasto report Santana, the Project a Java-based Goldcrest web transac- hosting tionsservice on and its Federalrendering income engine tax that returns. addressed To assistGurupa it ’ins performancedischarging thisand responsi-stability problems. Santana was first deployed on an Amazon website in 2007; by 2008 1 olu July 2001 Amazon entered into a Syndicated Stores agreement with Waterstone's,Amazon had c hao UKsen retailer.Santana aIts providedits preferre ford architecturea 5% referral for fee, future which software could in- devel- crease to 6% if certain aggregate sales thresholds were met. This agreement had an unusual feature whereby Amazon would also pay Waterstone's a one-time bounty of £7 for new purchases by certain customers. opment projects. This shift to Santana -required 52 - Amazon to rewrite virtually all of bility, it hired Deloitte LLP to calculate the required buy-in payment. In order to do this, Deloitte needed multi-year financial projections for the European business. Given the unpredictability of eCommerce revenue growth, Amazon for internal budgeting purposes did not make financial projections more than 12 or 18 months out. It assigned its tax department the task of creating longer term projections for this occasion.

The tax department started with Amazon's historical financial data and the most recent income-statement forecast, which included projections for the next 18 months. In consultation with business and finance personnel, the team forecast growth rates for revenue, gross margins, operating expenses, and operating margins for the U.S. and the European businesses. These projections covered calendar years 2005 through 2010.

In 2006 Deloitte supplied Amazon with a "Transfer Pricing Documentation

Report" to calculate the required buy-in payment. Deloitte determined that the best method for calculating the buy-in price was "an unspecified income-based method." See sec. 1.482-4(a)(4), Income Tax Regs. Although the method De- loitte employed was not "specified" in the regulations, Deloitte regarded it as similar in many respects to the specified residual profit split method. See sec. 1.482-6,

Income Tax Regs. - 5338 - its eCoDeloittemmerce determinedservices, an thatd th ethe ne intangiblew platform assets thus tookAmazon much US longer transferred to build to and

AEHTimplement had thana seven-year Amazon usefulhad expected. life. Relying on Amazon's 2005-2010 projections

(which TheDeloitte new platforextrapolatedm was to vastly 2011), superior Deloitte to determinedits predecessor. the future Java wasincome more streamsefficient of and AEHT performance reasonably oriented attributable than Perl/Mason, to these assets, and itthen was allocated a modern those pro- in- grammingcome streams language between that pre-existing made hiring and easier. subsequently Java reduced-developed the parallel intangible rendering property.problem Deloitte that determined had plagued that Gurupa, the appropriate and it significantly buy-in price reduced was $254.5 latency. million, Java was to be paidsupe roverior f oar seven-yearstreaming digitalperiod content commencing and, in in conjunction 2005. with Santana, it provided much betterAt trial throughput. petitioner supported its position with respect to the buy-in payment principallyC. onEvolution the basis of of Amazon the comparable’s Software uncontrolled Applications transaction (CUT) method.

See sec.Corresponding 1.482-4(c), Income to these Tax major Regs. shifts It contendedin Amazon that’s software each species architecture, of intan- the gibleapplications property or--the “services website” that technology, performed the specific marketing business intangibles, functions and underwent the Euro- peanconstant customer change. information The shift --hadto Santana to be valuedrequired separately. almost everything For each from species Gurupa of prop- to beerty, rewritten Amazon or submitted thrown out. expert Representative reports that examplesestimated arethe discussedproperty's below. useful life and valued it on the1. basisCustomer of available Master CUTs. Service

LaunchedRespondent around contended 2000, that Customer the best Master method Service for determining (CMS) was an the arm's first-length ser- buyvice-in launched payment in was Am azonthe discounted’s move toward cash fla owservice-oriented (DCF) methodology architecture. employed CMS by

Dr.initially Frisch. had Inlimited the event ambitions, the Court simply rejects allowing that methodology, customers to respondent change their submitted user namesexpert reportsor passwords. that employed As a result a CUT of constant methodology. revision For its each functionality species of was property, vastly expanded. CMS eventually functioned- as 54 a -“ broker” between the database storing respondent's experts supported values substantially higher than those determined by Amazon's experts.

For the website technology, petitioner's experts derived a CUT by reference to the prices Amazon charged its M.com clients for the technology needed to run those clients' eCommerce websites. Petitioner's expert John Wills testified as to his belief that Amazon offered these M.com customers its full suite of website technologies together with all necessary services. He opined that the M.com transactions thus furnished appropriate internal CUTs for the technology that

Amazon US made available to AEHT.

Four of petitioner's other technology experts--Ken Birman and Lorenzo

Alvisi, David Parkes, and Alan MacCormack--employed various approaches to ascertain the useful life of Amazon's website technology and the rate at which it would "ramp down" or decay in its utility. Applying these useful life conclusions to the pricing data derived from the M.com transactions, Dr. Wills concluded that the value of the website technology transferred by Amazon US to AEHT ranged between $117 million and $182 million.

Respondent's expert Harlow Higinbotham agreed that the CUT method

could be used to value the pre-existing technology and that the M.com transactions supplied a reliable source of CUTs. However, he concluded that Amazon's web- - 5539 - siteAm atechnologyzon’s custo hadmer anin findefiniteormation ausefulnd the life. vari oOnus retailthe basis segments of his useful(e.g., service life deter- cen- minations,ters, fulfillment Dr. Higinbotham centers, and thevalued website) the website that needed technology this customer transferred information. by Amazon

US to AEHTBy fall at2004 $3.34 CMS billion. had grown very large, complex, and fragile as Amazon’s evolvingFor business the marketing requirements intangibles, necessitated Robert constantReilly (petitioner's changes to expert)the software. and David

HaighCMS became (respondent's a bottleneck expert) and both experienced used an external more than CUT 50 methodology hours of outages to determine during anthe arm's December-length 2004 buy -inholiday price. season. In selecting To address their CUTs,these problems, both experts Am alsoazon relied em- on thebarked same on sources a complete of public re-arc information.hitecture of CMSBut the during two 2005experts and came 2006. to disparateAt the time valueof trial, determinations, CMS no longer chiefly existed, because having of been very replaced different by conclusions new software as to known the useful as lifeIdentity of the Service. transferred property and the proper royalty rate to apply over the property's useful life.2. Mr.Order Reilly Master concluded Service that the arm's-length value of the marketing intangibles“Ordering ranged” includes from $251 the million steps whereby to $312 amillion; customer Mr. places Haigh an determined order, payment a valueis authorized, of $3.13 a billion shipment for requestthe same is intangibleprepared, andproperty. the order is handed off for fulfillment.The This customer requires information interactions that with Amazon many USother transferred parts of Amazon to AEHT’s software,consisted includingof data about the systemsEuropean managing retail customers fraud prevention, who had transacted payment, saleswith thetax Europeancollection, andSubsidiaries fulfillment. before Am Mayazon 1, developed 2006. These Order data Master included Service names, (OMS) email around addresses, 2000 to phonehandle numbers,key aspec purchasingts of shopping history, carts, and orders, credit ship cardments, information. and related Amazon business viewed logic thisand messaging.customer information Although asit washaving built a outsideshort useful of Obidos, life: People it resembled change Obidos their phone in numbersbeing a large and monolithicemail addresses program often, that and was their difficult buying to habits support. change significantly - 5640 -

over time.By spring For its 2004 Similarities OMS was software, causing Amazon bottlenecks uses that only generated relatively fatal recent errors data in because1% of all it customer regards older sessions, data frustratingas having littlecustomers or no value.and generating other problems.

AmazonGiven’s engineers the relatively referre shortd to OMSuseful as life “the of newthe customer Obidos” becauseinformation, it “created Amazon's longexperts lead regarded times for Amazon bug fixes US and as havingnew features in essence and needlessly"referred" itstied European together unre-cus- tomerslated product to AEHT, launches. which” then Am azonbenefited concluded from havingthat OMS a base needed of inherited to be substantially customers whenrewritten it began to simplify operations it and on decouple May 1, 2006.it from Dr. the Wills software accordingly handling used paym asents, CUTs pro- themotion, referral shopping fees that cart, Amazon and fulfillment. paid its business partners in the Associates and Syn- dicatedBeginning Stores programs. in 2006 Amazon’s engineers “refactored” OMS into several differentTwo services. of petitioner's9 The software other experts was rewritten--Wendy in Moe a way and that Robert allowed Wentland-- multiple performedteams of programmers--e.g., analyses that estimated those futurewriting purchases software byfor thepayments referred and European sales tax collection--tocustomers and work the rate in parallel, at which thereby these individuals improving wouldefficiency convert and toavoiding direct cus-time- tomersconsuming of AEHT. collaboration. Using these By January estimates, 1, 2010,Dr. Wills there applied was virtually a referral nothing fee of left 5.9% of -- the averageOMS software referral that fee existedAmazon in itself 2005. paid to its Associates and Syndicated Stores partners--for 3all. purchasesDynam oby customers deemed to arrive at AEHT's websites by referral.An Dr. important Wills assumed component that of AEHT Amazon would’s ordering pay referral technology fees for is only its m sixuch- years, andimitated he discounted “shopping the cart, resulting” which revenueallows customers stream at 18%.to save This items generated they intend a buy to-in paymentpurchase ofin $52a single million location for the while customer they continue information to shop. that AmazonAmazon USinitially made stored available to AEHT. Dr. Wills determined that this value would rise to $66 million 9“Refactoring” means changing the internal structure of source code to ifim AEHTprove ipaidts ef freferraliciency -fees-e.g .,for by 10 removing years. dead code and unwanted dependencies-- without changing its essential function or external behavior. - 5741 - shoppingDr. cartHiginbotham information agreed in an that Oracle the database.commissions By Amazonthe end of paid 2004 third Am partiesazon’s for ocustomerverloade dreferrals shoppi nsuppliedg carts were appropriate driving theCUTs. Oracle However, databases he togave operate particular beyond the weightlimits of to their Amazon's capability, agreement causing with multi-day Waterstone's, outages ain Syndicated 2004. In early Stores 2005 partner Am a-in thezon ’UK.s shopping It provided cart had not “onlylow availability,for referral fees” which ranging meant from that 5% custo to 6%,mers but could also put for aite one-timems in their bounty carts, of experience £7 for new a sessionpurchases crash, by certainand return customers. to find theirUsing carts these empty. parameters,During 2005-2006 Dr. Higinbotham Amazon’s valuedengineers the developed customer informationa high-availability at $215 system million.

V.cal led Cost“Dyn Sharingamo” to Paymentsreplace the Oracle databases. Dynamo was fully implemented duringThe 2007 CSA and requiredlasted about AEHT five to years make before annual it costneeded sharing to be payments replaced. to compensate Amazon4 US. forPay ongoingments intangible development costs (IDCs), to the extent those IDCsAmazon (as ’determineds Payments bysoftware a revenue manages ratio) andbenefited secures the pay Luxembourgment transactions headquarters.with both Seeretail sec. customers 1.482-7(a)(1), and merchants. (d)(1), Income By late Tax 2004 Regs. this Virtuallysoftware allwas techno- experi- logicalencing stress.innovation To keep occurred Paym withinents running Amazon during US. theThus, 2004 the holiday larger the season, volume Ama- of

IDCszon’s thatengineers Amazon had US to workis treated around as having the clock, incurred, sleeping the in larger hotels the close cost to sharing its data- paymentscenters so thatthey AEHT could bewas available required in to the make. event of an emergency. By 2005, simply addingThe a new regulations payment definemethod IDCs required and providechanging that multiple costs that services contribute and consumed both to intangibleseveral months development of an engineer activity’s time.and to Aothermazon business’s engineers activities described must bethe allocated state of

"onthe Paymentsa reasonable system basis." as “prettySee id. dire para.” in (d)(1). 2006, Petitioner'swhen slow transaction cost accounting processing system duringcaused 2005-2006it to lose a significantdid not specifically amount of segregate revenues. IDCs Concluding or R&D thatexpenses small-scale from

other operating costs. Petitioner therefore developed a formula and applied it to revisions would not do the trick, Amazon- 58 decided - (in the words of Distinguished allocate to IDCs a portion of the costs accumulated in various "cost centers" under its method of accounting.

"Cost centers" are accounting classifications that enable a business to manage and measure operating expenses. Petitioner tracked expenses in six high-level

cost centers: (1) Cost of Sales, (2) Fulfillment, (3) Marketing, (4) Technology and

Content (T&C), (5) General and Administrative (G&A), and (6) Other. Each of these high-level cost centers is a "rollup" of numerous subsidiary cost centers. For some calendar quarters, more than 200 individual cost centers, each recording a specific type of expense, "rolled up" into intermediate cost centers and ultimately into one of the six top-level cost centers. For example, cost center 7710, "Systems and Network Engineering," rolls up into C210 ("Product Development") and C250

("Technology/External"). All costs accumulated in "Product Development" and

"Technology/External" roll up into the T&C category.

The parties agree that none of the costs accumulated in the "Cost of Sales" and "Other" categories are allocable to IDCs. Respondent accepts petitioner's

formula-based allocation to IDCs of costs accumulated in the "Fulfillment" and

"Marketing" categories, and he accepts petitioner's decision to allocate G&A costs to IDCs on the basis of the IDC outcomes for the other five categories. - 5942 -

EngineerThe Vosshal) parties' disputeto “declare focuses bankruptcy on the T&Con Pay category.ments and Respondent just start over. contends” The thatengineering 100% of team the costscompletely accumulated rewrote in this the softwareT&C category between constitute 2006 and IDCs; 2011, as re- a placingcorollary, all this but would“a few produce lines of codea commensurate that may persist increase in the in darkthe percentage corners.” of G&A

costs allocable5. to IDCs.Item MasterPetitioner urges that T&C costs must be allocated between AmazonIDCs and stores other informationactivities "on about a reasonable products basis"offered and on thatits websites its allocation in data- basesformula referre accomplishesd to as “the this catalog. result.” In 2001 Amazon began developing software called BroadlyItem Master speaking, as a single the costs repository accumulated for product in the information. T&C category This include software ex- pensesallowed related Merchants to technological and suppliers development to add item sand to Awebsitemazon ’content.s catalog Accordingand maintain to petitioner'scurrent, accurate SEC descriptionsfilings, its T&C of these category products expenses and their "consist attributes. principally of payroll and relatedItem Masterexpenses went for throughemployees three involved major revisions in research between and development, 2001 and 2010. includ- ingBy 2004application the software development, (then in editorialits second content, version) merchandising was encountering selection, scale systemslimita- andtions telecommunications and lacked functionality support, that and Am costsazon’ associateds expanding with business the systems required. and For tele- example,communications Item Master infrastructure." was unable T&Cto identify costs includedsituations costs where associated items listed with by ac- dif- quiredferent s websiteellers w econtent;re in fac payrollt the sa mande i trelatedem; this expenses damaged for the employees customer experienceinvolved in by research,returning websitemultiple development, search results and in response telecommunications to a query for support; a single and product. payroll To and relatedaddress expenses these and for other employees challenges, involved Amazon in categoryin 2006 beganexpansion developing (i.e., expanding a third

Amazon'sversion of theproduct software, offerings) Item Masterand buying. v3. Item Master v3 rebuilt the process for listing Duringand describing 2005-2006 items many in the employees catalog and whose entailed time awas substantial captured rewrite in T&C of cost

centers engaged solely in intangible development activity; certain employees en- - 6043 - gagedItem M solelyaster vin2. other Item types Mast eofr vactivity;3 was d eandplo ycertained in 2007 employees and ran engaged concurrently in both. with

ThisItem diversityMaster v2 of until tasks 2010, was whenreflected the inlatter their was job shut classifications. down. All Amazon employees have6 job. codesPersonalization beginning with a capital letter, one of which is "T," which stands Amazonfor "Technical."’s personalization Most cost technology centers that includes rolled up“Recommendations into T&C have a ”mix and of

T“Si-codedmilarities. and ”non The-T-coded “Recommendations workers. During” software the first tracks quarter information of 2006, forabout example, a cus-

35tomer T&C and cost suggests centers products had no The-coded or she employees; might wish 27 to hadbuy allon Tthe-coded basis employees;of prior pur- andchas 69es. had The a “mix.Simi lOnarit iaveragees” software during suggests 2005-2006, items there that resemblewere almost or are as compatiblemany T&C withcost centersan item with for which no T-coded the customer employees is shopping (31.4 cost (e.g., centers) “customers as there who were bought with thisall

Tite-codedm also employees bought item (31.9 X,” costor “ thiscenters). item and Item Y are frequently bought together”). The subsidiary cost centers that "rolled up" into T&C captured a significant volumePersonalization of non-IDC personnel poses two costs. sets ofThe problems. diversity Oneof the set employees' involves the tasks, algorith- which ismic reflected (or mathematical) in their annual challenges performance posed evaluations,by a constant11 effortis illustrated to refine by the these accuracy examples:of items suggested as “similar” or “recommended.” The second set of problems involves• Employeesscaling: As in the cost number center of 5155 customers, manage prior third purchases,-party digital and content products that for is viewedsale gro onws orge odownloadedmetrically, tfromhe nu Amazon.com.mber of links bCertainetween employeesthese varia bmanageles, and the the

"customerdata that m purchasingust be searched experience." to make “Otherrecommendations employees spend” and proposetime negotiating “similarities, and ” grows almost exponentially. "The performance evaluations show that certain employees whose time was capturedAs inof T&C January cost 2005, centers Am engagedazon’s Similarities in substantial software non-IDC was activity. scaling veryRelevant poorly cost centers include 7334, New Product Development; 7823, Data Warehouse Development;and faced significant 5355, Largechallenges Accounts related Services to latency. Account The Management;technology could and not7402, keep Payments Platform. -61- 44 - managingup with the the rapid logistics growth of of acquiring available website data; as content it took fromlonger third to update parties data, and deter-simi- mininglarities couldhow this not websitebe detected content using will the be most displayed recent todata. Amazon's This inability customers. to scale reduced• theEmployees technology in cost’s value. center 5357 build and improve technology that helps sellersDuring integrate 2004-2005 their products Amazon into tried Amazon.com. to build a newSome Similarities employees engine spend with signif- in- icantcreased time scaling helping capacity, sellers butlist thattheir effort products. failed. This During includes 2005-2006, assisting A sellersmazon inbuilt andfilling launched out spreadsheets a third Similarities and directing engine their that submissions engineers described to other Amazon as “a complete staff members.rethinking of the problem” and “a total game changer.” By employing “vastly more efficient• Employees algorithms, in cost” centerthe new 7723 Similarities design, expand,engine achieved and maintain speeds Amazon's 40 times productfaster than catalog. its predecessor Some write’s. codeIt significantly to compile reduced and display the time the catalogneeded toor assembleto allow andcustomers update to Si placemilarities orders. data. Others engage in routine maintenance and make minor

code adjustmentsAmazon’s Recommendations to alter the manner software in which likewise website facedcontent algorithmic, is displayed. scale, and latencyBecause challenges. petitioner's Because T&C costAmazon centers, did likenot knowits Fulfillment, which customers Marketing, would and visitG&A when, cost centers, the software captured had bothto process IDCs largeand other volu mcosts,es of it data devised very arapidly complex, in real mul- tim-stepe. Its formula algorithms to allocate had to costs select "between from and the account intangible for a developmentwide variety areaof inputs and thein dothereterm areasining or ex businessactly wh iactivities."ch items w oSeeuld sec.be re 1.482-7(d)(1),commended; for Income example, Tax aRegs. purchase The detailsof patio of furniture this formula years have ago wouldvaried notover yield time. useful The recommendationsformula that petitioner for a urgedcus- at trialtomer employed now shopping data derived for a computer. from a PricewaterhouseCoopers In an effort to ameliorate (PwC) latency study problems, that identifiedAmazon rewrote qualifying Recommendations research activities between for purposes May 2005 of claimingand May section2006, reducing 41 research and experimentation (R&E) credits for 2005 and 2006. its 60,000 lines of code to fewer than 15,000- 62 - lines. This redesign significantly

Because Amazon's employees did not record time specifically to R&E activities, the PwC study relied heavily on employee surveys. Most employees in

T&C cost centers, regardless of job code, were surveyed. Some employees outside

of T&C cost centers were surveyed if petitioner believed they engaged in quali-

fying research.

In these surveys PwC asked employees to complete questionnaires on which they divided their time among 14 specified activities. Eight of these activities involved software development, from the initial "requirements" phase through deployment and testing, together with direct supervision and direct support of software development. The time devoted to these eight activities was deemed to yield qualifying R&E expenses for section 41 purposes. Time devoted to five types of activities--specifically, routine engineering, routine data collection, reverse engineering, human resources/training, and activities outside the United

States--was deemed not to yield qualifying R&E expenses for section 41 purposes.

The 14th category captured days when no work was done, such as vacation days, sick days, and holidays.

From these surveys, PwC derived estimates to allocate employee time to section 41 qualifying activities. For each surveyed employee, PwC computed a

"qualified research expenditure" (QRE) percentage, reflecting the portion of that - 6345 - person'simproved time performance. that was spent Beca onuse qualified of “substantial research. changes In the across fourth every quarter m ajorof 2006, com- ponentfor example,” of the the Personalization average QRE technology,percentage for Am employeesazon’s engineers in the 7000estimated series that of costthe contributioncenters (capturing of that costs software, related as to it technologyexisted in January development, 2005, was maintenance, “no longer and mate- management)rial” within six was years. 61.15%. In that same quarter the average QRE percentage for

employees in7 the. 5000Messaging series of cost centers (capturing costs related to business line management)Once Amazon was moved 53.41%. toward PwC a service-orientedused these percentages architecture, in determining it required the section“messaging 41 credit” software to which to enable it believed the technological Amazon was components entitled. underlying its website to Notingcommunicate the similarity with each between other insection a unified 41 qualified way. In research2003 Am expendituresazon was using andcommercially IDCs, Amazon available employed publish-subscribe the PwC survey (or “ datapub-sub as a” )central messaging component software of sup-its pliedformula by forTIBCO, allocating a third costs party. under TIBCO section’s m 1.482-7(d)(1),essaging service Income at the Tax tim eRegs. was state-Sim- plifyingof-the-art, somewhat, but it was petitioner's being pushed formula to its limitsfor allocating by the uniquely T&C category heavy performancecosts be- tweendemands IDCs that and Am otherazon activitieswas placing proceeds upon it. in several steps. As the first step, petitioner Duringeliminated the from2003 theholiday T&C season, cost centers failures all in costs the TIBCOcaptured messaging in 26 general software ledger accountscaused outages that petitioner that could determined last hours toat bea ti unrelatedme. In early to intangible 2004 Am azondevelopment.’s engineers

Theexpressed resulting concern sum maythat introductionbe called "modified of new servicesT&C category could bringcosts." down Amazon’s websitAse b ethecau secondse of th step,e pro bpetitionerlems asso identifiedciated with the TIBCO employees messaging within software. the T&C Cis-cate- goryco Systems, who were which likely supplied to have A engagedmazon with in intangible routers and development. other networking Assuming equip- that ment,only T informed-coded employees the company were that likely its routers,to have indone conjunction this, petitioner with the divided TIBCO the soft- num- ber of such employees by the total number of employees in the T&C category. ware, would not support the “scaling up-” 64 required - for the 2004 holiday season.

This yielded what petitioner called the "T-ratio." Petitioner calculated a distinct

T-ratio for the T&C category for each calendar quarter during 2005-2006.

The next step was to examine the QRE survey results. Petitioner adjusted the PwC data to reflect the fact that certain costs ineligible for the section 41 credit

(e.g., costs attributable to reverse engineering and non-U.S. activities) may prop-

erly be includible in IDCs. Petitioner accordingly determined an "adjusted QRE percentage" for each person in the T&C category, representing the portion of that person's time spent on intangible development. Petitioner computed the arith- metic average of these "adjusted QRE percentages," which it called the "adjusted

QRE ratio" or "A-ratio."12 Petitioner then multiplied the T-ratio by the A-ratio to yield a "development ratio" for the T&C category. Finally, petitioner multiplied

"modified T&C category costs" (as determined at step 1) by the "development ratio" to determine the dollar volume of T&C category costs properly allocable to

IDCs. Petitioner made separate computations for each calendar quarter and summed these results to produce annual IDC figures for the T&C category.13

12If there was no PwC survey data for a particular T&C cost center--e.g., because that cost center was recently created or because it was determined not to contribute to section 41 qualifying research--petitioner applied the average A-ratio for cost centers with available survey data.

"Petitioner employed a similar methodology to determine the percentage of (continued...) - 6546 -

InOn October its 2005 2004 and 2006Amazon Federal stopped income using tax TIBCO returns, for petitioner its “biggest reported use cases. cost ” sharingIt then explored payments developing from AEHT its ofown $116,092,584 pub-sub software and $77,297,000, to overcome respectively. TIBCO’s per-

(Theseformance amounts and scaling were problems.reported as A reimbursedmazon ultimately R&E expenses, created and thus deployed reducing the other- wiseAmazon-allowable Messaging deductions.) Platform The(AMP) cost in sharing late 2007. payment for 2006 was determined using theD. PwCNew survey Products data asand described Services previously.After January Because 1, 2005 the PwC data were not availableMany A whenmazon petitioner products filed and itsservices 2005 return,familiar it toinitially consumers used todaya different did not sys- temexist to in determine January 2005. the 2005 These cost included sharing Kindle, payment. Amazon It subsequently Prime, the filed Fire ansmart- affirma- tivephone, claim Fire for TV, 2005, Am azonreporting’s digital a lower music cost and sharing video paymentofferings, computed cloud computing, under the methodologyand cloud storage used services. for 2006. Though By this some affirmative of these claim, products petitioner and services sought wereto reduce in thedevelop 2005m costent duringsharing 2005, payment none by generated approximately revenues $59 until million, later. or almost 50%.

VI. Kindle,Stock-Based Amazon Compensation’s eBook reader, enables customers to view digital books, newspapers,The CSA magazines, executed and by blogsAmazon directly US and on AEHTthe device. defined Kindle IDCs was to "includeprototyped all directin May and 2005 indirect and launched costs (including in the United Stock States-Based in Compensation November 2007. Costs)" In October relating to intangible2009, AEHT development. launched Kindle Specifically, 2, a subsequent IDCs were version defined of the to includedevice, in"compensa- France, tionGermany, provided and by the a UK.Party to its employees or independent contractors in the form of

equity Amazoninstruments, Prime options is a membership to acquire stock, program or rightsthat enables with respect customers to * to* * receive equity free one-or two-day shipping and discounted overnight shipping along with other 13( benefits. A.continued)mazon introduced Prime in the United States in 2005 and in Europe G&A category costs allocable to IDCs. Respondent does not object to the G&A methodology, except to the extent that it employs what respondent views as an unduly low allocation of IDCs to the T&C category. between 2007 and 2008. The Prime program- 66 - required major changes to the tech- instruments or stock options as defined in Treasury Regulation § 1.482-7(d)(2)(i)

(as amended by T.D. 9088)." The parties further elected, pursuant to section

1.482-7(d)(2)(iii)(B), Income Tax Regs., to take into account "all stock-based

compensation in the form of stock options in the same amount, and as of the same time, as the fair value of the stock options reflected as a charge against income in the audited financial statements of a Party." This election was made "without prejudice to the Party's right to challenge the validity of Treasury Regulation § 1.482-

7(d)(2)."

In filing its 2005 and 2006 returns, petitioner thus complied with the regulation requiring that stock-based compensation be included in the IDC "cost pool" upon which cost sharing payments are determined. Like many technology

companies, petitioner questioned the validity of this regulation. The CSA ac-

cordingly included a "clawback" provision that will apply in the event section

1.482-7(d)(2), Income Tax Regs., is

held to be an invalid regulation by a final decision in a court of law with respect to pending litigation involving another taxpayer including a U.S. Supreme Court decision, U.S. Court of Appeals decision upon denial of a writ of certiorari or lapse of time for filing such writ, or a decision by a federal trial court upon lapse of time for filing a notice of appeal, or * * * [is] revised or withdrawn by the Treasury Department such that the costs of stock-based compensation are not required to be included as costs for qualified cost sharing arrangements. - 6747 - nologyIn u stheed tevento ope rthisate Aregulationmazon’s fisulfillment ultimately centers, invalidated especially or withdrawn, during peak the shop- CSA providesping periods. that "stock Items -baseddestined compensation for Prime custo shallm ersnot had be includedto be picked, in the sorted, determina- pack- tionaged, of and * * shipped * [IDCs] in in a differentany Year m toanner which fro thism other Agreement items in applies." order to Forensure any the year in whichexpedited stock delivery-based thatcompensation Amazon promised. turns out to have been "improperly" included in

IDCs, "theAmazon Cost introduced Share shall A bemazon recomputed Unbox, withouta digital the video inclusion download of stock service,-based in

Septembercompensation 2006, in *and * * it [IDCs]," introduced and A "themazon Cost MP3 Share in theless United the Recomputed States in Septem- Cost berShare 2007. shall AEHT be refunded launched * * MP3* [to inthe Europe proper the party]." following The year.CSA providesDigital m thatedia any has suchbeco mrefunde an increa shall sbeingly "treated important as an partadjustment of Amazon to the’s business.Cost Share for the Year in which Amazonthe Triggering Web Services Event occurs (AWS), * * the *, andcom topany the’ sextent cloud-computing that such adjustment business, wasexceeds largely the developedCost Share, after the adjustmentJanuary 2005. shall It bewas applied launched to subsequent in the United Years States until in

2006.fully exhausted." It has grown significantly in terms of employee headcount, number of serversIn required Altera Corp. to operate v. Commissioner, the business, and145 revenuesT.C. 91 (2015), generated. this Court invalidated sectionIII. Amazon 1.482-7(d)(2),’s Third-Party Income Businesses Tax Regs., the provision that requires stock-based

compensationA. Merchants.com costs to be included in the IDC pool. Our decision in that case was appealedIn itsto M.comthe U.S. business, Court of AAppealsmazon usedfor the the Ninth technology Circuit that on Februarypowered 19,its own 2016.

Theretail case websites remains to buildpending and on operate appeal. eCommerce websites for other merchants.

Amazon’s principal M.com clients wereOPINION large retailers doing business in the

UnitedSection States and482 abroad; gives the there Commissioner were no material broad differe authoritynces to between allocate the gross tech- in-

come and deductions among commonly controlled entities if he determines that it nology “packages” that domestic and foreign- 68 - clients received. Amazon’s major is necessary "to prevent evasion of taxes or clearly to reflect the income." The purpose of section 482 is prevent artificial shifting of income by placing a controlled taxpayer on a tax parity with an uncontrolled taxpayer. Sec. 1.482-1(a)(1),

Income Tax Regs. The statute empowers the Commissioner to determine the "true taxable income" of a controlled taxpayer by ascertaining the income it would have

earned if it had dealt with unrelated parties at arm's length. See Commissioner v.

First Sec. Bank, 405 U.S. 394, 400 (1972); Seagate Tech., Inc. & Consol. Subs. v.

Commissioner, 102 T.C. 149, 163-164 (1994). "In determining the true taxable income, 'the standard to be applied in every case is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer.'" Veritas, 133 T.C. at 317 (quoting section 1.482-1(b)(1), Income Tax Regs.).

The Commissioner has broad discretion in applying section 482, and we will uphold his determination unless the taxpayer shows it to be arbitrary, capri-

cious, or unreasonable. Seagate Tech., 102 T.C. at 164; Sundstrand Corp. v. Com- missioner, 96 T.C. 226, 353 (1991). Whether respondent has abused his discretion is a question of fact. Sundstrand Corp., 96 T.C. at 353-354; Am. Terrazzo Strip

Co. v. Commissioner, 56 T.C. 961, 971 (1971).

In a series of transactions in 2005 and 2006, Amazon US transferred intangible property to AEHT. These transfers required AEHT to make an upfront buy- - 6948 - inclients payment included to compensate Target in the Amazon United US States, for the Marks value & of Spencer the assets in the thus UK, transferred. Mother- cSeeare sec.in th 1.482-7(a)(2),e UK, and Sea (g)(2),rs Cana Incomeda. Am Taxazon Regs.’s contract Respondent with Target urges went that into a DCF effect methodology,in 2001 and was as initiallyimplemented set to byexpire Dr. Frisch,in 2006; supplies it was later the best extended method several for times determiningvia amendm ents.an arm's Am-lengthazon eventually buy-in payment, decided andto terminate that the required the M.com payment program is and$3.468 shut billion. it down The altogether first question after 2010. we must answer is whether respondent abused his discretionM.com inretailers making sold this their determination. own products We on conclude their own that branded he did. websites; the

I.third-party Cost retailerSharing was Background the seller of record and owned all the inventory. Although

AmazonWe built begin and our operated analysis these with sites, the regulations it remained in “ behindeffect in the 2005 scenes when” as Amazon far as

USthe retailerand AEHT’s customers entered intowere the concerned. CSA. Where The partiesM.com have sites enteredemployed into the a qualifiedretailer’s webcost sharingaddress, arrangement URL, trade name,(QCSA), and they trademarks; share the M.com cost of clients developing had no intangible right to use property.Amazon’ s Seemarketing id. para. intangibles (a)(1). When and receivedone participant no information (here, Amazon about AUS)mazon makes’s pre-existingown retail custo intangiblemers. property available for purposes of research under a QCSA, that partyThe is clients deemed obtained, to have as transferred part of the an M.com interest “package, in such ”property the com toplete the suiteother of participant.Amazon’s website This requires technology, the other including participant the customer (here, AEHT) service, to fulfillment, make a "buy and-in re- payment"lated software to the that transferor. Amazon itselfId. para. used. (g)(1) M.com and (2).clients received all of the software updatesThe and required upgrades buy that-in benefitedpayment "isAm theazon arm's’s own length websites. charge There for the was use no of extra the intangible"charge for these multiplied upgrades; by the they controlled were included participant's within theshare basic of reasonably deal structure antici- re- patedgardless benefits. of whether Id. subpara. Amazon (2).’s contract The best with-method the client rule, included set forth an elsewhere explicit “infea- the regulations,ture parity” clause."seeks the most reliable measure of an arm's-length result." Veritas, -70-- 49 -

133 T.C.For at additional 327; see sec.fees, 1.482-1(c)(1), M.com clients Income could also Tax arrangeRegs. The to have regulations Amazon proper- videform thatcertain an arm'sservices-length for them, charge using must A bem azondetermined’s own facilities.under one Theseof four services methods:

(1)could the include comparable fulfillment, uncontrolled transportation, transaction customer (CUT) service, method; payment (2) the "comparable processing, profits"fraud prevention, method; (3) and/or the "profitmarketing. split" Not method; all M.co or (4)m clients an "unspecified" chose to avail method. them- See sec.selves 1.482-1(c), of these additional Income Tax services. Regs. "[T]hereIn some cases is no Astrictmazon priority agreed of tomethods, develop and for no methodM.com clientswill invariably (again for be additional considered fees) to be specific more reliabletechnologies than others." that Am Veritas,azon did 133

T.C.not use at 327;in its sec. own 1.482-1(c)(1), business. Income Tax Regs.

TheB. regulationsAssociates make and Syndicatedclear that the Stores buy-in payment represents compensation solelyThrough for the the use M.com of pre-existing program, A intangibles.mazon functioned Section essentially 1.482-7(g)(2), as a supplier Income

Taxof technology Regs., captioned to other "Pre-existing retailers. Through intangibles," the Associates states: and Syndicated Stores prograIfm sa, controlledAmazon en participanttered into relationships makes pre-existing with third intangible parties propertywith the goalin of en- which it owns an interest available to other controlled participants for hancingpurposes its own ofcustomer research base. in the In intangible both of the development latter programs, area underAmazon a paid refer- qualified cost sharing arrangement, then each such other controlled ral feesparticipant to the third must party make when a buyits customers-in payment or towebsite the owner. visitors * * m *ade purchases

Byfrom definition, Amazon. compensation Both programs for were subsequently in operation developed in 2005-2006; intangible only property the Associ- is not atescovered program by the continues buy-in payment. to operate Rather, today. it is covered by future cost sharing payments,In whereby the Associates each QCSA program, participant the third pays party its ratableor “associate share ”of includes ongoing on IDCs. its own websiteAs a inlink effect to Amazon during ’2005-2006,s site. When the a visitorregulations to the provided associate that’s website the Commis- “clicks sionerthrough "shall” to A notmazon make and allocations makes a purchase,with respect the toassociate a qualified earns cost a referra sharingl fee. arrange- As- ment" except in two respects. Id. para. (a)(2). Specifically, adjustments are per- sociates could be online retailers themselves,-71 - but more typically they maintain mitted only to ensure: (1) that an arm's-length buy-in payment is made for pre-

existing intangible property and (2) that each participant pays its appropriate share

of ongoing IDCs.

This Court interpreted and applied these cost sharing regulations in Veritas, supra. The taxpayer there, a domestic corporation (Veritas US), developed, manu-

factured, and sold throughout the world advanced storage-management software products. Pursuant to a QCSA executed in November 1999, Veritas US granted a

European subsidiary (Veritas Ireland) the right to use pre-existing intangible prop-

erty overseas. The assets thus transferred consisted of short-lived technology, including source code for software products to be sold outside the United States, as well as the right to use outside the United States trademarks, trade names, and service marks owned by Veritas US. Veritas Ireland made a buy-in payment of

$118 million for use of these pre-existing intangibles.

The IRS challenged the buy-in payment and ultimately determined that the required buy-in payment was $1.675 billion. Veritas, 133 T.C. at 312. The Com- missioner's expert, Dr. Hatch, "assumed that the preexisting intangibles ha[d] a perpetual useful life" and "characterized the CSA as 'akin' to a sale or geographic spinoff' of the U.S. parent's international business operations. Id. at 313. Dr.

Hatch "rejected the comparable uncontrolled transaction method" and "employ[ed] - 5072 - acontent-specific discounted cashflow sites or analysis" blogs that--specifically, offer product "the reviews income or method"similar information.--to determine theSome requisite have a sbuy the-inir ppayment.rincipal g oId.al atca 312,pturi n313.g we b traffic and linking their viewers to AmaDr.zon Hatch and other defined sellers the inbuy order-in payment to earn commissions.as "the present Generally value of royalty speaking, obli- gations"the associate expected earns to a commissionbe paid in perpetuity on any purchase under arm's the customer-length terms. makes Id. from at 313. Am a-

Hezon did within not value24 hours individually of “clicking any through of the specific” to Am azonintangible’s site. assets that Veritas US transferredThrough to its Syndicated Irish subsidiary. Stores, Instead,Amazon "he used employed its eCommerce an 'aggregate' technology valuation to sell approach"Amazon pr thatodu cproceededts through ina t threehird-p steps.arty retailer First,’ hes website estimated (called the arm'sthe “mirror-length site ”). royaltyIn this scenario that would Am beazon due was after the November merchant 1999making "on the a gosale;-forward it kept basis." the associated Ibid. retailSecond, markup he chose and apaid discount a referra ratel feeto convertto the Syndicated these estimated Stores future partner. royalty Although pay- mentsAmazon into derived November benefits 1999 from dollars. Syndicated Third, Stores he "calculated apart from the custo buy-inmer payment referral --as becauseequal to the partnerpresent wasvalue usually of the aroyalty web retailer, payments the estimatedprogram eli inm stepinated 1, discountedsome com- atpetition--the the rate determined fees Amazon in step paid 2." were Ibid. essentially This produced payments a buy for-in customer payment referra of $1.675ls. billion,Notwithstanding which Dr. Hatch their determined differences, to be petitioner economically viewed equivalent the Associates to "a 22.2 and per-

Syndicatedcent perpetual Stores annual programs royalty." similarly: Ibid. The primary purpose of both was to drive customWeers heldto A mthatazo then. Itbuy signed-in payment agreements thus determinedwith about 20 represented Syndicated an Stores abuse part-of discretion.ners (including Id. atEuropean 327. Although partners) we before found discontinuing several deficiencies the program. in Dr. Hatch'sWhereas methodology,these agreements his werecore errorindividually was to valuenegotiated, "short-lived agreements intangibles in the Associates* * * as if they pro- havegram awere perpetual not. The life." process Id. at by321. which We anfound associate that Veritas joined USthe "wasprogram in a wasperpetual sub- mode of innovation" and that the useful life of the pre-existing technology-related - 5173 - intangiblesstantially au wastom afourted ayears.nd th e Id.co matp 324,ensa t336.ion t eWerms found were fixedthat the and useful largely life non- of the trademarks,negotiable. brand names, and other marketing intangibles was seven years. Id. at

338. ItThe was stated unreasonable, commission we ratesconcluded, under bothfor respondent programs dependedto determine on productthe buy -inmix paymentand sales byvolumes. assuming Commission that a third rates party, generally acting at ranged arm's length,from 4% would to 8% pay in royaltiesthe inAssociates perpetuity program for use andof these from short-lived 4% to 6% inassets. the Syndicated Stores program. Refer- ral feesAs fo wer Sy emphasizedndicated Sto inre sVeritas, partners the generally cost sharing had a regulations per-unit cap; "unequivocally this meant that require[]the effect iav buye commission-in payment rate to becould made be withlower respect than the to nominaltransfers rate of 'pre-existing reflected in the intangiblecontract. A property.'mazon expected No buy that-in paymentmost people is required referred for to itsubsequently under these developedprograms intangibles."would be converted Id. at 323.into AmazonBy valuing customers, "short-lived on whose intangibles subsequent * * * aspurchases if they have no a perpetualreferral fees life," would the Commissioner'sbe due. It was accordingly buy-in computation willing to improperlypay relatively took high into up- ac- frontcount commissions the value of "intangiblesfor customer that referra werels. subsequently The average developedreferral fee rather Amazon than actu- pre- aexisting."lly paid u nId.de rat the 321. Associates We concluded and Syndicated in Veritas Stores that reliable programs CUTs was existed approximately for each

5.9%form ofof intangiblereferred sales. property10 transferred pursuant to the QCSA and that, with cer- tainIV. adjustments,The Buy-In "the Payment CUT method is the best method for determining the requisite buyPetitioner-in payment." knew thatId. at it 339.had a duty to report the Project Goldcrest transac-

II.tions onRespondent's its Federal income Determination tax returns. of the To Buy assist-In itPayment in discharging this responsi-

In this case respondent's primary position as to the appropriate buy-in pay- 10In July 2001 Amazon entered into a Syndicated Stores agreement with mentWaterstone was set’s, forth a UK in retailer. the expert It provided report of for Dr. a Frisch. 5% referra Likel fee, Dr. whichHatch couldin Veritas, increase to 6% if certain aggregate sales thresholds were met. This agreement had Dr.an unusual Frisch rejectedfeature wherebyuse of the A CUTmazon method would andalso applied pay Waterstone a DCF methodology’s a one-time to bounty of £7 for new purchases by certain customers. - 5274 - determinebility, it hired AEHT's Deloitte buy LLP-in obligation. to calculate His the valuation, required buy-in like that payment. of Dr. Hatch, In order pro- to doceeded this, inDeloitte three main needed steps. multi-year First, he financial estimated projections the future for cash the fl Europeanows of AEHT's business.European Given business. the unpredictability Second, he selected of eCommerce a discount rev enuerate to growth, convert A thesemazon estimated for in- ternalcash fl budgetingows into 2005 purposes dollars. did notThird, make he financialcalculated projections the buy-in more payment than as 12 equal or 18 to themonths present out. value It assigned of the cashits tax fl owsdepart determinedment the task at step of creating1, discounted longer at term the rate de- terminedprojections in forstep this 2. occasion.

ForThe steptax depart1, Dr.m Frischent started started with with A mtheazon projections’s historical by Amazon'sfinancial data management and the mostof revenues, recent income-state expenses, andment operating forecast, income which for included the European projections business for the for next 18 months.calendar yearsIn consultation 2005 through with 2011. business14 For and years finance after personnel, 2011 Dr. theFrisch team assumed forecast that thegrowth revenues, rates for expenses, revenue, and gross operating margins, income operating of the expenses, European and business operating would mar- growgins f oatr 3.8%the U .perS. a year,nd th ethe European rate at which businesses. the EU These economy projections as a whole covered was projectedcalendar toyears grow. 200515 Withthrough these 2010. assumptions, Dr. Frisch projected AEHT's operating in-

come intoIn 2006 the indefiniteDeloitte supplied future. Amazon with a “Transfer Pricing Documentation

ReportBelieving” to calculate that the future required cash flbuy-inows, ratherpayment. than Deloitteoperating determined income, would that the yield thebest best method estimate for calculating of an appropriate the buy-in buy price-in payment, was “an Dr. unspecified Frisch made income-based several ad- method.” See sec. 1.482-4(a)(4), Income Tax Regs. Although the method De- 14We will refer to these seven-year figures as "projections by Amazon's management"loitte employe deven was though not “specified the figures” in thefor 2011regulations, were extrapolated Deloitte regarded by Deloitte. it as si mi- lar in many15We respectsfind no fault to the with specified this assumption. residual profit As willsplit bemethod. discussed See later, sec. 1.482-6,various experts expressed divergent views as to how AEHT's growth rate should be calculated after 2011. Dr. Frisch's decision to drop down to the long-term projected growth rate of the European economy was conservative and reasonable. Income Tax Regs. - 75 - justments to AEHT's projected operating income. First, he subtracted the cost sharing payments that AEHT was projected to make to Amazon US under the

QCSA. Second, he added back expected depreciation because it involves no out- lay of cash. Third, he subtracted AEHT's projected future capital expenditures.

Finally, he made adjustments based on AEHT's projected working capital.

After estimating AEHT's future free cash flows, Dr. Frisch moved to step 2

of his analysis: selecting an appropriate discount rate. Generally speaking, the higher the discount rate, the lower the present value of future cash flows. For internal budgeting purposes, Amazon's treasury department employed a weighted average cost of capital (WACC) of 13%. Using market data, Dr. Frisch concluded that a discount rate of 18% was appropriate.

At step 3, Dr. Frisch discounted AEHT's future cash flows through 2024-- i.e., for 20 years out--at 18%. He determined that the present value of these cash

flows was $3.067 billion. He then computed a discounted "terminal value" of

$399 million for post-2024 cash flows; this calculation was necessary because he assumed that the intangible property subject to the buy-in payment had a perpetual

(he called it an "indeterminate") useful life. Finally, to isolate the future cash

flows attributable to AEHT's intangible assets, Dr. Frisch subtracted the value of the tangible assets it owned as of year-end 2004, which he determined to be neg- - 5376 - ative $1.8Deloitte million determined (representing that the a negative intangible cash assets position). Amazon This US yielded transferred a buy to-in paymentAEHT had of a$3.468 seven-year billion useful ($3.067 life. billion Relying + $399 on A millionmazon’ s+ 2005-2010 $1.8 million projections = $3.468 billion).(which Deloitte extrapolated to 2011), Deloitte determined the future income streamsOne of AEHTdoes not reasonably need a Ph.D. attributable in economics to these to assets,appreciate then the allocated essential those similar- in- itycom betweene stream thes b eDCFtween methodology pre-existing thatand Dr.subsequently-developed Hatch employed in Veritas intangible and proper-the

DCFty. Deloitte methodology determined that Dr. that Frisch the appropriate employed buy-inhere. Bothprice assumedwas $254.5 that m theillion, pre- to be paidexisting over intangibles a seven-year transferred period commencing under the QCSA in 2005. had a perpetual useful life; both determinedAt trial the petitioner buy-in payment supported by itsvaluing position into with perpetuity respect the to thecash buy-in flows payment sup- posedlyprincipa lattributablely on the basis to theseof the pre-existing comparable intangibles; uncontrolled and transaction both in effect (CUT) treated method. the transferSee sec. of1.482-4(c), pre-existing Income intangibles Tax Regs. as economically It contended equivalent that each species to the sale of intan- of an en- tiregible business. property--the Respondent website admitted technology, as much the marketing on brief, urgingintangibles, that "Project and the Euro-Gold- pcrestean ctransferredustomer in allfor mcashatio flnows--had relating to be valued to the separately. European operation For each tospecies AEHT of in prop- whaterty, Awas,mazon as an submitted economic expert matter, reports a transfer that esti of mtheated European the property Websites’s useful Business life and for thevalued indefinite it on the future." basis of available CUTs.

ByRespondent assuming contended a perpetual that useful the best life, m Dr.ethod Frisch for faileddetermining to restrict an arm his ’valuations-length tobuy-in the "pre-existing payment was intangible the discounted property," cash flow sec. 1.482-7(g)(2),(DCF) methodology Income employed Tax Regs., by thatDr. Frisch.Amazon In US the actually event the transferred Court rejects to AEHT that m inethodology, 2005. As explainedrespondent in submitted connec- tionexpert with reports petitioner's that employed CUT methodology, a CUT methodology. see infra pp. For 103-107, each species the website of property, technology that Amazon US initially transferred to AEHT had a useful life of - 5477 - aboutrespon sevendent’s years. exper tsThus, supported after decayingvalues substantially or "ramping higher down" than in value those over determined a seven- yearby A period,mazon’ sAmazon's experts. website technology as it existed in January 2005 would have hadFor relatively the website little technology, value left petitionerby year-end’s experts 2011. Butderived approximately a CUT by refere 58% ofnce

Dr.to the Frisch's prices proposedAmazon chargedbuy-in payment, its M.com or clients roughly for $2 the billion, technology is attributable needed to to run cash thoseflows clientsbeginning’ eCommerce in 2012 and websites. continuing Petitioner in perpetuity.'’s expert John Wills testified as to his beliefConversely, that Amazon it is offeredclear that these Dr. M.comFrisch, customerslike Dr. Hatch, its full improperly suite of website included in thetechnologies buy-in payment together the with value all ofnecessary "subsequently services. developed He opined intangibles." that the M.com Veritas,

133transactions T.C. at 323. thus furnishedManagement's appropriate projections internal for CUTs the European for the technology business were that based

Amazonon the (extremely US made high) available growth to AEHT. rates that Amazon had achieved in the past. Such growthFour rates of could petitioner be sustained’s other technologyonly through experts--Ken constant innovation, Birman and including Lorenzo inno- vationsAlvisi, Davidconcerning Parkes, products and Alan and MacCormack--employed services that did not yet variousexist in approachesmarketable to ascertainform." Projects the useful that life would of A contributemazon’s website to high technology future growth and rates,the rate some at which of which it werewould in “ rampearly developmentdown” or decay as ofin Januaryits utility. 2005, Applying included these the useful Kindle, life Amazon conclusions to the pricing data derived from the M.com transactions, Dr. Wills concluded that 16As explained more fully infra pp. 117-120, we do not conclude that the websitethe value technology of the website transferred technology in January transferred 2005 by had A mbecomeazon US wholly to AEHT worthless ranged at year-end 2011. It continued to have some residual value; it could be used for researchbetween $117and as m aillion springboard and $182 for m developingillion. replacement technology. We conclude that a "tail" of 3-1/2 years is appropriate to capture this residual value. But thisRespondent residual value,’s expert when Harlow added Higinbotham to the initial seven-yearagreed that value,the CUT does method not come close to Dr. Frisch's $3.468 billion figure. could be used to value the pre-existing technology and that the M.com transactions 17Dr. Frisch admitted that he did not investigate the manner in which Ama- zon constructed its revenue projections, testifying that he "couldn't do a detailed analysis of what was in the projections in terms of individual product." supplied a reliable source of CUTs. However,- 78 - he concluded that Amazon’s web-

Prime, the Fire smartphone, Fire TV, digital music/video offerings, cloud computing and storage, and the EFN, which implemented standardized and improved

fulfillment operations across Europe.

These new products and services, as well as the next generation of Ama- zon's website platform, would be created thanks to massive projected IDC investments by Amazon in years after 2004. But AEHT would have paid, via cost sharing, its ratable share of these future IDCs, and it would thus co-own these subsequently-developed intangibles. Because AEHT would pay for these assets via cost sharing, it was not required to pay for them through the upfront buy-in payment.

As we held in Veritas, 133 T.C. at 323: "No buy-in payment is required for subsequently developed intangibles."

Dr. Frisch's DCF methodology resembles Dr. Hatch's in another respect: It is based in essence on an "akin to a sale" theory. See id. at 313, 316, 320-321. Dr.

Frisch computes the buy-in payment not by valuing the specific intangible assets transferred under the CSA but by determining an enterprise value for Amazon's

entire European business. He deems the pre-existing intangibles to have a value

equal to AEHT's enterprise value, less its initial tangible assets. By employing an

enterprise valuation, Dr. Frisch necessarily sweeps into his calculation assets that - 5579 - weresite technology not transferred had an under indefinite the CSA useful and life. assets On that the were basis not of hiscompensable useful life "intan-deter- gibles"minatio ntos ,begin Dr. H with.iginb otham valued the website technology transferred by Amazon

US to "[F]orAEHT theat $3.34 definition billion. of an intangible," the cost sharing regulations in effect

for 2005-2006For the m referarketing to the intangibles, definition Robertset forth Reilly in section (petitioner 1.482-4(b),’s expert) Income and DavidTax

HRegs.aigh (Seerespondent id. sec. ’1.482-7(a)(2)s expert) both (last used sentence). an external This CUT definition methodology is essentially to determine the samean arm as’s-length that set forthbuy-in in price. section In 936(h)(3)(B). selecting their In CUTs, both provisions,both experts "intangible" also relied on is definedthe same to sources include of five public enumerated information. categories But the of two assets, experts each cameof which to disparate has "sub- stantialvalue de valuetermi nindependentations, chief lyof becausethe services of very of any different individual." conclusions These as include to the usefulpat- lents,ife o finventions, the transfe rcopyrights,red propert yknow-how, and the pr otrademarks,per royalty ratetrade to names, apply overand 20 the other proper- specifiedty’s useful intangibles. life. Mr. Reilly Each concluded definition thatalso the includes arm’s-length a sixth valuecategory, of the consisting marketing of

"otherintangibles similar ranged items" from in the$251 regulatory million to definition $312 million; and "any Mr. similarHaigh determined item" in the a stat- utoryvalue definition.of $3.13 billion The formerfor the saelaboratesme intangible slightly property. on the latter by stating that, If]or purposesThe of customer section 482, information an item isthat considered Amazon USsimilar transferred to those to * AEHT* * [enumerated] consisted ifof itdata derives about its European value not retail from customers its physical who attributes had transacted but from with its intellectualthe European con- tentSubsidiaries or other beforeintangible May properties." 1, 2006. These Sec. data1.482-4(b)(6), included names, Income email Tax addresses,Regs. phone Annumbers, enterprise purchasing valuation history, of a business and credit includes card information. many items ofAm valueazon thatviewed are notthis "intangibles"customer information as defined as above.having Thesea short include useful life:workforce People in change place, theirgoing phone con- numberscern value, and goodwill, email addresses and what often, trial andwitnesses their buying described habits as "growthchange significantly options" and

corporate "resources" or "opportunities." Unlike the "intangibles" listed in the - 8056 - statutoryover time and. Fo regulatoryr its Simila definitions,rities softw athesere, Amazon items cannot uses only be bought relatively and recent sold inde- data pendently;because it regards they are older an inseparable data as having component little or ofno an value. enterprise's residual business value. GivenThese the items relatively often do short not usefulhave "substantial life of the customer value independent information, of theAm serv-azon’s icesexperts of anyregarded individual." Amazon Sec. US 936(h)(3)(B)as having in essence(last clause); “referre sec.d” 1.482-4(b), its European Income cus-

Taxtomers Regs. to AEHT, And these which contributors then benefited to value from are having not "similar" a base of to inherited the enumerated customers intangibleswhen it began because operations they doon notMay derive 1, 2006. their Dr. value Wills from accordingly their "intellectual used as CUTscontent theor other referra intangiblel fees that properties." Amazon paid Sec. its 1.482-4(b)(6),business partners Income in the Tax Associates Regs.18 andThus, Syn- as wedicated concluded Stores inprograms. Veritas, there was for the tax years at issue "no explicit author- ization"Two in theof petitionercost sharing’s other regulations experts--Wendy for "respondent's Moe and 'akin' Robert to Wentland-- a sale theory or performed* * * [his] inclusionanalyses thatof workforce estimated infuture place, purchases goodwill, by or the going referre-concernd European value" in determiningcustomers and the the buy rate-in atpayment which these for pre-existing individuals intangibles. would convert 133 to T.C. direct at cus-316. 19 tomers of AEHT. Using these estimates, Dr. Wills applied a referral fee of 5.9%-- 18This conclusion is supported by the regulations' history. See DHL Corp. v.the Commissioner, average referra 285l fee F.3d Amazon 1210 itself (9th paidCir. 2002),to its Associates aff g in part, and rev'g Syndicated in part StoresT.C. Memo. 1998-461; Austin v. Commissioner, 141 T.C. 551, 561 (2013) ("The historypartners--for of a regulation all purchases may by be customers helpful in deemedresolving to ambiguitiesarrive at AEHT in it.").’s websites In 1993 by the IRS considered updating the 1968 transfer pricing regulations. Via temporary and proposedreferral. Dr. regulations, Wills assumed the Secretary that AEHT requested would commentspay referra specificallyl fees for only as tosix whether years, "the definition of intangible property * * * should be expanded to include items notand normallyhe discounted considered the resulting to be items revenue of intellectual stream at 18%. property, This suchgenerated as work a buy-in force in place, goodwill or going concern value." 58 Fed. Reg. 5312 (Jan. 21, 1993). Afterpayment receiving of $52 numerousmillion for comments the customer opposing information such an that expansion, Amazon theUS IRSmade decided not to change the definition of intangible property. See T.D. 8552, 1994-2 C.B. 93 (explainingavailable to thatAEHT. the revisedDr. Wills regulations determined merely that this clarified value thewould 1968 rise definition). to $66 million 'Even if certain items discussed in the text were thought to constitute "in- (continued...) if AEHT paid referral fees for 10 years.- 81 -

Respondent urges that Dr. Frisch's adoption of a business enterprise valuation is supported by the "aggregation" principle. Under the caption "Aggregation

of transactions," the regulations in effect during 2006 provided that the combined

effect of multiple transactions may be considered "if such transactions, taken as a whole, are so interrelated that consideration of multiple transactions is the most reliable means of determining the arm's length consideration for the controlled transactions." Sec. 1.482-1(f)(2)(i)(A), Income Tax Regs.

We rejected respondent's "aggregation" argument in Veritas, 133 T.C. at

321, and we likewise reject it here. The buy-in payment represents compensation

for "pre-existing intangible property" owned by the transferor. Sec. 1.482-7(g)(2),

Income Tax Regs. For at least two reasons, the type of "aggregation" proposed by respondent does not yield a reasonable means, much less the most reliable means,

of determining an arm's-length buy-in payment. See id. sec. 1.482-1(f)(2)(i)(A).

19( .continued) tangibles" for cost sharing purposes, they were not necessarily owned directly by Amazon US or covered by the CSA. The European Subsidiaries had been in business--in Germany and the UK, very successfully--for more than six years as of January 1, 2005. They had substantial assets apart from their tangible property, including workforce in place and going-concern value. AEHT inherited these values when it acquired the stock and assets of the European Subsidiaries pursuant to the European Subsidiary Contribution, the European Business Contribution, and the Four-Party Agreement. See supra pp. 25-26. AEHT was not required to compensate Amazon US for these assets via the buy-in payment. - 8257 -

First, Dr.Dr. Frisch'sHiginbo businesstham agr-enterpriseeed that the approach commissions improperly Amazon aggregates paid third pre-existing parties for intangiblescustomer referra (whichls suppliedare subject appropriate to the buy CUTs.-in payment) However, and hesubsequently gave particular developed intangiblesweight to A (whichmazon’ sare agreement not). Second, with Waterstone his business’s,-enterprise a Syndicated approach Stores improperly partner in aggregatesthe UK. It providedcompensable not only"intangibles" for referra (suchl fees as ranging software fro programsm 5% to 6%, and but trademarks) also for anda one-time residual bounty business of £assets7 for new(such purchases as workforce by certain in place custo andm growthers. Using options) these that doparameters, not constitute Dr. Higinbotham "pre-existing valued intangible the customer property" information under the cost at $215 sharing million. regula- tionsV. inCost effect Sharing during Pay 2005-2006.ments See Veritas, 133 T.C. at 321-323; see also

GuidantTh LLCe CS Av. rCommissioner,equired AEHT 146to m T.C.ake a 60,nnu 82-83al cost (2016). sharing20 payments to compensate AmazonIn a related US for vein, ongoing respondent intangible defends development Dr. Frisch's costs approach (IDCs), under to the the extent "real- isticthose alternatives" IDCs (as determined principle. by The a revenue regulations ratio) authorize benefited the the Commissioner Luxembourg head-to "con- siderquarters. the alternatives See sec. 1.482-7(a)(1), available to (d)(1),the taxpayer Income in Tax determining Regs. Virtually whether all the techno- terms of logical innovation occurred within Amazon US. Thus, the larger the volume of

IDCs that20In A2011mazon the US Secretary is treated finalized as having new incurred, cost sharing the larger regulations the cost that sharing replaced the 1995 regulations involved in this case. T.D. 9568, 2012-12 I.R.B. 499. Issued inpayments temporary that form AEHT in 2009was required and effective to make. (as relevant here) in January 2009, these new regulations replaced the buy-in payment with the concept of a "platform contributionThe regulations transaction" define (PCT). IDCs 74 and Fed. provide Reg. 341-342that costs (Jan. that 5,contribute 2009). The both to preamble to the temporary regulations noted objections from commenters that the intangiblePCT "included development elements activity such as and workforce, to other goodwillbusiness activitiesor going concernmust be value,allocated or business opportunity, which in the commentators' view either do not constitute intangibles,“on a reasonable or are basis. not being” See transferred, id. para. (d)(1). and so, Petitioner in the commentators'’s cost accounting view, system are not compensable." 74 Fed. Reg. 342. The Treasury Department replied by stating thatduring the 2005-2006 new regulations did not "do specifically not limit platformsegregate contributions IDCs or R&D that expenses must be from compensated * * * to the transfer of intangibles defined in section 936(h)(3)(B)." Id. As we noted in Veritas, 133 T.C. at 315-316, 329-330, the 2009 regulations did not apply in that case, and they have no application to this case either. other operating costs. Petitioner therefore- 83 developed - a formula and applied it to the controlled transaction would be acceptable to an uncontrolled taxpayer faced with the same alternatives and operating under comparable circumstances." Sec.

1.482-1(f)(2)(ii)(A), Income Tax Regs. Respondent contends that Amazon US had a "realistic alternative" available to it, namely, continued ownership of all the intangibles in the United States. If dealing with an unrelated party, respondent urges, Amazon US would clearly have preferred this alternative to a cost sharing arrangement that would give a competitor access to its "crown jewels." Respond-

ent asserts that Dr. Frisch's analysis captures the value of this "realistic alternative" by estimating the future cash flows of Amazon's entire European business.

We find this argument unpersuasive for many reasons, but it suffices to mention two. First, respondent's argument proves too much. Whenever related parties enter into a QCSA, they presumably have the "realistic alternative" of not

entering into a QCSA. From this truism respondent concludes that the buy-in payment must be determined as if the parties had not elected cost sharing but had instead continued to operate the business as they had done previously. This would make the cost sharing election, which the regulations explicitly make available to taxpayers, altogether meaningless. See id. sec. 1.482-7(a)(3) (providing that a

QCSA "produces results that are consistent with an arm's length result" provided that all requirements of the cost sharing regulations are satisfied). - 8458 - allocatSecond,e to IDC ass a we po rtionnoted of in the Veritas, costs 133accumulated T.C. at 321 in variousn.29, the “ costregulation centers enun-” under itsciating method the "realisticof accounting. alternatives" principle also states that the IRS "will evaluate the results“Cost of centers a transaction” are acc aso actuallyunting classifications structured by thatthe taxpayerenable a businessunless its to struc- man- tureage andlacks m easureeconomic operating substance." expenses. Sec. Petitioner1.482-1(f)(2)(ii)(A), tracked expenses Income in Tax six Regs.high-level

Thus,cost centers: even where (1) Cost a realistic of Sales, alternative (2) Fulfillment, exists, the (3) CommissionerMarketing, (4) "will Technology not restruc- and tureContent the transaction(T&C), (5) asGeneral if the alternativeand Administrative had been (G&A), adopted and by the(6) Other.taxpayer," Each so of long asthe these h taxpayer'sigh-level c oactualst cen structureters is a “ hasrollup economic” of numerous substance. subsidiary Ibid.; seecost Claymont centers. For

Invs.,some calendarInc. v. Commissioner, quarters, more T.C. than Memo. 200 individual 2005-254, cost 90 centers, T.C.M. each (CCH) recording 462, 467 a

("Finally,specific type because of expense, the transaction “rolled up had” into economic intermediate substance, cost centerssection and1.482-1(f), ultimately In- intocome one Tax of Regs., the six prohibits top-level respondent cost centers. from For restructuring example, cost the center terms 7710, as if his “Systems alternativeand Ne hadtwo rbeenk En gadoptedineering by,” rpetitioners.").olls up into C210 (“Product Development”) and C250

(“Technology/ExternalThe transaction actually”). All costsstructured accumulated by Amazon in “Product US was Development a cost sharing” and arrangement,“Technology/External and respondent” roll up does into not the contendT&C category. that this structure lacked economic substance.The partiesThe regulations agree that innone effect of theduring costs 2005-2006 accumulated unambiguously in the “Cost entitledof Sales ”

Amazonand “Other US” cato tenteregories into are a allocableQCSA; it tocannot IDCs. be Respondent deprived of accepts this entitlement petitioner on’s the theoryformula-based that it had allocation the alternative to IDCs of of doing costs somethingaccumulated else. in theBecause “Fulfillment Dr. Frisch” and did not“M alimitrketi nhisg” buycate-ingo rpaymenties, and htoe atheccepts value petitioner of the pre-existing’s decision tointangibles allocate G&A transferred costs to IDCs on the basis of the IDC outcomes for the other five categories. - 8559 - pursuantThe to parties the QCSA,’ dispute his focusesapproach on violated the T&C the category. cost sharing Respondent regulations contends and must bethat rejected 100% of for the that costs reason. accumulated21 in the T&C category constitute IDCs; as a corollary,Characterizing this would produceVeritas asa co a mhighlymensurate fact-bound increase opinion, in the respondentpercentage ofattempts G&A tocosts distinguish allocable it to on IDCs. several Petitioner grounds. urges First, that he T&Ccontends costs that must Dr. be Frisch, allocated unlike be- Dr.

Hatch,tween IDCs "did notand opine other oractivities assume “ thaton a the reasonable transferred basis intangibles” and that hadits allocation a perpetual life."formula Rather, accomplishes Dr. Frisch this posited result. that the pre-existing intangibles had an "indefinite" usefulBroadly life, speaking, in the sense the costs that "theiraccumulated useful lives,in the andT&C thus category their value, include are ex- in- pensescreasingly related uncertain to technological over time." development Regardless andof what website adjective content. one According employs, Dr. to

Frischpetitio nclearlyer’s SEC valued filings, the itsintangibles T&C category as if they expenses would “ consistretain value principally forever, of dis-payroll acountingnd relate 20d e years'xpense worths for e mofployees cash flows involved and then in research computing and a development, "terminal value." includ-

Dr.ing applicationFrisch admitted development, on cross-examination editorial content, that hismerchandising methodology selection, produced, systems in math- andematical telecommunications terms, precisely support, the outcome and coststhat would associated occur with if one the assumed systems aand perpetual tele- usefulcommunications life. infrastructure.” T&C costs included costs associated with acquired Respondentwebsite content; seeks payroll to minimize and related this error, expenses noting for that, employees after 20 involved years, Dr. in

Frisch'sresearch, terminal website valuedevelopment, accounts and for telecommunicationsa small fraction of his support; $3.468 and billion payroll total. and

Butrelated most expenses of the intangibles for employees had involveda useful lifein category much shorter expansion than 20(i.e., years, expanding and the

Amazon’s product offerings) and buying.

21DuringDr. Frisch 2005-2006 stated thatmany his employees DCF valuation whose would time wasbe consistent captured inwith T&C the cost approach of the 2011 cost sharing regulations, and respondent's "realistic alternatives"centers argument engaged maysolely represent in intangible an attempt development to apply activity; those regulations certain employees retroactively. en- Cf. Veritas, 133 T.C. at 315-316. - 8660 - usefulgaged solelylife of inthe other technology types of-related activity; intangibles and certain was employees only seven engaged years. inSee both. infra pp.This 103-107. diversity Aboutof tasks 58% was of reflected Dr. Frisch's in their total job value, classifications. or roughly All$2 billion,Amazon is em- at- tributableployees have to cash job codesflows beginningafter 2011, with when a capitalAmazon's letter, underlying one of which website is “ T,technolo-” which gy,stands as itfor existed “Technical. on January” Most 1, cost2005, centers was expected that rolled to haveup into lost T&C most have of its a mixvalue. of

ThisT-coded is not and a denon-T-coded minimis error. workers. During the first quarter of 2006, for example,

35 T&CSecond, cost centers respondent had no urges T-coded that Dr.employees; Frisch, by 27 subtracting had all T-coded AEHT's employees; projected acostnd 6sharing9 had a payments,mix. On a excludedverage du cashring 2fl0ows05-2 attributable006, there were to "subsequently almost as many devel- T&C costoped centers intangibles" with no and T-coded thus avoided employees the error (31.4 committed cost centers) by Dr.as there Hatch. were See with Veri- all tas,T-coded 133 T.C.employees at 323. (31.9 In effect, cost centers).respondent says, this allowed AEHT to earn a return ofT 18%he su (thebsid discountiary cost ratecenters Dr. thatFrisch “rolled applied) up” oninto its T&C share captured of the IDCs a significant that vcreatedolume theof n subsequentlyon-IDC perso developednnel costs. intangibles. The diversity In ofrespondent's the employees view,’ tasks, an 18% which rateis re fofle creturnted in wastheir more annual than performance generous for evaluations, a company11 likeis illustrated AEHT, which by these respond- exam- ples:ent views as a "cash box."

This• Em argumentployees in is cost unpersuasive center 5155 for m atanage least third-party two reasons. digital First, content AEHT that was is notviewed an empty on or downloadedcash box. The from European Amazon.com. Subsidiaries, Certain of employeeswhich AEHT manage became the the parent,“customer had purchasing been in business experience. for approximately” Other employees six years. spend They time had negotiating a skilled and workforce; they owned tangible and intangible assets; and they had goodwill and 11The performance evaluations show that certain employees whose time was goingcaptured-concern in T&C value. cost centersWhen making engaged the in Europeansubstantial Subsidiary non-IDC activity.Contribution Relevant to cost centers include 7334, New Product Development; 7823, Data Warehouse Development; 5355, Large Accounts Services Account Management; and 7402, Payments Platform. - 8761 -

AEHTmanagi inng Maythe l o2006,gistic petitioners of acquiring valued website the European content froSubsidiariesm third parties at approximately and determining$196 million. how this website content will be displayed to Amazon’s customers.

•Second, Employees and more in cost fundamentally, center 5357 build respondent's and improve argument technology ignores that the helps fact thatsellers AEHT, integrate by making their products cost sharing into A payments,mazon.com. became Some a employeesgenuine co-owner spend signif- of the subsequentlyicant time helping developed sellers intangibles list their products. that the IDCsThis includesfinanced. assisting Under Dr.sellers Frisch's in approach,filling out AEHTspreadsheets is allowed and directingto subtract their from submissions its buy-in obligationto other Amazon an amount staff equal tome themb ers.present value of its projected cost sharing payments, i.e, its discounted cost

of acquiring• Employees the subsequently in cost center developed 7723 design, intangibles. expand, But and all m futureaintain European Amazon ’s businessproduct catalog. profits generated Some write by code those to intangibles, compile and in display excess theof that catalog cost, or would to allow be allocatedcustomers to to Amazon place or dUSers through. Others the engage buy-in in payment.routine maintenance and make minor code adjustmentsAs respondent to alter urges, the the manner discounting in which process website by content which Dr.is displayed. Frisch computes the buyBecause-in payment petitioner would’s arguablyT&C cost afford centers, AEHT like aits limited Fulfillment, return Marketing,on the invest- and mentG&A representedcost centers, by captured its share both of the IDCs IDCs. and Butother the costs, regulations it devised simply a complex, do not mauth-ul- torizei-step such formula an artificial to allocate cap costs on the “between expected the returns intangible that AEHT development could realize area and as theco- oownerther a rofea Amazon'ss or busine futuress acti vintangibleities.” See assets. sec. 1.482-7(d)(1), Under the regulations Income Tax in effectRegs. dur- The ingdeta 2005-2006,ils of this formula the IRS have may varied not make over allocations time. The withformula respect that topetitioner a QCSA urged "except at totrial the employed extent necessary data derived to make from each a PricewaterhouseCoopers controlled participant's (PwC)share *study * * [of that IDCs] identifiedequal to its qualifying share of reasonably research activities anticipated for purposesbenefits." of Sec. claiming 1.482-7(a)(2), section 41 Income re-

Tax Regs. The corollary of this rule is that each QCSA participant can expect to search and experimentation (R&E) cred-its 88 for - 2005 and 2006. receive its proportionate share of the profit attributable to the future intangibles.

See id. paras. (e)(2), (f)(3)(iii). For this purpose, it is immaterial whether the participant engages in actual technology development or simply makes cost sharing payments in cash. By allocating to Amazon US all of AEHT's future profits in

excess of the discount rate, Dr. Frisch's approach is irreconcilable with the gov-

erning regulations.

If Veritas cannot be distinguished on the facts, respondent urges that it be

overruled. He contends that the outcome in Veritas was dictated solely by fact

finding, so that "any assertions made by the Court about governing law are dicta and not controlling." As the previous discussion has made clear, we do not agree with respondent's characterization of Veritas, and we decline his invitation to

overrule that Opinion.'

22Petitioner urges that Dr. Frisch made other errors that affect the reliability of his conclusions. For example, when subtracting AEHT's projected capital expenditures from its future cash flows, he neglected to exclude startup expenses for the Luxembourg headquarters and the Irish data center. According to petitioner, correction of this oversight would reduce Dr. Frisch's valuation by $400 million. Separately, when subtracting AEHT's projected cost sharing payments from its future cash flows, Dr. Frisch assumed that Amazon's IDCs would grow at an annual rate of only 5% after 2005. If Dr. Frisch had used the IDCs as calculated by Dr. Higinbotham, petitioner contends that the valuation would be reduced to $2.946 billion. Although these (and other) challenges to Dr. Frisch's report have force, we need not consider them in detail. Respondent's "business enterprise" approach to determining an arm's-length buy-in payment for pre-existing intan- (continued...) - 8962 -

III. BecausePetitioner's Amazon Determination’s employees of the did Buy not-In record Payment time specifically to R&E activities,Having the PwCconcluded study thatrelied respondent's heavily on employeeprimary valuation surveys. approach Most employees was arbi- in traryT&C andcos tcapricious, centers, reg weard turnless otof janob assessment code, were ofsu rpetitioner'sveyed. Some methodology. employees outsidePeti- tioner'sof T&C expertscost centers applied were the surveyed CUT method if petitioner to determine believed an theyappropriate engaged buy in -inquali- pay- mentfying forresearch. all three species of intangible assets--website technology, marketing intangibles,In these and Europeansurveys PwC customer asked informationemployees to--that complete Amazon questionnaires US made available on which to

AEHT.they divided Petitioner their time submits among that 14 the specified CUT method activities. "is the Eight best ofmethod these activitiesfor valuing theinvolved pre-existing software intangibles." development, from the initial “requirements” phase through deploymentThe CUT and methodtesting, togetherdetermines with an direct arm's supervision-length charge and for direct a controlled support of trans- actionsoftware by development. reference to the The amount time devoted charged to in these a comparable eight activities uncontrolled was deemed transac- to tion.yield qualifyingSec. 1.482-4(c)(1), R&E expenses Income for Tax section Regs. 41 If purposes. an uncontrolled Time devoted transaction to five in- volvestypes of transfer activities--specifically, of the same intangible routine under engineering, the same routine or substantially data collection, similar re- cir- versecumstances, engineering, the CUT human method resources/training, will generally yield and activities the most outsidereliable themeasure United of the arm'sStates--was-length deemed result. notId. subpara.to yield qualifying (2)(ii). If R&Euncontrolled expenses transactions for section involving41 purposes. the sameThe 14th intangible category under captured the same days or when substantially no work wassimilar done, circumstances such as vacation cannot days, be sick days, and holidays.

From these surveys, PwC derived estimates to allocate employee time to section22 41(...continued) qualifying activities. For each surveyed employee, PwC computed a gibles is flawed in its central premise because it is inconsistent with the pre-2009 cost sharing regulations. That being so, modifying the details of Dr. Frisch's implementation of that approach would not carry the day. “qualified research expenditure” (QRE)- percentage,90 - reflecting the portion of that identified, uncontrolled transactions involving "comparable intangibles under

comparable circumstances" may be used, but the results may be less reliable. Ibid.

In order for intangibles involved in controlled and uncontrolled transactions to be comparable, both intangibles must be "used in connection with similar products or processes within the same general industry or market" and must have

"similar profit potential." Id. subdiv. (iii)(B)(1). In determining whether controlled and uncontrolled transactions are comparable, the regulations direct us to

consider comparability with respect to the relevant property or services, functions,

contract terms, risks, and prevailing economic conditions. Id. sec. 1.482-1(d)(1).

Respondent's and petitioner's experts agree that the CUT method may reli- ably be used to value separately the website technology, the marketing intangibles, and the customer information, though they disagree mightily about the outcomes that this method should produce. We conclude that the CUT method provides the best method for determining the fair market value of all three species of intangible property, but we do not wholly agree with the results reached by either party in implementing this approach. Because petitioner has failed to prove that its proposed valuation meets the arm's-length standard, the Court must determine for itself, with respect to each category of property, the required buy-in payment. See -91- 63 - personSundstrand’s time Corp., that was96 T.C. spent at on354; qualified G.D. Searle research. & Co. In v. the Commissioner, fourth quarter 88of T.C.2006,

252,for example, 367 (1987). the average QRE percentage for employees in the 7000 series of cost centersA. (capturing Website costs Technology related to technology development, maintenance, and management)Petitioner's was expert61.15%. Dr. In Wills that sameopined quarter that the the M.com average transactions QRE percentage between for

Amazonemployees and in itsthe clients 5000 seriesprovided of cost reliable centers internal (capturing CUTs costs for the related transaction to business by whichline management) Amazon US was made 53.41%. its website PwC technology used these availablepercentages to AEHT.in determining In its M.com the businesssection 41 Amazon credit to used which the it technology believed A thatmazon powered was entitled. its own websites to build and

operateNoting eCommerce the sim websitesilarity between for other section merchants. 41 qualified Amazon's research principal expenditures M.com andclients IDCs, were A mlargeazon retailers employed operating the PwC in surveythe United data Statesas a central and abroad. component There of were its noformula material for differencesallocating costs between under the section technology 1.482-7(d)(1), "packages" Income that domesticTax Regs. and Sim- plifyingforeign clients somewhat, received. petitioner ’s formula for allocating T&C category costs between Dr.IDCs Wills and analyzedother activities the M.com proceeds agreements in several in steps.an effort As to the determine first step, the peti- roy- altytion erater eliminated that an unrelated from the party,T&C costacting centers at arm's all costslength, captured would payin 26 Amazon general US ledger for theaccounts right tothat use petitioner the website determined technology. to be He unrelated found thatto intangible the M.com development. agreements wereThe resulting priced "holistically"; sum may be called by this “ modifiedhe meant T&Cthat the category "headline" costs. commission” rate stated Ains each the s agreementecond step ,covered petition enotr id onlyentified the thewebsite employees technology within but the also T&C ancil- cate- larygory services who were that likely Amazon to have furnished engaged to in that intangible particular develop client.m Toent. the Assuming extent these that ancillaryonly T-coded services employees were supplied were likely in addition to have to done the this,website petitioner technology, divided Dr. the Wills num-

concluded that an appropriate adjustment to the headline rate was warranted. ber of such employees by the total num-ber 92 ofemployees in the T&C category.

Dr. Wills adjusted the commission rates appearing in 12 M.com agreements to eliminate profit attributable to ancillary services. He thus derived royalty rates ranging from 1.4% to 4.4%, with a median of 3.3%. He concluded that AEHT would be entitled to a downward "volume adjustment" because M.com clients with the largest sales volumes paid a lower implied commission rate. Applying a volume adjustment, he came up with a reduced royalty rate ranging from 1.4% to

2.4%. He concluded that no further adjustments were needed to account for dif-

ferences in geography or profit potential (respondent's experts accept this latter

conclusion).

Dr. Wills then determined a useful life and a decay curve for Amazon's website technology by relying on the analyses of four of petitioner's technology

experts, Drs. Birman and Alvisi, Parkes, and MacCormack. On the basis of their analyses, he concluded that the website technology had an average useful life of six years but that it would decline in value or "decay" quite rapidly during this period. For example, he concluded that during 2007 the average value of the technology would be 56.1% of its January 1, 2005, value, and that during 2009 its av-

erage value would be 24.8% of that initial value.

Dr. Wills multiplied his volume-adjusted royalty rates (ranging from 1.4% to 2.4%) by the decay percentage to generate final royalty rates for each year. - 9364 -

Thus,This yielded for example, what petitioner the effective called "high" the “ royaltyT-ratio. rate” Petitioner for 2007 calculated was 1.35% a distinct(2.4% x

.561)T-ratio and for the the effective T&C category "low" forroyalty each rate calendar for 2007 quarter was during0.79% 2005-2006.(1.4% x .561). For years afterThe next2010 step he added was to a examine"tail" of the3-1/2 QRE years, survey at a results.flat royalty Petitioner rate, to adjusted account thefor anyPwC "continued data to reflect presence the fact of somethat certain base of costs code" ineligible after six for years. the section 41 credit

(e.g., costsDr. Wills attributable applied to these reverse declining engineering royalty and rates non-U.S. to a revenue activities) base may equal prop- to

AEHT'serly be includible projected in annual IDCs. revenue Petitioner for accordingly2005-2011 (extendeddetermined through an “adjusted 2014 using QRE a percentage50% declining” for balance each person method) in the23 to T&C generate category, an annual representing royalty theobligation. portion ofHe that thenperson discounted’s time spent this on stream intangible of royalty development. payments Petitionerat 18% (the co samemputed discount the arith- rate usedmetic by average Dr. Frisch) of these to produce“adjusted a lumpQRE -sumpercentages, net present” which value. it calledThis generatedthe “adjusted a buyQRE-in ratio valuation” or “A-ratio. for the” website12 Petitioner technology then m rangingultiplied between the T-ratio $117 by andthe A-ratio$182 mil- to lion.yield a “development ratio” for the T&C category. Finally, petitioner multiplied

“modifiedRespondent's T&C category expert costs Dr.” Higinbotham (as determined agreed at step that 1) theby theM.com “development transactions providedratio” to determine a reliable sourcethe dollar of CUTsvolume for of valuing T&C category the website costs technology. properly allocable For his to royaltyIDCs. Petitionerrate he used made the separate4% "headline" computations commission for each rate calendar appearing quarter in a pre and-2005

M.comsummed agreement these results between to produce Amazon annual and IDC Target. figures For for his the revenue T&C basecategory. he used13 management projections of AEHT's revenues through 2011. For years after 2011 12If there was no PwC survey data for a particular T&C cost center--e.g., because that cost center was recently created or because it was determined not to contribute to section 41 qualifying research--petitioner applied the average A-ratio for cost centers with available survey data.

2313PetitionerUnder a "50% employed declining a similar balance" methodology method, the to determinegrowth rate the is percentagereduced by of 50% each year until it reaches a "stable" growth rate. (continued...) - 9465 - he assumedOn its significantly 2005 and 2006 higher Federal revenue income growth tax returns,than Drs. petitioner Wills and reported Frisch cost(who assumedsharing payments that AEHT's from revenues AEHT of would $116,092,584 grow at the and rate $77,297,000, of the EU economy).respectively.

(TheseDr. amounts Higinbotham were reported applied as a reimbursedflat 4% royalty R&E rate expenses, to these thus projected reducing revenues otherwise-allowablefor years 2005 through deductions.) 2024, Thethen cost added sharing a "terminal payment value" for 2006 reflecting was determined royalty pay- mentsusing thein perpetuity.PwC survey Unlike data as Dr. described Wills, he previously. did not adjust Because the royalty the PwC rate data to accountwere notfor decayavailable in the when value petitioner of the website filed its technology 2005 return, as it it initially existed usedin January a different 2005. sys-24

Instead,tem to determine he assumed the that2005 this cost loss sharing in value payment. would beIt subsequentlyreflected in the filed cost an sharing affirma- paymentstive claim thatfor 2005,AEHT reporting would make a lower to secure cost sharing replacement payment technology. computed Heunder accord- the inglymetho estimateddology used Amazon's for 2006. future By thisIDCs affirmative and subtracted claim, from petitioner AEHT's sought future to reduceroyalty paymentsthe 2005 cost its projected sharing pay costm entsharing by approximately payments. He $59 discounted million, orthis al mstreamost 50%. of future netVI. royaltyStock-Based payments Compensation at 14% to produce a lump-sum present value of $3.3 billion as the buyThe-in CSA payment. executed by Amazon US and AEHT defined IDCs to “include all direct andWhile indirect the parties' costs (includingexperts have Stock-Based adopted somewhat Compensation similar Costs) approaches,” relating they to disagreeintangible on development. four major inputs Specifically, into the CUTIDCs valuation:were defined (1) to the include proper “ compensa-royalty rate;

(2)tion the pro propervided busefuly a Pa rlifety t ando its decayemplo curveyees or for independent the website contractors technology; in (3) the the form reve- of nueequity base instruments, to which the options royalty to shouldacquire be stock, applied; or rights and (4)with the respect appropriate to * * discount* equity rate. We discuss these issues in turn.

13(...continued) G&A category24tH his work costs for allocable private -sectorto IDCs. clients, Respondent Dr. Higinbotham does not object has employed to the G&A decaymethodology, curves (similar except toto thethose extent used that by petitioner'sit employs what experts) respondent when implementing views as an valuationsunduly low under allocation the 1995 of IDCs cost tosharing the T&C regulations. category. - 9566 - instruments or1. stockRoyalty options Rate as defined in Treasury Regulation § 1.482-7(d)(2)(i)

(as amendedThe parties by T.D. have 9088). two ”major The disputesparties further concerning elected, the pursuant royalty rate.to section The first involves1.482-7(d)(2)(iii)(B), selection of theIncome appropriate Tax Regs., base to rate. take The into second account involves “all stock-based the necessity compensationof a downward in adjustment the form of for stock sales options volume in and the (ifsame necessary) amount, itsand magnitude. as of the same time, asDr. the Higinbotham fair value of selected the stock a optionsbase royalty reflected rate ofas 4%,a charge the headline against income commis- in sionthe audited rate appearing financial in statements a pre-2005 of M.com a Party. agreement” This election between was Amazon made “ withoutand Target. pre-

Dr.judice Wills to the derived Party his’s right royalty to challenge rate from the12 M.comvalidity agreements,of Treasury includingRegulation the § 1.482-Target agreement.7(d)(2).” He concluded that it was inappropriate to rely solely on the headline

commissionIn filing rates its stated2005 and in these 2006 agreements returns, petitioner because thus the complieddeals had with multiple the reg- reve- nueulat isources,on requiring including that stock-based ancillary services. compensation be included in the IDC “cost pool” uponDr. Wills which based cost thesharing latter payments conclusion are in determined. part on the testimonyLike many of technology Charles

Moore,companies, who petitioner headed the questioned M.com business the validity during of this2005 regulation. and 2006. TheMr. CSA Moore ac- tes- tifiedcordingly that includedAmazon dida “clawback not always” provision expect to that earn will a profit apply on in the the ancillaryevent section services standing1.482-7(d)(2), alone; Income the headline Tax Regs., rate was is designed to ensure a reasonable profit on those servicesheld to be as anwell invalid as compensate regulation Amazon by a final for decision use of itsin atechnology. court of law He further with respect to pending litigation involving another taxpayer testifiedincluding that his abusiness U.S. Supreme team used Court detailed decision, financial U.S. Court spreadsheets of Appeals called "deal decision upon denial of a writ of certiorari or lapse of time for filing decks"such to analyze writ, or the a decision overall economics by a federal of trial an M.com court upon transaction. lapse of25 time Using for the filing a notice of appeal, or * * * [is] revised or withdrawn by the Treasury Department such that the costs of stock-based compensation 25areThe not "deal required decks" to beare included complex as financial costs for spreadsheets qualified cost that sharing Amazon used to evaluatearrangements. and negotiate the M.com agreements. These spreadsheets contained reve- (continued...) - 9667 -

"deal decks"In the event to back this out regulation the revenues is ultimately attributable invalidated to ancillary or withdrawn, services, Dr. the Wills CSA derivedprovides a that royalty “stock-based rate range compensation of 1.4% to 4.4%, shall with not bea median included rate in ofthe 3.3%. determination ofThe * * *parties [IDC sagree] in a nthaty Y theear tTargeto whic arrangementh this Agreem ise ntthe applies. most comparable” For any year in

M.comwhich stock-based transaction compensationfor purposes of turns implementing out to have the been CUT “improperly approach.” Targetincluded was in theIDCs, largest “the M.comCost Share retailer shall and be therecomputed most comparable without theto AEHT inclusion in termsof stock-based of sales volume.compensation Target, likein * AEHT, * * [IDCs], had ”a andbroad “the product Cost Share line and less wide the Recproductomputed selection. Cost

AndShare Target shall bewas refunded contractually * * * [to entitled the proper to receive party]. from” The Amazon CSA provides US all technology that any updatessuch refund as they shall occurred. be “treated But as the an Targetadjustment agreement to the Costwas not Share comparable for the Year in one in majorwhich respect:the Triggering It included Event a occursvariety * of * ancillary*, and to services,the extent such that assuch fulfillment adjustment and exceedscustomer the service, Cost Share, that Amazon the adjustment US did notshall provide be applied to AEHT. to subsequent Years until fully exhausted.Target and” Amazon executed their original M.com agreement on August 31,

2001. InTarget Altera thereby Corp. agreedv. Commissioner to pay commissions,, 145 T.C. 91 computed (2015), thison revenues Court invalidated derived sectionfrom its 1.482-7(d)(2), website sales, Incomeof 5% during Tax Regs., 2001-2002, the provision 4.5% during that requires 2003, andstock-based 4% during

2004-2006.compensation This costs agreement to be included was amended in the IDC twice pool. before Our 2006 decision (once in inthat August case was

2003appealed and toagain the U.S.in August Court 2005); of Appeals both foramendments the Ninth retainedCircuit on the February 4% headline 19, 2016. com- missionThe case rate remains for 2004-2006. pending on Theappeal. agreement was amended a third time in July

2006, about 18 months after AmazonOPINION US and AEHT executed the CSA. This final

Section 482 gives the Commissioner broad authority to allocate gross in- 25(...continued) nuecome projections and deductions over theamong term commonly of each agreement, controlled taking entities into if accounthe determines historical that in-it formation and ex ante profit and loss projections. - 9768 - amendmentis necessary replaced“to prevent the evasion 4% rate of with taxes a tiered or clearly commission to reflect structure the income. based” Theon sales volumes;purpose of it section also included 482 is preventa dollar artificialcap on the shifting amount of ofincome commissions by placing that a Targetcon- wastrolled required taxpayer to pay.on a tax parity with an uncontrolled taxpayer. Sec. 1.482-1(a)(1),

IncomeWe Ta disagreex Regs. Thewith statute Dr. Higinbotham's empowers the exclusive Commissioner reliance to ondetermine the 4% headlinethe “true ratetaxable set forthincome in” the of originala controlled Target taxpayer agreement. by ascertaining He acknowledged the income on itcross-exami- would have nationearned thatif it thehad "holistic" dealt with pricing unrelated of theparties M.com at arm agreements’s length. posed See Commissioner an impediment v. to relyingFirst Sec. solely Bank on, 405 the U.S.stated 394, commission 400 (1972); rate. Seagate And he Tech., conceded Inc. & that Consol. the "deal Subs. v. decks"Commissioner should ,be 102 afforded T.C. 149, more 163-164 weight (1994). than he “gaveIn determining them in determining the true taxable project- income,ed revenue ‘the fl standardows. Thus, to bewhile applied Dr. Higinbothamin every case properlyis that of considereda taxpayer dealingthe version at armof the’s lengthTarget withagreement an uncontrolled in effect when taxpayer. the CSA’” Veritas was executed,, 133 T.C. his at analysis317 (quoting suf- sectionfered from 1.482-1(b)(1), reliance on Incomea headline Tax rate Regs.). that included pricing for ancillary services as wellThe as websiteCommissioner technology. has broad discretion in applying section 482, and we will upholdDr. Wills his determination sought guidance unless from the the taxpayer "deal decks" shows to it addressto be arbitrary, the latter capri- prob- lem.cious ,But or u nonr e"dealasona decks"ble. Seagate could Tech.be found, 102 for T.C. any at version 164; Sundstrand of the Target Corp. agreement v. Com- mexceptission theer, 9July6 T .2006C. 22 final6, 353 amendment. (1991). Whether Using respondent the "deal deck" has abused for the his July discretion 2006 amendment,is a question Dr.of fact. Wills Sundstrand estimated thatCorp. an, 96appropriate T.C. at 353-354; royalty rateAm .for Terrazzo the Target Strip agreement,Co. v. Commissioner adjusted to, 56 back T.C. out 961, ancillary 971 (1971). service revenues, would be 2.05%. But the JulyIn 2006 a series amendment of transactions post-dated in 2005 the and CSA 2006, transaction Amazon by US 18 transferred months, and intan- the partiesgible property understood to AEHT. that this These amendment transfers would required reduce AEHT Target's to make payment an upfront obligation buy- - 9869 - asin pcomparedayment to with com thepen flsaatte 4%Am commissionazon US for structurethe value prevailingof the assets on thus January transferred. 1, 2005.

WhileSee sec. ex 1.482-7(a)(2), post data of this (g)(2), sort Incomemay provide Tax Regs. a reference Respondent point or urges sanity that check, a DCF we thinkmethodology, Dr. Wills as gave implemented the July 2006 by Dr. amendment Frisch, supplies undue theweight. best method for determiningIn short, an whilearm’s-length the Target buy-in arrangement payment, theoreticallyand that the requiredoffers the payment best compar- is able,$3.468 it isbillion. imperfect The infirst part question because we the must documentary answer is recordwhether is respondentincomplete. abused See sec.his discretion 1.482-1(c)(2), in making Income this Tax determination. Regs. (directing We attentionconclude tothat "the he degreedid. of com- parabilityI. Cost between Sharing the Background controlled transaction * * * and any uncontrolled comparables,We and begin the our quality analysis of the with data the and regulations assumptions in effect used inin 2005the analysis"). when Am azonNone- theless,US and AEHTwe find entered that the into Target the CSA.agreements Where do parties bracket have the enteredrange of into acceptable a qualified roy- altycost rates.sharing From arrangement the agreement (QCSA), in effect they shareon January the cost 1, of2005, developing we conclude intangible that a royaltyproperty. rate See adjusted id. para. to (a)(back1). out When ancillary one participant service revenue (here, should Amazon be US)meaningfully makes belowpre-ex i4%.sting Andintan fromgible thepro agreementperty available in effect for purposes in July 2006, of research which underwas designed a QCSA, to reducethat party Target's is deemed commission to have transferredobligation, anwe interest conclude in suchthe proper property base to royalty the other rate shouldparticipant. be meaningfully This requires above the other 2.05%. participant (here, AEHT) to make a “buy-in paymentSince” to thethe Targettransferor. agreements Id. para. provide (g)(1) andan imperfect (2). comparable, we expand

our analysisThe required to include buy-in the paymentother M.com “is the agreements. arm’s length Dr. charge Higinbotham for the use reviewed of the

15intangible M.com” agreements; multiplied by he the noted controlled that no participantagreement’ hads share a "headline" of reasonably commission antici- ratepated below benefits. 3% and Id. subpara.concluded (2). that The these best-method agreements rule, yielded set forth a royalty elsewhere rate range in the of

3% to 5%. Analyzing the "holistic" pricing of the 12 M.com agreements with regulations, “seeks the most reliable measure- 99 - of an arm’s-length result.” Veritas,

"deal decks," Dr. Wills determined a royalty rate range of 1.4% to 4.4%, with a median rate of 3.3%.

Evaluating all the evidence, we conclude that an arm's-length base royalty rate for the website technology, before applying any volume adjustment, is 3.3%.

We find this rate acceptable because it properly backs out revenues attributable to ancillary services; it is the median rate determined by Dr. Wills; it is within Dr.

Higinbotham's range; and it is near the midpoint of the commission rates bracket-

ed by the various Target agreements.

We next must decide whether to apply a downward "volume adjustment" to the 3.3% base royalty rate. Dr. Wills noted that the sales volumes expected to be generated by AEHT were "substantially larger" than the sales volumes generated by any of the 12 comparable M.com retailers, including Target. He found it "clear

from even a casual inspection of the data that there is a negative correlation between the commission rate and the associated sales volume," noting Mr. Moore's testimony that "[v]olume impacted deal pricing pretty significantly." Dr. Higin- botham agreed that this "negative correlation" existed and that AEHT's projected sales volumes were substantially larger than the median sales volume of the 12

M.com retailers that Dr. Wills surveyed. -- 100 70 --

133 T.C.We at believe 327; see that sec. some 1.482-1(c)(1), volume adjustment Income Taxis required. Regs. The But regulations we find that pro- Dr.

Willsvide that erred an inarm applying’s-length a volumecharge must adjustment be determined as large underas 200 one basis of pointsfour methods: (e.g., reducing(1) the comparable the royalty uncontrolled rate at the high transaction end of his (CUT) range method; from 4.4% (2) the to 2.4%).“comparable Dr.

Willsprofit sinitially” metho dattempted; (3) the “ toprofit quantify split” a method; "volume or differential" (4) an “unspecified using a ”statistical method. See analysis,sec. 1.48 2but-1( che), Ifoundncom ethis Ta xapproach Regs. “ [unreliableT]here is no (e.g., strict because priority it ofyielded methods, negative and no impliedmethod wroyaltyill invariably rates in be some considered cases). toHe be then more made reliable a "judgment than others. call"” Veritasand esti-, 133 matedT.C. at a 327; 200 -basissec. 1.482-1(c)(1),-point adjustment. Income He Tax admitted Regs. that he had no authority for this particularThe estimateregulations and m thatake it clear was thatnot "verythe buy-in scientific." payment We represents agree with co mthatpensa- assess- ment.tion so lely for the use of pre-existing intangibles. Section 1.482-7(g)(2), Income

Tax Regs.,Although captioned we do “ Pre-existingnot accept Dr. intangibles, Wills' 200” -basisstates:-point adjustment, we con-

cur in hisIf a viewcontrolled that Amazon's participant agreements makes pre-existing with its largest intangible M.com property clients in are the which it owns an interest available to other controlled participants for most logicalpurpos placeses of re tosearc lookh forin t hevidencee intang iofbl ewhat dev eanlo pappropriatement area u volumender a adjustment qualified cost sharing arrangement, then each such other controlled might be.participant Those fourmust clients make awere buy-in Target, payment Mothercare to the owner. (a UK * retailer * * specializing inBy baby definition, products compensation and toys), Marks for subsequently & Spencer (adeveloped UK department intangible store property chain), is and not coveredSears Canada. by the buy-in payment. Rather, it is covered by future cost sharing payments,As whereby of January each 1, QCSA 2005, participant the Target paysagreement its ratable specified share aof fl ongoingat commission IDCs. rate ofAs 4% in on effect sales. during No explicit 2005-2006, volume the adjustmentregulations was provided incorporated that the intoCommis- that agreementsioner “sha untilll not July mak 2006.e allocations The parties with respectinitially to agreed, a qualified moreover, cost sharing that the arrange- com- mission rate would remain at 4% for the period beginning January 1, 2004, and ment” except in two respects. Id. para.- (a)(1012 -). Specifically, adjustments are per-

ending on December 31, 2006. Since the volume of Target's website sales was

expected to increase substantially during this three-year period, the Target agreement provides inconclusive support for a volume adjustment or its appropriate size.

The other three M.com agreements were executed after January 1, 2005.

The Mothercare agreement specified a commission rate starting at 1% on the low-

est tranche of website sales. This rate increased to 3.75% when annual sales hit a

certain volume, then decreased to a flat rate of 3.0% when annual sales exceeded

£80 million. Since AEHT's expected annual sales volumes were expected to be many times larger than this, the Mothercare agreement provides inconclusive support for a volume adjustment or its appropriate size.

Amazon's other two largest M.com clients were Sears Canada and Marks &

Spencer. The Sears Canada agreement specified a base commission rate of 3%; this rate decreased to 2.5% when sales exceeded CAD $200 million and decreased again to 2.0% when sales exceeded CAD $500 million. The Marks & Spencer agreement specified a base commission rate of 3%; this rate decreased to 2.5% when sales exceeded £350 million.

Review of these four agreements confirms our conclusion that Dr. Wills'

200-basis-point downward adjustment is unwarranted. But the agreements do not -- 102 71 -- yieldmitted a onlymathematical to ensure: formula (1) that for an calculatingarm’s-length a properbuy-in volumepayment adjustment. is made for Indeed,pre- existingeach agreement intangible could property conceivably and (2) be that read each to participantsuggest a fl paysat commission its appropriate rate atshare the veryof ongoing large sales IDCs. volumes that AEHT was expected to generate, which would imply at bestThis a modest Court downward interpreted adjustment. and applied Dr. these Higinbotham cost sharing agreed regulations that a involume Veritas , adjustmentsupra. The wouldtaxpayer not there, be illogical, a domestic while corporation offering no (Veritas opinion US), as to developed, what an appro- manu- priatefactured, adjustment and sold wouldthroughout be. Using the world our bestadvanced judgment storage-management as applied to the evidencesoftware andproducts. testimony Pursuant as a whole, to a QCSA we conclude executed that in November a 25-basis -point1999, Veritasadjustment US grantedis appro- a priate.European After subsidiary application (Veritas of that Ireland) adjustment, the right we to conclude use pre-existing that an arm's intangible-length prop- roy- altyerty rateoverseas. payable The by assets AEHT thus for transferredthe website consisted technology of short-livedmade available technology, under the iCSAnclu disin 3.05%g source (3.30%-0.25%). code for software products to be sold outside the United States, as well as the2. right Usefulto use outside Life and the Decay United Curve States trademarks, trade names, and serviceThe marks parties owned have by three Veritas main US. disputes Veritas concerning Ireland m adethe auseful buy-in life payment and decay of

$118curve: m (1)illion whether for use the of usefulthese pre-existing life of the website intangibles. technology should be a relatively short termThe ofIRS years, challenged as petitioner the buy-in argues, payment or indefinite, and ulti asmately respondent determined contends; that the (2) whetherrequired thebuy-in Court payment should was apply $1.675 a decay billion. curve Veritas to the website, 133 T.C. technology at 312. The during Com- its usefulmissioner life’ sand expert, (if so) Dr. what Hatch, the “rateassu ofm eddecay that should the preexisting be; and (3) intangibles whether andha[d] how a

AEHTperpetual must useful compensate life” and Amazon “characterized US for the the CSA research as ‘ akinvalue’ to of a the sale website or geographic technol- spinoffogy during” of thean ensuingU.S. parent "tail"’s internationalperiod. We address business these operations. issues in Id. turn. at 313. Dr. Hatch “rejected the comparable uncontrolled- 103 - transaction method” and “employ[ed]

a. Useful Life

Dr. Wills determined that the website technology made available to AEHT had a useful life, on average, of six years. In reaching this conclusion, he relied mainly on the analyses of petitioner's principal technology experts, Drs. Birman and Alvisi, Parkes, and MacCormack. Dr. Wills considered those experts' analyses reasonable in light of his experience pricing technology intangibles for Silicon

Valley clients.

Drs. Birman and Alvisi adopted a qualitative approach to this problem by

considering the major technological improvements (as distinct from ordinary maintenance and routine extensions) that the website technology, as it existed in

January 2005, would need in the near future. They identified eight looming issues that Amazon would be required to address, including messaging technology, scaling issues, shopping cart database outages, and problems with Dynamo, Obidos and Gurupa. Given the magnitude of these problems, Drs. Birman and Alvisi con-

cluded that a reasonable useful life for the website technology was three to five years.

Dr. Parkes conducted a somewhat similar ex ante analysis and a more quantitative ex post analysis. In his ex ante analysis, he examined the challenges (in terms of scaling, code complexity, low-quality functionality, and other problems) -- 104 72 - - aconfronting discounted eight cash fmajorlow a nsoftwarealysis”-- scomponentspecifically, “(Applicationthe income methodEngine;” --toCatalog; determine Mer- thechandising; requisite Search/Browse; buy-in payment. Ordering; Id. at 312, Payments/Fraud/Identity; 313. Pricing; and Ful-

fillment)Dr. as Hatch of January defined 1, the 2005. buy-in He paymentexamined as the “the information present value compiled of royalty by Ama- obli- zon'sgations engineers” expected as toof be that paid date in toperpetuity assess their under likely arm expectations’s-length terms. as to Id. how at 313.long thisHe did software not value would individually last. He determinedany of the specific on the basis intangible of this assets analysis that that Veritas a useful US lifetransferred of two toto fiveits Irish years subsidiary. could reasonably Instead, have “he employedbeen anticipated. an ‘aggregate ’ valuation approachFor” histhat ex proceeded post analysis, in three Dr. steps. Parkes First, evaluated he estimated the degree the toarm which’s-length the eight softwareroyalty that components would be duelisted after above November were actually 1999 “ modifiedon a go-forward over time. basis. For” Ibid. each year afterSecond, 2005, he hechose assigned a discount to each rate component to convert athese rating estimated of 1, 2, 3,future or 4, royalty depending pay- on whetherments into it remainedNovember essentially 1999 dollars. the same Third, as he in “Januarycalculated 2005, the hadbuy-in source payment code inas developmentequal to the present that would value replace of the royaltyit, had beenpayments substantially estimated modified, in step 1, or discounted had been replacedat the rat ealtogether. determine dOn in sthetep basis 2.” I ofbid this. T hisnumerical produced rating a buy-in system, pay Dr.ment Parkes of $1.675 billion,opined thatwhich any Dr. "meaningful Hatch determined contribution" to be economically of Amazon's equivalentJanuary 2005 to “ websitea 22.2 per- technologycent perpetual had annual disappeared royalty. after” Ibid. six years.

Dr.We MacCormackheld that the buy-in performed paym aent quantitative thus determined ex post represented analysis that an examined abuse of actualdiscretion. changes Id. atto 327.source Although code. He we employed found several two metrics deficiencies--component in Dr. Hatch changes’s and architecturalmethodology, or his "dependency" core error was changes to value--to “ short-livedmeasure the intangibles relative contribution * * * as if they of the haveoriginal a perpetual source code life. ”(i.e., Id. sourceat 321. code We infound existence that Veritas in January US “ 2005)was in fora perpetual each year through 2013. Component changes measured the share that the original source mode of innovation” and that the useful- 105life -of the pre-existing technology-related

code represented of operative source code at later dates. Architectural changes, an alternative measure of software evolution, captured the extent to which "depend-

encies" among source files changed over time. On the basis of this quantitative analysis, Dr. MacCormack concluded that a useful life of six years or less was reasonable, noting that "a substantial portion" of the source code remaining after six years was "dormant or commoditized."26

The conclusions of petitioner's technology experts were generally consistent with the testimony of its software engineers. Brad Porter, a Distinguished En- gineer, explained that Amazon built software "very, very quickly, very quick and dirty and expected to just throw things away after a couple of years and rebuild."

Amazon's software development process "leveraged the future." By building a piece of software quickly, Amazon chose "the expedient path" over "the right path" and built up "technical debt" that inhered in software with a relatively short useful life.

Amazon's website architecture was undergoing rapid change as of January

2005. It had become clear that Obidos, the original monolithic architecture, would

'Dr. MacCormack employed a variety of "robustness" checks to confirm his conclusion, including an analysis of actual changes to Amazon's source code between 2000 and 2005. This ex ante analysis, like his ex post analysis, focused both on component changes and architectural changes. Dr. MacCormack's ex ante analysis yielded decay curves resembling those generated by his ex post data. -- 106 73 -- notintangibles last much was longer four years.given theId. "scaling"at 324, 336. demands We found that thatAmazon the useful faced. life Amazon of the attemptedtrademarks, to brand solve names,these problems and other by marketing gradually intangibles shifting work was off seven Obidos years. and Id. mov- at ing338. to It a wasdistributed unreasonable, system wecalled concluded, Gurupa. for By respondent January 2005 to determine the move theto Gurupabuy-in waspaym wellent bunderway,y assumin gyet that Obidos a third was party, not actingcompletely at arm shut’s length, down woulduntil August pay royalties 31,

2006.in perpetuity Gurupa for was use plagued of these by short-lived latency issues; assets. by 2012 Amazon had migrated most

of its websiteAs we emphasized platform from in VeritasGurupa, theto Santana, cost sharing but it regulations was still using “unequivocally Gurupa for somerequire[] applications a buy-in paymentas late as to November be made with2014. respect The evolution to transfers of ofAmazon's ‘pre-existing website architectureintangible property. thus reveals’ No abuy-in pattern payment of continuity is required amid forchange: subsequently Elements developed of Obidos andinta nGurupagibles.” each Id. apersistedt 323. By for valuing nine years “short-lived or more intangibles while Amazon * * * was as if transitioning they have a toperpetual its new life,platform.” the Co mmissioner’s buy-in computation improperly took into account theThe value software of “ intangiblesapplications that or "services"were subsequently that Obidos, developed Gurupa, rather and thanSantana pre- existing.called likewise” Id. at went 321. through We concluded major changes in Veritas after that January reliable 2005. CUTs The existed key servicesfor each thatform Amazon of intangible needed property to run itstransferred website--Customer pursuant to Master the QCSA Service, and that,Order with Master cer- tainService, adjustments, Dynamo, “ Payments,the CUT method and Personalization is the best method--were for all determining rewritten and the replaced requi- duringsite buy-in 2004-2010. payment. See” Id. supra at 339. pp. 38-45. The software underlying these individual servicesII. Respondent had a useful’s Determination life ranging from of the three Buy-In to eight Payment years.

In sum,this case the evidencerespondent clearly’s primary establishes position that as Amazon'sto the appropriate website buy-intechnology pay- didmen nott wa haves set af operpetualrth in the orex "indefinite"pert report o usefulf Dr. Fr life,isch and. Li weke Dr.reject Ha respondent'stch in Veritas ,

contention that it did. Dr. Wills' estimate of a six-year useful life comes close to Dr. Frisch rejected use of the CUT method- 107 and - applied a DCF methodology to the mark, but we think his estimate gives insufficient weight to the persistence of

Obidos and Gurupa architectural elements, some of which survived nine years or more. Using our best judgment as applied to the evidence and testimony as a whole, we conclude that Amazon's website technology--ignoring the "tail" dis-

cussed more fully below--had on average a useful life of seven years.

b. Decay Curve

Dr. Wills used decay curves prepared by Drs. Parkes and MacCormack to

"ramp down," over the useful life of the website technology, the royalty rate that

AEHT would be required to pay. Petitioner contends that this "ramp down" is necessary to correlate the buy-in payment to the value of the pre-existing intangibles. The website technology in existence in January 2005 gradually declined in value as major components were modified or replaced, and AEHT paid for the replacement technology with ongoing cost sharing payments. We agree that an uncontrolled taxpayer in AEHT's position would insist that its royalty payments decline ratably with the decline in value of the original technology.

Respondent first contends that no "ramp down" at all is required, noting that

"[n]one of the M.com agreements had declining royalties based on obsolescence

of licensed technology." That observation is correct, but immaterial. All of Ama- zon's M.com clients received technology updates for free; they paid a constant -- 108 74 - - royaltydetermine rate AEHT for the’s packagebuy-in obligation. of pre-existing His valuation, and subsequently like that developed of Dr. Hatch, intan- pro- gibles.ceeded inAEHT, three bymain contrast, steps. didFirst, not he receive estimated technology the future updates cash flows for free, of AEHT but made’s

Europeancost sharing business. payments Second, by which he selected it became a discounta co-owner rate of to the convert subsequently these estimated devel- cashoped flowsintangibles. into 2005 dollars. Third, he calculated the buy-in payment as equal to the presentUnless value AEHT's of the royalty cash flows rate weredetermined ramped at down step 1, to discounted reflect decay at thein the rate value de- terminedof the original in step technology, 2. AEHT would be required to pay for the subsequently developedFor stepintangibles 1, Dr. Frisch twice, started once through with the cost projections sharing andby A againmazon through’s management an arti- officially revenues, inflated expenses, buy-in andpayment. operating This income would forviolate the Europeanthe cost sharing business regulations. for calendarSee sec. 1.482-7(g),years 2005 throughIncome Tax2011. Regs.14 For We years accordingly after 2011 conclude Dr. Frisch here, assumed as we thatdid inthe Veritas, revenues, that expenses, "an adjustment and operating must be income made to of the the starting European royalty business rate wouldto account gforro wthe a tstatic 3.8% nature per ye aofr, thethe [original]rate at wh itechnology."ch the EU ec oVeritas,nomy as 133 a whole T.C. wasat 337 projected (con- tocluding grow. that15 With royalty these rates assumptions, "must be ramped Dr. Frisch down projected * * * at AEHT a rate ’ofs operating 33 percent in- per year"come frominto the prior indefinite-year royalty future. rate).27

Believing that future cash flows, rather than operating income, would yield the best27 Inestimate Veritas of we an derived appropriate the royalty buy-in ratepayment, ramp downDr. Frisch from m theade taxpayer's several ad- "other agreements involving static technology," 133 T.C. at 337, rather than from the source code analysis performed by the taxpayer's expert, which we found "simplistic14We andwill mechanical," refer to these id. seven-year n.44. On figures this point as “ theprojections instant case by A differsmazon from’s Veritasmanagement in two” evenrespects. though None the offigures the M.com for 2011 agreements were extrapolated used as comparables by Deloitte. here provided for a ramp down of the royalty rate, since each client received all technology updates15We find for nofree. fault In withthe absence this assumption. of such evidence, As will bewe discussed necessarily later, rely various on an analysisexperts expressed of the technology. divergent Andviews in as this to casehow highlyAEHT ’qualifieds growth expertsrate should for eachbe calcu- side performedlated after 2011.source Dr. code Frisch analyses’s decision that were to drop comprehensive, down to the sophisticated,long-term projected and nuanced.growth rate of the European economy was conservative and reasonable. -- 109 75 -- justmentsDr. toParkes AEHT derived’s projected a ramp operating down or income."decay" curveFirst, heby subtractedapplying his the 1/2/3/4 cost sharingcoding analysispayments to that eight AEHT key software was projected components. to make See to A supramazon p. US104. under He conclud- the

QCSA.ed that, withinSecond, six he years added of back the CSA expected transfer depreciation date, any "meaningfulbecause it involves contribution" no out- layof Amazon's of cash. Third, pre-existing he subtracted website AEHT technology’s projected had disappeared. future capital He expenditures. developed the

Finally,following he decay made curve:adjustments based on AEHT’s projected working capital.

After estimating AEHT’s future free cash flows, Dr. DecayFrisch moved to step 2 Year (percent) of his analysis: selecting an appropriate discount rate. Generally speaking, the 2005 100 higher the discount2006 rate, the lower the present value of future76.4 cash flows. For internal budgeting purposes,2007 Amazon’s treasury department employed55.3 a weighted 2008 37.5 average cost of capital (WACC) of 13%. Using market data, Dr. Frisch concluded 2009 24.3 that a discount rate of 18% was appropriate. 2010 10.6 At step 3, Dr.2011 Frisch discounted AEHT’s future cash flows2.9 through 2024-- i.e., for 20 years out--at2012 18%. He determined that the present2.9 value of these cash 2013 2.9 flows was $3.067 billion. He then computed a discounted “terminal value” of 2014 2.9 $399 million for post-2024 cash flows; this calculation was necessary because he Dr. MacCormack derived his decay curves by examining changes to source assumed that the intangible property subject to the buy-in payment had a perpetual code. See supra pp. 104-105. For both of his metrics (component changes and (he called it an “indeterminate”) useful life. Finally, to isolate the future cash architectural or "dependency" changes), he performed a "relative contribution" flows attributable to AEHT’s intangible assets, Dr. Frisch subtracted the value of analysis. The premise of this approach can be illustrated by a simple example. the tangible assets it owned as of year-e- n110d 2004, - which he determined to be neg-

Suppose that 1,000 lines of code existed in January 2005; that 500 of those lines still existed in January 2010; and that 1,000 new lines of code had been written in the interim. Dr. MacCormack would find that the "relative contribution" of the

original source code, as of January 2010, was 33% (500 ÷ 1,500). Employing this analysis on an ex post basis to actual code changes from 2005 through 2013, Dr.

MacCormack calculated the following decay curves:

Component Dependency Year (percent) (percent) 2005 100.0 100.0 2006 50.2 57.1 2007 32.0 33.8 2008 25.5 28.8 2009 19.3 18.8 2010 12.9 14.3 2011 11.2 10.0 2012 9.4 7.9 2013 7.0 5.8 -- 111 76 -- ative $1.8Dr. MacCormackmillion (representing then performed a negative a "robustness cash position). check" This that yielded examined a buy-in code paymentchanges betweenof $3.468 2000 billion and ($3.067 2005 and billion applied + $399 the resultsmillion to + 2005-2013.$1.8 million See= $3.468 supra notebillion). 26. This yielded decay curves as follows:28

One does not need a Ph.D. in Componenteconomics to appreciate theDependency essential similar- Year (percent) (percent) ity between the DCF methodology that Dr. Hatch employed in Veritas and the 2005 100.0 100.0 DCF methodology2006 that Dr. Frisch employed62.8 here. Both assumed that53.0 the pre- existing intangibles2007 transferred under the39.4 QCSA had a perpetual useful28.0 life; both 2008 24.7 14.8 determined the buy-in payment by valuing into perpetuity the cash flows sup- 2009 15.5 7.9 posedly attributable to these pre-existing intangibles; and both in effect treated the 2010 9.7 4.2 transfer of pre-existing2011 intangibles as economically6.1 equivalent to the2.2 sale of an entire business.2012 Respondent admitted as m3.8uch on brief, urging that “Project1.2 Gold- 2013 2.4 0.6 crest transferred all cash flows relating to the European operation to AEHT in Dr. Wills examined the decay curves prepared by Drs. Parkes and MacCor- what was, as an economic matter, a transfer of the European Websites Business for mack. Reasonably adopting a conservative approach, he accepted for each year the indefinite future.”

By assuming a perpetual useful life, Dr. Frisch failed to restrict his valuation 28Dr. MacCormack reasonably decided, for two reasons, not to base his con- toclusions the “pre-existing solely on ex intangible ante data. property, First, during” sec. 2002-20051.482-7(g)(2), Amazon Income was Tax migrating Regs., from one code repository to another; because of the risk of overlapping or missing thatfiles Aduringmazon this US period, actually Dr. transferred MacCormack to AEHT believed in 2005. that ex As post explained data were in connec- more reliable because that migration had been completed. Second, because Amazon's softwaretion with waspetitioner undergoing’s CUT "significant methodology, architectural see infra pp. change" 103-107, during the 2002-2005,website owing to the shift from Obidos to Gurupa, Dr. MacCormack found that "there was no guarantee that the pace and nature of Amazon's software evolution observed in years prior to 2005 could be used to project into the future." technology that Amazon US initially transferred- 112 - to AEHT had a useful life of the decay percentage that revealed the slowest rate of change from the previous year. Dr. Wills accordingly derived the following decay curve:29

Decay Year (percent) 2005 100.0 2006 76.4 2007 55.3 2008 37.5 2009 24.3 2010 12.9 2011 11.2

Assuming arguendo that some "ramp down" is appropriate, respondent challenges Dr. Wills' decay curve principally by disputing the methodology that Dr.

MacCormack used to measure changes to source code. Whereas Dr. MacCormack

'Dr. Wills made two modifications to the decay curve shown in the text. He first adjusted the curve to reflect a "gestation lag" of six months to account for new technology that may have been partially developed during a prior period. Al- though no other technology expert included a "gestation lag," he believed that a six-month lag was reasonable on the basis of his experience. In the absence of technical support for a six-month "gestation lag" and any consensus that it is necessary, we will not adopt this modification. Second, Dr. Wills extended the initial period on his chart to end on April 30, 2006, rather than December 31, 2005, to reflect the fact that the former was the "business transfer date." This had the effect of reducing the decay percentage for the initial period from 100% to 90.4%. Because no other expert made this adjustment, and because we find no justification or need for it, we will not adopt this modification either. -- 113 77 -- aemployedbout seve an "relativeyears. Thus, contribution" after decaying approach or “ramping in evaluating down ”changes in value to over source a seven- code, yearGeoff period, Cohen, A onemazon of ’respondent'ss website technology experts, adoptedas it existed a "persistence" in January 2005 approach. would haveSource had code relatively "persistence" little value measures left by the year-e extentnd to2011. which But source approximately code existing 58% in of yearDr. F 1ri scontinuesch’s proposed to exist, buy-in or "persist," payment, in or subsequent roughly $2 years. billion, is attributable to cash flows beginningThe difference in 2012 between and continuing the "relative in perpetuity.contribution"16 and "persistence" ap- proachesConversely, may be illustrated it is clear by that the Dr. example Frisch, usedlike Dr.previously. Hatch, improperly Suppose that included 1,000 in linesthe buy-in of code pay existedment the in valueJanuary of 2005;“subsequently that 500 developedof those lines intangibles. still existed” Veritas in Jan-, uary133 T.C. 2010; at and323. that Management 1,000 new’ liness projections of code hadfor the been European written inbusiness the interim. were basedDr.

MacCormackon the (extremely would high) find growth that the rates "relative that A contribution"mazon had achieved of the original in the past. source Such growthcode, as rates of January could be 2010, sustained was 33% only (500 through ÷ 1,500). constant By innovation,contrast, Dr. including Cohen would inno- vationsfind that concerning the "persistence" products of and the servicesoriginal sourcethat did code, not yet as existof January in marketable 2010, was form.50% (50017 Projects ÷ 1,000). that Itwould can be contribute seen that to the high essential future differencegrowth rates, between some theseof which ap- proacheswere in early concerns development the denominator as of January of the 2005, fraction. included the Kindle, Amazon

Predictably, Dr. Cohen's "persistence" analysis yielded much slower rates 16As explained more fully infra pp. 117-120, we do not conclude that the websiteof decay technology than the "relative transferred contribution" in January analyses 2005 had of become petitioner's wholly experts. worthless Dr. at year-end 2011. It continued to have some residual value; it could be used for researchCohen determined, and as a springboard for example, for that developing more than replacement half of Amazon's technology. source We code in conclude that a “tail” of 3-1/2 years is appropriate to capture this residual value. developmentBut this residual or deployed value, when in January added to 2005 the initialwas still seven-year deployed value, in January does not2013, come and close to Dr. Frisch’s $3.468 billion figure. that 36% of the dependencies that Dr. MacCormack identified as of January 2005 17Dr. Frisch admitted that he did not investigate the manner in which Ama- stillzon cexistedonstruc inte dJanuary its reve 2013.nue projections, testifying that he “couldn’t do a detailed analysis of what was in the projections in terms of individual product.” -- 114 78 - -

Prime,We the rejectFire smartphone, Dr. Cohen's Fire "persistence" TV, digital approach music/video for theofferings, same reason cloud thatcom- we haveputing rejected and storage, other andaspects the EFN,of respondent's which implemented valuation: standardizedIt fails to eliminate and improved from the buyfulfillment-in payment operations the value across of subsequentlyEurope. developed intangibles. In terms of lines

of code,These Amazon's new products code base and grew services, by about as well 400% as the from next January generation 2005 ofto Ama-January

2011,zon’s websiterepresenting platform, an annual would growth be created rate betweenthanks to 23% massive and projected28%. New IDC code invest- and newments technologies by Amazon accountedin years after for 2004.93% of But the AEHT code base would by have2012, paid, and AEHTvia cost paid shar- for thising, newits ratable technology share ofthrough these futurecost sharing IDCs, payments.and it would In thus determining co-own these the extent subse- to whichquentl ythe-de Januaryveloped 2005intangibles. technology Because had decayedAEHT would in value, pay thefor relevantthese assets question via cost is thesharing, extent it towas which not required that original to pay technology for them through contributed the upfront to the "stock" buy-in ofpayment. tech- nologyAs we held required in Veritas to operate, 133 AEHT'sT.C. at 323: websites “No buy-inin each payment subsequent is required year. for sub- sequentlyPetitioner's developed experts intangibles. answer” that question correctly, under their "relative

contribution"Dr. Frisch analysis,’s DCF by methodology using as the rese denominatormbles Dr. ofHatch each’s fraction in another the respect: code base It iexistings based iinn eeachssen subsequentce on an “ak year.in to aBy sale using” theory. as the See denominator id. at 313, of316, each 320-321. fraction Dr. the historicalFrisch computes code base the existingbuy-in payment in January not 2005, by valuing respondent's the specific "persistence" intangible approach assets substantiallytransferred under understates the CSA the but true by ratedetermining of decay anand enterprise in effect valuerequires for AEHTAmazon to’ pays entirefor the European subsequently business. developed He deems intangibles the pre-existing twice, once intangibles via cost sharing to have and a value again throughequal to anAEHT artificially’s enterprise inflated value, buy -inless payment. its initial Thistangible violates assets. the By cost employing sharing reg- an ulations.enterprise Seevaluation, sec. 1.482-7(g), Dr. Frisch Income necessarily Tax Regs.sweeps into his calculation assets that -- 115 79 - - were nRespondentot transferre draises unde ar secondthe CSA challenge and assets to thatpetitioner's were not decay compensable curve, which “intan- againgibles ”focuses to begin on with. the denominator of the fraction. Dr. MacCormack included in his denominators“[F]or the definition every line of of an source intangible, code ”existing the cost on sharing the relevant regulations date, includingin effect forfiles 2005-2006 that may have refer been to the generated definition automatically set forth in section by a computer 1.482-4(b), (such Income as "XML," Tax

"arff,"Regs. Seeand id.other sec. file 1.482-7(a)(2) extensions). (last Dr. sentence). MacCormack's This definitiondenominators is essentially also included the samefiles relating as that setprincipally forth in sectionto presentation 936(h)(3)(B). of webpage In both content provisions, (such “asintangible "html" and” is

"xsl").defined to include five enumerated categories of assets, each of which has “sub- stantialDr. value Cohen independent opined that of the linesservices of codeof any thus individual. produced” shouldThese includebe eliminated patents,from inventions,the denominator. copyrights, A single know-how, computer trademarks,-generated tradefile can names, have and tens 20 of other thou- sandsspecified of lines, intangibles. many of Each which definition contain alsoonly includes data as opposed a sixth category, to meaningful consisting instruc- of tions.“other Insim Dr.ila rCohen's items” i nview, the r eitg isul ainappropriatetory definition to and equate “any these similar lines item of ”code, in the for stat- measurementutory definition. purposes, The former to lines elaborates of code writtenslightly byon athe programmer latter by stating or software that, “ [f]orengi- neer.purposes Dr. ofCohen section noted 482, that an itemcode iswritten considered to generate similar presentation to those * * content * [enumerated] concerns theif it "lookderives and its feel" value of not the from website its physical as opposed attributes to its functionalbut from its operation. intellectual Because con- thesetent or lines other of intangible code are typicallyproperties. written” Sec. by 1.482-4(b)(6), "painters" rather Income than Tax "plumbers," Regs. he

opinedAn that enterprise they should valuation likewise of bea business excluded includes from the many denominators. items of value that are not “intangiblesWe agree” with as defined Dr. Cohen above. on bothThese counts. include On workforce the basis in of place, his critique, going con-Dr. cernCohen value, recalculated goodwill, Dr. and MacCormack's what trial witnesses "relative described contribution" as “growth percentages options ”by and corporate “resources” or “opportunities.- 116” Unlike - the “intangibles” listed in the

eliminating from the denominators the lines of code described above. This gen-

erated modified versions of Dr. MacCormack's decay curves, as follows:

MacCormack's original Modified component component Year (percent) (percent) 2005 100.0 100.0 2006 50.2 65.5 2007 32.0 45.4 2008 25.5 36.5 2009 19.3 29.2 2010 12.9 26.2 2011 11.2 17.7 2012 9.4 14.3 2013 7.0 11.6

In sum, we agree with petitioner that the royalty rate for the website technology must be ramped down over its seven-year useful life on a decay curve. We also agree with Dr. Wills in accepting for each year, from among the decay curves the experts have supplied, the decay percentage that reveals the slowest rate of

change from the previous year. However, we will substitute for Dr. MacCor- mack's original decay curves the modified curves, set forth in the previous para- graph, reflecting Dr. Cohen's critique. Applying Dr. Wills' approach to the -- 117 80 - - availablestatutory anddecay regulatory curves as definitions, thus modified, these we items calculate, cannot forbe thebought seven-year and sold useful inde- lifependently; of the website they are technology, an inseparable ramped component-down royalty of an enterprise rates as follows:’s residual business value. These items often do not haveDecay “substantial curve value independentRoyalty of therate serv- Year (percent) (percent) ices of any individual.” Sec. 936(h)(3)(B) (last clause); sec. 1.482-4(b), Income 2005 100 3.05 Tax Regs. 2006And these contributors to value76.4 are not “similar” to the enumerated2.33 intangibles 2007because they do not derive their55.3 value from their “intellectual1.69 content 2008 37.5 1.14 or other intangible properties.” Sec. 1.482-4(b)(6), Income Tax Regs.18 Thus, as 2009 29.2 0.89 we concluded in Veritas, there was for the tax years at issue “no explicit author- 2010 26.2 0.80 ization” in t2011he co st sharing regulations f17.7or “ respondent’s ‘akin’ to a0.54 sale theory or

* * * [his] inclusionc. of workforce"Tail" Period in place, goodwill, or going-concern value” in

19 determiningDr. Wills the recognizedbuy-in payment that Amazon'sfor pre-existing website intangibles. technology 133 retained T.C. at value 316.

following the useful-life period he posited. Indeed, as shown in the table above, 18This conclusion is supported by the regulations’ history. See DHL Corp. thev. Commissioner technology had, 285 non F.3d-trivial 1210 value (9th left Cir. at 2002), year-end aff ’2011.g in part, Dr. rev Wills’g in accounted part T.C. Memo. 1998-461; Austin v. Commissioner, 141 T.C. 551, 561 (2013) (“The hforist thisory ovaluef a regulation by adding m toay thebe helpfuluseful-life in resolving period a "tail"ambiguities of three in and it.” ).a halfIn 1993 years, the IRS considered updating the 1968 transfer pricing regulations. Via temporary and duringproposed which regulations, AEHT was the toSecre payt arya fl atrequested annual royaltycomments of 0.2%. specifically We agree as to that whether a “the definition of intangible property * * * should be expanded to include items "tail"not nor periodmally isconsidered appropriate, to be but items we find of intellectual that it should property, bear a suchhigher as royalty work force rate. in place, goodwill or going concern value.” 58 Fed. Reg. 5312 (Jan. 21, 1993). After receDr. iWillsving numerousexplained commentsthat he added opposing "a tail suchroyalty an toexpansion, reflect the the continued IRS decided not to change the definition of intangible property. See T.D. 8552, 1994-2 C.B. 93 presence(explaining of thatsome the base revised of source regulations code over merely an extended clarified theperiod 1968 of definition). time" and to 19Even if certain items discussed in the text were thought to constitute “in- reflect the fact "that even `commoditized' code may have some value."(continued...) In re- -- 118 81 - - spondent'sRespondent view, Dr. urges Wills' that "tail" Dr. Frisch does ’nots adoption capture ofthe a fullbusiness residual enterprise value of valua- Ama- zon'stion is technology supported by because the “aggregation he focused” only principle. on the Undercontinued the captionpresence “Aggregation of source ofcode. transactions, As respondent” the regulations notes, AEHT in effectwas required during 2006 to pay provided for the valuethat the of combinedintangible propertyeffect of multiplemade available transactions to it "for may purposes be considered of research “if such in thetransactions, intangible taken develop- as a mentwhole area.", are so Sec. interrelated 1.482-7(g)(2), that consideration Income Tax of Regs. multiple Respondent transactions urges is thatthe mostAma- re- zon'sliable websitemeans of technology determining had the value arm ’fors length research consideration purposes that for Dr.the controlledWills did not transactions.factor into his” analysis.Sec. 1.482-1(f)(2)(i)(A), Income Tax Regs.

We agreerejected with respondent respondent’s “ toaggregation some extent.” argu Dr.m entCohen's in Veritas testimony,, 133 T.C. coupled at with321, andthat weof Amazon'slikewise reject software it here. engineers, The buy-in established payment that represents Amazon compensation practiced

(amongfor “pre -eotherxisting things) intangible "concept property reuse,"” owned "partitioning," by the transferor. and "refactoring" Sec. 1.482-7(g)(2), when de- velopingIncome Tax subsequent Regs. For iterations at least twoof its reasons, website the technology. type of “aggregation "Concept reuse"” proposed refers by torespondent the practice does of not reusing yield ideas,a reasonable algorithms, means, and m waysuch less of working. the most reliable"Partitioning," means, whichof determining splits a centralized an arm’s-length software buy-in system pay mintoent. units See ofid. work sec. 1.482-1(f)(2)(i)(A).or storage, and "re-

factoring," which restructures prior software, see supra note 9, may also entail

19 reuse of(...continued) prior solutions and concepts. Colloquially speaking, Amazon's old tech- tangibles” for cost sharing purposes, they were not necessarily owned directly by nologyAmazon gave US orit a covered "head start" by the or CSA. "leg up" The in European developing Subsidiaries new technology. had been in business--in Germany and the UK, very successfully--for more than six years as of JanuarOny 1 ,the 20 0other5. T hhand,ey ha dthe su evidencebstantial assetsestablished apart fromthat Amazon their tangible reused property, earlier code including workforce in place and going-concern value. AEHT inherited these tovalues a limited when degree, it acquired prioritizing the stock speed and assetsof innovation of the European over software Subsidiaries reuse. pursuantIts engi- to the European Subsidiary Contribution, the European Business Contribution, and neersthe Four-Par would tofteny Agreement. start over, See more supra or less pp. 25-26.from scratch, AEHT when was notbuilding required new to archi- compensate Amazon US for these assets via the buy-in payment. -- 119 82 -- tectureFirst, D orr. Fservices.risch’s b uThissine swass-enterprise attributable approach in part improperly to Amazon's aggregates high turnover pre-existing rates: intangiblesLater hired (whichengineers are often subject found to the their buy-in predecessors' payment) codingand subsequently difficult to developed under- standintangibles and preferred (which are a fresh not). start. Second, his business-enterprise approach improperly aggregTheates switchcompe ntosa newble “ softwareintangibl elanguagess” (such as posed software another programs impediment and trademarks) to reusing andold code.residual During business the transitionassets (such from as workforceObidos to inGurupa, place andAmazon growth abandoned options) that docatsubst not constitute (an arcane “pre-e programmingxisting intangible language property it created)” under and the shifted cost tosharing Perl/Mason regula- tionsfor building in effec webpages.t during 2005-2006. Amazon could See Veritas reuse very, 133 littleT.C. ofat the321-323; Obidos see software also whenGuidant it movedLLC v. to Commissioner Gurupa. Amazon, 146 subsequentlyT.C. 60, 82-83 abandoned (2016).20 Perl/Mason, a

"dying"In languagea related unfamiliarvein, respondent to the defendsnext generation Dr. Frisch of’ programmers;s approach under again the much “real- pre-existingistic alternatives source” principle. code was The discarded. regulations This authorize tendency the applied Commissioner not only to to coding “con- butsider also the to alternatives concepts: availableMany concepts to the taxpayer that underlay in determining the monolithic whether Obidos the terms archi- of tecture were inapplicable to a distributed system.

20 ManyIn 2011 aspects the Secre of Amazon'stary finalized technology, new cost moreover, sharing regulations were completely that replaced novel the 1995 regulations involved in this case. T.D. 9568, 2012-12 I.R.B. 499. Issued andin te couldmporary not for relym inextensively 2009 and oneffective pre-existing (as relevant concepts here) or inways January of working. 2009, these new regulations replaced the buy-in payment with the concept of a “platform Kindle,contribution Fire TV,transaction Fire smartphones,” (PCT). 74 cloud Fed. Reg.computing, 341-342 and (Jan. cloud 5, 2009). storage The were cre- preamble to the temporary regulations noted objections from commenters that the atedPCT and“included marketed elements after Project such as Goldcrest workforce, was goodwill completed. or going The concern revenue value, base on or business opportunity, which in the commentators’ view either do not constitute whichintang iAEHTbles, o rwas are tono payt be iroyaltiesng transferred, included and projected so, in the revenues commen fromtators these’ view, new are not compensable.” 74 Fed. Reg. 342. The Treasury Department replied by stating inventions.that the new Thereregulations is no indication“do not limit that platform these new contributions inventions thatrelied m uston oldbe source compensated * * * to the transfer of intangibles defined in section 936(h)(3)(B).” Icoded. As or we prior no tideased in orVer (ifit atheys, 1 3did)3 T.C. that a tsuch 315 -reliance316, 32 9-was33 0significant., the 2009 regulations did not apply in that case, and they have no application to this case either. -- 120 83 -- the controlledWe thus transaction confront a woulddilemma be similaracceptable to others to an weuncontrolled face in this taxpayer case. Re- faced spondentwith the same plausibly alternatives contends and that operating the "tail" under proposed comparable by Dr. circumstances. Wills may not ”capture Sec. the1.482-1(f)(2)(ii)(A), full residual value Income of the websiteTax Regs. technology Respondent transferred contends under that Athem azonCSA. US But respondent'shad a “realistic alternative alternative is” to available insist that to theit, na technologymely, continued has a perpetualownership useful of all life; the weintangibles have rejected in the thatUnited argument, States. andIf dealing respondent's with an experts unrelated have party, not offeredrespondent a urges,coherent Am formulaazon US for would calculating clearly a have revised preferre "tail"d period.this alternative That being to a so,cost we sharing will acceptarrangement as appropriate that would the give 3-1/2 a -yearcompetitor "tail" accessperiod toproposed its “crown by Dr.jewels. Wills.” Respond- ent assertsWe conclude,that Dr. Frisch however,’s analysis that the captures 0.20% theroyalty value proposed of this “ realisticby Dr. Wills alterna- for thistive ”"tail" by estimating period is thetoo futurelow. He cash chose flows that of rateAmazon by "stepping’s entire Europeandown" from business. the

0.27%We rate find that this he usedargument for the unpersuasive final year of for the many technology's reasons, usefulbut it suffices life. We to have determinedmention two. that First, the appropriaterespondent’ sroyalty argument rate provesfor the toofinal m yearuch. of Whenever the technology's related usefulparties lifeenter is into0.54%, a QCSA, or twice they as presumablyhigh. See supra have p. the 117. “realistic We accordingly alternative ”find of notthat theente royaltyring int rateo a Q forCS theA. "tail"From periodthis truism should respondent be twice concludesas high as thatthat theproposed buy-in by pay-

Dr.ment Wills, must orbe 0.40%. determined We conclude as if the partiesthat this had higher not elected royalty cost rate, sharing paid throughout but had in- the

3stead-1/2 -yearcontinued "tail" to period operate commencing the business January as they 1, had 2012, done will previously. adequately This compensate would

Amazonmake the US cost not sharing only forelection, the continued which the presence regulations of source explicitly code m butake also available for the to researchtaxpayers, value altogether of its originalmeaningless. technology. See id.3° sec. 1.482-7(a)(3) (providing that a

QCSA “produces results that are consistent with an arm’s length result” provided 30Respondent's expert James Conley argues that petitioner's valuation of the website technology does not capture the full value of Amazon's patents. The trial (continued...) that all requirements of the cost sharing- 121regulations - are satisfied). 3. Revenue Base

While relying on management projections in determining AEHT's revenue base for 2005-2011, the experts disagree about the proper revenue base for calculating royalties thereafter. Dr. Wills used a "50% declining balance" method to

estimate AEHT's post-2011 revenues.31 Dr. Higinbotham projected much higher post-2011 revenues, relying chiefly on a draft spreadsheet that an Amazon employee created in December 2005 to estimate future "goodwill impairment" for

financial reporting purposes. Dr. Higinbotham also relied on a report prepared in

October 2013 by a third-party investment analyst. Using these sources Dr.

30( -continued) established that the value of Amazon's patents was fairly inconsequential. In any event, AEHT would be required to compensate Amazon US only for European patents; the vast bulk of Amazon's patents were issued in the United States and would have little or no value in Europe. Scott Hayden credibly testified that it was much more difficult for Amazon to obtain patents for its inventions in Europe. Given these facts, we find that the European patent portfolio had a relatively low value and that the useful life of the technology plus the "tail" period adequately captures the value of this portfolio.

31Under a "50% declining balance" method, the growth rate is reduced by 50% each year until it reaches a "stable" growth rate. Dr. Wills and Mr. Reilly selected 4% as AEHT's stable growth rate, based on predicted long-term growth and inflation projections for the eurozone. -- 122 84 --

HiginbothamSecond, projected as we noted that in AEHT's Veritas ,post 133-2011 T.C. atrevenues 321 n.29, would the regulationgrow at a rateenun- up tociating three the times “realistic faster thanalternatives projected” principle by Dr. Wills. also states32 that the IRS “will evaluate the resultsWe findof a severaltransaction flaws as inactually Dr. Higinbotham's structured by approach. the taxpayer The unless "goodwill its struc- im- pairment"ture lacks economicmodel on whichsubstance. he relied” Sec. was 1.482-1(f)(2)(ii)(A), developed by a new Income employee Tax Regs.in Ama- zon'sThus, accountingeven where department.a realistic alternative This employee exists, testifiedthe Com thatmissioner he was “ willthen not in hisrestruc- torientationure the tran period;saction thatas if he the was alternative given the had prior been year's adopted model by andthe taxpayer,told to "mark” so longit up";as the and taxpayer that he’s spent actual his structure first few has weeks economic at Amazon substance. learning Ibid. how; see the Claymont model workedInvs., Inc. by v. plugging Commissioner in different, T.C. variables. Memo. 2005-254, There is no90 indicationT.C.M. (CCH) that this462, spread- 467 sheet(“Finally, presented because reliable the transaction projections had of economicAmazon's substance, future revenue. section Moreover, 1.482-1(f), both In- thecome "goodwill Tax Regs., impairment" prohibits respondent spreadsheet from (prepared restructuring in December the terms 2005) as ifand his the alter- thirdnative-party had beeninvestment adopted report by petitioners. (prepared” in). October 2013) post-dated the CSA transferThe on transactionJanuary 1, 2005.actually Dr. structured Higinbotham's by Am azonprojections US was would a cost have sharing been more reliablearrangement, had he and relied respondent on ex ante does sources, not contend as Dr. that Wills this did. structure lacked economic substance.The growth The regulations rates assumed in effect by Dr.during Higinbotham 2005-2006 were unambiguously outliers even entitled among respondent'sAmazon US experts. to enter Dr.into Frisch a QCSA; and itMr. cannot Haigh be (in deprived his opening of this report) entitlement assumed on thethat

AEHT'stheory that post it -2011had the revenues alternative would of doing grow somethingat annual rates else. between Because 3.8% Dr. Frisch and 4%; did not limit his buy-in payment to the value of the pre-existing intangibles transferred 32Dr. Higinbotham assumed that AEHT's revenues would grow at an annual rate of 22.5% during 2010-2015, 17.5% during 2016-2020, and 8% during 2021- 2030. After 2030 he adopted a terminal growth rate of 3.4% based on predicted long-term growth and inflation projections for the eurozone. -- 123 85 --

Dr.pur sHiginbothamuant to the QCSA, assumed his thatapproach AEHT's violated post-2011 the cost revenues sharing would regulations grow atand annual must ratesbe rejected ranging for from that areason. high of21 22.5% to a low of 8%. We accordingly reject Dr.

Higinbotham'sCharacterizing approach Veritas and asaccept a highly the postfact-bound-2011 revenues opinion, determinedrespondent byattempts Dr.

Wills.to distinguish it on several grounds. First, he contends that Dr. Frisch, unlike Dr.

Hatch,A “ didfinal not question opine or concerns assume thethat starting the transferred date for intangibles AEHT's royalty had a payments.perpetual

Thelife. ”CSA Rather, was Dr.effective Frisch as posited of January that the 1, 2005,pre-existing and AEHT intangibles made cost had sharingan “indef- pay- mentsinite” usefulstarting life, as inof thethat sense date. thatBut “ thetheir "business useful lives, transfer" and thus did nottheir occur value, until are Mayin-

1,creasingly 2006, and uncertain AEHT earnedover time. no gross” Regardless revenues of (attributable what adjective to Amazon's one employs, website Dr. businessFrisch clearly or otherwise) valued the before intangibles that date. as 33if theyDr. Wills would noted retain that value May forever, 1, 2006, dis- was thecounting date on 20 which years’ AEHT worth becameof cash flowsthe "economic and then coprincipal"mputing fora “ terminalthe European value. mar-” ketDr. andFrisch "commenced admitted on use cross-examination of the intangibles that for his its mownethodology account." produced, He accordingly in math- eopinedmatica thatl ter mMays, p 1,re c2006,isely twashe o theutco appropriateme that wo ustartingld occur date if one for assumedpayment aof perpetual royalties usefulfor the life.website technology. Dr. Frisch reached the same conclusion in his DCF analysis.Respondent seeks to minimize this error, noting that, after 20 years, Dr.

Frisch’Wes term concurinal vina ltheue accoconsensusunts fo thatr a s thesemall fract two iexpertson of h ireached.s $3.468 bIndeed,illion t onotal.

Butexpert most for of either the intangibles side opined had that a AEHTuseful lifeshould much be shorterrequired than to pay20 years, royalties and for the the

3321Dr.To enableFrisch AEHTstated that to make his DCF its required valuation cost would sharing be consistent payments withbefore the May 1, 2006,approa Amazonch of the US 20 1made1 cos tcapital sharing contributions regulations, toand AEHT respondent through’s a“ realisticseries of alterna- trans- actionstives” a rinvolvinggument m cashay re andpres preferredent an att estock.mpt to Respondentapply those hasregulations not challenged retroactively. any of thoseCf. Veritas transactions., 133 T.C. at 315-316. -- 124 86 - - websiteuseful life technology of the technology-related for any period before intangibles May 1, was 2006. only Because seven years. an unrelated See infra third partypp. 103-107. would not About pay royalties58% of Dr. until Frisch it actually’s total beganvalue, earningor roughly income $2 billion, from the is at- tEuropeanributable twebsiteo cash f business,lows after the 2011, starting when date Am azonfor payment’s underlying of royalties website is technolo-May 1,

2006.gy, as it existed on January 1, 2005, was expected to have lost most of its value.

This is not a 4.de minimisDiscount error. Rate

TheSecond, discount respondent rate is urgesused to that convert Dr. Frisch, future by income subtracting streams AEHT--here,’s AEHT'sprojected projectedcost sharing royalty payments, payments excluded--into casha lump flows-sum attributable present value. to “ subsequentlyDr. Wills adopted devel- the discountoped intangibles rate calculated” and thus by avoidedMr. Reilly, the anothererror committed of petitioner's by Dr. experts. Hatch. SeeMr. Veri-Reilly, applyingtas, 133 T.C. the capitalat 323. asset In effect, pricing respondent model (CAPM), says, this34 opinedallowed that AEHT an 18% to earn discount a re- rateturn properlyof 18% (the corresponded discount rate to Amazon'sDr. Frisch weightedapplied) on average its share cost of of the capital IDCs that

(WACC)."created the subsequently developed intangibles. In respondent’s view, an 18% rate ofDr. return Higinbotham was more thanalso generousused the CAPM for a company to determine like AEHT, his WACC, which but respond- he se- lectedent views 14% as as a the“cash appropriate box.” discount rate. He differed from Mr. Reilly chiefly in how heThis determined argument Amazon's is unpersuasive "beta," for a key at least element two inreasons. the CAPM First, calculus. AEHT was not an empty cash box. The European Subsidiaries, of which AEHT became the 34CAPM is a standard and widely used method to determine a company's parent,cost of equityhad been capital. in business Under for the approximately CAPM the expected six years. rate They of return had a for skilled a company's equity is generally the risk-free rate of return plus the product of beta andworkforce; an equity they risk owned premium. tangible and intangible assets; and they had goodwill and going-concern"In Veritas, value. 133 When T.C. atm aking324 n.33, the Europeanwe explained: Subsidiary "The WACCContribution provides to 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." -- 125 87 - -

"Beta"AEHT imeasuresn May 20 the06, volatilitypetitioner (and valu henceed the riskiness)European ofSubsidiaries a security inat comparisonapproximately to the$196 market million. as a whole. Both experts used stock market data compiled by Bloom- berg forSecond, 2000-2004 and m toore calculate fundamentally, Amazon's respondent beta. But’s whereasargument Mr. ignores Reilly the used fact monthlythat AEHT, data, by Dr. making Higinbotham cost sharing used payments, weekly data. became Using a genuine monthly co-owner data, Mr. of Reilly the subsequentlycalculated a beta developed of 2.00; intangibles using weekly that data, the IDCs Dr. Higinbotham financed. Under calculated Dr. Frisch a beta’s of

1.55.appro ach, AEHT is allowed to subtract from its buy-in obligation an amount equal to the presentPetitioner value contends, of its projected with strong cost support sharing from payments, its experts, i.e, its that discounted monthly costdata moreof acquiring accurately the subsequentlymeasure Amazon's developed volatility intangibles. compared But to all the future overall European market. Ac- businesscording to profits Dr. Unni: generated "While by weeklythose intangibles, measurements in excess of returns of that provide cost, would more databe points,allocated it skewsto Am azonthe measurement US through theof Amazon'sbuy-in payment. beta downwards because serial cor- relationsAs inrespondent stock returns, urges, which the discounting distort the measurementprocess by which of beta, Dr. areFrisch pronounced computes whenthe buy-in the returns payment interval would is arguably as short affordas a week, AEHT but a are limited substantially return on less the evidentinvest- withment ar ereturnspresen tintervaled by its of sh aa rmonth."e of the IDCs.Leading But finance the regulations textbooks simply and important do not auth- scholarlyorize such articles an artificial use five cap years on the of expected monthly returnsstock market that AEHT data tocould calculate realize a ascom- co- pany'sowner ofbeta.' Amazon Major’s future providers intangible of financial assets. information Under the regulations(such as Ibbotson in effect and during 2005-2006, the IRS may not make allocations with respect to a QCSA “except 36See Fischer Black, Michael C. Jensen & Myron Scholes, The Capital Asset toPricing the extent Model: necessary Some Empiricalto make each Tests, controlled in Studies participant in the Theory’s share of *Capital * * [of Markets IDCs] 85-87 (Jensen ed. 1972); Zvi Bodie, Alan J. Marcus & Alex Kane, Investments 258equal (9th to itsed. share 2011); of Richardreasonably A. Brealeyanticipated & Stewart benefits. C.” Myers,Sec. 1.482-7(a)(2), Principles of Income Corporate Finance 217 (10th ed. 2011); Eugene F. Fama & James D. MacBeth, "Risk, Return, and Equilibrium: Empirical Tests," 81 J. Political Econ. 607-636 (continued...) Tax Regs. The corollary of this rule isthat 126 each- QCSA participant can expect to

Standard & Poor's), as well as more popular sources (such as Motley Fool, First

Call, and MSN Money), do the same.37

Petitioner's experts have presented the more compelling case on this point.

Dr. Higinbotham acknowledged that his decision to use a weekly rather than a monthly beta was "virtually a random choice." Dr. Frisch, respondent's principal valuation expert, used an 18% discount rate under his DCF approach; like Mr.

Reilly, he calculated a beta of 2.00 using five-year monthly data. The adjustments in the notice of deficiency were based on Dr. Frisch's report, and he affirmed at trial his belief that an 18% discount rate was correct. Dr. Higinbotham agreed that switching to a monthly beta would increase his WACC to roughly 18%, and we

find that the appropriate discount rate on January 1, 2005, was 18%.38

36( .continued) (1973); Reinhold P. Lamb & Katheryn Northington, "The Root of Reported Betas," J. Investing 50-53 (2001).

'Mr. Haigh, respondent's trademark expert, cited a treatise by Shannon Pratt to support use of five-year weekly data. But that treatise provides at best inconclusive support for this proposition. See Shannon P. Pratt, Cost of Capital (2d ed. 2002) ("Monthly is the most common frequency, although Value Line uses five years of weekly data.").

38Respondent notes that Amazon's treasury department, for internal discussion purposes, used a discount rate of 13% when evaluating prospective investments. But Dr. Frisch characterized this internal rate as an inaccurate measure of the riskiness of AEHT's business. In that respect his views align with those of Mr. (continued...) -- 127 88 - - receiveB. its proportionateMarketing Intangibles share of the profit attributable to the future intangibles.

See id.The paras. marketing (e)(2), (f)(3)(iii). intangibles For made this available purpose, toit isAEHT immaterial include whether the Amazon the par- name,ticipant domain engages names, in actual trademarks, technology trade development names, and or trade simply dress. makes The cost parties' sharing paymentsexperts agreed in cash. that Bythe allocating CUT method to Amazon provides US the all best of AEHTmethod’s forfuture determining profits in the arm'sexcess-length of the buydiscount-in payment rate, Dr. for Frisch the marketing’s approach intangibles. is irreconcilable They alsowith usedthe gov- the sameerning sources regulations. of public information --licensing information reported in the ktMINEIf Veritasdatabase" cannot--to derivebe distinguished their external on theCUTs. facts, respondent urges that it be overruled.Petitioner's He contends expert that Mr. the Reilly outcome identified in Veritas six comparable was dictated license solely agreements by fact withfinding, royalty so that rates “any ranging assertions from m0.125%ade by tothe 1% Court of sales. about Hegoverning selected law the aremedian dicta of theseand not rates, controlling. or 0.59%,” Asas histhe baseprevious rate, discussionwhich he reduced has made to clear,reflect we a volume do not agreedis- withcount. respondent He estimated’s characterization that the marketing of Veritas intangibles, and we had decline a remaining his invitation useful lifeto of

10overrule to 15 years,that Opinion. and he 22identified the revenue stream associated with their use on the basis of management's projections and a growth assumption after 2011. 22Petitioner urges that Dr. Frisch made other errors that affect the reliability of his conclusions. For example, when subtracting AEHT’s projected capital expenditures from its future cash flows, he neglected to exclude startup expenses for the Luxembourg headquarters and the Irish data center. According to petitioner, correction of this oversight would reduce Dr. Frisch’s valuation by $400 million. Separately,38(...continued) when subtracting AEHT’s projected cost sharing payments from its futureSzkutak, cash Amazon's flows, Dr. chief Frisch financial assumed officer. that AmazonHe testified’s IDCs that would the treasury grow at depart- an an- mentnual rate rate of was only a mere 5% after benchmark 2005. Ifthat Dr. was Frisch increased, had used to therates IDCs above as 18%,calculated for spec- by ulativeDr. Higinbotha investmentsm, petitioner related to contends future performance. that the valuation We declinewould beto reducedadopt as tothe appropriate$2.946 billion. discount Although rate the these benchmark (and other) rate thatchallenges Amazon to usedDr. Frisch internally.’s report have force, we need not consider them in detail. Respondent’s “business enterprise” approach39The to determiningktMINE database an arm includes’s-length more buy-in than payment 15,000 forintangible pre-existing asset intan-agreements and allows subscribers to conduct customized searches. (continued...) -- 128 89 - -

ApplyingIII. Petitioner a discount’s Determination rate of 18%, ofhe the calculated Buy-In Paymenta value of $251 million to $312 millionHaving for all concludedof the European that respondent marketing’ sintangibles. primary valuation approach was arbitrary andDavid capricious, Franklyn, we another turn to ofan petitioner'sassessment experts,of petitioner opined’s m thatethodology. these values Peti- musttioner be’s expertsadjusted applied to reflect the the CUT fact method that the to European determine Subsidiaries an appropriate before buy-in Project pay- mentGoldcrest for all already three speciesowned certainof intangible of these assets--website marketing intangibles. technology, After marketing excluding in- thetang valueibles, ofan previouslyd European owned custom intangibles,er information--that which Mr. Amazon Franklyn US believed made available to rep- to resentAEHT. about Petitioner 50% of submits the total that value, the CUT Mr. Reillymethod concluded “is the best that m ethodthe buy for-in valuing payment requiredthe pre-existing from AEHT intangibles. for the” marketing intangibles was $115 to $165 million.

TheRespondent's CUT method expert determines Mr. Haigh an initiallyarm’s-length identified charge four for comparable a controlled license trans- agreementsaction by refere (includingnce to the one amount selected charged by Mr. in Reilly) a comparable with royalty uncontrolled rates ranging transac- from tion.0.5% Sec.to 2% 1.482-4(c)(1), of sales. He Incomeselected Tax the highestRegs. If of an these uncontrolled rates, or 2.0%,transaction as his in- base rate,volves and transfer he applied of the no same volume intangible discount. under He the assumed same or that substantially the marketing similar intangi- cir- blescumstances, had a perpetual the CUT or m "indefinite"ethod will generally useful life. yield Applying the most a reliablediscount measure rate of 13.3%of the toarm an’s-length assumed result. revenue Id. base, subpara. he calculated (2)(ii). If inuncontrolled his opening transactions report a value involving of $1.8 the billionsame intangible for the marketing under the intangibles. same or substantially Adopting similareven higher circumstances revenue assumptions cannot be in his rebuttal report, he valued the marketing intangibles at $3.13 billion. Re- spondent contends that this figure should not be reduced to account for prior own-

22 ership of(...continued) any marketing intangibles by the European Subsidiaries. gibles is flawed in its central premise because it is inconsistent with the pre-2009 cost sharing regulations. That being so, modifying the details of Dr. Frisch’s implementation of that approach would not carry the day. -- 129 90 -- identified,While uncontrolled the parties' transactions experts have involving adopted “similarcomparable approaches, intangibles they underdisagree comparableon five major circumstances inputs into the” may CUT be valuation: used, but the(1) resultsthe proper may royalty be less rate;reliable. (2) the Ibid. useful Inlife order of the for marketing intangibles intangibles; involved in (3) controlled the revenue and base uncontrolled to which transactionsthe royalty shouldto be co bem parable,applied; both (4) the intangibles appropriate must discount be “used rate; in connectionand (5) the withextent similar (if any) prod- to whichucts or theprocesses buy-in withinpayment the must same be general adjusted industry to reflect or marketthe European” and must Subsidiaries' have prior“similar ownership profit potential. of certain” Id.marketing subdiv. intangibles.(iii)(B)(1). InWe determining address these whether issues con- in turn. trolled and uncontrolled1. Royalty transactions Rate are comparable, the regulations direct us to considerPetitioner's comparability expert with Mr. respect Reilly tosearched the relevant for exclusive property trademark or services, licensing functions, agreementscontract terms, that risks, involved and prevailingproducts similar econo mtoic those conditions. sold by Id.Amazon sec. 1.482-1(d)(1). and that calculated royaltiesRespondent as a’ spercentage and petitioner of revenue,’s experts with agree no thatcollateral the CUT transactions. method may From reli- theably 167 be uagreementssed to valu ethat sep heara foundtely the in website the retail technology, and Internet the categories, marketing40 intangibles, he initially selectedand the customer the following information, six transactions though they as comparable disagree mightily and chose about as histhe baseoutcomes royalty thethat median this method of these should rates, produce. or 0.59%: We conclude that the CUT method provides the best method for determining the fair market value of all three species of intangible property, but we do not wholly agree with the results reached by either party in implementing this approach. Because petitioner has failed to prove that its pro- 40in posed valuationhis ktMINE meets thedatabase arm’s-length search, standard,Mr. Reilly the found Court 7,724 must agreements determine forin it- effect on January 1, 2005. Of these, 865 were in the "marketing intangible" self,category. with respectNarrowing to each his categorysearch to ofthe property, retail and the Internet required industries buy-in payment. yielded 167 See agreements, all of which he reviewed to find CUTs. He conducted similar searches using two other search engines (Royalty Source and Royalty Range) but did not identify any additional CUTs. -- 130 91 --

SundstranLicensord Corp., 96 T.C. at 354; G.DLicensee. Searle & Co. v. ComRoyaltymissioner (percent), 88 T.C.

252,Merchandising 367 (1987). Corp. Sports Archive 1.00 Sports Authority Mega Sports Co. 0.850 MichiganA. Website Technology RampagePetitioner Licensing’s expert Dr. CharlotteWills opined Russe that the M.com transactions0.750 between F.A.O. Schwarz Fdn. The Right Start 0.438 Amazon and its clients provided reliable internal CUTs for the transaction by Kmart Corp. Kmart Australia 0.188 which Amazon US made its website technology available to AEHT. In its M.com Kmart Corp. Kmart New Zealand 0.125 business Amazon used the technology that powered its own websites to build and Mr. Haigh initially selected from the ktMINE database the following four operate eCommerce websites for other merchants. Amazon’s principal M.com transactions as comparable and opined that Amazon's brand strength justified clients were large retailers operating in the United States and abroad. There were choosing as his base royalty the highest of these rates, or 2.0%: no material differences between the technology “packages” that domestic and Licensor Licensee Royalty (percent) foreign clients received. SNAP! ValueVision Int'l 2.00 MacMarkDr. Wills analyzed the EquilinkM.com agreements Licensing in an effort to determine2.00 the roy- aSportslty rate Authoritythat an un related parMegaty, act iSportsng at a rCo.m’s length, would pay A1.20mazon US for Michigan theRadio right Shack to use the website technology.InterTAN Australia He found that the M.com agreements1.00 were priced “holistically”; by this he meant that the “headline” commission rate In his rebuttal report Mr. Reilly accepted one of Mr. Haigh's choices--the stated in each agreement covered not only the website technology but also ancil- Radio Shack agreement--as a valid comparable. At trial Mr. Haigh found no fault lary services that Amazon furnished to that particular client. To the extent these in two of Mr. Reilly's choices--the Merchandising Corp. and Rampage Licensing ancillary services were supplied in addition to the website technology, Dr. Wills agreements--as valid comparables. We will accept all three agreements as comparables, evidencing royalty rates of 1.0%, 1.0%, and 0.75%, respectively. concluded that an appropriate adjustment- 131 to -the headline rate was warranted.

Both experts selected the Sports Authority Michigan license as a comparable but derived different royalty rates from it. That agreement specified a royalty rate starting in 2003 at 1.2% and declining annually to 0.5% in 2015. Whereas

Mr. Haigh selected the starting rate (1.2%), Mr. Reilly took the simple average

(0.85%) of all rates in the agreement. Mr. Reilly's choice was reasonable because the rate during most years of the initial term was 0.8%; Mr. Haigh acknowledged that extending the agreement's terms to perpetuity would yield a rate close to

0.5%. We accept the Michigan Sports Authority agreement as a comparable evidencing a 0.85% royalty rate as determined by Mr. Reilly.

The experts disagree as to the comparability of the other five licensing agreements. For the following reasons, we find that none of them supplies a reliable comparable.

• The F.A.O. Schwarz trademark was licensed by the F.A.O. Schwarz Fam- ily Foundation to The Right Start, which in 2001 had purchased 23 of the remaining F.A.O. Schwarz toy stores in North America. The media described that transaction as "resembling a distress sale." This is not the sign of a financially healthy

company or brand; the F.A.O. Schwarz brand was in serious decline, whereas the

Amazon brand was on the opposite trajectory. Petitioner has failed to convince us that this is a reliable comparable. -- 132 92 --

Dr.• The Wills Kmart adjusted trademark the commission was licensed rates in 1994 appearing by Kmart in 12 US M.com to Kmart agreements New

Zealandto eliminate and profitKmart attributable Australia, bothto ancillary of which services. were then He owned thus derived by an unrelatedroyalty rates party.ranging The from Kmart 1.4% brand to 4.4%, was with also ain median decline: of Many3.3%. of He its concluded US stores that were AEHT outdated andwould in decayingbe entitled condition, to a downward and by “ volumethe 1990s adjustment the press” labeled because Kmart M.com a "'discount clients storewith thedud' largest in need sales of revitalization."volumes paid a lowerPerhaps implied for that commission reason, the rate. royalty Applying rates a specifiedvolume adjustment, in these agreements he came up (0.125% with a reducedand 0.188%) royalty are rate extremely ranging low from by 1.4% com- to parison2.4%. He with concluded the others. that Petitioner no further has adjustments failed to convince were needed us that to accountthese two for (sub- dif- stantiallyferences in similar) geography agreements or profit furnish potential reliable (respondent comparables.’s experts accept this latter conclusion).• A trademark for all MacGregor branded products was licensed in 2000 by

MacMarkDr. Willsto Equilink. then determined We agree a with useful Mr. life Reilly and athat decay this curveagreement for A mis azonnoncom’s - parablewebsite fortechnology three reasons. by relying First, on "it the covers analyses the rightsof four to of use petitioner trademarks’s technology to manufac- ture,experts, brand, Drs. and Birman sell physical and Alvisi, products," Parkes, whereasand MacCormack. Amazon's marketingOn the basis intangibles of their doanalyses, not convey he concluded such rights. that Second,the website this technology license agreement had an averagewas executed useful aslife part of of asix litigation years but settlement; that it would the declineparties' inrelative value orbargaining “decay” quitepower rapidly is unclear, during and this the royaltyperiod. rateFor mayexam reflectple, he other concluded concessions. that during Third, 2007 the the agreement's average value pricing of the pro- tech- visionsnology wouldare complex; be 56.1% Mr. of Haigh its January admitted 1, 2005, that the value, actual and royalty that during rate could 2009 beits asav- lowerage as value 0.56% would under be certain 24.8% conditions, of that initial well value. below the 2% headline rate. For all these reasons,Dr. Wills respondent multiplied has his failedvolume-adjusted to convince royalty us that ratesthis agreement(ranging from furnishes 1.4% a to 2.4%) by the decay percentage to generate final royalty rates for each year. -- 133 93 -- reliableThus, for comparable example, the (or effec if it betive thought “high” comparable)royalty rate for that 2007 it supports was 1.35% a royalty (2.4% as × high.561) as an 2.0%.d the e ffective “low” royalty rate for 2007 was 0.79% (1.4% × .561). For years after• The 2010 SNAP! he addedtrademark a “tail was” of licensed 3-1/2 years, to ValueVision at a flat royalty in 1999. rate, Weto account find this agreementfor any “continued noncomparable presence for of three some reasons. base of codeFirst,” aftermost sixof theyears. products it covered were highDr. -marginWills applied jewelry these items; declining AEHT royaltywas not rates a high to -margina revenue retailer, base equal and an to un- relatedAEHT’ partys projected in its positionannual revenue would considerfor 2005-2011 that fact (extended in determining through whether 2014 using to pay a a50% royalty declining as high balance as 2%. method)41 Second,23 to the generate parties an to annualthis agreement royalty obligation. were almost He related:then discounted General Electric, this stream through of royalty its NBC pay subsidiary,ments at 18% owned (the asame significant discount stake rate in

ValueVision,used by Dr. Frisch) and SNAP! to produce became a lump-sum a wholly ownednet present subsidiary value. ofThis NBC generated one month a later.buy-in Third, valuation NBC for in the 2001 website announced technology a rebranding ranging strategybetween and $117 "effectively and $182 mtermi-il- natedlion. the Snap trademark license [agreement]." In effect, therefore, the SNAP! agreementRespondent was a dead’s expert letter Dr. when Higinbotham the CSA was agreed executed that the in JanuaryM.com transactions2005. providedAfter a reliable eliminating source the of five CUTs license for valuing agreements the website we find technology. to be noncomparable, For his weroyalty are leftrate with he used the followingthe 4% “headline four agreements” commission that therate parties appearing agree in supplya pre-2005 reli- ableM.com CUTs, agreement with the between following Amazon royalty and rates: Target. For his revenue base he used management projections of AEHT’s revenues through 2011. For years after 2011

410n cross-examination Mr. Haigh was surprised to learn that he had relied on inflated profit margins that did not account for AEHT's projected IDC expenses.23 UHend eacknowledgedr a “50% decl ithatning AEHT's balance ”actual method, profit the margins growth couldrate is dictate reduced a roy-by alty50% rate each below year untilthe 2% it reaches rate he chose.a “stable ” growth rate. -- 134 94 - - he assumeLicensord signifi cantly higher revenueLicensee growth than Drs. WillsRoyalty and Frisch(percent) (who assumedMerchandising that AEHT Corp.’s revenuesSports would Archives grow at the rate of the EU economy).1.00 America RadioDr. Shack Higinbotha m appliedInterTAN a flat 4% Australia royalty rate to these projected1.00 revenues foSportsr year sAuthority 2005 thro ugh 2024, Megathen a Sportsdded a Co.“terminal value” reflecting0.85 royalty pay- Michigan ments in perpetuity. Unlike Dr. Wills, he did not adjust the royalty rate to account Rampage Licensing Charlotte Russe 0.75 for decay in the value of the website technology as it existed in January 2005.24 Given the strength of Amazon's brand in 2005, we agree with Mr. Haigh Instead, he assumed that this loss in value would be reflected in the cost sharing that it is appropriate to select as the base royalty rate the highest of these rates payments that AEHT would make to secure replacement technology. He accord- (1.0%), which does not differ greatly from the median (0.925%) or the average ingly estimated Amazon’s future IDCs and subtracted from AEHT’s future royalty (0.90%). payments its projected cost sharing payments. He discounted this stream of future Mr. Reilly noted that trademark license agreements sometimes include a net royalty payments at 14% to produce a lump-sum present value of $3.3 billion "waterfall" structure that reduces the base royalty rate at higher sales volumes. as the buy-in payment. Opining that a downward volume adjustment would be reasonable here, he re- While the parties’ experts have adopted somewhat similar approaches, they duced his starting royalty rate by up to 33 basis points as AEHT's projected reve- disagree on four major inputs into the CUT valuation: (1) the proper royalty rate; nues reached certain thresholds. He cited his valuation experience, as opposed to (2) the proper useful life and decay curve for the website technology; (3) the reve- specific external or internal CUT evidence, to justify this reduction. nue base to which the royalty should be applied; and (4) the appropriate discount Mr. Reilly acknowledged that "waterfall" structures are atypical in agree- rate. We discuss these issues in turn. ments that license marketing intangibles. Of the 167 such agreements that he

found 24inIn the his retail work and for Internetprivate-sector categories, clients, only Dr. eight Higinbotham had downward has employed adjustments decay curves (similar to those used by petitioner’s experts) when implementing valuations under the 1995 cost sharing regulations. -- 135 95 - - keyed to higher1. salesRoyalty volumes. Rate Mr. Reilly acknowledged that "in certain instances trademarkThe licenseparties haveroyalty two rates major increase disputes over concerning time or with the increasedroyalty rate. revenue." The first In involvesfact, Mr. selectionHaigh looked of the at appropriate 700 agreements base rate.and found The second 21 that involves featured the increasing necessity royaltyof a downward rates. adjustment for sales volume and (if necessary) its magnitude.

WeDr. Higinbothafind that flatm royaltyselected rates a base are royalty the norm rate in of agreements 4%, the headline of this type.commis- Even ifsion a volume rate appearing adjustment in a werepre-2005 thought M.com appropriate, agreement the between evidence A misazon conflicting and Target. as to whetherDr. Will sthe de rrateived should his royalty be adjusted rate from upward 12 M.com or downward. agreements, We including thus conclude the Target that theagreement. arm's-length He concluded royalty AEHT that it must was payinappropriate for the marketing to rely solely intangibles on the isheadline a flat

1.00%."commission rates stated in these agreements because the deals had multiple revenue sources, 2.including Useful ancillary Life services.

TheDr. Wills parties based disagree the latter as to conclusionwhether the in marketing part on the intangibles testimony hadof Charles a limited usefulMoore, life who (as headed petitioner the M.comcontends) business or a perpetual during 2005 or "indefinite" and 2006. usefulMr. Moore life (as tes- respondenttified that A contends).mazon did notPetitioner always presented expect to testimonyearn a profit from on fivethe ancillary expert witnesses. services

Theystanding were alone; unanimous the headline in concluding rate was thatdesigned the useful to ensure life ofa reathes onablemarketing profit intan- on those services as well as compensate Amazon for use of its technology. He further testified that his business team used detailed financial spreadsheets called “deal decks”42 toWhen analyze valuing the overall the website economics technology, of an M.com we applied transaction. a 25-basis25 Using-point thedown- ward adjustment to the royalty rate because Amazon's M.com agreements, used as comparables there, provided evidence justifying a modest volume discount. Here we are25 consideringThe “deal decks external” are rather complex than financial internal spreadsheetsCUTs, and the that external Amazon CUTs used sup- to plyevaluate no convincing and negotiate evidence the M.com to support agreements. reducing These the royalty spreadsheets rate at higher contained sales reve- volumes. (continued...) -- 136 96 -- gibles,“deal d ewhilecks” tlengthiero back o uthant the that rev eofnues the attributablewebsite technology, to ancillary was services, not perpetual. Dr. Wills We agree.derived a royalty rate range of 1.4% to 4.4%, with a median rate of 3.3%.

Mr.The Reillyparties estimated agree that that the theTarget useful arrangement life of the ismarketing the most intangiblescomparable was in theM.com range transaction of 10 to 15 for years. purposes Like of Dr. implementing Unni and Mr. the Lasinski, CUT approach. he began Target by focusing was tonhe thelarg termsest M of.co them r erelationshiptailer and th betweene most co Amazonmparable US to andAEHT AEHT. in terms After of Maysales 1, vol-

2006,ume. Target,AEHT waslike responsibleAEHT, had fora broad all advertising, product line development, and wide product and trademark selection.- maintenanceAnd Target was expenses contractually relating entitled to the European to receive marketing from Amazon intangibles. US all technology Mr. Reilly updatesopined that as they this occurred.is unusual Butin trademark the Target license agreement agreements; was not typically,comparable at leastin one somemajor trademarkrespect: It-related included expenses a variety continue of ancillary to be services, borne by such the licensoras fulfillment during and the licensecustomer term. service, that Amazon US did not provide to AEHT.

BecauseTarget and the Amazon going-forward executed value their of original the marketing M.com intangiblesagreement onwould August in- 31,

2001.creasingly Target be attributablethereby agreed to marketing to pay commissions, investments computed by AEHT, on an revenues unrelated derived party infro itsm ipositionts websi twoulde sales, not of agree5% during to pay 2001-2002, royalties forever. 4.5% during As Mr. 2003, Reilly and explained: 4% during

"A200 trademark4-2006. Th is,is at a ganyreeme specificnt wa smoment, amende dthe tw productice before of 2investments006 (once i nof A theugu past.st

2003* * * [F]utureand again investments in August 2005); can replace both amendmentsthose made in retained the past, the and 4% therefore headline thecom- valuemission of ratea trademark for 2004-2006. built by The investments agreement of wasthe pastamended will diminish. a third time Its in place July will then2006, be about taken 18 by m theonths value after resulting Amazon from US andnew AEHT investment." executed See the Nestle CSA. Holdings, This final

Inc. v. Commissioner, T.C. Memo. 1995-441, 70 T.C.M. (CCH) 682, 696 25(...continued) ("Trademarksnue projection slose ove substantialr the term of value each without agreement, adequate taking investment, into account management, historical information and ex ante profit and loss projections. -- 137 97 - - marketing,amendmen tadvertising, replaced the and 4% sales rate withorganization."), a tiered commission rev'd in partstructure and remanded based on saleson volumes;other grounds, it also 152 included F.3d 83 a dollar(2d Cir. cap 1998). on the amount of commissions that Target was requiredPetitioners' to pay. experts also noted that the value of Amazon's trademarks or

"brand"We was disagree closely with linked Dr. to Higinbotham the state of ’itss exclusive technology. reliance If consumers on the 4% were headline dis- satisfiedrate set forth with in their the shoppingoriginal Target experience, agreement. Amazon's He acknowledged marketing intangibles on cross-exami- would rapidlynation t hdeclineat the “ inho value.listic” pAEHTricing owasf the responsible, M.com agreements not only posedfor ongoing an impediment marketing to relyingexpenses, solely but alsoon the (under stated the commission CSA) for its rate. pro And rata heshare conceded of future that IDCs the “thatdeal were decksessential” should to sustaining be afforded the websitemore weight technology. than he gave them in determining projected revenueAs Dr. flows. Unni Thus,put it: while "[T]he Dr. incremental Higinbotham profits properly associated considered to [the the marketing] version intangiblesof the Target are agreement progressively in effec attributablet when the to CSA the future was executed, business hisefforts analysis and tech-suf- nologyfered fr ocom-development reliance on a ofhea Amazondline ra tEurope."e that inc lHeude determinedd pricing for that an cianyllary profits servi ces attributableas well as website to such technology. intangibles after a period of 15 to 20 years would reflect the qualityDr. of AEHT'sWills sought ongoing guidance business from execution the “deal anddecks the” toeffectiveness address the oflatter supporting prob- technologylem. But no and “deal subsequently decks” could developed be found intangibles for any version for which of the AEHT Target had agreement paid.

Mr.except Lasinski the July similarly 2006 final opined amendment. that, if a licenseeUsing the anticipates “deal deck incurring” for the substantialJuly 2006 amendment,future expenses Dr. toWills sustain estimated the value that of an the appropriate licensed marks, royalty it rate will for negotiate the Target for limitedagreement,-duration adjusted payment to back structures, out ancillary lower service royalty revenues, rates, or wouldother concessionary be 2.05%. But provisions.the July 2006 amendment post-dated the CSA transaction by 18 months, and the parties understood that this amendment- 138would - reduce Target’s payment obligation

Robert Dolan approached this problem from a different perspective, employing a well-established marketing methodology that analyzed the risks the

Amazon brand faced as of January 1, 2005. These risks included low switching

costs for customers; problems stemming from excessively fast growth; intense pressure from online competitors and brick-and-mortar stores; and the risk that key collaborators (such as suppliers or delivery services) would disappoint. He noted that, owing to the lack of "emotional appeal" in Amazon's value proposition, the relative contribution of its brand--as opposed (say) to the Hermes and

Gucci brands--was quite limited.' For these reasons, he concluded that Amazon's marketing intangibles should not be valued into perpetuity.

Peter Golder, another of petitioner's experts, used empirical data for technology-driven companies to estimate a useful life for Amazon's marketing intangibles. As he explained: "It is important to remember that expectations about Ama- zon's brand are being made as of January 1, 2005, and therefore must not incor-

"To support this proposition Professor Dolan cited academic literature and Millward Brown's "brand contribution" measure of Amazon. Millward Brown uses a 1 to 5 scale to measure the importance that brand (as compared with price and product features) plays in a company's success. Companies with an index of 5 (including such luxury brands as Hermes, Gucci, Rolex, and Porsche) derive the greatest proportion of their value from the brand itself. Companies with an index of 1 (including Domino's Pizza and 76 Motor Fuels) derive the least proportion of their value from the brand itself. Millward Brown gave Amazon a rating of 2 on this scale, which is consistent with a relatively low brand impact assessment. -- 139 98 -- porateas compared today's with hindsight." the flat 4% He commission noted that the structure dot.com prevailing crash had on occurred January just 1, 2005. four yearsWhile previously; ex post data that of thisthousands sort m ayof provideInternet acompanies reference pointhad failed; or sanity that check, Internet we retailingthink Dr. (especially Wills gave inthe Europe) July 2006 was amendment still in its infancy; undue weight. that Amazon's ability to

extendIn its short, reach while into newthe Targetproduct arrangement categories wastheoretically uncertain; offers and that the best75% compar- of inde- pendentable, it i sfinancial imperfect analysts in part inbecau 2005se had the ad osellcume or nholdtary ratingrecord on is iAmazon'sncomplete. stock. See sec. 1.482-1(c)(2),For his second Income empirical Tax Regs.analysis, (directing which weattention found tomost “the persuasive, degree of com-Dr. parabilityGolder estimated between the the longevity controlled of transaction leaders and * significant * * and any competitors uncontrolled in com-seven peCommercearables, and markets: the qual itonliney of the brokerages, data and assumptions Internet search used engines, in the analysis online ”social). None- networks,theless, we travel find thatwebsites, the Target web agreementsbrowsers, smartphones, do bracket the and range video of game acceptable consoles. roy-

Healty determined rates. From that the many agreement well-known in effect brands on January had failed, 1, 2005, including we conclude more than that halfa royaltyof the market rate adjusted pioneers, to backwhich out had ancillary an average service time revenue to failure should of seven be m years.eaningfully His analysisbelow 4%. generated And from estimated the agreement useful lives in effect ranging in July from 2006, 10.9 which to 16.5 was years designed for all to sevenreduce markets, Target’s which commission increased obligation, to 19.9 yearswe conclude when pioneers the proper that base failed royalty early ratewere shouldomitted. be meaningfully above 2.05%.

SinceRespondent's the Target expert agreements Mr. Haigh provide focused an imperfecton the useful com lifeparable, of the we Amazon expand

"brand,"our analysis acknowledging to include the that other there M.com is "little agreements. consensus Dr. on Higinbothamwhether a brand reviewed has a

15finite M.com or an agreements; indefinite" usefulhe noted life. that He no noted agreement that, under had a applicable “headline ”accounting commission standards,rate below "the3% andfacts concluded indicate whether that these the agreements asset has a yielded finite life a royalty or not." rate He range then of made the following assumption: 3% to 5%. Analyzing the “holistic” pricing- 140 -of the 12 M.com agreements with

It is my assumption that the brand has an indefinite * * * [useful life]. This is based on the assumption that there is no foreseeable limit to the period over which the brand is expected to generate net cash inflows for its businesses. This also assumes that trademark registration renewals are filed at the appropriate time and sufficient investment is made in terms of marketing and communication to maintain the value inherent in the brand.

Mr. Haigh's opening report referenced only one perpetual license, and that agreement included a lifetime cap on royalties. He admitted that he would not have advised AEHT to pay perpetual royalties for the marketing intangibles.

Other than Mr. Haigh, respondent relied on two experts in an effort to de- monstrate the longevity of Amazon's "brand" as of January 1, 2005. Dr. Conley, relying on a theory of "value transference," opined that properly managed technology assets enhance the value and extend the life of a company's brand. He sought to illustrate "value transference" with examples involving an artificial sweetener and generic pharmaceuticals. But Dr. Dolan showed that these examples proved the opposite: Once the patent expired, the products lost significant value and market share. Dr. Conley admitted that his "value transference" theory has never been adopted within the valuation community, is not incorporated in any accounting standards, and has not been adopted by any court. We did not find it persuasive. -- 141 99 --

“deal dRespondent'secks,” Dr. W ifinallls de expert,termine Robertd a roy aJ.lt Wilcox,y rate ra nopinedge of 1.4% that ato brand 4.4%, name with a simplifiesmedian rate consumers' of 3.3%. decision making, that brand names are important in the

online Evaluatingworld, and allthat the Amazon evidence, in Januarywe conclude 2005 thathad ana strong arm’s-length brand in base Europe. royalty

Althoughrate for the we website found technology,this testimony before persuasive, applying Dr. any Wilcox volum dide adjustment, not opine onis 3.3%.the actualWe find useful this ratelife acceof Amazon'sptable because trademarks it properly or brand. backs His out report revenues does attributable not support to respondent'sancillary services; contention it is the that median the marketing rate determined intangibles by Dr. had Wills; a perpetual it is within useful Dr. life.

HiginbothamHaving’ sconsidered range; and the it is testimony near the midpoint of these eightof the experts comm issionin light rates of our bracket- find- ingsed by of the fact, various we conclude Target agreements. that the marketing intangibles did not have a perpetual useful Welife, next and mweust reject decide respondent's whether to contentionapply a downward that they “ volumedid. Our adjustment conclusion” tois basedthe 3.3% on numerousbase royalty factors rate. asDr. to Wills which noted petitioner's that the expertssales volumes testified, expected including to bethe generatedfact that the by Internet AEHT wereretail “industrysubstantially was young,larger” thethan fact the that sales Amazon volumes had generated operated inby Europeany of tforhe 1only2 co msixp ayears,rable Mand.co them rfactetai lthaters, iAmazon'sncluding Target. success He depended found it heavily “clear fromon short-lived even a casual technology inspection assets. of theBut data our that conclusion there is arests negative chiefly correlation on the facts bethat

AEHTtween the assumed commission sole responsibility rate and the associatedto maintain sales and volume,develop ”the noting marketing Mr. Moore intan-’s giblestestimony in Europe that “[v]olume and paid, impacted through costdeal sharing,pricing pretty for the significantly. technological” Dr.improve- Higin- mentsbotham essential agreed thatto maintaining this “negative the correlation value of those” existed marketing and that intangibles. AEHT’s projected sales volumesPetitioner's were experts substantially presented larger us withthan theuseful median life estimates sales volume for the of themarketing 12 intangiblesM.com retailers that rangedthat Dr. between Wills surveyed. 8 and 20 years. Mr. Reilly and Dr. Dolan embraced a 10-15 year range. Dr. Unni embraced a 15-20 year range. Dr. Golder - 142100 -

opinedWe that believe the useful that lifesome could volume be as adjustment short as 8 isyears required. but (with But certain we find assump- that Dr. tionsWills anderred adjustments) in applying coulda volume be as adjustment long as 20 as years. large as 200 basis points (e.g., reducingWe the conclude royalty thatrate aat useful the high life end at the of tophis rangeof these from ranges 4.4% is to appropriate. 2.4%). Dr. We agreeWills withinitially Dr. attemptedWilcox that to Amazonquantify aat “ year-endvolume differe 2004 hadntial a” veryusing strong a statistical brand in analysis,Europe and but that he foundthe strength this approach of its brand unreliable supports (e.g., a relatively because it long yielded useful negative life. By

2000implied Amazon's royalty ratesprimary in some domains cases). in the He UK, then Germany, made a “judgment and France call represented” and esti- the threemated most a 200-basis-point popular online adjustment. retail domains He admittedin Europe. that In he all had three no countriesauthority Amazonfor this hadpart ithecul ahighestr estim abrandte and awareness that it was of not any “very online scientific. retailer.” WhenWe agree asked with about that placesassess- toment. shop on the Internet in 2005, European customers told pollsters that Amazon was theAlthough brand that we first do notcame accept to mind. Dr. Wills Considering’ 200-basis-point all the evidence, adjustment, we findwe con- that thecur marketingin his view intangibles that Amazon had’s aagreements useful life withof 20 its years, largest which M.com is the clients top end are ofthe Dr.

Unni'smost lo gandica lDr. pla Golder'sces to look ranges for evidence and not tooof what far from an appropriate the high end volume of Mr. adjustment Reilly's range."might be. Those four clients were Target, Mothercare (a UK retailer specializing in baby products and toys), Marks & Spencer (a UK department store chain), and

Sears Canada.

As of January 1, 2005, the Target agreement specified a flat commission rate of44 4%Mr. on Reilly sales. believed No explicit that avolume "ramp adjustmentdown" could was be incorporated justified toward into thethat end of the marketing intangibles' useful life, but he did not include a decay curve in hisagreement valuation. until As July he 2006.explained, The thisparties was initially a conservative agreed, massumptionoreover, that that the arguably com- introduced "an upward bias in his final buy-in price conclusion." Since petitioner does not urge application of a decay curve here, we have no occasion to decide whether it would be appropriate. mission rate would remain at 4% for the-143- period beginning January 1, 2004, and

3. Revenue Base

With one minor exception noted below, the parties agree that royalties for the marketing intangibles should be figured on the same revenue base as royalties

for the website technology, namely, AEHT's projected revenues over the useful life of the relevant assets. All experts agree on using management projections to determine AEHT's revenue base for 2005-2011. We have already approved, in

connection with the website technology, Dr. Wills' use of a "50% declining balance" method to estimate AEHT's post-2011 revenues. See supra pp. 121-123.

We again approve use of that method to estimate AEHT's revenues beginning in

2012 and continuing through the end of the 20-year useful life we have ascribed to the marketing intangibles.

Employing the 50% declining balance method, Mr. Reilly reduced AEHT's revenue growth rate by 50% for each post-2011 year until it reached a "stable" rate. He selected 4% as AEHT's stable growth rate, using long-term growth and inflation projections for the eurozone. Under this approach, which we accept here,

AEHT's rate of revenue growth declined to its 4% stable rate starting in 2017.

In his opening report, Mr. Haigh adopted a more conservative assumption.

He likewise selected 4% as AEHT's long-term growth rate, but he assumed that

AEHT would reach this lower rate much more quickly, beginning in 2012. In his - 144101 - rebuttalending on report, December by contrast, 31, 2006. Mr. SinceHaigh the switched volum eto of use Target of a ’10s website-year, straight-line sales was declineexpected from to increa AEHT'sse substantially 2011 growth during rate; thisthis nearlythree-year doubled, period, to the$3.13 Target billion, agree- his buyment-in provides valuation inconclusive of the marketing support intangibles. for a volume He adjustment offered no or convincing its appropriate rationale size.for this 11th-hour change of opinion, and we did not find it persuasive.'

The partiesother three disagree M.co concerningm agreements one were small executed detail of after the revenueJanuary base1, 2005. calculation,The Mothercare namely, whether agreement revenues specified attributable a commission to giftwrap, rate starting shipping, at 1% and on miscel- the low- laneousest tranche services of website should sales. be excluded This rate from increased AEHT's to 3.75%projected when revenue annual stream sales hitfor a purposescertain volu of mcalculatinge, then decrea royaltiessed to on a flatthe ratemarketing of 3.0% intangibles. when annual Mr. sales Reilly exceeded exclud-

£ed80 these million. revenues Since because AEHT’ theses expected services annual were sales projected volum toes operatewere expected at a significant to be loss;many in ti meshis opinion, larger than an arm'sthis, the-length Mothercare licensee a gwouldreement not provides pay royalties inconclusive on negative sup- revenueport for astreams. volume adjustmentMr. Haigh tookor its the appropriate opposite position,size. urging that "[t]hese sourcesAmazon of revenue’s other are twodirectly largest linked M.com to the clients brand were because Sear [they]s Canada * * and* would Marks not & ariseSpencer. unless The the Sears customer Canada gravitated agreement towards specified the websitea base commission through, in part,rate of the 3%; mak- ingthis availablerate decre ofas ethed t oAmazon 2.5% w brandhen sa lines Europe." exceeded CAD $200 million and decreased again to 2.0% when sales exceeded CAD $500 million. The Marks & Spencer agreement45Because specified Mr. aHaigh base commissiondid not, before rate his of rebuttal3%; this report, rate decrea questionsed to the 2.5% pro- priety of using the 50% declining balance method, the testimony and other evi- dencewhen saleson this exceeded point were £350 limited. million. During his oral testimony Mr. Reilly cited a pub- lication by McKinsey & Co., "Valuation: Measuring and Managing the Value of Companies,"Review for of thethese proposition four agreements that the confirms 50% declining our conclusion balance methodthat Dr. isWills a stan-’ dard valuation technique for moving from revenue projections to long-term growth rates.200-basis-point On the basis downward of the limited adjust mtestimonyent is unwarranted. provided to But us, thewe agreementshave no reason do notto question the appropriateness of employing that method here. - 145102 - yield aWe mathe concludematical that formula Mr. Reilly for calculating correctly aexcluded proper volume these revenues. adjustment. Before Indeed, eachProject agreement Goldcrest could various conceivably intercompany be read agreements to suggest designated a flat commission the European rate at Sub- the sidiariesvery large "commissionaires" sales volumes that for AEHT Amazon was US,expected entitling to generate, them to commissionswhich would basedimply aton best their a netmodest sales. downward The term adjustment. "net sales" was Dr. definedHiginbotham to exclude agreed giftwrap, that a volume shipping, andadjustment miscellaneous would not services be illogical, revenue. while Because offering Amazon no opinion US refused as to what to pay an com-appro- missionspriate adjust on mtheseent wouldtypes ofbe. revenue, Using our we bestconclude judgment that AEHT,as applied operating to the evidence at arm's length,and testimony would likewiseas a whole, refuse we concludeto pay royalties that a 25-basis-pointthereon.46 adjustment is appropriate. A After final application question concerns of that adjustment,the starting wedate conclude for AEHT's that anpayment arm’s-length of royalties roy- altyfor the rate marketing payable by intangibles. AEHT for Asthe forwebsite the website technology technology, made available we find underthat the the startingCSA is 3.05%date for (3.30%-0.25%). payment of royalties is May 1, 2006. By its terms, the Assign- ment Agreement2. conveyingUseful Life the and right Decay to use Curve the marketing intangibles remained

executoryThe untilparties May have 1, 2006,three mainthe "business disputes concerningtransfer date." the usefulAll of petitioner'slife and decay curve: (1) whether the useful life of the website technology should be a relatively short term of years, as petitioner argues, or indefinite, as respondent contends; (2) whether the Court should apply a decay curve to the website technology during its 460ne month after filing his simultaneous answering brief respondent sought leaveuseful to life file and an (ifamended so) what opening the rate brief of decay containing should citations be; and (3)of otherwhether intercompany and how agreements that allegedly defined "net sales" differently. We denied that motion asAE unfairlyHT mus prejudicialt compensa ttoe Apetitioner.mazon U SSee for sec.the r151(e)(3)esearch value (requiring of the websitethat a party's technol- opening brief include citations of "the pages of the transcript or the exhibits or ogyother during sources an reliedensuing upon “tail to” support"period. We each address proposed these finding issues of in fact,turn. thus enabling the opposing party to "set forth any objections, together with the reasons there- for"). We note that exclusion of giftwrap, shipping and miscellaneous service revenues results in a very small adjustment to the revenue base. - 146103 -

experts, and all but a.one ofUseful respondent's Life experts, agreed that May 1, 2006, was the appropriateDr. Wills starting determined date for thatpayment the website of royalties, technology and we m adeshare available their consensus.' to AEHT had a useful life,4. onDiscount average, Rateof six years. In reaching this conclusion, he relied mainlyWe on havethe analyses already ofdetermined petitioner that’s principal an 18% technology discount rate experts, is appropriate Drs. Birman when valuingand Alvisi, the Parkes,website and technology. MacCormack. See supra Dr. Willspp. 124-126. considered We those see no experts reason’ analy- to adoptses reasonable a different in discountlight of his rate experience when valuing pricing the technologymarketing intangibles.intangibles forWe Silicon will brieflyValley clients.address Mr. Haigh's submission that a 13.3% discount rate should be used instead.Drs. Birman and Alvisi adopted a qualitative approach to this problem by consideringIn determining the major histechnological discount rate, improve Mr. Haighments accords (as distinct Amazon from aordinary 1.45 beta, as maintenanceopposed to the and 2.0 routine beta upon extensions) which Mr. that Reilly the website and Dr. technology, Frisch agreed. as it existedThis differ- in

Jenceanua partlyry 200 reflects5, woul dMr. need Haigh's in the usenear of future. weekly They rather identified than monthly eight loomingstock market issues data,that A whichmazon we would have be already required rejected. to address, See supraincluding pp. 124-126. messaging The technology, rest of the scal- differenceing issues, reflectsshopping the cart fact database that Mr. outages, Haigh does and problemsnot compute with the Dynamo, beta for ObidosAmazon itself;and G uinsteadrupa. G heiv usesen th ean m averageagnitud eof o fbetas these derived problems, from Drs. companies Birman andhe regards Alvisi con-as cludedcomparable, that a suchreasonable as eBay, useful Yahoo!, life for Netflix, the website Overstock.com, technology Barnes was three & Noble, to five and

1years.-800-Flowers.

Dr. Parkes conducted a somewhat similar ex ante analysis and a more quantitative'Mr. ex post Haigh analysis. calculated In his his ex buy ante-in analysis, obligation he forexamined the marketing the challenges intangibles (in starting January 1, 2005. He provided no explanation for choosing this date, other than his understanding that his assignment was to value the intangibles as of December 31, 2004. terms of scaling, code complexity, low-quality- 147 - functionality, and other problems)

We reject this approach. As Dr. Unni explains, a valuation expert typically looks to comparable companies to derive a beta when the subject company's stock is thinly traded or not publicly traded at all. That is not the situation here: Ama- zon was a very actively traded stock, with an average daily NASDAQ trading volume of 8.51 million shares during 2004. Because the Bloomberg market data were more than sufficient to compute Amazon's beta directly, as every other expert in this case did, there was no need to consult data concerning other companies.48

5. European Portfolio

Petitioner contends that roughly half the value of the marketing intangibles was owned by the European Subsidiaries before Project Goldcrest. Because the assets to that extent were not owned by Amazon US or transferred to AEHT under the License or Assignment Agreement, petitioner urges that their value should be

excluded from the buy-in payment. Petitioner tasked one of its experts, Mr.

Franklyn, with responsibility for examining the European registration files, ascertaining which domain names and marks were legally owned by the European Sub-

48We think Mr. Haigh also erred, when calculating Amazon's equity risk premium, in rejecting the Ibbotson Associates data upon which all the other experts relied. As we noted in Veritas, 133 T.C. at 325, Ibbotson Associates presents "the recognized industry standard of historical capital markets data." - 148104 - sidiaries,confronting and eight determining major software what percentage components of (Applicationthe overall value Engine; should Catalog; be allocated Mer- tochandising; those assets. Search/Browse; This task was Ordering; complicated Payments/Fraud/Identity; by the fact that certain Pricing; marks (asand ex- Ful- plainedfillment) more as of fully January below) 1, 2005. had been He exaregisteredmined thein Europeinform ationboth bycompiled Amazon by US Am anda- byzon Amazon’s engineers Germany. as of that date to assess their likely expectations as to how long this softwareWe will would refer tolast. the He intangibles determined owned on the by basis the European of this analysis Subsidiaries that a usefuland/or legallylife of two registered to five inyears their could names reasonably as the European have been portfolio. anticipated. Mr. Franklyn determined Forthat his the ex European post analysis, portfolio Dr. consistedParkes evaluated of the following: the degree (1) to whichthe editorial the eight scontentoftware of co themp UK,onen German,ts listed a andbov eFrench were a websites,ctually m odifiedowned respectivelyover time. For by eachAmazon year

UK,after Amazon2005, he Germany,assigned to and each Amazon component France; a rating (2) at ofleast 1, 2,10 3, trademarks or 4, depending registered on bywhether Amazon it remained Germany, essentially including the "Amazon," same as in "Amazon.com," January 2005, hadand source"Amazon code and in

Design"developm (oftenent that called would the replace "Amazon it, had Smile"); been substantially(3) numerous m domainodified, names or had owned been byreplaced Amazon altogether. Germany, On the the most basis important of this numerical of which ratingwas "amazon.de"; system, Dr. Parkesand (4) opinedcertain thatdomain any names“meaningful owned contribution by Amazon” France, of Amazon the most’s January important 2005 of website which was

"amazon.fr."technology had disappeared after six years.

Dr. MacCorma.ack performedOwnership a quantitativeof the European ex post Portfolio analysis that examined actual Respondentchanges to s opresentsurce code. as a He threshold employed question two m whetheretrics--component the European changes Sub- and sidiariesarchitectural should or “ bedependency considered,” changes--to for Federal mincomeeasure taxthe purposes,relative contribution as truly "owning" of the theoriginal European source Portfolio. code (i.e., For source assets code that in are existence legally protected,in January like2005) those for here,each yearthe regulations provide that "[t]he legal owner of a right to exploit an intangible ordi- through 2013. Component changes measured- 149 - the share that the original source narily will be considered the owner." See sec. 1.482-4(f)(3)(ii)(A), Income Tax

Regs.; cf id. subdiv. (ii)(B) (considering developer to be the owner of intangibles that are not legally protected). However, a different ownership agreement may be imputed "if the conduct of the controlled taxpayers indicates the existence in substance of such an agreement." Sec. 1.482-4(f)(3)(ii)(A), Income Tax Regs.; see sec. 1.482-1(d)(3)(ii)(B)(2, Income Tax Regs. (authorizing district director to

"impute a contractual agreement between the controlled taxpayers consistent with the economic substance of the transaction").

Respondent contends that Amazon US was the true equitable owner of any marketing intangibles legally owned by the European Subsidiaries. In respond-

ent's view, Amazon US "made all of the investments and took all of the risks involved in building up the value of any items of IP that were registered in the Euro- pean affiliates' names." Respondent accordingly urges that we should impute an agreement whereby Amazon US held an exclusive license to use any marketing intangibles nominally owned by the European Subsidiaries, or, alternatively, that the European Subsidiaries acted as "agents" of Amazon US in holding title to these assets. See Commissioner v. Bollinger, 485 U.S. 340, 346 (1988); Nat'l

Carbide Corp. v. Commissioner, 336 U.S. 422, 436-437 (1949) (listing six factors as relevant to corporate "agency" determination). - 150105 - code representedWe find neither of operative of respondent's source code arguments at later persuasive.dates. Architectural There clearly changes, exist- an alternativeed valid business measure reasons of software for localizing evolution, ownership captured of the the extent European to which Portfolio “depend- in the enciesEuropean” among Subsidiaries. source files Under changed the laws over of time. Germany On the and basis France of this at the quantitative relevant times,analysis, only Dr. local MacCormack companies concluded could obtain that country a useful-specific life of six domain years namesor less (e.g.,was

Amazon.dereasonable, notingand Amazon.fr). that “a substantial Accordingly, portion Amazon” of the Germanysource code and remaining Amazon Franceafter registeredsix years was for “theirdorm countryant or commoditized.-specific domain”26 names. Amazon Germany registered a numberThe of trademarks,conclusions ofincluding petitioner important’s technology marks experts like "Amazon" were generally and "Ama- consis- zon.com,"tent with the to testienablemony it to of apply its software for international engineers. registrations Brad Porter, in a aDistinguished simplified man- En- nergineer, through explained the "Madrid that Am Protocol."'azon built software At the relevant “very, very times, quickly, Amazon very US quick could and not dodirty this and directly expected because to just the throw United things States away was after not aa couplesignatory of yearsof the and Madrid rebuild. Proto-”

Amazoncol. ’s software development process “leveraged the future.” By building a piece of software quickly, Amazon chose “the expedient path” over “the right path” and built up “technical debt” that inhered in software with a relatively short useful 'Underlife. the Protocol Relating to the Madrid Agreement Concerning the International Registration of Marks (Madrid Protocol), a trademark owner can file a singleAmazon trademark’s website-registration architecture application was undergoing with a single rapid office, change in one as oflanguage, January in one currency, with one set of fees. After filing this original application, the owner 2005.can submit It had an become "international clear that application" Obidos, the listing original additional monolithic countries architecture, in which would a trademark registration will be sought. The initial country's trademark office will confirm that the international application complies with local requirements, then forward26Dr. it to MacCor the Worldmack Intellectual employed Propertya variety Organizationof “robustness (WIPO).” checks Theto confirm WIPO submitshis conclusion, the international including applicationan analysis toof theactual individual changes trademark to Amazon offices’s source of thecode betweencountries 2000 designated and 2005. in the This international ex ante analysis, application. like his The ex designatedpost analysis, countries focused willboth thenon c oexaminemponen tthe ch ainternationalnges and architectural application changes. in accordance Dr. MacCor with theirmack own’s ex pro- ante analysiscedures foryielded national decay trademarks. curves resembling those generated by his ex post data. - 151106 - not lastEqually much longer clearly, given the European the “scaling Subsidiaries” demands usedthat Amazonthese domain faced. names Amazon and marksattemp inted the to sactiveolve these conduct problems of their by business. gradually Before shifting January work off 2005 Obidos the European and mov- ingSubsidiaries to a distributed were service system providers called Gurupa. for Amazon By January US. They 2005 had the numerousmove to Gurupa employ- wasees of well their underway, own who yet were Obidos responsible was not for co mvendorpletely and shut customer down until relationships. August 31,

Because2006. G uofrupa differing was plagued cultural by preferences, latency issues; retail by traditions, 2012 Am azonand national had migrated regula- most tions,of its websitethe details platform of these from operations Gurupa oftento Santana, varied but from it was country still tousing country. Gurupa Local for teamssome applicationswere thus integral as late toas Amazon'sNovember success 2014. Thein Europe. evolution of Amazon’s website architectureAt the thus relevant reveals times, a pattern the European of continuity Subsidiaries amid change: bore significant Elements marketingof Obidos risk.and Gurupa For example, each persisted under an for October nine years 2001 or "Sales more whileCommissionaire Amazon was Agreement," transitioning

Amazonto its new US platform. provided Amazon Germany "with appropriate incentives to perform a key roleThe in softwarecontributing applications to the growth or “services of the ”Website's that Obidos, Customer Gurupa, base" and givenSantana its uniquecalled likewise "ability wentto attract through and retainmajor customerschanges after for Januarythe Website 2005. through The key its servicesunder- standingthat Amazon of German needed culture."to run its Underwebsite--Customer this agreement Master Amazon Service, Germany Order was Master enti- tledService, to a one-timeDynamo, bountyPayments, for eachand Personalization--were new customer, as well all as rewritten commissions and replacedbased on newdurin customerg 2004-2 0sales10. Seeand suprarevenues pp. 38-45.from part The of software its international underlying 3PS these business. individual servicesUnder had athis useful and lifesimilar ranging agreements, from three the to European eight years. Subsidiaries had an actual businessIn sum,risk because the evidence they received clearly establishes only a percentage that Am ofazon revenues.’s website There technology was no guarantydid not have that a they perpetual would or earn “indefinite a profit ”based useful on life, their and marketing we reject efforts. respondent Respond-’s

ent thus errs in asserting that Amazon US "took all of the risk." At the time the contention that it did. Dr. Wills’ estimate- 152 of - a six-year useful life comes close to

European Subsidiaries registered the trademarks and domain names included in the European Portfolio, they bore meaningful business risk.50

The European Subsidiaries also owned and operated the physical infrastructure supporting the European websites. This entailed complete responsibility for the warehouses, inventory, and fulfillment. The ultimate value of the European

Portfolio hinged on the European Subsidiaries' ability to fulfill Amazon's promise

of fast and accurate delivery. Their success in doing so contributed meaningfully to the value of these domain names and marks.

On these facts, we cannot find that the European Subsidiaries were mere

"agents" of Amazon US for the purpose of holding title to the European Portfolio.

conduct of their business. "[T]he mere fact of the parent's control over the subsidiaries * * * [does] not establish the existence of an agency, since such control is typical of all shareholder-corporation relationships." Commissioner v. Bollinger,

"Amazon UK and Amazon Germany bore less business risk after December 31, 2003, when they began to supply services to Amazon US on a cost-plus basis. -153-- 107 -

485the mark, U.S. atbut 346 we (citing think hisNat'l estimate Carbide gives Corp., insufficient 336 U.S. weight at 429-434); to the seepersistence Merck & of

ObidosCo. v. United and Gurupa States, architectural 24 Cl. Ct. 73, elements, 88 (1991) some ("A of parent which corporation survived nine may years create or subsidiariesmore. Using and our determine best judgment which as among applied its to subsidiaries the evidence will and earn testi income.mony as Thea merewhole, power we conclude to determine that A whomazon in a’s controlled website technology--ignoring group will earn income the “cannottail” dis- jus- tifycussed a Section more fully 482 below--hadallocation from on average the entity a useful that actually life of sevenearned years. the income.").

Nor will we "imputeb. Decay a contractual Curve agreement between the controlled taxpay-

ers" toDr. deem Wills Amazon used decay US the curves equitable prepared owner by of Drs. the ParkesEuropean and Portfolio. MacCormack Sec. to

1.482-1(d)(3)(ii)(B)(2),“ramp down,” over the useful Income life Tax of Regs.the website The Europeantechnology, Subsidiaries the royalty used rate thethat domainAEHT would names be and required marks into pay.the active Petitioner conduct contends of their that business; this “ramp they down helped” is developnecessary the to value correlate of these the buy-in intangible payment assets; to andthe valuethey took of the on pre-existing significant intan-market- inggibles. risk. The The website ownership technology structure in didexistence not lack in economicJanuary 2005 substance, gradually and declined there is in thusvalue no as justification major components for departing were modified from the orgeneral replaced, rule and set forthAEHT in paid the regulations.for the replacementSee Claymont technology Invs., Inc., with 90 T.C.M.ongoing (CCH) cost sharing at 467; payments. sec. 1.482-4(f)(3)(ii)(A), We agree that anIn- uncontrolledcome Tax Regs. taxpayer (for legally in AEHT protected’s position property, would "[t]he insist legal that itsowner royalty of a payments right to declineexploit anratably intangible with the ordinarily decline willin value be considered of the original the owner"); technology. sec. 1.482-

1(d)(3)(ii)(B)(2),Respondent Income first contends Tax Regs. that (authorizing no “ramp down district” at alldirector is required, to impute noting a that

“contrary[n]one of agreement the M.co monly ag reemeif "consistentnts had dwithecli ntheing economic royalties bsubstanceased on o ofbs othelescence transaction").of licensed technology.” That observation is correct, but immaterial. All of Ama- zon’s M.com clients received technology- 154 updates - for free; they paid a constant

b. Allocating Value to the European Portfolio

Before 2005 Amazon was growing rapidly and accounted for its trademarks and domain names rather haphazardly. Scott Hayden, petitioner's vice president

of intellectual property, explained that Amazon in its early years did not have a systematic approach to its trademark portfolio and that its documentation revealed systemic errors. He testified that, if he questioned different people about Ama- zon's intangible property on different days, he would often get different answers.

In its tax reporting, Amazon treated the European Portfolio as a distinct group of assets but accorded it a much lower value than urged at trial. A Deloitte report entitled "Project Goldcrest: Transfer of Miscellaneous EU Subsidiary IP" noted that, under the Four-Party Agreement, the European Subsidiaries assigned their interests in the European Portfolio to AEHT for about $2 million. Deloitte determined that this price was reasonable. After discovering a clerical error in these numbers, petitioner increased the valuation of the European Portfolio to about $5 million. Mr. Franklyn, by contrast, opined that the European Portfolio was worth between $136 million and $147 million.

For trial purposes, Mr. Franklyn created two models--the "goods and services" model and the "coexistence" model--to allocate the value of the marketing intangibles between the European Portfolio and the US Portfolio (comprising the - 155108 - trademarksroyalty rate andfor thedomain package names of pre-existingthat Amazon and US subsequently owned). These developed models intan-differed gibles.chiefly inAEHT, how Mr. by contrast,Franklyn did accounted not receive for overlappingtechnology updates and competing for free, claimsbut made that

Amazoncost sharing US paymentsand Amazon by whichGermany it became had to thea co-owner same trademarks. of the subsequently In his "goods devel- and services"oped intangibles. model, Mr. Franklyn attempted to allocate value on the basis of the par- ticularUnless Nice classes AEHT that’s royalty the competing rate were trademark ramped down registrations to reflect covered. decay in51 theIn valuehis

"coexistence"of the original model,technology, he allocated AEHT wouldvalue 50-50be required between to paythe forEuropean the subsequently and the US developedPortfolios inintangibles cases of overlapping twice, once throughcoverage, cost regardless sharing andof registration again through priority an arti- or

Niceficially classifications inflated buy-in claimed. payment. This would violate the cost sharing regulations.

See sec.Under 1.482-7(g), both models, Income Mr. Tax Franklyn Regs. We assigned accordingly the trademarks conclude tohere, one as of we three did tiers,in Veritas depending, that “ anon adjustmenttheir assumed must importance be made to to the Amazon's starting business.royalty rate To to tier account 1 he assignedfor the static Amazon's nature ofthree the most[original] important technology. marks,” "Amazon," Veritas, 133 "Amazon.com," T.C. at 337 (con- and

"Amazoncluding that and royalty Design." rates To “must tier 2be he ramped assigned down the *five * * marks at a rate covering of 33 percent the most per sig- nificantyear” fro Europeanm prior-year domain royalty names. rate). To27 tier 3 he assigned 31 trademarks, the vast majority of which were owned by Amazon US. He deemed the marks assigned to

27In Veritas we derived the royalty rate ramp down from the taxpayer’s “other 51agreementsThe Nice Classification involving static is antechnology, international” 133 system T.C. at recognized 337, rather by than national from trademarkthe source officescode analysis as a means performed of describing by the taxpayer and classifying’s expert, goods which and we services found in trademark“simplistic applications. and mechanical, For” example,id. n.44. teaOn maythis pointbe appropriate the instant for case Nice differs class from 5 as medicinalVeritas in twotea and respects. for Nice None class of 30 the as M.com non-medicinal agreements tea. used By registeringas comparables a mark here pforro vteaide ind fclassor a r30,am pan d oapplicantwn of the may roya forfeitlty rate, any since protection each client that receivedmight be all claimed techno- underlogy updates class 5. for In free. Europe, In the Nice absence classes of have such an evidence, important we practical necessarily impact rely on on the an scopeanalysis of ofprotection the technology. that a trademark And in this affords. case highlyAmazon qualified US and experts Amazon for Germanyeach side performedfiled, at various source times, code overlappinganalyses that and were competing comprehensive, registrations sophisticated, of the same and trade- marksnuanced. under different Nice classes. - 156109 - tier 1 toDr. possess Parkes 75% derived of the a ramp total downtrademark or “decay value,” curvethe marks by applying assigned his to 1/2/3/4tier 2 to possesscoding a 18.8%nalysis of to theeig htotalt ke ytrademark software components.value, and the See marks supra assigned p. 104. to He tier conclud- 3 to possessed that, within6.2% of six the years total of trademark the CSA transfervalue. He date, allocated any “meaningful the value ofcontribution the marks ” withinof Amazon each’ stier pre-existing to the European website or technology the US Portfolio had disappeared. on the basis He of developedgeographic the followingcoverage, trademarkdecay curve: date priority, the existence of competing or overlapping

claims, goods or services covered, and the projected revenuesDecay attributable to the Year (percent) various marks. 2005 100 Under both the "goods and services" and the "coexistence" models, the 2006 76.4 European Portfolio2 0received07 a very modest proportion of the55.3 tier 2 trademark value

(averaging 21%) and200 a8 minuscule proportion of the tier 3 trademark37.5 value (aver- 2009 24.3 aging 3.4%). But Mr. Franklyn allocated to the European Portfolio the bulk of the 2010 10.6 tier 1 trademark value201 1(63.6% and 50.7% under the "goods and2.9 services" and "co-

existence" models,2 respectively).012 Because the tier 1 marks were2.9 weighted so heav- 2013 2.9 ily (at 75%) and the tier 3 marks so lightly (at 6.2%), the European Portfolio ended 2014 2.9 up with 52% and 42% of the aggregate trademark value under Mr. Franklyn's two Dr. MacCormack derived his decay curves by examining changes to source approaches. Those percentages rose to 54% and 47% of the total intangible value code. See supra pp. 104-105. For both of his metrics (component changes and after he accounted for domain names.52 architectural or “dependency” changes), he performed a “relative contribution” analysis.52For The the premise domain of name this allocation,approach can Mr. be Franklyn illustrated calculated by a simple total example. 2005-2012 sales through the various European websites; allocated this revenue between the (continued...) - 157110 -

SupposeRespondent's that 1,000 lines expert of Mr.code Haigh existed pointed in January out that 2005; Mr. that Franklyn 500 of didthose not lines rely stillon any existed recognized in January valuation 2010; authorityand that 1,000 in devising new lines his twoof code methodologies had been written and that in histhe resultsinterim. were Dr. inconsistentMacCormack with would the findconclusions that the that“relative Deloitte contribution had reached” of inthe the reportorigina mentionedl source co dsuprae, as p.of 154.Janu aUsingry 2010, the was trademark 33% (500 and ÷ domain 1,500). values Employing de- this terminedanalysis on by an Deloitte, ex post Mr.basis Haigh to actual estimated code changes that only fro 30%m 2005 of the through overall 2013, value Dr. shouldMacCor bem ackallocated calculated to the the European following Portfolio. decay curves: After adjusting the Deloitte results

certain marks, Mr. Haigh to eliminate what he regarded as doubleComponent-counting of Dependency Year (percent) (percent) opined that at most 25% of the overall value of the marketing intangibles should 2005 100.0 100.0 be allocated to the European Portfolio. 2006 50.2 57.1 We conclude2007 that respondent has32.0 the stronger side of this argument.33.8 Mr.

Franklyn provided2008 no theoretical or technical25.5 support for his "coexistence"28.8 model 2009 19.3 18.8 as a valuation technique. In every case of overlapping trademarks, that model 2010 12.9 14.3 allocated value201 150-50 between the European11.2 and the US Portfolios,10.0 regardless of registration2 priority,012 Nice classifications9.4 claimed, and the relative strength7.9 of the 2013 7.0 5.8 registrants' competing claims. We find this approach to be arbitrary and unreliable.

52(...continued) US and the European Portfolios based on ownership of the domain names; and weighted the trademarks at 75% and the domain names at 25%. - 158111 -

WhileDr. Ma Mr.cCo Franklyn'srmack then "goodsperform anded a services" “robustn emodelss check may” that have examined a firmer codecon- cceptualhanges footing, between we 2000 agree and with 2005 respondent's and applied critique the results of histo 2005-2013.implementation See ofsupra this approach.note 26. This First, yielded it seems decay clear curves to us as that follows: Mr. Franklyn28 overweighted tier 1 and underweighted tier 3. He testified thatComponent he used the "rule of the mean"Dependency to allocate Year (percent) (percent) 75% of the total value to tier 1 and a mere 6.2% to tier 3. Respondent urges, and 2005 100.0 100.0 we agree, that this was little more than a guess and was not based on any recog- 2006 62.8 53.0 nized principles2007 governing valuation of39.4 intellectual property. 28.0

Mr. Franklyn2008 placed in tier 3 a total24.7 of 31 trademarks, the vast14.8 majority of 2009 15.5 7.9 which were owned by Amazon US. Nine of these marks were rated as "signifi- 2010 9.7 4.2 cant" by Deloitte.2011 Mr. Haigh reasonably6.1 concluded that several other2.2 tier 3 marks, including "Amazon.com2012 & Design" and3.8 the "Amazon Smile" logo, were1.2 likewise 2013 2.4 0.6 very important to Amazon's business. It seems clear to us that the tier 3 trade- Dr. Wills examined the decay curves prepared by Drs. Parkes and MacCor- marks accounted for substantially more than 6.2% of the overall value. mack. Reasonably adopting a conservative approach, he accepted for each year We also find that Mr. Franklyn erred in allocating to the European Portfolio more than half the value of the tier 1 marks. Tier 1 comprised petitioner's three 28Dr. MacCormack reasonably decided, for two reasons, not to base his con- mostclusions important solely ontrademarks ex ante data.--"Amazon," First, during "Amazon.com," 2002-2005 A andmazon "Amazon was m andigrating De- from one code repository to another; because of the risk of overlapping or missing sign."files during In his this "goods period, and Dr. services" MacCormack model, believed Mr. Franklyn that ex reasonably post data wereallocated more 95% reliable because that migration had been completed. Second, because Amazon’s softwareof the "Amazon.com" was undergoing mark “significant to the US architecturalPortfolio. But change we think” during he erred 2002-2005, in his owing to the shift from Obidos to Gurupa, Dr. MacCormack found that “there was treatmentno guaran tofee thethat other the pace two andmarks. nature of Amazon’s software evolution observed in years prior to 2005 could be used to project into the future.” - 159112 - the decAmazonay perce USntag ande th aAmazont reveale Germanyd the slowest both rate filed of registrations change from for the the previous "Ama- zon"year. mark. Dr. Wills Amazon accordingly US had derived clear date the priority,following because decay curve:its application29 was filed

was not filed until 2000. Mr. Franklyn in 1996, whereas Amazon Germany's Decay Year (percent) nevertheless allocated 85% of this trademark's value to the European Portfolio; he 2005 100.0 did so because Amazon Germany's application included Nice class 35, which was 2006 76.4 not among the three20 Nice07 classes that Amazon US had claimed55.3 four years previ-

ously. According 2to0 0Mr.8 Franklyn, Nice class 35 covered "online37.5 retail sale of 2009 24.3 physical goods," from which the vast bulk of AEHT's revenues would be derived. 2010 12.9 We find that2 Mr.011 Franklyn overemphasized the importance11.2 of the Nice

classes,A asssu comparedming argu toen dtrademarko that som datee “r apriority,mp dow nand” is that app rheopriate, particularly respondent erred chal-in givinglenges Dr.outsized Wills importance’ decay curve to principallyNice class 35.by disputingIn concluding the methodology that this class that covered Dr. "online retail MacCormack saleused of to physical measure goods," changes he to relied source on code. a definition Whereas of Dr. Nice MacCormack class 35 that appears in the 2012 version of the Nice Classification. That version, repre-

29 senting Dr.the 10thWills edition made twoof the modifications Classification, to the postdates decay curve the registrations shown in the at text.issue by He first adjusted the curve to reflect a “gestation lag” of six months to account for morenew technology than a decade. that may have been partially developed during a prior period. Al- though no other technology expert included a “gestation lag,” he believed that a six-monthIn 1996 lag wasand reasonable2000, when on Amazon the basis US of and his Amazonexperience. Germany In the respectivelyabsence of technical support for a six-month “gestation lag” and any consensus that it is nec- registeredessary, we theirwill notoverlapping adopt this "Amazon" modification. marks, Second, the 7th Dr. edition Wills ofextended the Nice the Classifi- initial period on his chart to end on April 30, 2006, rather than December 31, 2005, to rcationeflect wasthe f inac teffect. that th eIt f madeormer nowa mentions the “business of eCommerce, transfer date. websites,” This or had online the effectsales of reducing the decay percentage for the initial period from 100% to 90.4%. inBecause its description no other ofexpert class m 35,ade which this adjustment, was captioned and "Advertising;because we find business no justifica- manage- tion or need for it, we will not adopt this modification either. - 160113 - ment;emplo ybusinessed a “re ladministration;ative contributi onoffice” approach functions.' in evaluating The eighth changes edition to source of the code,Nice

GeoffClassification Cohen, onewas ofin respondenteffect through’s experts, 2007; itadopted likewise a “doespersistence not mention” approach. eCom- merce,Source websites,code “persistence or online” measuressales in the the class extent 35 todescription. which source code existing in year 1 Amazoncontinues US to inexist, 1996 or registered “persist,” thein subsequent "Amazon" years. mark under Nice classes 9,

37, andThe 42. difference Those classes between covered the “ datarelative processing contribution equipment” and “ persistenceand computers,” ap- scientificproaches manday technologicalbe illustrated byservices, the example and the used design previously. and development Suppose thatof computer 1,000 hardwarelines of code and existed software. in JanuaryThe trial 2005; testimony that 500 established of those linesthat thesestill existed classes in were Jan- uarycommon 2010; selections and that for1,000 early new online lines systems;of code had Amazon's been written business in the was interi coveredm. Dr. by,

MacCoror at leastm ackanalogous would findto, these that theclasses. “relative The contribution seventh edition” of ofthe the original Nice Classifica-source tioncode, states as of thatJanuary services 2010, not was specifically 33% (500 covered ÷ 1,500). by Byany contrast, class should Dr. Cohen be grouped would by

"analogyfind that the with “persistence other comparable” of the services";original source if a service code, ascould of January not otherwise 2010, was be

50%classified, (500 ÷it 1,000).was "in Itprinciple can be seenclassified that the in essentialClass 42." difference Because between Amazon these US se- ap- lectedproaches Nice concerns class 42 the when denominator registering of thethe "Amazon" fraction. trademark in 1996, and becausePredictably, it had four Dr. years Cohen of date’s “ persistencepriority over” analysisAmazon yielded Germany's much overlapping slower rates of decay than the “relative contribution” analyses of petitioner’s experts. Dr.

Cohen determined, for example, that more than half of Amazon’s source code in develop53mClassent or35 deployed at the time in didJanuary include 2005 "the was bringing still deployed together, in forJanuary the benefit 2013, andof others, of a variety of goods (excluding the transport thereof), enabling customers tothat conveniently 36% of the dependenciesview and purchase that Dr. those MacCormack goods." Jorge identified Luis Contreras, as of January one 2005of respondent's experts, credibly testified that this language was interpreted to refer to "swap shops" and "flea markets" and that class 35 at the time "specifically exclude[d] the actual sale of the goods." still existed in January 2013. - 161 - mark, we find that most or all of the value of the "Amazon" mark should be allo-

cated to the US Portfolio.'

The third trademark that Mr. Franklyn put in tier 1 is "Amazon and Design."

Amazon US and Amazon Germany filed European registration applications for this mark on the same day and under the same four Nice classes. Whereas Mr.

Franklyn allocated 100% of the value of this mark to the European Portfolio, respondent's experts persuaded us that Amazon US and Amazon Germany both had very plausible claims. If we were to make an estimate under the Cohan rule, see

Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930), we would allocate the value of this mark roughly equally between the European and the US Port-

folios.

54In his "coexistence" model, Mr. Franklyn rationalized allocating to the European Portfolio half the value of numerous trademarks, including the "Ama- zon" mark, under principles of "acquiescence." Under that doctrine, a trademark holder (such as Amazon US) can be divested of its trademark protection if it does not challenge an overlapping mark (such as that registered by Amazon Germany) within five years. Mr. Franklyn offered no authority to support the proposition that "acquiescence" would apply with full force inside a corporate group or that a parent corporation could be divested of trademark protection by an action taken by its subsidiary. In any event, even if "acquiescence" applied to the same corporate group, Amazon Germany did not register its "Amazon" mark until mid-2000, and the valuation here is being performed as of January 1, 2005, less than five years later. On January 1, 2005, Amazon US (or a hypothetical third party that had acquired the trademark from Amazon US) could still have challenged Amazon Germany's mark and potentially excluded Amazon Germany from using it. - 162114 -

InWe sum, reject we Dr. conclude Cohen’ thats “persistence Mr. Franklyn” approach made several for the errorssame reasonthat caused that we him toha voverstatee rejecte dsignificantly other aspects the of value respondent of the’ Europeans valuation: Portfolio. It fails toHe eliminate substantially from the undervaluedbuy-in paym entthe thetier value 3 marks, of subsequently which were owneddeveloped overwhelmingly intangibles. Inby terms Amazon of lines US, andof code, he significantly Amazon’s code over base-allocated grew toby theabout European 400% from Portfolio January the 2005value toof January the tier 1 marks.2011, representing Moreover, therean annual is no growth technical rate or between evidentiary 23% support and 28%. for theNew code and n75%/18.8%/6.2%ew technologies aweightingccounted fheor accorded93% of the the code three base tiers. by 2012,Given and these AEHT errors, paid we for thisfind newthat technologythe best evidence through available cost sharing is Mr. payments. Haigh's opinion: In determining On the thebasis extent of his to adjustmentswhich the January to Deloitte's 2005 technology findings, he had determined decayed in that value, 25% the of relevantthe overall question value isof the marketingextent to which intangibles that original should technology be allocated contributed to the European to the “Portfolio.stock” of55 tech- We accordinglynology required conclude to operate that thisAEHT 25%’s portionwebsites must in each be excluded subsequent from year. the value of the marketingPetitioner intangibles,’s experts as otherwiseanswer that determined question correctly,under this under Opinion, their when “relative comput- ingcontribution the appropriate” analysis, buy by-in usingpayment. as the denominator of each fraction the code base existing in eachC. subsequentCustomer year. Information By using as the denominator of each fraction the historicalThe code customer base existinginformation in January that Amazon 2005, respondent US made available’s “persistence to AEHT” approach con- sistedsubstantially of data understates about European the true retail rate customers of decay andwho in had effect transacted requires with AEHT the Euro-to pay for the subsequently developed intangibles twice, once via cost sharing and again 55We have neither the data nor the ability to perform a precise "correction" throughof Mr. Franklyn's an artificially "goods inflated and services"buy-in payment. model to This eliminate violates the the errors cost discussedsharing reg- in the text and other errors of which respondent complains. However, if the bulk of theulations. tier 1 trademarkSee sec. 1.482-7(g), value were Income allocated Tax to Regs. the US Portfolio as we think necessary, and if the tier 3 trademarks were given an appropriate heavier weighting (say 20% instead of 6.2%), we suspect that reasonable permutations of Mr. Franklyn's model would gravitate toward Mr. Haigh's 25% conclusion. - 163115 - pean SubsidiariesRespondent beforeraises aMay second 1, 2006. challenge These to data petitioner included’s decay names, curve, email which address- againes, phone focuses numbers, on the credit deno mcardinator information, of the frac andtion. purchasing Dr. MacCormack history. includedBy making in thishis d informationenominators available every line to of AEHT, source Amazon code existing US in oneffect the relevantwas referring date, itsincluding exist- ingfiles European that may customershave been togenerated AEHT andautomatically furnishing byit witha computer certain (suchinformation as “XML, about” them.“arff,” and other file extensions). Dr. MacCormack’s denominators also included files relatingThe parties principally agree thatto presentation the Associates of webpage and Syndicated content Stores(such asagreements “html” and between“xsl”). Amazon and its business partners provide useful internal CUTs for purposes

of determiningDr. Cohen the opined fair market that the value lines of of the code customer thus produced information. should Under be eliminated those agreements,from the deno Amazonminator. paid A single referral co fees,mputer-generated in the form of file "commissions," can have tens toof athou- third partysands whenof lines, the m latter'sany of customerswhich contain or website only data visitors as opposed made purchases to meaningful from instruc- Ama- zon.tions. While In Dr. concurring Cohen’s view, that theseit is inappropriate agreements supply to equate useful these data lines for of valuing code, forthe mcustomereasurem information,ent purposes ,the to lpartiesines of disagreecode wri abouttten by the a programmer mechanics of or the software valuation engineer.exercise. Dr. Cohen noted that code written to generate presentation content concerns the “lookAmazon and feel had” ofthousands the website of Associates as opposed agreements to its functional and more operation. than 20 Because Syn- dicatedthese lines Stores of code agreements are typically with U.S.written and by European “painters partners.” rather than The “ statedplumbers, commis-” he sionopined rates that under they bothshould programs likewise depended be excluded on productfrom the mix denominators. and sales volumes.

CommissionWe agree rates with generally Dr. Cohen ranged on bothfrom counts. 4% to 8% On in the the basis Associates of his critique, program Dr. and

Cohenfrom 4% recalculated to 6% in the Dr. Syndicated MacCormack Stores’s “ relativeprogram. contribution Referral fees” percentages for Syndicated by

Stores partners generally had a per-unit cap; this meant that the effective commis- - 164116 - sionelim iratenati ncouldg fro mbe t hlowere den thanomin theator nominals the lines rate of reflectedcode described in the contract.above. This The gen- aver- ageerated referral modified fee Amazonversions actuallyof Dr. MacCor paid undermack the’s decay Associates curves, and as Syndicated follows: Stores programs was approximately 5.9%MacCormack of referred’s original sales. Modified component component Dr. Higinbotham Year examined two(percent Syndicated) Stores agreements(percent and) based his valuation principally2005 on Amazon's contract100.0 with Waterstone's, a U.K.100.0 retailer. He 2006 50.2 65.5 explained that he focused on that contract because Waterstone's did business sole- 2007 32.0 45.4 ly in an EU member state. He did not elaborate on the significance of this distinc- 2008 25.5 36.5 tion or explain200 9why it justified limiting 19.3his focus largely to this one29.2 contract.

The Waterstone's2010 agreement provided12.9 for commissions ranging26.2 from 5% to 2011 11.2 17.7 6% of referred sales. It also included a feature unique among the Syndicated 2012 9.4 14.3 Stores contracts:2013 a one-time bounty of £77.0 for customers who clicked11.6 on a link

embedded in certain promotional emails and subsequently made a purchase on an In sum, we agree with petitioner that the royalty rate for the website tech- Amazon site. Dr. Higinbotham determined that people arriving at Amazon nology must be ramped down over its seven-year useful life on a decay curve. We through a mirror site typically converted to direct Amazon customers within 90 also agree with Dr. Wills in accepting for each year, from among the decay curves days. He accordingly valued the customer information as the sum of: (1) a £7 the experts have supplied, the decay percentage that reveals the slowest rate of bounty for each European customer that Amazon U.S. transferred to AEHT on change from the previous year. However, we will substitute for Dr. MacCor- May 1, 2006, and (2) a 6% commission computed on AEHT's total sales during mack’s original decay curves the modified curves, set forth in the previous para- the 90 days immediately following the May 1, 2006, business transfer. He thus graph, reflecting Dr. Cohen’s critique. Applying Dr. Wills’ approach to the derived a value of $214.5 million for the customer information. - 165117 - availabAtle trialdeca yDr. cu Higinbothamrves as thus m agreedodified that, we the calculate, Waterstone's for the contract seven-year was useful atypical andlife ofthat the Dr. website Wills' technology, analysis, which ramped-down considered royalty all the rates Associates as follows: and Syndicated

Stores agreements, was more robustD thanecay his curve own. We agree onR bothoyalty counts. rate In Year (percent) (percent) his post-trial briefs respondent abandoned his reliance on Dr. Higinbotham's ap- 2005 100 3.05 proach and instead proposed modifications to Dr. Wills' valuation methodology, 2006 76.4 2.33 to which we2 0now07 turn. 55.3 1.69

Dr. Wills'2008 first step was to determine37.5 an arm's-length referral1.14 fee. For this 2009 29.2 0.89 he used the weighted average of the actual commission rates paid under all Asso- 2010 26.2 0.80 ciates and Syndicated2011 Stores agreements17.756 in place for the European0.54 Subsidiaries during 2004-2006. c.(By using“Tail actual” Period rates he accounted for cases where fee caps or similarDr. provisions Wills recognized caused variance that Am fromazon ’thes website nominal technology rate.) He retainedthus determined value an averagefollowing referral the useful-life fee equal period to 5.9% he ofposited. referred Indeed, sales. asRespondent shown in the agrees table that above, this reflectsthe technology an accurate had non-trivialinterpretation value of leftthe relevantat year-e data.nd 2011. Dr. Wills accounted for thisDr. va lWills'ue by anextddin stepg to twashe useful-life to estimate period the revenue a “tail” stream of three to and which a half this years, 5.9% referralduring which fee should AEHT apply. was toIn pay approaching a flat annual this royalty question, of 0.2%.he noted We that agree Amazon that a would“tail” period pay a commissionis appropriate, to butan Associate we find that only it shouldif the customer bear a higher arrived royalty directly rate. from the Associate'sDr. Wills siteexplained and made that a he purchase added “ withina tail royalty 24 hours. to reflect Amazon the continuedwas willing to presence of some base of source code over an extended period of time” and to 56Unless otherwise specified, subsequent references to the Associates program also include the Syndicated Stores program. reflect the fact “that even ‘commoditized- 166’ code - may have some value.” In re- pay a large commission on this initial purchase because it was confident that the purchaser would soon become a direct Amazon customer, on whose future pur-

chases no commissions would be due. Dr. Wills accordingly concluded that

AEHT, operating at arm's length, would not pay referral fees to Amazon US on revenues derived from the initially referred European customers once those individuals had "converted" to AEHT customers and purchased items by coming directly to AEHT's sites. Dr. Higinbotham agreed with this proposition.

To ascertain the "conversion" rate, Dr. Wills relied on analyses performed by Dr. Moe and Mr. Wentland. Using Associates program data from January 2004 through April 2006, Dr. Moe analyzed subsequent spending by European customers who had originally arrived at an Amazon website via referral. To the

extent these customers made future purchases by coming to an Amazon site directly, rather than by referral from a partner's site, she deemed them to have

"converted."

Her analysis shows a very rapid rate of conversion, with 83.5% of referred

customers becoming direct Amazon customers within one year. After eight years,

only 10% of customers who had initially been referred from a partner's site continued to return to Amazon by referral, thus generating additional referral fees. - 167118 -

Thesespondent additional’s view, fees,Dr. Wills while’ “lesstail” numerous, does not capture tended theto be full more residual lucrative value because of Ama- thesezon’s customerstechnology spent because above he-average focused onlyamounts on the on continuedeach Amazon presence shopping of source trip. code. Dr.As respondentWills concluded notes, that AEHT the wasfuture required revenue to stream pay for on the which value AEHT of intangible would haveproperty to pay made referral available fees toequaled it “for the purposes sum of: of (1)research the initial in the purchases intangible that develop- the re- mentferred area. European” Sec. customers 1.482-7(g)(2), made Income from AEHT Tax Regs. and (2) Respondent subsequent urges purchases that A thosema- individualszon’s website would technology make from had AEHTvalue for upon research referral purposes from a thatmirror Dr. site Wills rather did thannot as

"converted"factor into his AEHT analysis. customers. Dr. Moe's analysis provided an estimate of the medianWe and agree average with amounts respondent that to customers some extent. would Dr. spend, Cohen per’s testimony,visit to AEHT's coupled sites,with that during of A themazon 10-year’s software period followingengineers, the established business thattransfer. Amazon Dr. practicedWills used the median(among amountsother things) in his “ conceptanalysis reuse, and concluded” “partitioning, that AEHT,” and “ refactoringoperating at” whenarm's de- length,velopin wouldg subs eagreequen tto it erapayti oreferralns of i tfeess we bonlysite fortec hsixno lyears.ogy. “Concept reuse” refers to the practiceCombining of reusing the customer ideas, algorithms,retention and and conversion ways of working. analyses with“Partitioning, the median” whichestimated splits spending a centralized per customer, software Dr. system Wills into calculated units of thework revenue or storage, that AEHT and “re- wouldfactoring, derive” which from restructures customers inheritedprior software, from Amazonsee supra US note who 9, weremay alsoexpected entail to arrivereuse ofat priorAEHT's solutions websites and by concepts. referral duringColloquially the six speaking, years following Amazon the’s oldbusiness tech- transfer.nology gave Multiplying it a “head the start estimated” or “leg annualup” in developingcustomer spending new technology. by the 5.9% referral

fee andOn discounting the other hand, this revenue the evidence stream established at 18%, he that opined Amazon that thereused arms earlier-length code buyto a -inlim paymentited degr foree, theprioritizing customer speed information of innovation was $51.9 over million. software reuse. Its engineers would often start over, more or less- 168 from - scratch, when building new archi-

Respondent challenges Dr. Wills' $51.9 million valuation on several grounds, the first of which concerns the cutoff date for paying referral fees. Dr.

Wills acknowledged that there was a long "tail" of unconverted customers in the

Associates program; indeed, 10% of customers initially referred from a partner's site continued to return to Amazon by referral eight years later. Dr. Wills admitted that there was no obvious "bright line" dictating when referral fees should stop.

Although he had data from the Associates program going out 10 years, he opined that a term of 6 years would be generous.

We agree with respondent that Dr. Wills' selection of a truncated six-year period was arbitrary. Although he assumed that AEHT would refuse to pay for the long "tail" of customer referrals, Amazon did just that in its Associates program.

There is no evidence that Amazon placed any cap on the length of time it was willing to pay commissions on purchases by customers who came to its websites by referral, even if those customers had previously purchased from Amazon directly. Since Dr. Wills had reliable data for 10 years, we conclude that the buy-in payment should reflect referral fees for that entire period. Dr. Wills performed this calculation and determined that the buy-in payment (holding all other aspects

of his computation constant) would rise to $66.3 million if a 10-year cutoff were used. - 169119 - tectureSecond, or services. respondent This was contends attributable that Dr. in partWills to understated Amazon’s high the revenueturnover stream rates:

Laterfor computing hired engineers referral often fees byfound using their the predecessors median rather’ coding the average difficult amounts to underthat standcustomers and preferre were expectedd a fresh to start. spend per visit. Dr. Moe's analysis showed that a small subsetThe switch of customers to new software was responsible languages for posed a disproportionate another impediment dollar amountto reusing of sales.old code. Thus During the average the transition spending from per Obidos customer to Gurupa,was significantly Amazon abandonedhigher than the mediancatsubst spending (an arcane per programming customer.' language it created) and shifted to Perl/Mason for buildingDr. Wills webpages. testified A thatmazon using could the medianreuse very was little appropriate of the Obidos because software using the averagewhen it mwouldoved likelyto Gurupa. overestimate Amazon future subsequently customer abandoned spending. Perl/Mason,Extrapolating a customer“dying spending” language out unfamiliar a decade toresulted the next in generationa subset of ofcustomers programmers; with very again high much spending.pre-existing Dr. source Wills code reasoned was discarded. that customers This wouldtendency not applied increase not their only spending to coding yearbut also after to year concepts: indefinitely, Many andconcepts he used that Dr. underlay Moe's medianthe monolithic figures Obidosto reduce archi- the impacttecture wereof outliers inapplicable caused toby a the distributed extrapolation. system.

ManyRespondent's aspects ofexpert Amazon Dr. Wilcox’s technology, opined mthatoreover, use of were average completely spending novel was moreand could appropriate. not rely extensivelyHe noted that on retailers pre-existing often concepts expect to or earn ways a significantof working. portion

Kindle,of their profitsFire TV, from Fire a smartphones,small subset ofcloud their computing, customers. and A desirecloud storageto reduce were the cre-im- ated and marketed after Project Goldcrest was completed. The revenue base on which AEHT was to pay royalties included projected revenues from these new inventions.57A simplified There is noexample indication may thatillustrate these thisnew difference. inventions reliedAssume on that old 1,000source customers are referred to Amazon's website from mirror sites, with 900 making purchases of $20 and 100 making purchases of $100. The median spending per customer would be $20, but the average spending would be $28. code or prior ideas or (if they did) that -such 170 reliance- was significant. pact of high-spending customers, he opined, was not a sufficient justification for rejecting the use of average data.

We agree with Dr. Wilcox. High-spending customers are the customers a retailer most desires to have. We see no reason why AEHT, operating at arm's length, would insist on paying referral fees calculated to exclude these customers.

Petitioner did not show that high-spending customers tend to "convert" to direct

Amazon customers at a different rate from low-spending customers. Nor did petitioner offer any other persuasive reason for minimizing their impact on projected

future revenue streams. Dr. Wills may be right that extrapolating customer spending out 10 years ultimately yields very high spending by the biggest hitters. But we do not find it illogical to assume that these fortunate individuals will keep spending more money each year. In any event, discounting out-year spending at

18% will tend to mitigate the effect of any distortion.

In his rebuttal report Dr. Wilcox revised Dr. Wills' calculations by using average spending levels and a 10-year cutoff for payment of referral fees. He thus derived a value of $129 million for the customer information. We find this to be the arm's-length buy-in payment for this group of intangibles.

Respondent contends that Dr. Wills' approach, even if modified as we have done above, does not capture the full value of Amazon's customer information. - 171120 -

ForrestWe Oswald, thus confront one of respondent's a dilemma similar experts, to othersopined we that face Dr. in Wills this erredcase. byRe- valu- ingspondent solely plausibly the customer contends referral, that rather the “tail than” proposed the complete by Dr. universe Wills m ofay customer not capture data

(includingthe full residual purchase value history, of the websiteaddresses, technology and credit transferred card information) under the that CSA. Amazon But

USrespondent made available’s alternative to AEHT. is to insistMr. Oswaldthat the opinedtechnology that thehas lattera perpetual information useful wouldlife; weenable have AEHT rejected to providethat argument, a more andstreamlined respondent and’s personalized experts have usernot offeredexperience, a coherenteven after formula the referred for calculating customers a had revised become “tail regular” period. AEHT That customers. being so, we will accept Whileas appropriate Mr. Oswald the 3-1/2-yearis correct that “tail Amazon's” period proposed customer by information Dr. Wills. had uses apart fromWe conclude, customer however,referral, the that trial the established 0.20% royalty that proposed this value by had Dr. a Willsvery short for life.this “Amazontail” period US is used too low.customer He chose information that rate to by power “stepping its "Similarities" down” from and the "Rec-

0.27%ommendations" rate that he software, used for as the well final as yearto improve of the technologythe customer’s usefulexperience life. Wethrough have determinedone-click shopping that the andappropriate email marketing. royalty rate But for Amazon the final itself year regardedof the technology this histori-’s usefulcal data life as ishaving 0.54%, limited or twice utility; as high. stored See addresses supra p. and117. credit We accordinglycard information find that rapidlythe roya becomelty rate foutdated,or the “ta iandl” p customers'eriod shoul dbuying be twice habits as h changeigh as t significantlyhat proposed overby time.Dr. Wills, For itsor 0.40%.Similarities We concludesoftware, that Amazon this higher uses only royalty relatively rate, paid recent throughout data be- the

3-1/2-yearcause it regards “tail” older period data co masmencing having littleJanuary or no 1, value.2012, willIndeed, adequately older data compensate may haveAmazon negative US not value only because for the continuedthey yield presenceirrelevant of or source inappropriate code but recommen- also for the dations.research value of its original technology.30

Dr. Wilcox offered a different critique of Dr. Wills' approach by emphasiz- 30Respondent’s expert James Conley argues that petitioner’s valuation of the ingwebsite the strength technology of Amazon's does not capture brand. theThe full customer value of information Amazon’s thatpatents. Amazon The UStrial (continued...) - 172121 - made available3. to AEHTRevenue concerned Base individuals who had previously purchased

from Amazon.While relying These on customers management presumably projections had in a favorabledetermining opinion AEHT of’s Amazon; revenue arguably,base for 2005-2011, this "brand the loyalty" experts would disagree predispose about the them proper to keep revenue patronizing base for AEHT. calcu-

Dr.lating Wilcox royalties urged thereafter. that the customers Dr. Wills usedthus referreda “50% decliningwere more balance valuable” method than the to estimatecustomers AEHT referred’s post-2011 to Amazon revenues. through31 the Dr. Associates Higinbotham and projectedSyndicated m uchStores higher programs,post-2011 some revenues, of whom relying may never chiefly have on avisited draft spreadsheetan Amazon thatsite previously.an Amazon employee Wecrea concludeted in December that Dr. 2005Wills' to overall estimate analysis future adequately“goodwill impair accountsment for” for the strengthfinancial of reporting Amazon's purposes. brand. AlthoughDr. Higinbotham he looked also to relied the Associates on a report and prepared Syndicat- in

Octobered Stores 2013 agreements by a third-party to derive investment an arm's-length analyst. commission Using these rate, sources he used Dr. Ama- zon's experience to estimate customers' future spending. Those spending levels presumably reflect the value of Amazon's brand.

As discussed previously, customers' willingness to return to Amazon's websites depended30(...continued) chiefly on their satisfaction with Amazon's execution of the "three established that the value of Amazon’s patents was fairly inconsequential. In any pillars,"event, AEHT not on would their beimpression required ofto Amazon'scompensate "brand." Amazon See US supraonly forp. 12.European Dr. Wills' patents; the vast bulk of Amazon’s patents were issued in the United States and methodology,would have lit tinle whichor no v Dr.alu eHiginbotham in Europe. Scott ultimately Hayden concurred, credibly reasonablytestified that cap- it was much more difficult for Amazon to obtain patents for its inventions in Europe. turesGiven the these arm's facts,-length we find value that of thethe Europeancustomer patentreferrals portfolio that Amazon had a relativelyUS made lowto value and that the useful life of the technology plus the “tail” period adequately AEHT.captures Wethe concludevalue of this that portfolio. any value associated with the customer information in

31 excess ofUnder the value a “50% of customerdeclining referralbalance was” method, short-lived the growth and immaterial rate is reduced or was by 50% each year until it reaches a “stable” growth rate. Dr. Wills and Mr. Reilly adequatelyselected 4% accounted as AEHT ’fors stable in Dr. growth Wills' rate,valuation based of on the predicted marketing long-term intangibles growth and and inflation projections for the eurozone. - 173122 - websiteHiginbo ttechnology,ham project eond twhichhat AE theHT strength’s post-2011 of Amazon's revenues brand would was grow based. at a rateWe up accordinglyto three times find faster that than Dr. projectedWills' approach, by Dr. Wills.as modified32 in the two respects dis-

cussedWe above, find yieldsseveral an flaws appropriate in Dr. Higinbotham arm's-length’ sbuy approach.-in payment The of“goodwill $129 million im- pairmentfor the customer” model information.on which he relied was developed by a new employee in Ama- zonW. ’s accountingCost Sharing department. Payments This employee testified that he was then in his orientationWhere period; parties that have he enteredwas given into the a QCSA,prior year they’s mshareodel theand cost told of to developing “mark it intangibleup”; and that property. he spent A his participant's first few weeks "costs at of A mdevelopingazon learning intangibles how the * model * * mean allworked of the by costs plugging incurred in different * * * related variables. to the Thereintangible is no development indication that area." this spread-Sec.

1.482-7(d)(1),sheet presented Income reliable Tax projections Regs. "Costs of Amazon incurred’s future related revenue. to the intangible Moreover, devel- both theopment “goodwill area" generallyimpairment consist” spreadsheet of operating (prepared expenses in December (other than 2005) depreciation and the third- or amortizationparty investment expense), report plus(prepared charges in forOctober use of 2013) certain post-dated tangible theproperty. CSA t rIbid.ansfe r"If on aJa particularnuary 1, 2 cost005. contributes Dr. Higinbotha to them ’intangibles projections development would have area been and m otherore reliable areas or hadother he business relied on activities, ex ante sources, the cost asmust Dr. be Wills allocated did. between the intangible devel-

opmentThe area growth and the rates other assu areasmed or by business Dr. Higinbotham activities wereon a reasonableoutliers even basis." among Ibid. re- spondeOncent’s e thexpe totalrts. D poolr. F rofisc IDCsh and isMr. determined, Haigh (in thesehis opening costs must report) be allocatedassumed thatto

AEHTeach QCSA’s post-2011 participant revenues "based would on factors grow atthat annual can reasonably rates between be expected 3.8% and to 4%; re-

flect that participant's share of anticipated benefits." Id. paras. (b)(2), (f)(1). In

32 the CSA,Dr. Amazon Higinbotham US and assu AEHTmed usedthat AEHTa revenue’s revenues-based formula would growto determine at an annual their rate of 22.5% during 2010-2015, 17.5% during 2016-2020, and 8% during 2021- respective2030. After benefit 2030 shares.he adopted That a terminalformula isgrowth not in rate dispute. of 3.4% based on predicted long-term growth and inflation projections for the eurozone. - 174123 -

Dr. HiginbothaWhat is inm disputeassumed is that the AEHTtotal volume’s post-2011 of IDCs revenues that Amazon would US grow incurred; at annual the largerrates ranging the volume, from thea high larger of 22.5%the cost to sharing a low of payments 8%. We thataccordingly AEHT must reject make. Dr.

TheHiginbotham parties refer’s approach to this issue and acceptas the "cost the post-2011 pool" issue. revenues For this determined issue, as byfor Dr. the issuesWills. discussed previously, we will uphold respondent's determination unless pe- titionerA shows final question it to be arbitrary, concerns capricious,the starting ordate unreasonable. for AEHT’s Seagateroyalty payments. Tech., 102

T.C.The CSAat 164; was Sundstrand effective as Corp., of January 96 T.C. 1, at2005, 353. and AEHT made cost sharing payments A.starting Respondent's as of that date. Position But the “business transfer” did not occur until May

1, 2006,Petitioner and AEHT tracked earned expenses no gross in revenuessix high-level (attributable cost centers: to Am azon(1) Cost’s website of Sales,

(2)business Fulfillment, or otherwise) (3) Marketing, before that (4) date.Technology33 Dr. Wills and notedContent that (T&C), May 1, (5) 2006, General was andthe dateAdministrative on which AEHT (G&A), became and (6) the Other. “economic The parties principal agree” for that the none European of the m costsar- accumulatedket and “commenced in the "Cost use ofof theSales" intangibles and "Other" for its categories own account. are allocable” He accordingly to IDCs. oRespondentpined that M acceptsay 1, 2 petitioner's006, was the formula appropriate-based starting allocation date tofor IDCs payment of costs of royalties accu- mulatedfor the website in the "Fulfillment"technology. Dr. and Frisch "Marketing" reached categories, the same conclusion and he accepts in his petition- DCF analysis.er's decision to allocate G&A costs to IDCs on the basis of the IDC outcomes for the otherWe five concur categories. in the consensus that these two experts reached. Indeed, no expert Thefor eitherparties' side dispute opined focuses that AEHT on the should T&C becategory. required In to the pay notice royalties of defi- for the

ciency respondent determined that 100% of the costs accumulated in T&C cost

33 centers constituteTo enable IDCs.AEHT Petitionerto make it schallenges required c othisst sharing determination, payments contending before May that 1, 2006, Amazon US made capital contributions to AEHT through a series of trans- theseactions costs involving are "mixed cash andcosts," preferre that is,d stock. costs that Respondent "contribute[] has not to thechallenged intangible any of those transactions. - 175124 - developmentwebsite techn oarealog yand for other any p areaseriod orbefore other May business 1, 2006. activities." Because See an unrelatedsec. 1.482- third party7(d)(1), would Income not payTax royaltiesRegs. According until it actually to petitioner, began earningtherefore, income the regulations from the requireEuropean that website T&C categorybusiness, costs, the starting like Fulfillment date for payment and Marketing of royalties costs, is "beMay al- 1, located2006. between the intangible development area and the other areas or business activities on 4a .reasonableDiscount basis." Rate Ibid.

InThe May discount 2014 petitionerrate is used filed to convert a motion future for partial incom esummary streams--here, judgment AEHT on this’s issue.projected See royalty Amazon.Com, payments--into Inc. & Subs.a lump-sum v. Commissioner, present value. T.C. Dr. Memo. Wills 2014-149,adopted the

108discount T.C.M. rate (CCH) calculated 87. Weby Mr. denied Reilly, that another motion, of finding petitioner material’s experts. facts inMr. dispute Reilly, at thatapplying time. the Specifically, capital asset we pricing ruled that,model "[u]ntil (CAPM), petitioner34 opined establishes that an 18% that discount the T&C ratecategory properly contains corresponded a nontrivial to Amazonamount ’ofs weighted'mixed' costs, average we costcannot of capitalrule as to whether(WACC). respondent35 abused his discretion in determining that 100% of T&C category costsDr. Higinbothaconstitute IDCs."m also used108 theT.C.M. CAPM (CCH) to determine at 88. his WACC, but he selected The14% evidence as the ap atpr otrialpria establishedte discount rate.that T&C He differed cost centers from doMr. indeed Reilly contain chiefly in

"mixedhow he determinedcosts." Employees Amazon whose’s “beta, time” a waskey elementcaptured in in the T&C CAPM cost centerscalculus. engaged in substantial non-IDC activities, such as helping vendors list their products on 34CAPM is a standard and widely used method to determine a company’s Amazon'scost of equity websites, capital. making Under minor the CAPM adjustments the expected to how rate website of return content for ais dis- company’s equity is generally the risk-free rate of return plus the product of beta played,and an equity and managing risk premium. third-party digital content that is viewed on or downloaded

35 from Amazon.com.In Veritas, 133 Some T.C. employees at 324 n.33, whose we explained: time was captured “The WACC in T&C provides cost cen- the expected rate of return for a company on the basis of the average portion of debt tersand negotiatedequity in the contracts company with’s capital vendors structure, and documented the current routine required activities return onfor equity them; (i.e., cost of equity), and the company’s cost of debt.” - 176125 -

“otherBeta ”employees measures werethe volatility responsible (and for hence Sarbanes-Oxley riskiness) of compliance.a security in comparisonPetitioner's to theSEC market Form 10-Kas a whole. notes that Both T&C experts category used stockcosts includedmarket data costs compiled involved by in Bloom-

"merchandisingberg for 2000-2004 selection, to calculate category Amazon expansion’s beta. and But buying, whereas and Mr. ordering Reilly products."used

Thesemonthly activities, data, Dr. when Higinbotham conducted used by brickweekly-and data.-mortar Using stores, monthly are not data, likely Mr. toReilly calculatedcreate intangible a beta ofproperty. 2.00; using weekly data, Dr. Higinbotham calculated a beta of

1.55. Both parties' experts recognized that T&C category costs include mixed

costs. PetitionerRoman Weil, contends, one of with petitioner's strong support experts, from reached its experts, this conclusion that monthly on the data basismore ofacc interviewsurately measure with Amazon Amazon employees.’s volatility comparedDr. Higinbotham, to the overall one of m respond-arket. Ac- cordingent's experts, to Dr. agreed Unni: that“While substantial weekly non-IDCsmeasurements were of accumulated returns provide in the more T&C data cost pcenters,oints, it and skews he usedthe measurement a modified version of Amazon of petitioner's’s beta downwards cost-allocation because method serial cor- whenrelations determining in stock returns, his buy which-in payment distort for the the measurement website technology. of beta, are Indeed, pronounced Dr.

Higinbothamwhen the returns agreed interval that, is if as he short were as to atreat week, 100% but areof T&C substantially costs as lessIDCs evident as determinedwith a returns in the interval notice of deficiency,a month.” Leading AEHT's finance future costtextbooks sharing and payments important would bescholarly so large articles as to produce use five ayears negative of monthly buy-in paymentstock market under data his to income calculate method a com- analysis.pany’s beta. 36 Major providers of financial information (such as Ibbotson and

Notwithstanding his expert's conclusions and trial testimony, respondent 36See Fischer Black, Michael C. Jensen & Myron Scholes, The Capital Asset arguesPricing thatMo dpetitionerel: Some cannotEmpirical use Tests,an allocation in Studies methodology in the Theory until of it Capital first estab- Markets 85-87 (Jensen ed. 1972); Zvi Bodie, Alan J. Marcus & Alex Kane, Investments lishes,258 (9th on ed. a cost 2011);-by -costRichard basis, A. whichBrealey particular & Stewart costs C. Myers,relate only Principles partially of to in- Corporate Finance 217 (10th ed. 2011); Eugene F. Fama & James D. MacBeth, tangible“Risk, Return, development. and Equilibrium: We addressed Empirical this very Tests, point” 81 inJ. ourPolitical prior Econ.opinion, 607-636 stating: (continued...) - 177126 -

"ItSta nisd notard necessary& Poor’s) ,that as w theell partiesas mor epainstakingly popular sources examine (such each as Motley cost in Fool, the 200 First- plusCall, baseline and MSN cost Money), centers do in the order same. to determine37 whether a nontrivial portion of

T&C categoryPetitioner costs’s experts are 'mixed."' have presented 108 T.C.M. the more (CCH) compelling at 89. Respondent's case on this auditpoint. teamDr. Higinbotha did not requirem acknowledged this level of that granularity his decision when to accepting use a weekly petitioner's rather than allocation a methodmonthly with beta respectwas “virtually to the Marketing a random andchoice. Fulfilment” Dr. Frisch, categories. respondent We see’s principal no logi- valuationcal reason expert, for imposing used an harsher 18% discount requirements rate under on petitioner his DCF beforeapproach; allowing like Mr. it to allocateReilly, he costs calculated within athe beta T&C of 2.00category. using58 five-year monthly data. The adjustments in the noticeIn sum, of we deficiency agree with were petitioner based on that Dr. respondent Frisch’s report, abused and his he discretion affirmed inat determiningtrial his belief that that 100% an 18% of the discount costs accumulatedrate was correct. in the Dr. T&C Higinbotham cost centers agreed constitute that

IDCs.switching Petitioner to a monthly has established beta would through increase documentary his WACC evidenceto roughly and 18%, expert and testi-we monyfind that that the substantial appropriate non-IDCs discount were rate capturedon January in 1,these 2005, cost was centers. 18%.38 By deeming

100% of T&C category costs to be IDCs, respondent's position as set out in the 36(...continued) notice(1973) ;of R deficiencyeinhold P. Lviolatesamb & theKa tregulatoryheryn Nor tcommandhington, “ Thethat "[c]ostsRoot of thatReported do not Betas,” J. Investing 50-53 (2001). contribute to the intangible development area are not taken into account." Sec. 37Mr. Haigh, respondent’s trademark expert, cited a treatise by Shannon 1.482-7(d)(1),Pratt to support Income use of five-yearTax Regs. weekly data. But that treatise provides at best inconclusive support for this proposition. See Shannon P. Pratt, Cost of Capital (2d ed. 2002) (“Monthly is the most common frequency, although Value Line uses five years of weekly data.”). "Respondent's position would apparently require evaluation of 500 general- ledger 38accountsRespondent and notes100 general that Am-ledgerazon’ saccount treasury rollups department, for each for of internal the T&C discus- cost sioncenters. purposes, Because used petitioner a discount had rate between of 13% 162 when and evaluating 221 T&C prospectivecost centers invest-during 2005ments. and But 2006, Dr. Frischthis would characterized necessitate this several internal hundred rate as thousand an inaccurate discrete measure evalua- of tions.the riskiness This would of AEHT plainly’s business. be overkill; In that the respectregulations his views require align only with that those the alloca- of Mr. tion be made "on a reasonable basis." Sec. 1.482-7(d)(1), Income Tax(continued...) Regs. - 178127 -

B. MarketingPetitioner's Intangibles Position

WeThe havemarketing described intangibles supra pp. made 62-65 available the methodology to AEHT include petitioner the usedAmazon for

2006,name, anddomain urges names, here, fortrademarks, determining trade the names, subset and of T&Ctrade categorydress. The costs parties properly’ allocableexperts agreed to IDCs. that Respondent'sthe CUT method expert, provides Dr. Higinbotham, the best method examined for determining this metho- the dologyarm’s-length carefully buy-in when payment preparing for thehis marketingexpert report. intangibles. Under his They income also method, used the he wassame required sources toof estimatepublic information petitioner's --licensing future IDCs information in order to reported calculate in a the buy -in pricektMINE for databasethe website39--to technology. derive their He external therefore CUTs. needed to employ a method for allocatingPetitioner costs ’tos expertIDCs. Mr.He spentReilly a identified "significant six amount comparable of time" license developing agreements an appropriatewith royalty method,rates ran becauseging fro mhis 0.125% ultimate to conclusion 1% of sales. necessarily He selected depended the median on the of

IDCs'these rates, being or calculated 0.59%, as properly. his base rate, which he reduced to reflect a volume discount. In He estimating estimated future that the IDCs, marketing Dr. Higinbotham intangibles usedhad a petitioner's remaining usefulallocation life of methodology,10 to 15 years, as and described he identified above, the with revenue two significant stream associated modifications. with their Petitioner use on hasthe basisaccepted of management the cost-pool’s resultsprojections thus andreached a growth by Dr. assumption Higinbotham, after with 2011. one

further adjustment (discussed below) to which Dr. Higinbotham assented at trial.

We agree with Dr. Higinbotham's two modifications subject to this further adjustment, and38(...continued) we reject respondent's contention that further modifications are re- Szkutak, Amazon’s chief financial officer. He testified that the treasury depart- quired."ment rate was a mere benchmark that was increased, to rates above 18%, for spec- ulative investments related to future performance. We decline to adopt as the appropriate discount rate the benchmark rate that Amazon used internally. "Respondent argues that Dr. Higinbotham, when preparing his expert reports, did39Th note k thaveMIN Eenough databa evidencese includes to decidemore than upon 15,000 an accurate intangible allocation asset agree- method. ments and allows subscribers to conduct customized searches. (continued...) - 179128 -

ApplyiDr.ng aHiginbotham's discount rate of first 18%, adjustment he calculated concerned a value petitioner's of $251 m useillion of tothe $312

"Tmillion-ratio." for Usingall of thethe EuropeanQRE survey marketing results compiledintangibles. by PwC, petitioner determined an "adjustedDavid QREFranklyn, percentage" another orof "Apetitioner-ratio" ’fors experts, each person opined who that recorded these values time in

T&Cmust becost adjusted centers. to Petitionerreflect the multiplied fact that the this European "A-ratio" Subsidiaries by the applicable before "TProject-ratio" toGoldcrest yield a "developmentalready owned ratio" certain for of the these T&C m arketingcategory. intangibles. See supra p.After 64. excludingPetitioner thenthe value multiplied of previously "modified owned T&C intangibles, category costs" which (as Mr. determined Franklyn believedpreviously) to rep-by the

"developmentresent about 50% ratio" of theto determine total value, the Mr. dollar Reilly volume concluded of T&C that category the buy-in costs payment prop- requirederly allocable from toAEHT IDCs. for the marketing intangibles was $115 to $165 million.

Dr.Respondent Higinbotham’s expert opined Mr. thatHaigh petitioner's initially identified insertion fourof the comparable "T-ratio" intolicense this acalculusgreements artificially (including diluted one selectedthe cost byallocation Mr. Reilly) to IDCs. with royaltyPetitioner rates derived ranging the from

"T0.5%-ratio" to 2% by of dividing sales. Hethe selectednumber ofthe T highest-coded ofemployees these rates, in theor 2.0%,T&C categoryas his base by therate, total and numberhe applied of employeesno volume indiscount. that category. He assu Petitionermed that theadded marketing this step intangi- to its allocationbles had a perpetualformula on or the “indefinite assumption” useful that life.only TApplying-coded employees a discount were rate oflikely 13.3% to toengage an assumed in intangible revenue development base, he calculated activity. in his opening report a value of $1.8 billionWe for agreethe marketing with Dr. intangibles.Higinbotham Adopting in rejecting even this higher assumption. revenue assumptionsDuring 2005-

2006in his thererebuttal were report, almost he asvalued many the T&C marketing cost centers intangibles with no at T $3.13-coded billion. employees Re- as spondent contends that this figure should not be reduced to account for prior own- 59( .continued) Butership the of parties any m conductedarketing intangibles very extensive by the discovery European in Subsidiaries. this case; if Dr. Higin- botham believed he lacked certain necessary information, respondent was free to request it. In any event, respondent stands behind Dr. Higinbotham's ultimate conclusion, which necessarily includes his underlying calculations. - 180129 - with allWhile T-coded the partiesemployees.’ experts In compilinghave adopted its data,similar PwC approaches, surveyed theymost disagree employees whoon five recorded major inputstime to into T&C the cost CUT centers, valuation: regardless (1) the of proper their job royalty classifications, rate; (2) the and ituseful computed life of a the QRE marketing percentage intangibles; for each (3)employee the revenue thus surveyed.base to which Since the there royalty were nonshould-T-coded be applied; employees (4) the whose appropriate efforts discount directly rate;or indirectly and (5) thefurthered extent intangible(if any) to development,which the buy-in the paymentuse of the m Tust-ratio be adjusted resulted toin reflectunderstating the European petitioner's Subsidiaries IDCs.' ’ prior ownershipTo remedy of this certain flaw, marketing Dr. Higinbotham intangibles. significantly We address reduced these or issues eliminated in turn. the role of the1 .T-ratio.Royalty For costRate centers in the 7000 series, he set the T-ratio at

100%,Petitioner effectively’s eliminatingexpert Mr. Reilly it. He searched did the same for exclusive for cost centerstrademark in the licensing 5000 seriesagreem withents atth aleastt involved an 80% products response similar rate to to the those QRE sold survey by A andmazon for andcertain that other calcu- lated5000 -seriesroyalties cost as centersa percentage with "a of logic revenue, behind with doing no collateral it." For transactions.the remaining From 5000 - seriesthe 167 cost agreements centers, he that assigned he found the in same the retail T-ratio and that Internet Amazon categories, had assigned,40 he initially but madeselect emodificationsd the followin tog sixbetter transactions capture the as costcomparable of interns and as chose if they as were his base T-coded royalty theemployees. median ofDr. these Higinbotham rates, or 0.59%: described these adjustments as his "most important"

change to petitioner's cost-allocation formula. Petitioner has accepted all of these adjustments, and we find them to be appropriate.

40In his ktMINE database search, Mr. Reilly found 7,724 agreements in effect on January 1, 2005. Of these, 865 were in the “marketing intangible” category.'A corollaryNarrowing to his this search flaw wasto the the retail exclusion and Internet of time industries spent by paidyielded interns. 167 Theyagreements, completed all of QRE which surveys he reviewed and recorded to find time CUTs. to T&C He conducted cost centers, similar but they did notsearches have usinga T-coded two otherjob classification. search engines Use (Royalty of the SourceT-ratio andeffectively Royalty eliminated Range) but theirdid not time identify from theany cost additional pool even CUTs. if they did 100% intangible development. - 181130 - Dr. LicensorHiginbotham's second adjustmentLicensee to petitioner's formulaRoyalty involved (percent) the treatmentMerchandising of certain Corp. indirect costs.Sports TheArchive QRE survey data compiled1.00 by PwC cap- Sports Authority Mega Sports Co. 0.850 tured time devoted to "direct supervision and support" of qualifying research ac- Michigan tivity.Rampage However, Licensing petitioner's Charlotte formula didRusse not capture the costs of "indirect0.750 supervision"F.A.O. (e.g., Schwarz time Fdn. spent by a Thehigher Right level Start supervisor) or "indirect support"0.438 (e.g., Kmart Corp. Kmart Australia 0.188 time spent by a supervisor's executive assistant). Because the CSA defined IDCs Kmart Corp. Kmart New Zealand 0.125 to include "all direct and indirect costs" of intangible development, Dr. Higin- Mr. Haigh initially selected from the ktMINE database the following four botham concluded that an additional modification to petitioner's cost-allocation transactions as comparable and opined that Amazon’s brand strength justified formula was necessary. choosing as his base royalty the highest of these rates, or 2.0%: To implement this modification, Dr. Higinbotham recalculated the A-ratio Licensor Licensee Royalty (percent) for employees in the T&C category. He did this chiefly by reallocating to IDCs a SNAP! ValueVision Int’l 2.00 portionMacMark of the time that employeesEquilink had Licensing reported on their QRE surveys2.00 as spent on

"humanSports Authorityresources/training," Megawhich SportsPwC had Co. excluded for section 411.20 credit pur- Michigan poses.Radio TheShack impact of this adjustmentInterTAN was Australia to increase the A-Ratio for1.00 certain individuals and the corresponding A-ratio for the cost center in which those individ- In his rebuttal report Mr. Reilly accepted one of Mr. Haigh’s choices--the uals were assigned. Petitioner has accepted this adjustment, and we find it to be Radio Shack agreement--as a valid comparable. At trial Mr. Haigh found no fault appropriate. in two of Mr. Reilly’s choices--the Merchandising Corp. and Rampage Licensing These two modifications by Dr. Higinbotham were significant, increasing agreements--as valid comparables. We will accept all three agreements as com- petitioner's IDCs by more than $50 million for each year at issue. At trial Dr. parables, evidencing royalty rates of 1.0%,- 182 1.0%, - and 0.75%, respectively.

Higinbotham agreed with Dr. Weil that, whereas salary weighting was appropriately applied to employee costs, headcount weighting was more appropriately applied to the remaining costs. This further adjustment reduced Dr. Higin- botham's results by $3 million and $5 million for 2005 and 2006, respectively.

We conclude that Dr. Higinbotham's results, as thus adjusted, yield a formula that allocates costs "between the intangible development area and the other areas or business activities on a reasonable basis." Sec. 1.482-7(d)(1), Income Tax Regs.

We do not accept three further modifications to petitioner's allocation

formula that respondent has urged at various times. First, in the notice of defi-

ciency respondent contended that petitioner erred in eliminating from the T&C

cost centers all costs captured in 26 general ledger accounts that petitioner deemed unrelated to intangible development. See supra p. 63. Examples of the eliminated accounts include 64168 (Pallet Expense), 64712 (Warehouse Supplies), 64715

(Safety Supplies), 64331 (Depreciation: Heavy Equipment), and 64332

(Depreciation: Vehicles). Drs. Weil and Higinbotham agreed that it was reasonable to exclude from IDCs the costs captured in these accounts solely on the basis

of the account description, without investigating the subsidiary costs in detail.

Respondent in his post-trial briefs largely abandoned any challenge to this conclusion, which we believe to be correct. - 183131 -

BothSecond, experts respondent selected urges the Sports a further Authority adjustment Michigan to the licensePWC survey as a compara- data. blePetitioner but derived recognized different that royalty certain rates costs from ineligible it. That for agreement the section specified 41 credit a royaltymay neverthelessrate starting inconstitute 2003 at 1.2%IDCs. and Petitioner declining accordingly annually to added 0.5% backin 2015. two typesWhereas of

Mr.costs Haigh reflected selected on the the QRE starting survey rate forms (1.2%),--"reverse Mr. Reilly engineering" took the simple costs andaverage costs of non-U.S.(0.85%) o activitiesf all rates--that in the are agreement. ineligible Mr.for theReilly R&E’s choicecredit. wasRespondent reasonable contends because thatthe rate two during other types most ofyears costs of--those the initial of "routine term was engineering" 0.8%; Mr. Haigh and "routine acknowledged data thatcollection" extending--should the agreement also be added’s terms back to forperpetuity purposes would of determining yield a rate the close IDCs to pool.

0.5%. Neither We acce Dr.pt theWeil Michigan nor Dr. HiginbothamSports Authority believed agreement that these as a comparabletwo species evi-of dencingcosts should a 0.85% be added royalty back. rate Inas supportdetermined of a by contrary Mr. Reilly. view, respondent points to an

exampleThe in experts the regulations disagree indicatingas to the comparability that "field testing of the costs" other forfive a licensingnew invention mayagree constitutements. Fo IDCsr the fthatollo mustwing berea shared.sons, we See find sec. that 1.482-7(d)(3), none of them Example supplies (2J,a In- reliablecome Tax comparable. Regs. We find this analogy inapposite. The costs of field testing a new invention• The are F.A.O. not comparable Schwarz trademark to costs of was routine licensed data bycollection the F.A.O. and Schwarz routine engi-Fam- neering.ily Foundation Petitioner to The agrees Right that Start, field which testing in 2001new software had purchased generates 23 ofIDCs the remain-and notesing F.A.O. that the Schwarz QRE survey toy stores properly in North captured America. such Thecosts. media61 described that transaction as “resembling a distress sale.” This is not the sign of a financially healthy company61Petitioner's or brand; the version F.A.O. of Schwarzfield testing brand is calledwas in Weblabs. serious decline, The QRE whereas survey the administered by PwC required employees to report such activity under category 5, Acaptioned:mazon br "Testing:and was o nDesign the op andposi executionte trajectory. of plans Petitioner to test has the failed concepts to convince and soft- us ware. Includes code sequence testing, unit testing, system testing, and the use of Weblabs. Also involves redesign and re-testing as a result of initial testing results." that this is a reliable comparable. - 184 -

Finally, respondent challenges the reliability of the PwC survey data, noting that petitioner's employees did not record their time contemporaneously. While we agree that contemporaneous time records are always preferable, PwC apparently secured its data within a year of the periods in which the employees rendered their services. The regulations required petitioner to devise a formula that would allocate costs "on a reasonable basis," id. subpara. (1), and we think petitioner acted logically in using the best data it had.

For purposes of claiming section 41 credits, it was in petitioner's interest to have its employees show the highest possible percentage of their time as allocable to R&E activities. All time allocated to R&E activities in the QRE surveys will necessarily be allocated to IDCs. To the extent that petitioner's employees, lack- ing contemporaneous time records, made approximations in reporting how their time was spent, it seems unlikely that the results, as applied here, would be biased in petitioner's favor.

In sum, we conclude that petitioner's cost-allocation methodology, as adjusted by Dr. Higinbotham and further modified by him at trial, yields a formula that allocates costs "between the intangible development area and the other areas

or business activities on a reasonable basis." Sec. 1.482-7(d)(1), Income Tax

Regs. Dr. Higinbotham needed an accurate allocation methodology for his own - 185132 - valuation• The exercise, Kmart tradeand hem arkcarefully was licensed considered in 1994 and bymodified Kmart petitioner'sUS to Kmart formula New

Zealandfor this purpose. and Kmart Petitioner Australia, accepts both of that which result, were and then so do owned we.62 by an unrelated party. C.The KmartStock brand-Based was Compensation also in decline: Many of its US stores were outdated and in Thedecaying CSA executedcondition, by and Amazon by the US1990s and the AEHT press defined labeled IDCsKmart to a "include “‘discount all directstore dud and’ indirectin need ofcosts revitalization. (including ”Stock Perhaps-Based for Compensationthat reason, the Costs)" royalty relating rates to intangiblespecified in development. these agreements The (0.125%parties further and 0.188%) elected areto take extremely into account low by "all com- stock - basedparison compensation with the others. in the Petitioner form of hasstock failed options to convince in the same us that amount, these andtwo as(sub- of the samestantially time, similar) as the fairagreements value of furnish the stock reliable options comparables. reflected as a charge against in-

come"• in A eithertrademark party's for financial all MacGregor statements. branded Id. productssubpara. was(2)(iii)(B). licensed This in 2000 election by wasMacMark made "withoutto Equilink. prejudice We agree to the with Party's Mr. Reilly right tothat challenge this agreement the validity" is noncom- of the regulation.parable for three reasons. First, “it covers the rights to use trademarks to manufac- ture, brand,In filing and its sell 2005 physical and 2006 products, returns,” whereas petitioner Amazon thus complied’s marketing with intangibles the regu- lationdo not requiringconvey such that rights. stock-based Second, compensation this license beagreement included was in the executed cost pool. as part Like of manya litigation technology settlem companies,ent; the parties petitioner’ relative questioned bargaining the power validity is unclear,of this regulation. and the royalty rate may reflect other concessions. Third, the agreement’s pricing pro- 62Respondent notes that the regulation requiring costs to be allocated "on a reasonablevisions are basis"complex; states, Mr. inHaigh the next admitted sentence, that thethat actual "it is necessaryroyalty rate to couldestimate be asthe total benefits attributable to the cost incurred." Sec. 1.482-7(d)(1), Income Tax lowRegs. as While0.56% urgingunder certainthat petitioner conditions, has notwell satisfied below the the 2% latter headline requirement, rate. For re- all spondent has not advanced a coherent theory as to how a taxpayer would go about theseestimating reasons, the respondent"total benefits" has failed attributable to convince to costs us accumulatedthat this agreement within furnisheseach of a several thousand cost centers. We conclude that a properly constructed allocation formula, such as that approved in the text, will accomplish the desired result in petitioner's case. - 186133 -

Therelia bCSAle co accordinglymparable (o rincluded if it be t ah ought"clawback" comparable) provision that that it supports will apply a royalty in the eventas sectionhigh as 1.482-7(d)(2),2.0%. Income Tax Regs., is

held• The to SNAP! be an invalidtrademark regulation was licensed by a final to ValueVision decision in ain court 1999. of We law find this with respect to pending litigation involving another taxpayer, agreementincluding noncomparable a U.S. Supreme for three Court rea decision,sons. First, U.S. most Court of the of Appealsproducts it covered decision upon denial of a writ of certiorari or lapse of time for filing were high-marginsuch writ, or jewelry a decision items; by AEHTa federal was trial not court a high- uponmargin lapse retailer, of time and for an un- filing a notice of appeal, or * * * [is] revised or withdrawn by the relatedTreasury party in itsDepartment position would such that consider the costs that offact stock in determining-based compensation whether to pay are not required to be included as costs for qualified cost sharing a royaltyarrangements. as high as 2%. 41 Second, the parties to this agreement were almost related: InGeneral the event Electric, this regulation through its is NBC ultimately subsidiary, invalidated owned or a withdrawn,significant stakethe CSA in providesValueVision, that "stockand SNAP!-based became compensation a wholly shall owned not subsidiarybe included of in NBC the determi-one month nationlater. T ofhi *rd *, N* B[IDCs]C in 2 0in0 1any an nYearounc toed whicha rebranding this Agreement strategy and applies." “effectively For any termi- year natedfor which the Snapstock trademark-based compensation license [agreement]. turns out ”to In have effect, been therefore, "improperly" the SNAP! included inagreement IDCs, "the was Cost a dead Share letter shall when be recomputedthe CSA was without executed the in inclusion January of2005. stock-based

compensationAfter eliminating in [IDCs]," the and five "the license Cost agreements Share less the we Recomputedfind to be noncomparable, Cost Share shallwe ar bee l erefundedft with th [toe f othello wpropering fo party]."ur agreements The CSA that providesthe parties that agree any supplysuch refund reli- shallable CUTs, be "treated with asthe an following adjustment royalty to the rates: Cost Share for the Year in which the

Triggering Event occurs * * *, and to the extent that such adjustment exceeds the

Cost Share, the adjustment shall be applied to subsequent Years until fully ex-

41 hausted."On cross-examination Mr. Haigh was surprised to learn that he had relied on inflated profit margins that did not account for AEHT’s projected IDC expenses. He acknowledged that AEHT’s actual profit margins could dictate a royalty rate below the 2% rate he chose. - 187134 - In Altera Corp. v. Licensor Commissioner,Licensee 145 T.C. 91, this CourtRoyalty invalidated (percent) sec- tionMerchandising 1.482-7(d)(2), Corp. Income TaxSports Regs., Archives the provision that requires stock1.00-based America compensation costs to be included in the IDC pool. Our decision in that case was Radio Shack InterTAN Australia 1.00 appealedSports Authority to the U.S. Court ofMega Appeals Sports for Co.the Ninth Circuit on February0.85 19, 2016. Michigan The case remains pending on appeal, and the CSA's clawback provision is not yet Rampage Licensing Charlotte Russe 0.75 operative. Given the strength of Amazon’s brand in 2005, we agree with Mr. Haigh The parties agree that the CSA is a "qualified cost sharing arrangement." that it is appropriate to select as the base royalty rate the highest of these rates This agreement requires petitioner to adhere to section 1.482-7(d)(2), Income Tax (1.0%), which does not differ greatly from the median (0.925%) or the average Regs., until such time as that regulation is withdrawn by the Department of the (0.90%). Treasury or finally invalidated by judicial decree. If and when either of those Mr. Reilly noted that trademark license agreements sometimes include a "Triggering Events" occurs, the CSA states that appropriate adjustments will be “waterfall” structure that reduces the base royalty rate at higher sales volumes. made to the parties' respective cost shares in the relevant future years. Because Opining that a downward volume adjustment would be reasonable here, he re- there is no scenario in which an adjustment would be required to AEHT's cost duced his starting royalty rate by up to 33 basis points as AEHT’s projected reve- sharing obligation for 2005 or 2006, the years before the Court, we conclude that nues reached certain thresholds. He cited his valuation experience, as opposed to both petitioner on its original returns and respondent in the notice of deficiency specific external or internal CUT evidence, to justify this reduction. correctly included stock-based compensation in the cost pool. Mr. Reilly acknowledged that “waterfall” structures are atypical in agreements that license marketing intangibles. Of the 167 such agreements that he found in the retail and Internet categories, only eight had downward adjustments - 188135 - keyed Toto h implementigher sales thevol uforegoing,mes. Mr. Reilly acknowledged that “in certain instances trademark license royalty rates increase over time or with increased revenue.” In Decision will be entered under fact, Mr. Haigh looked at 700 agreements and found 21 that featured increasing Rule 155. royalty rates.

We find that flat royalty rates are the norm in agreements of this type. Even if a volume adjustment were thought appropriate, the evidence is conflicting as to whether the rate should be adjusted upward or downward. We thus conclude that the arm’s-length royalty AEHT must pay for the marketing intangibles is a flat

1.00%.42

2. Useful Life

The parties disagree as to whether the marketing intangibles had a limited useful life (as petitioner contends) or a perpetual or “indefinite” useful life (as respondent contends). Petitioner presented testimony from five expert witnesses.

They were unanimous in concluding that the useful life of the marketing intan-

42When valuing the website technology, we applied a 25-basis-point downward adjustment to the royalty rate because Amazon’s M.com agreements, used as comparables there, provided evidence justifying a modest volume discount. Here we are considering external rather than internal CUTs, and the external CUTs supply no convincing evidence to support reducing the royalty rate at higher sales volumes. - 189136 - gibles, while lengthier than that of theAPPENDIX website technology, was not perpetual. We agree. Petitioner's Expert Witnesses

1. Mr.Lorenzo Reilly Alvisi estimated that the useful life of the marketing intangibles was in the ranDr.ge oAlvisif 10 to is 1 5a professoryears. Lik ofe Dcomputerr. Unni and science Mr. Lasinski,at the University he began of by Texas focusing at

Austin.on the terms He received of the relationship his undergraduate between degree Amazon in physicsUS and AEHT.from the After University May 1, of

Bologna2006, AEHT and hiswas M.S. responsible and Ph.D. for inall computer advertising, science develop fromm ent,Cornell and University.trademark- He hasmaintenance been a visiting expenses professor relating at tovarious the European institutions marketing around intangibles. the world, including Mr. Reilly schoolsopined that in Italy, this isChina, unusual Germany, in trademark and the license United agreements; States. His typically, research athas least focused someon security trademark-related issues in computer expenses systems. continue He to has be writtenborne by 21 the published licensor articles during thein additionlicense term. to book chapters and conference papers relating to the security of computer systems.Because theFor going-forward purposes of this value case, of he the co marketing-drafted a intangiblesreport with wouldKen Birman in- regardingcreasingly the be attributableuseful life of to Amazon's marketing eCommerce investments software by AEHT, technologies an unrelated and party retail websites.in its position However would he not did agree not totestify pay royaltiesat trial. forever. As Mr. Reilly explained:

2.“A tradKenemar Birmank is, at any specific moment, the product of investments of the past.

* * * [F]utureDr. Birman invest is ma entsprofessor can replace of computer those madescience in atthe Cornell past, and University. therefore theHis researchvalue of ahas trademark focused builton distributed by investments computing, of the faultpast willtolerance, diminish. security, Its place and will scalability.then be take nHe by received the valu ehis re B.A.sultin ing fromcomputer new investment.science from” ColumbiaSee Nestle University Holdings, andInc. hisv. Commissioner M.S. and Ph.D., T.C. in computer Memo. 1995-441, science from 70 T.C.M.the University (CCH) 682,of California, 696

Berkeley. In addition to teaching, he has founded three companies in the comput- (“Trademarks lose substantial value without- 190 -adequate investment, management, ing systems space and has written 150 research papers and 5 books in the field of

computer science. For purposes of this case, he co-drafted a report with Lorenzo

Alvisi regarding the useful life of Amazon's eCommerce software technologies and retail websites. The Court recognized Dr. Birman as an expert in computer science.

3. Bradford Cornell

Dr. Cornell holds a Ph.D. in financial economics and is a visiting professor

of financial economics at the California Institute of Technology. He received his

A.B. in physics, philosophy, and psychology from Stanford University, his M.S. in statistics from Stanford, and his Ph.D. in financial economics from Stanford. His work and research has focused on financial economics and valuation. He has published over 100 articles focused on the practical and empirical applications of financial economic theory. Part of his research focuses exclusively on technology

companies. He has also served as the vice president and director of securities litigation group for the Economic Analysis Corporation, a senior consultant for

CRA and Compass Lexecon, and a managing director for San Marino Business

Partners. The Court recognized Dr. Cornell as an expert in financial economics and valuation. - 191137 -

4.m arketRoberting, ad vDolanertisin g, and sales organization.”), rev’d in part and remanded on other groundsDr. Dolan, 152 is aF.3d Baker 83 Foundation(2d Cir. 1998). professor of business administration at

HarvardPetitioners Business’ School.experts alsoHe receivednoted that his the B.A. value in ofmathematics Amazon’s fromtrade mBostonarks or Col- lege“brand and” wasan M.B.A. closely andlinked a Ph.D. to the in state business of its administrationtechnology. If fromconsumers the University were dis- of satisfiedRochester with in New their York. shopping He experience,previously taught Amazon at ’thes m Universityarketing intangibles of Michigan would rapidlyStephen decline M. Ross in Schoolvalue. ofAEHT Business was responsible,and the University not only of for Chicago ongoing Graduate marketing expenses,School of butBusiness. also (under He has the extensive CSA) for teaching its pro rata and share consulting of future experience IDCs that in were the areasessential of customer to sustaining purchasing the website decisions technology. and building brand awareness. He has publishedAs Dr. numerous Unni put books it: “ [T]heand articles incremental on marketing, profits associated product pricing, to [the andmarketing] brands.

Theintangibles Court recognized are progressively Dr. Dolan attributable as an expert to the in future marketing. business efforts and tech- nology5. David co-development Franklyn of Amazon Europe.” He determined that any profits attributableProfessor to such Franklyn intangibles is a professor after a period of intellectual of 15 to 20 property years would law at reflect the Univer- the sityqual ofity Sanof A FranciscoEHT’s on gSchooloing business of Law. execution He received and histhe B.A. effectiveness in history, of philosophy, supporting andtech nreligionology and from subsequently Evangel College developed and his intangibles J.D. from for the which University AEHT of had Michigan paid.

Mr.Law Lasinski School. similarlyHe is also opined the executive that, if a director licensee of anticipates the McCarthy incurring Institute substantial for Intel- lectualfuture expenses Property toand sustain Technology the value Law of atthe the licensed University marks, of Sanit will Francisco negotiate and for the directorlimited-duration of the Center payment for Empiricalstructures, Study lower ofroyalty Trademark rates, orLaw other at the concessionary McCarthy In- stitute.provisions. He has experience working as a consultant, advising companies on issues relating to trademarks and management of trademark portfolios. He is also the co- - 192138 - authorRobert and editor Dolan in chiefapproached of McCarthy's this problem Desk from Encyclopedia a different of perspective, Intellectual em- Pro- perty,ploying and a well-established he has written numerous marketing articles methodology on trademark that analyzed law. The the Court risks re-the

Amazoncognized brand Professor faced Franklyn as of January as an 1,expert 2005. in Theseinternational risks included trademark low law switching and em- piricalcosts for evaluation customers; of problemstrademarks. stemming from excessively fast growth; intense

6.pre ssuPeterre fro mGolder onlin e competitors and brick-and-mortar stores; and the risk that key collaboratorsDr. Golder is(such a professor as suppliers of marketing or delivery at services)Tuck School would of Businessdisappoint. at Dart-He mouthnoted that, College. owing He to receivedthe lack ofhis “ emotionalB.S. in mechanical appeal” in engineering Amazon’s fromvalue the propo- Uni- versitysition, the of Pennsylvaniarelative contribution and his ofPh.D. its brand--as in business opposed administration (say) to the (marketing) Hermès and from theGucci University brands--was of Southern quite limited. California.43 For Beforethese reasons, teaching he at concluded Dartmouth, that he A taughtmazon at’s themarketing Stern School intangibles at New should York not University. be valued Hisinto research perpetuity. and publications focus on the historyPeter of Golder, markets another and brands, of petitioner specifically’s experts, on using used the empirical historical data method for techno- to removelogy-driven survival companies bias from to estimate marketing a useful analyses, life globalfor Amazon marketing,’s marketing and product intangi- life bles.cycles. As The he explained:Court recognized “It is important Dr. Golder to asremember an expert that in marketing,expectations market about leader-Ama- ship,zon’s duration,brand are and being survival made time.as of January 1, 2005, and therefore must not incor-

7. Marco Iansiti 43To support this proposition Professor Dolan cited academic literature and MillwardDr. BrownIansiti ’iss “thebrand David contribution Sarnoff Professor” measure of of Business Amazon. Administration Millward Brown at uses a 1 to 5 scale to measure the importance that brand (as compared with price Harvardand prod uBusinessct featur eSchool.s) plays Hein a holds comp anan yA.B.’s success. in physics Companies and a Ph.D. with in an physics index of 5 (including such luxury brands as Hermès, Gucci, Rolex, and Porsche) derive the greatestfrom Harvard proportion University of their and value has fromtaught the there brand for itself. over 25 Co years,mpanies where with he an was index the of 1 (including Domino’s Pizza and 76 Motor Fuels) derive the least proportion of theirfirst facultyvalue from member the brand to focus itself. on the Millward computer Brown industry. gave AmazonHis research a rating focuses of 2 on this scale, which is consistent with a relatively low brand impact assessment. - 193139 - innovationporate today of’s the hindsight. Internet” and He technologynoted that the companies. dot.com crash In addition had occurred to teaching just four and researching,years previously; Dr. Iansiti that thousands is an eCommerce of Internet entrepreneur, companies hadfounding failed; Model that Internet N, an retailingeCommerce (especially technology in Europe) provider, was and still a technologyin its infancy; strategy that A consultant,mazon’s ability founding to

Keystoneextend its Strategy,reach into a new consulting product firm categories providing was both uncertain; business and and that litigation 75% of-related inde- technologypendent financial advice. analysts The Court in 2005 recognized had a sell Dr. or Iansiti hold rating as an onexpert Amazon in innovation’s stock. and eCommerceFor his second technology. empirical analysis, which we found most persuasive, Dr.

8.Golder Michael estimated Lasinski the longevity of leaders and significant competitors in seven eCommerceMr. Lasinski markets: is aonline managing brokerages, director Internet and chief search executive engines, officer online of social284 networks,Partners, LLC, travel an websites, intellectual web property browsers, valuation, smartphones, strategy, and consulting,video game and consoles. trans- actionalHe determined firm. He that holds many a well-knownB.S. in electrical brands engineering had failed, and including an M.B.A. more from than the half

Universityof the market of Michigan.pioneers, which He is had also an a averagecertified time public to accountantfailure of seven with years.a special His analysiscertification generated in financial estimated forensics. useful Helives has ranging worked from in intellectual 10.9 to 16.5 property years for for all approximatelyseven markets, 20wh years.ich inc rHeeas wased to formerly 19.9 years the when president pioneers at the that Licensing failed early Exec- were utivesomitted. Society of the United States and Canada. Mr. Lasinski's work has focused primarilyRespondent on reviewing’s expert and Mr.analyzing Haigh hundredsfocused on of the intellectual useful life property of the Amazon license agreements.“brand,” acknowledging He has reviewed that there thousands is “little of consensuslicense agreements on whether and a brandhas negotiated has a betweenfinite or an50 indefiniteand 100 license” useful agreements. life. He noted The that, Court under recognized applicable Mr. accounting Lasinski as an standards,expert in intellectual “the facts -propertyindicate whether licensing. the asset has a finite life or not.” He then made the following assumption: - 194 -

9. Alan MacCormack

Dr. MacCormack is an adjunct professor of business administration at Har- vard Business School. He received his B.S. in electrical and electronic engineering from the University of Bath in England, an M.S. in management from the

MIT Sloan School of Management, and a Ph.D. in business administration from the Harvard Business School. His work has focused on analyzing software systems and software releases. He has written 30 to 40 publications analyzing software development processes and software architecture and has received awards for papers on the topics of software development and design. He has applied his analyses to his consulting work for numerous large companies. The Court recognized

Dr. MacCormack as an expert in the management of innovation, the management

of technology and new product development, including the software industry, and the management and evaluation of software code, architecture, and evolution.

10. Haim Mendelson

Dr. Mendelson is the Kleiner Perkins Caufield & Byers professor of electronic business and commerce and management at the Stanford Graduate School

of Business. He previously taught business administration at the University of

Rochester. He received his B.S. in mathematics and physics from Hebrew Uni- versity in Jerusalem, his M.S. in management sciences from Tel Aviv University, - 195140 - and hisIt Ph.D. is my inassumption mathematical that sciencesthe brand from has anTel indefinite Aviv University. * * * [useful A scholar life]. of This is based on the assumption that there is no foreseeable limit to eCommerce,the period he has over written which a the number brand of is caseexpected studies to generateon eCommerce net cash companies inflows for its businesses. This also assumes that trademark and brickregistration-and-mortar renewals retailers are with filed an at onlinethe appropriate channel. timeHe has and also sufficient helped build investment is made in terms of marketing and communication to Internetmaintain and eCommerce the value companiesinherent in boththe brand. as a professor assisting student entrepre- neursMr. Haigh and as’s openinga paid adviser. report refereThe Courtnced onlyrecognized one perpetual Dr. Mendelson license, andas an that expert agree- in mentelectronic included business. a lifetime cap on royalties. He admitted that he would not have ad-

11.vised AEHTDavid toParkes pay perpetual royalties for the marketing intangibles.

Dr.Other Parkes than isMr. the Haigh, area dean respondent for computer relied onscience two experts and the in George an effort F. Colonyto de- monstrateProfessor ofthe Computer longevity Science of Amazon and’ sHarvard “brand ”College as of January Professor 1, 2005. at Harvard Dr. Conley, Univer- sity.relying He on received a theory his of master's“value transference, degree in engineering” opined that and properly computer managed science tech- from nologyOxford assetsUniversity enhance and thea Ph.D. value in and computer extend theand lifeinformation of a company science’s brand. from the He Uni- versitysought toof illustratePennsylvania. “value He transference teaches courses” with relatedexamples to eCommerce,involving an artificial intel- ligence,sweetener machine and generic learning, pharmaceuticals. multi-agent systems, But Dr. andDolan economics showed atthat Harvard. these exam- He is plescurrently proved the the chair opposite: of the ACM Once Specialthe patent Interest expired, Group the onproducts Electronic lost significantCommerce, thevalue leading and market computer share. eCommerce Dr. Conley professional admitted that organization. his “value transferenceHe also serves” theory as the hchairas n eofve ther be ACMen ado Specialpted wi tInteresthin the valuationGroup on community,Electronic Commerce is not incorporated and has pub- in any lishedaccounting over standards,80 papers relatedand has to not eCommerce. been adopted The by Court any court. recognized We did Dr. not Parkes find it as anpersuasive. expert in computer science and eCommerce technology. -196-- 141 -

12. RespondentRobert Reilly’s final expert, Robert J. Wilcox, opined that a brand name simplifiesMr. consumersReilly is a ’managing decision mdirectoraking, thatof Willamette brand nam Managementes are important Associates, in the a onlinefirm that world, provides and thatfinancial Amazon advisory in January services 2005 relating had a strongto business brand and in Europe.intangible assetAlthough valuation. we found He thisreceived testimony his B.A. persuasive, in economics Dr. Wilcox and his did M.B.A. not opine in finance on the actualfrom Columbia useful life University. of Amazon He’s trademarks was previously or brand. a partner His reportand national does not director support at

Deloitterespondent and’s Touche,contention vice that president the marketing of Arthur intangibles D. Little had Valuation, a perpetual Inc., useful a valuation life. servicesHaving firm, directorconsidered of corporatethe testimony development of these eight for Huffy experts Corporation, in light of ourand find-a seniorings of consultant fact, we conclude for Booz, that Allen the marketing& Hamilton. intangibles He has publisheddid not have 12 avaluation perpetual textbooksuseful life, and and over we reject 300 journal respondent articles’s contention in the field that of valuation.they did. OurHe conclusionhas also is valuedbased on trademarks numerous over factors 500 as times. to which The petitioner Court recognized’s experts Mr. testified, Reilly including as an expert the infact valuation. that the Internet retail industry was young, the fact that Amazon had operated

13.in E uropeJames for Roper only six years, and the fact that Amazon’s success depended heavily on shoMr.rt-li vedRoper technology is the chairman assets. andBut founderour conclusion of the Interactive rests chiefly Media on the in factsRetail that

AEHTGroup (IMRG),assumed asole United responsibility Kingdom toeCommerce maintain and industry develop association. the marketing During intan- his timegibles at in IMRG, Europe Mr. and Roper paid, hasthrough advised cost governments sharing, for theabout technological eCommerce im andprove- given numerousments essential presentations to maintaining on eCommerce. the value ofHe those previously marketing worked intangibles. as a business de- velopmentPetitioner director’s experts for New presented Media Productions us with useful and life Convergent estimates Communications.for the marketing

Theintangibles Court recognized that ranged Mr. between Roper 8 as and an 20 expert years. in Mr.eCommerce. Reilly and Dr. Dolan embraced a 10-15 year range. Dr. Unni embraced-197- a 15-20 year range. Dr. Golder 14. Sanjay Unni

Dr. Unni holds a Ph.D. in economics and is currently the director of the

Berkeley Research Group, an expert services firm specializing in economics and

financial analysis. He received his B.A. in economics from the University of

Delhi in India and his master's degree and Ph.D. in economics from Southern

Methodist University. He previously served as the director in the securities practice of LECG, another expert services firm. He has also taught courses on corporate finance, investment analysis, market structures, and finance at several institutions in the United States and the United Kingdom. As a transfer pricing economist he has drafted more than 30 transfer pricing reports, primarily related to technology firms. He has also published and taught in the field of financial economics. The Court recognized Dr. Unni as an expert in economics, financial economics, and transfer-pricing economics.

15. Roman Weil

Dr. Weil holds a Ph.D. in economics and is currently the V. Duane Rath professor emeritus of accounting at the Chicago Booth School of Business. He re-

ceived his B.A. in economics and mathematics from Yale University and his M.S. in industrial administration and a Ph.D. in economics from Carnegie Mellon Uni- versity. He has served on the faculties of nearly a dozen other schools, including - 198142 - asop ian evisitingd that t hprofessore useful lofife accounting could be as at short the Radyas 8 years School but of (with Management certain assump- at the

Universitytions and adjust of Californiaments) could San Diego.be as long He as has 20 also years. served on the Financial Account- ing StandardsWe conclude Advisory that Councila useful andlife atthe the Public top of Company these ranges Accounting is appropriate. Oversight We

Board.agree with He Dr.has Wilcoxfocused that his Aresearchmazon aton year-end accounting 2004 and had has a writtenvery strong numerous brand in booksEurope and and articles that the on strength cost accounting. of its brand The supports Court arecognized relatively longDr. Weil useful as life. an expert By in20 0cost0 A accounting.mazon’s pri mary domains in the UK, Germany, and France represented the

16.thre e mRobertost po pWentlandular onlin e retail domains in Europe. In all three countries Amazon had theMr. highest Wentland brand is awareness a managing of directorany online at Navigantretailer. When Consulting. asked aboutHe received places histo shop B.B.A. on thein accounting Internet in from2005, the European University customers of Wisconsin told pollsters Madison. that HeAmazon is a wasC.P.A. the and brand is alsothat certifiedfirst came by to the m ind.AICPA Considering in financial all forensics.the evidence, He wepreviously find that workedthe marketing for Arthur intangibles Anderson had as a usefulan accounting life of 20 and years, consulting which ispartner the top and end for of Dr.

HuronUnni’s Consultingand Dr. Golder as a’ Managings ranges and Director. not too farMr. from Wentland the high has end provided of Mr. forensicReilly’s accountingrange.44 and data analysis services related to international tax controversies, including transfer pricing disputes, for nearly 20 years. The Court recognized Mr.

Wentland as an expert in financial statement analysis and forensic accounting.

17. Robert Willig

44 Dr.Mr. Willig Reilly holds believed a Ph.D. that in a “economicsramp down and” could is a professor be justified of towardeconomics the endand of the marketing intangibles’ useful life, but he did not include a decay curve in publichis valuation. affairs at As Princeton he explained, University. this was He a conservativereceived his A.B.assumption in mathematics that arguably from introduced “an upward bias in his final buy-in price conclusion.” Since petitioner Harvarddoes not University,urge application his M.S. of a indecay operations curve here,research we havefrom no Stanford occasion University, to decide and whether it would be appropriate. - 199143 - his Ph.D. in economics3. Revenue from Base Stanford. While teaching at Princeton, he also served as a principalWith one external minor advisorexception at notedthe Inter below,-American the parties Development agree that Bank, royalties a Deputy for

Assistantthe marketing Attorney intangibles General should at the be U.S. figured Department on the sa ofm Justice,e revenue and base a supervisor as royalties at

Bellfor the Laboratories, website technology, among other namely, consulting AEHT ’roles.s projected His research revenues and over publications the useful lifefocus of onthe asset relevant decay, assets. how Allmarkets experts work, agree how on markets using m influenceanagement economic projections out- to determinecomes, and AEHT how the’s revenue forces of base economics for 2005-2011. affect the We marketplace. have already The approved, Court recog- in nizedconnection Professor with Willigthe website as an technology,expert in microeconomics. Dr. Wills’ use of a “50% declining bal-

18.ance ” methodJohn Wills to estimate AEHT’s post-2011 revenues. See supra pp. 121-123.

We againDr. approveWills holds use aof Ph.D. that m inethod economics to estimate and is AEHT the principal’s revenues of Wills beginning Consult- in ing,2012 a and consulting continuing firm through specializing the end in oftransfer the 20-year pricing useful economics. life we Hehave received ascribed his to

B.A.the marketing in economics intangibles. from Claremont Men's College (now Claremont McKenna

College)Em andploying his M.A. the 50% and decliningPh.D. in economics balance method, from the Mr. University Reilly reduced of Washington. AEHT’s

Herevenue was previouslygrowth rate the by head 50% offor Ernst each & post-2011 Young's yeartransfer until pricing it reached practice a “stable in the”

Westernrate. He regionselected of 4% the as United AEHT States,’s stable an growtheconomist rate, in using Deloitte long-term & Touche's growth Nation- and alin fTaxlatio Office,n proje candtion as Legislativefor the eurozone. Assistant Under at the this United approach, States which Senate. we acceptHe has here, workedAEHT’s in rate transfer of revenue pricing growth economics declined for tomore its 4%than stable 25 years. rate startingMost of in his 2017. work has focusedIn his on opening transfer report, pricing Mr. associated Haigh adopted with technology a more conservative companies, assu particularlymption. intangiblesHe likewise transactions selected 4% and as AEHT cost-sharing’s long-term arrangements. growth rate, The but Court he assu recognizedmed that Dr.

Wills as an expert in economics and transfer pricing economics. AEHT would reach this lower rate much- 200 more - quickly, beginning in 2012. In his

Respondent's Expert Witnesses

1. Geoff A. Cohen

Dr. Cohen is a computer scientist at Elysium Digital LLC where he is a technical consultant to firms and government agencies involved in computer- science-related litigation. He received his A.B. from Princeton University and his

Ph.D. in computer science from Duke University. Before working at Elysium, he was a principal at Coherence Engine and a senior consultant and manager at the

Cap Gemini Ernst & Young Center for Business Innovation. He was also a consultant at the National Research Council, where he assisted in the research for and production of a report on the intersection of computer science and biology. He has published extensively in the area of computer science. The Court recognized Dr.

Cohen as an expert in computer science and software.

2. James G. Conley

Dr. Conley is a marketing professor at the Kellogg School of Management and an engineering professor at the McCormack School of Engineering at North- western University where he teaches innovation process management and intellectual capital management. He received his B.S. in nuclear engineering from the

University of Virginia and his master's in management and Ph.D. in materials sci-

ence and engineering from Northwestern University. He is also a director at the -201- 144 - rebuttalGlobal Economics report, by contrast, Group LLC. Mr. HaighHe was switched previously to use a principal of a 10-year, at Chicago straight-line Part- ners,decline an fromintellectual AEHT ’capitals 2011 managementgrowth rate; thisand nearlylitigation doubled, consulting to $3.13 firm, billion, and a his buy-infounder valuation of Syndia of Corporation, the marketing a productintangibles. development He offered and no intellectual convincing property rationale licensingfor this 11th-hour firm. He change was also of anopinion, appointed and wemember did not of find the Trademarkit persuasive. Public45 Ad- visory TheCommittee parties disagreeto the U.S. concerning Patent and one Trademark small detail Office. of the He revenue has researched base calcu- and publishedlation, namely, extensively whether in revenues the areas attributable of intellectual to giftwrap, property shipping,management and andmiscel- process management.laneous services The should Court be recognized excluded fromDr. Conley AEHT as’s projectedan expert revenuein intellectual stream for propertypurposes management.of calculating royalties on the marketing intangibles. Mr. Reilly exclud-

3.ed theseJorge revenues Luis Contreras because these services were projected to operate at a significant loss; inProfessor his opinion, Contreras an arm is’s-length an intellectual licensee property would not law pay professor royalties at onthe negative American

University,revenue streams. Washington Mr. Haigh College took of the Law opposite and the position, founder urging of Contreras that “[t]hese Legal Stra- tegy,sources LLC, of revenue a boutique are legaldirectly advisory linked firm. to the He brand received because his [they] B.A. in* *English * would and not

B.S.arise inunless electrical the customer engineering gravitated from Rice towards University the website and his through, J.D. from in part, Harvard the mak- Law ingSchool. available He was of the previously Amazon an brand associate in Europe. and partner” at Wilmer, Cutler, Pickering,

Hale, and Don LLP where he advised clients on transactions involving intellectual

45 property,Because including Mr. licensing, Haigh did technology not, before development, his rebuttal report, and product question manufactur- the pro- priety of using the 50% declining balance method, the testimony and other evi- ing,denc distribution,e on this poi nandt w esale.re lim Heite dhas. During published his oralextensively testimony in Mr.the areasReilly of cited intellectual a pub- lication by McKinsey & Co., “Valuation: Measuring and Managing the Value of property,Companies, technology” for the proposition licensing, technical that the 50% standards, declining patent balance litigation, method and is regula- a standard valuation technique for moving from revenue projections to long-term growth rates. On the basis of the limited testimony provided to us, we have no reason to question the appropriateness of employing that method here. - 202145 - tion ofWe science. conclude The that Court Mr. recognized Reilly correctly him as excluded an expert these in U.S. revenues. and foreign Before intel- lectualProject propertyGoldcrest law, various domain intercompany name law, andagreements intellectual designated property the licensing. European Sub-

4.sidiaries Edward “commissionaires W. Felten ” for Amazon US, entitling them to commissions based on theirDr. net Felten sales. is The the directorterm “net of sales the ”Center was defined for Information to exclude Technology giftwrap, shipping, Policy and themiscellaneous Robert E. Kahn services professor revenue. of computerBecause Amazon science andUS publicrefused affairs to pay at com- Prince- tonmissions University. on these He types received of revenue, his B.S. we in concludephysics from that AEHT,the California operating Institute at arm of’s

Technologylength, would and likewise his M.S. refuse and toPh.D. pay inroyalties computer thereon. science46 and engineering from the

UniversityA final of Washington.question concerns He has the held starting numerous date for other AEHT positions’s payment in the of area royalties of forcomputer the marketing science, intangibles. including chief As fortechnologist the website at technology,the Federal Tradewe find Commission, that the startingconsulting date computer for payment scientist of royalties at Elysium is May Digital 1, 2006. LLC, Byand its consultant terms, the at Assign- Electronic

Frontierment Agreement Foundation, conveying in addition the right to serving to use onthe various marketing advisory intangibles and consulting remained boards.executory He until has Maywritten 1, 2006,two books the “ businessand over transfer 100 articles date. relating” All of topetitioner computer’s sci-

ence and intellectual property policy. The Court recognized Dr. Felten as an

expert in computer science.

5. Daniel J. Frisch 46One month after filing his simultaneous answering brief respondent sought leave toDr. file Frisch an amended holds a openingPh.D. in briefeconomics containing specializing citations in of transfer other intercompany pricing agreements that allegedly defined “net sales” differently. We denied that motion analysisas unfairly and prejudicial is the managing to petitioner. director See at Horstsec. 151(e)(3) Frisch, Incorporated, (requiring that an a independ- party’s opening brief include citations of “the pages of the transcript or the exhibits or otherent economics sources relied consulting upon tofirm. support He received” each proposed his A.B., finding M.A., ofand fact, Ph.D. thus in enabling econom- the opposing party to “set forth any objections, together with the reasons there- icsfor ”from). We Harvard note that University. exclusion Heof giftwrap, previously shipping worked and as amiscellaneous principal at KPMG service Peat revenues results in a very small adjustment to the revenue base. -203- 146 -

Marwickexperts, a nandd a lasl b au tdirector one of rforesp internationalondent’s experts, taxation agreed and that international May 1, 2006, economist was the at theappropriate U.S. Treasury starting Department's date for payment Office of of royalties, Tax Analysis. and we Heshare also their worked consensus. as a 47 senior staff economist4. Discount at the RateCouncil of Economic Advisers and an assistant pro-

fessor Weof economics have already at the determined University that of an Washington 18% discount in Seattle. rate is appropriateHis practice when has valuingfocused theon consultingwebsite technology. for U.S. and See foreign supra pp.multinational 124-126. Wecompanies see no reasonwith regard to to transferadopt a differentpricing policies. discount Herate has when published valuing extensively the marketing in the intangibles. area of transfer We will pricing.briefly The address Court Mr.recognized Haigh’s Dr.submission Frisch as that an experta 13.3% in discounteconomics rate and should transfer be usedpric- ing.instead.

6. InPaul determining A. Gompers his discount rate, Mr. Haigh accords Amazon a 1.45 beta, as opposedDr. to Gompers the 2.0 beta is the upon administration which Mr. Reilly and faculty and Dr. chair Frisch of the agreed. elective This curric- differ- ulumence partly at the reflectsHarvard Mr. University Haigh’s Graduateuse of weekly School rather of Business than monthly Administration. stock market He receiveddata, which his weA.B. have in biologyalready fromrejected. Harvard See supraCollege, pp. his124-126. M.Sc. inThe economics rest of the from differenceOxford University, reflects the and fact his that Ph.D. Mr. in Haigh business does economics not compute from the Harvard beta for University. Amazon

Heitself; has instead researched he uses and an written average extensively of betas derived in the areas from ofcompanies venture capital, he regards private as comparable,equity industries, such andas eBay, entrepreneurial Yahoo!, Netflix, finance. Overstock.com, He has also served Barnes as & a Noble,consultant and and1-800-Flowers. adviser to numerous companies with regard to fundraising, future projections, investments, and valuation. The Court recognized Dr. Gompers as an expert in

47 financialMr. economics, Haigh calculated valuation his of buy-in businesses obligation and assets, for the private marketing equity, intangibles and entre- starting January 1, 2005. He provided no explanation for choosing this date, other preneurialthan his understanding finance. that his assignment was to value the intangibles as of December 31, 2004. -204-- 147 -

7. DavidWe reject Haigh this approach. As Dr. Unni explains, a valuation expert typically looks toMr. comparable Haigh is a companies chief executive to derive at Brand a beta Finance, when the a Unitedsubject Kingdomcompany ’brands stock isconsultancy thinly traded firm or specializing not publicly in traded brand at valuation, all. That evaluation,is not the situation research, here: and Astrate-ma- gy.zon wasHe received a very actively his B.A. traded in English stock, literaturewith an average from Bristol daily University.NASDAQ trading He there- aftervolume joined of 8.51 PwC m asillion an auditorshares duringand later 2004. worked Because as a managementthe Bloomberg consultant. market data

Whilewere more there than he became sufficient qualified to compute as a charteredAmazon’ saccountant. beta directly, After as every leaving other PwC ex- he workedpert in this as acase consultant did, there at variouswas no needfirms to during consult which data timeconcerning he earned other a post- com- graduatepanies.48 diploma in marketing. He has written extensively on brand valuation and brand strategy5. and hasEuropean also lectured Portfolio on the subjects at schools in the United States, the UnitedPetitioner Kingdom, contends Singapore, that roughly and Switzerland. half the value The of theCourt marketing recognized intangibles him as anwas expert owned in by brand the Europeanevaluation Subsidiaries and brand valuation. before Project Goldcrest. Because the

8.assets Harlowto that extent Higinbotham were not owned by Amazon US or transferred to AEHT under the LicenseDr. Higinbotham or Assignment holds Agreement, a Ph.D. in petitioner economics urges and thatis a theirchartered value financial should be analystexcluded currently from the serving buy-in aspayment. the senior Petitioner vice president tasked ofone National of its experts, Economic Mr. Re- searchFranklyn, Associates with responsibility (NERA). He for received examining his the A.B. European in applied registration mathematics files, from ascer-

Harvardtaining which University, domain completed names and graduate marks were studies legally at the owned London by Schoolthe European of Econom- Sub- ics, and received his Ph.D. in economics from the University of Chicago. Before

48 joining NERA,We think he Mr. served Haigh as A.T.also erred,Kearney's when chief calculating economist, Amazon leading’s equity its transfer risk premium, in rejecting the Ibbotson Associates data upon which all the other ex- pricingperts re lpractice.ied. As w Hee n ohasted published in Veritas, extensively 133 T.C. at on 325, transfer Ibbotson pricing Associates and has presentsalso “the recognized industry standard of historical capital markets data.” - 205148 - servedsidiarie ass, aannd expert determining witness what in prior percentage proceedings of the related overall to value cost shoulddetermination. be allocated The toCourt those recognized assets. This him task as an was expert complicated in transfer by pricing.the fact that certain marks (as ex- plained9. Thomas more fully Hoeren below) had been registered in Europe both by Amazon US and by AmProfessorazon Germany. Hoeren is a foreign intellectual property law professor at the Uni- versityWe of Munsterwill refer in to Germany. the intangibles He received owned byhis thefirst European degree in Subsidiaries theology and and/or philosophy,legally registered his doctorate in their in theology,names as andthe Europeana law degree portfolio. from the Mr. University Franklyn ofdeter- Mun- ster.mined He that has the been European a professor portfolio in intellectual consisted ofproperty the following: law for over (1) the20 years,editorial lec- turingcontent at of universities the UK, German, around andthe world.French websites,He has written owned extensively respectively on by intellectual Amazon propertyUK, Amazon and trademarkGermany, law.and AThemazon Court France; recognized (2) at leasthim as10 an trademarks expert in trademarkregistered law,by A domainmazon Germany, name law, including and intellectual “Amazon, property.” “Amazon.com, ” and “Amazon and

10.Design Forrest” (often Oswald called the “Amazon Smile”); (3) numerous domain names owned by AmMr.azon Oswald Germany, is a thesenior most IRS important economist of whichin the transferwas “amazon.de pricing practice”; and (4) group.

Hecer treceivedain doma hisin n B.A.ames in o weconomicsned by Am andazo an minorFrance, in the mathematics most important from ofPepperdine which was

University.“amazon.fr. ”Before working at the IRS, he worked for KPMG and FTI Consulting in their transfer pricinga. groups.Ownership He has of theparticipated European in Portfolio transfer pricing evaluations

for variousRespondent intercompany presents transactions, as a threshold including question intellectual whether the property, European services, Sub- goods,sidiaries and should loans, be and considered, for a variety for Federalof industries, income including tax purposes, retail, as software, truly “owning finan-” thecial Europeanservices, automotive,Portfolio. For and assets entertainment. that are legally The Courtprotected, recognized like those Mr. here, Oswald the as an expert in transfer pricing and valuation. regulations provide that “[t]he legal owner- 206 of - a right to exploit an intangible ordi- 11. Jim Timmins

of Business. Before joining Teknos, he was a managing director of Pagemill Part- ners (now a Duff & Phelps Business), an investment bank, managing director of the Daiwa Securities Group, NIF Ventures (now NIF Sumitomo Mitsui Banking

Corporation Ventures), and a general partner of the venture capital firms Glen- wood Ventures and Glenwood Capital. He has provided valuation services, venture capital investing, and investment banking services to hundreds of companies

for more than 30 years. The Court recognized Mr. Timmins as an expert in valuation.

12. Ronald T. Wilcox

Dr. Wilcox holds a Ph.D. in economics, is the Ethyl Corporation professor

of business administration at the University of Virginia's Darden School of Busi- ness, and associate dean of the M.B.A. for executives program at Darden. He received his B.A. in economics from Xavier University and his Ph.D. in business administration from Washington University in St. Louis. Before Darden, he was - 207149 - annarily assistant will be professor considered of industrialthe owner. administration” See sec. 1.482-4(f)(3)(ii)(A), at the Graduate School Income of Tax

IndustrialRegs.; cf. id.Administration subdiv. (ii)(B) (now (co nsideringTepper School developer of Business) to be the at owner Carnegie of intangibles Mellon

University.that are not legallyHe was protected). also an economist However, at thea different U.S. Securities ownership and agreement Exchange m Com-ay be missionimputed from“if the 1999 conduct to 2000, of the in controlledaddition to taxpayers serving as indicates a marketing the existence consultant in forsub- variousstance of organizations. such an agreement. He has” publishedSec. 1.482-4(f)(3)(ii)(A), extensively on theIncome topic Tax of marketing. Regs.; see

Thesec. 1.482-1(d)(3)(ii)(B)(2),Court recognized Dr. Wilcox Income as Taxan expert Regs. in(authorizing marketing, district marketing director modeling, to and“impute consumer a contractual behavior. agreement between the controlled taxpayers consistent with the economic substance of the transaction”).

Respondent contends that Amazon US was the true equitable owner of any marketing intangibles legally owned by the European Subsidiaries. In respondent’s view, Amazon US “made all of the investments and took all of the risks involved in building up the value of any items of IP that were registered in the Euro- pean affiliates’ names.” Respondent accordingly urges that we should impute an agreement whereby Amazon US held an exclusive license to use any marketing intangibles nominally owned by the European Subsidiaries, or, alternatively, that the European Subsidiaries acted as “agents” of Amazon US in holding title to these assets. See Commissioner v. Bollinger, 485 U.S. 340, 346 (1988); Nat’l

Carbide Corp. v. Commissioner, 336 U.S. 422, 436-437 (1949) (listing six factors as relevant to corporate “agency” determination). - 150 -

We find neither of respondent’s arguments persuasive. There clearly existed valid business reasons for localizing ownership of the European Portfolio in the

European Subsidiaries. Under the laws of Germany and France at the relevant times, only local companies could obtain country-specific domain names (e.g.,

Amazon.de and Amazon.fr). Accordingly, Amazon Germany and Amazon France registered for their country-specific domain names. Amazon Germany registered a number of trademarks, including important marks like “Amazon” and “Ama- zon.com,” to enable it to apply for international registrations in a simplified manner through the “Madrid Protocol.”49 At the relevant times, Amazon US could not do this directly because the United States was not a signatory of the Madrid Proto- col.

49Under the Protocol Relating to the Madrid Agreement Concerning the International Registration of Marks (Madrid Protocol), a trademark owner can file a single trademark-registration application with a single office, in one language, in one currency, with one set of fees. After filing this original application, the owner can submit an “international application” listing additional countries in which a trademark registration will be sought. The initial country’s trademark office will confirm that the international application complies with local requirements, then forward it to the World Intellectual Property Organization (WIPO). The WIPO submits the international application to the individual trademark offices of the countries designated in the international application. The designated countries will then examine the international application in accordance with their own procedures for national trademarks. - 151 -

Equally clearly, the European Subsidiaries used these domain names and marks in the active conduct of their business. Before January 2005 the European

Subsidiaries were service providers for Amazon US. They had numerous employees of their own who were responsible for vendor and customer relationships.

Because of differing cultural preferences, retail traditions, and national regulations, the details of these operations often varied from country to country. Local teams were thus integral to Amazon’s success in Europe.

At the relevant times, the European Subsidiaries bore significant marketing risk. For example, under an October 2001 “Sales Commissionaire Agreement,”

Amazon US provided Amazon Germany “with appropriate incentives to perform a key role in contributing to the growth of the Website’s Customer base” given its unique “ability to attract and retain customers for the Website through its understanding of German culture.” Under this agreement Amazon Germany was entitled to a one-time bounty for each new customer, as well as commissions based on new customer sales and revenues from part of its international 3PS business.

Under this and similar agreements, the European Subsidiaries had an actual business risk because they received only a percentage of revenues. There was no guaranty that they would earn a profit based on their marketing efforts. Respond- ent thus errs in asserting that Amazon US “took all of the risk.” At the time the - 152 -

European Subsidiaries registered the trademarks and domain names included in the European Portfolio, they bore meaningful business risk.50

Portfolio hinged on the European Subsidiaries’ ability to fulfill Amazon’s promise of fast and accurate delivery. Their success in doing so contributed meaningfully to the value of these domain names and marks.

On these facts, we cannot find that the European Subsidiaries were mere

“agents” of Amazon US for the purpose of holding title to the European Portfolio.

As the ultimate parent, Amazon US had the ability to decide how ownership of the marketing intangibles would be dispersed within the corporate family. But there was a valid business justification for the European Subsidiaries’ ownership of these domain names and marks, and they actually used these assets in the active conduct of their business. “[T]he mere fact of the parent’s control over the subsidiaries * * * [does] not establish the existence of an agency, since such control is typical of all shareholder-corporation relationships.” Commissioner v. Bollinger,

50Amazon UK and Amazon Germany bore less business risk after December 31, 2003, when they began to supply services to Amazon US on a cost-plus basis. - 153 -

485 U.S. at 346 (citing Nat’l Carbide Corp., 336 U.S. at 429-434); see Merck &

Co. v. United States, 24 Cl. Ct. 73, 88 (1991) (“A parent corporation may create subsidiaries and determine which among its subsidiaries will earn income. The mere power to determine who in a controlled group will earn income cannot justify a Section 482 allocation from the entity that actually earned the income.”).

Nor will we “impute a contractual agreement between the controlled taxpayers” to deem Amazon US the equitable owner of the European Portfolio. Sec.

1.482-1(d)(3)(ii)(B)(2), Income Tax Regs. The European Subsidiaries used the domain names and marks in the active conduct of their business; they helped develop the value of these intangible assets; and they took on significant marketing risk. The ownership structure did not lack economic substance, and there is thus no justification for departing from the general rule set forth in the regulations.

See Claymont Invs., Inc., 90 T.C.M. (CCH) at 467; sec. 1.482-4(f)(3)(ii)(A), In- come Tax Regs. (for legally protected property, “[t]he legal owner of a right to exploit an intangible ordinarily will be considered the owner”); sec. 1.482- 1(d)(3)

(ii)(B)(2), Income Tax Regs. (authorizing district director to impute a contrary agreement only if “consistent with the economic substance of the transaction”). - 154 -

b. Allocating Value to the European Portfolio

Before 2005 Amazon was growing rapidly and accounted for its trademarks and domain names rather haphazardly. Scott Hayden, petitioner’s vice president of intellectual property, explained that Amazon in its early years did not have a systematic approach to its trademark portfolio and that its documentation revealed systemic errors. He testified that, if he questioned different people about Ama- zon’s intangible property on different days, he would often get different answers.

In its tax reporting, Amazon treated the European Portfolio as a distinct group of assets but accorded it a much lower value than urged at trial. A Deloitte report entitled “Project Goldcrest: Transfer of Miscellaneous EU Subsidiary IP” noted that, under the Four-Party Agreement, the European Subsidiaries assigned their interests in the European Portfolio to AEHT for about $2 million. Deloitte determined that this price was reasonable. After discovering a clerical error in these numbers, petitioner increased the valuation of the European Portfolio to about $5 million. Mr. Franklyn, by contrast, opined that the European Portfolio was worth between $136 million and $147 million.

For trial purposes, Mr. Franklyn created two models--the “goods and services” model and the “coexistence” model--to allocate the value of the marketing intangibles between the European Portfolio and the US Portfolio (comprising the - 155 - trademarks and domain names that Amazon US owned). These models differed chiefly in how Mr. Franklyn accounted for overlapping and competing claims that

Amazon US and Amazon Germany had to the same trademarks. In his “goods and services” model, Mr. Franklyn attempted to allocate value on the basis of the particular Nice classes that the competing trademark registrations covered.51 In his

“coexistence” model, he allocated value 50-50 between the European and the US

Portfolios in cases of overlapping coverage, regardless of registration priority or

Nice classifications claimed.

Under both models, Mr. Franklyn assigned the trademarks to one of three tiers, depending on their assumed importance to Amazon’s business. To tier 1 he assigned Amazon’s three most important marks, “Amazon,” “Amazon.com,” and

“Amazon and Design.” To tier 2 he assigned the five marks covering the most significant European domain names. To tier 3 he assigned 31 trademarks, the vast majority of which were owned by Amazon US. He deemed the marks assigned to

51The Nice Classification is an international system recognized by national trademark offices as a means of describing and classifying goods and services in trademark applications. For example, tea may be appropriate for Nice class 5 as medicinal tea and for Nice class 30 as non-medicinal tea. By registering a mark for tea in class 30, an applicant may forfeit any protection that might be claimed under class 5. In Europe, Nice classes have an important practical impact on the scope of protection that a trademark affords. Amazon US and Amazon Germany filed, at various times, overlapping and competing registrations of the same trademarks under different Nice classes. - 156 - tier 1 to possess 75% of the total trademark value, the marks assigned to tier 2 to possess 18.8% of the total trademark value, and the marks assigned to tier 3 to possess 6.2% of the total trademark value. He allocated the value of the marks within each tier to the European or the US Portfolio on the basis of geographic coverage, trademark date priority, the existence of competing or overlapping claims, goods or services covered, and the projected revenues attributable to the various marks.

Under both the “goods and services” and the “coexistence” models, the

European Portfolio received a very modest proportion of the tier 2 trademark value

(averaging 21%) and a minuscule proportion of the tier 3 trademark value (averaging 3.4%). But Mr. Franklyn allocated to the European Portfolio the bulk of the tier 1 trademark value (63.6% and 50.7% under the “goods and services” and “coexistence” models, respectively). Because the tier 1 marks were weighted so heavily (at 75%) and the tier 3 marks so lightly (at 6.2%), the European Portfolio ended up with 52% and 42% of the aggregate trademark value under Mr. Franklyn’s two approaches. Those percentages rose to 54% and 47% of the total intangible value after he accounted for domain names.52

52For the domain name allocation, Mr. Franklyn calculated total 2005-2012 sales through the various European websites; allocated this revenue between the (continued...) - 157 -

Respondent’s expert Mr. Haigh pointed out that Mr. Franklyn did not rely on any recognized valuation authority in devising his two methodologies and that his results were inconsistent with the conclusions that Deloitte had reached in the report mentioned supra p. 154. Using the trademark and domain values determined by Deloitte, Mr. Haigh estimated that only 30% of the overall value should be allocated to the European Portfolio. After adjusting the Deloitte results to eliminate what he regarded as double-counting of certain marks, Mr. Haigh opined that at most 25% of the overall value of the marketing intangibles should be allocated to the European Portfolio.

We conclude that respondent has the stronger side of this argument. Mr.

Franklyn provided no theoretical or technical support for his “coexistence” model as a valuation technique. In every case of overlapping trademarks, that model allocated value 50-50 between the European and the US Portfolios, regardless of registration priority, Nice classifications claimed, and the relative strength of the registrants’ competing claims. We find this approach to be arbitrary and unreliable.

52(...continued) US and the European Portfolios based on ownership of the domain names; and weighted the trademarks at 75% and the domain names at 25%. - 158 -

While Mr. Franklyn’s “goods and services” model may have a firmer con- ceptual footing, we agree with respondent’s critique of his implementation of this approach. First, it seems clear to us that Mr. Franklyn overweighted tier 1 and underweighted tier 3. He testified that he used the “rule of the mean” to allocate

75% of the total value to tier 1 and a mere 6.2% to tier 3. Respondent urges, and we agree, that this was little more than a guess and was not based on any recognized principles governing valuation of intellectual property.

Mr. Franklyn placed in tier 3 a total of 31 trademarks, the vast majority of which were owned by Amazon US. Nine of these marks were rated as “significant” by Deloitte. Mr. Haigh reasonably concluded that several other tier 3 marks, including “Amazon.com & Design” and the “Amazon Smile” logo, were likewise very important to Amazon’s business. It seems clear to us that the tier 3 trademarks accounted for substantially more than 6.2% of the overall value.

We also find that Mr. Franklyn erred in allocating to the European Portfolio more than half the value of the tier 1 marks. Tier 1 comprised petitioner’s three most important trademarks--“Amazon,” “Amazon.com,” and “Amazon and De- sign.” In his “goods and services” model, Mr. Franklyn reasonably allocated 95% of the “Amazon.com” mark to the US Portfolio. But we think he erred in his treatment of the other two marks. - 159 -

Amazon US and Amazon Germany both filed registrations for the “Ama- zon” mark. Amazon US had clear date priority, because its application was filed in 1996, whereas Amazon Germany’s was not filed until 2000. Mr. Franklyn nevertheless allocated 85% of this trademark’s value to the European Portfolio; he did so because Amazon Germany’s application included Nice class 35, which was not among the three Nice classes that Amazon US had claimed four years previously. According to Mr. Franklyn, Nice class 35 covered “online retail sale of physical goods,” from which the vast bulk of AEHT’s revenues would be derived.

We find that Mr. Franklyn overemphasized the importance of the Nice classes, as compared to trademark date priority, and that he particularly erred in giving outsized importance to Nice class 35. In concluding that this class covered

“online retail sale of physical goods,” he relied on a definition of Nice class 35 that appears in the 2012 version of the Nice Classification. That version, representing the 10th edition of the Classification, postdates the registrations at issue by more than a decade.

In 1996 and 2000, when Amazon US and Amazon Germany respectively registered their overlapping “Amazon” marks, the 7th edition of the Nice Classifi- cation was in effect. It made no mention of eCommerce, websites, or online sales in its description of class 35, which was captioned “Advertising; business manage- - 160 - ment; business administration; office functions.”53 The eighth edition of the Nice

Classification was in effect through 2007; it likewise does not mention eCom- merce, websites, or online sales in the class 35 description.

Amazon US in 1996 registered the “Amazon” mark under Nice classes 9,

37, and 42. Those classes covered data processing equipment and computers, scientific and technological services, and the design and development of computer hardware and software. The trial testimony established that these classes were common selections for early online systems; Amazon’s business was covered by, or at least analogous to, these classes. The seventh edition of the Nice Classifica- tion states that services not specifically covered by any class should be grouped by

“analogy with other comparable services”; if a service could not otherwise be classified, it was “in principle classified in Class 42.” Because Amazon US selected Nice class 42 when registering the “Amazon” trademark in 1996, and because it had four years of date priority over Amazon Germany’s overlapping

53Class 35 at the time did include “the bringing together, for the benefit of others, of a variety of goods (excluding the transport thereof), enabling customers to conveniently view and purchase those goods.” Jorge Luis Contreras, one of respondent’s experts, credibly testified that this language was interpreted to refer to “swap shops” and “flea markets” and that class 35 at the time “specifically exclude[d] the actual sale of the goods.” - 161 - mark, we find that most or all of the value of the “Amazon” mark should be allocated to the US Portfolio.54

The third trademark that Mr. Franklyn put in tier 1 is “Amazon and Design.”

Amazon US and Amazon Germany filed European registration applications for this mark on the same day and under the same four Nice classes. Whereas Mr.

Franklyn allocated 100% of the value of this mark to the European Portfolio, respondent’s experts persuaded us that Amazon US and Amazon Germany both had very plausible claims. If we were to make an estimate under the Cohan rule, see

Cohan v. Commissioner, 39 F.2d 540, 543-544 (2d Cir. 1930), we would allocate the value of this mark roughly equally between the European and the US Port- folios.

54In his “coexistence” model, Mr. Franklyn rationalized allocating to the European Portfolio half the value of numerous trademarks, including the “Ama- zon” mark, under principles of “acquiescence.” Under that doctrine, a trademark holder (such as Amazon US) can be divested of its trademark protection if it does not challenge an overlapping mark (such as that registered by Amazon Germany) within five years. Mr. Franklyn offered no authority to support the proposition that “acquiescence” would apply with full force inside a corporate group or that a parent corporation could be divested of trademark protection by an action taken by its subsidiary. In any event, even if “acquiescence” applied to the same corporate group, Amazon Germany did not register its “Amazon” mark until mid-2000, and the valuation here is being performed as of January 1, 2005, less than five years later. On January 1, 2005, Amazon US (or a hypothetical third party that had acquired the trademark from Amazon US) could still have challenged Amazon Germany’s mark and potentially excluded Amazon Germany from using it. - 162 -

In sum, we conclude that Mr. Franklyn made several errors that caused him to overstate significantly the value of the European Portfolio. He substantially undervalued the tier 3 marks, which were owned overwhelmingly by Amazon US, and he significantly over-allocated to the European Portfolio the value of the tier 1 marks. Moreover, there is no technical or evidentiary support for the

75%/18.8%/6.2% weighting he accorded the three tiers. Given these errors, we find that the best evidence available is Mr. Haigh’s opinion: On the basis of his adjustments to Deloitte’s findings, he determined that 25% of the overall value of the marketing intangibles should be allocated to the European Portfolio.55 We accordingly conclude that this 25% portion must be excluded from the value of the marketing intangibles, as otherwise determined under this Opinion, when computing the appropriate buy-in payment.

C. Customer Information

The customer information that Amazon US made available to AEHT consisted of data about European retail customers who had transacted with the Euro-

55We have neither the data nor the ability to perform a precise “correction” of Mr. Franklyn’s “goods and services” model to eliminate the errors discussed in the text and other errors of which respondent complains. However, if the bulk of the tier 1 trademark value were allocated to the US Portfolio as we think necessary, and if the tier 3 trademarks were given an appropriate heavier weighting (say 20% instead of 6.2%), we suspect that reasonable permutations of Mr. Franklyn’s model would gravitate toward Mr. Haigh’s 25% conclusion. - 163 - pean Subsidiaries before May 1, 2006. These data included names, email addresses, phone numbers, credit card information, and purchasing history. By making this information available to AEHT, Amazon US in effect was referring its existing European customers to AEHT and furnishing it with certain information about them.

The parties agree that the Associates and Syndicated Stores agreements between Amazon and its business partners provide useful internal CUTs for purposes of determining the fair market value of the customer information. Under those agreements, Amazon paid referral fees, in the form of “commissions,” to a third party when the latter’s customers or website visitors made purchases from Ama- zon. While concurring that these agreements supply useful data for valuing the customer information, the parties disagree about the mechanics of the valuation exercise.

Amazon had thousands of Associates agreements and more than 20 Syn- dicated Stores agreements with U.S. and European partners. The stated commission rates under both programs depended on product mix and sales volumes.

Commission rates generally ranged from 4% to 8% in the Associates program and from 4% to 6% in the Syndicated Stores program. Referral fees for Syndicated Stores partners generally had a per-unit cap; this meant that the effective commis- - 164 - sion rate could be lower than the nominal rate reflected in the contract. The average referral fee Amazon actually paid under the Associates and Syndicated Stores programs was approximately 5.9% of referred sales.

Dr. Higinbotham examined two Syndicated Stores agreements and based his valuation principally on Amazon’s contract with Waterstone’s, a U.K. retailer. He explained that he focused on that contract because Waterstone’s did business solely in an EU member state. He did not elaborate on the significance of this distinc- tion or explain why it justified limiting his focus largely to this one contract.

The Waterstone’s agreement provided for commissions ranging from 5% to

6% of referred sales. It also included a feature unique among the Syndicated

Stores contracts: a one-time bounty of £7 for customers who clicked on a link embedded in certain promotional emails and subsequently made a purchase on an

Amazon site. Dr. Higinbotham determined that people arriving at Amazon through a mirror site typically converted to direct Amazon customers within 90 days. He accordingly valued the customer information as the sum of: (1) a £7 bounty for each European customer that Amazon U.S. transferred to AEHT on

May 1, 2006, and (2) a 6% commission computed on AEHT’s total sales during the 90 days immediately following the May 1, 2006, business transfer. He thus derived a value of $214.5 million for the customer information. - 165 -

At trial Dr. Higinbotham agreed that the Waterstone’s contract was atypical and that Dr. Wills’ analysis, which considered all the Associates and Syndicated

Stores agreements, was more robust than his own. We agree on both counts. In his post-trial briefs respondent abandoned his reliance on Dr. Higinbotham’s approach and instead proposed modifications to Dr. Wills’ valuation methodology, to which we now turn.

Dr. Wills’ first step was to determine an arm’s-length referral fee. For this he used the weighted average of the actual commission rates paid under all Asso- ciates and Syndicated Stores agreements56 in place for the European Subsidiaries during 2004-2006. (By using actual rates he accounted for cases where fee caps or similar provisions caused variance from the nominal rate.) He thus determined an average referral fee equal to 5.9% of referred sales. Respondent agrees that this reflects an accurate interpretation of the relevant data.

Dr. Wills’ next step was to estimate the revenue stream to which this 5.9% referral fee should apply. In approaching this question, he noted that Amazon would pay a commission to an Associate only if the customer arrived directly from the Associate’s site and made a purchase within 24 hours. Amazon was willing to

56Unless otherwise specified, subsequent references to the Associates program also include the Syndicated Stores program. - 166 - pay a large commission on this initial purchase because it was confident that the purchaser would soon become a direct Amazon customer, on whose future purchases no commissions would be due. Dr. Wills accordingly concluded that

AEHT, operating at arm’s length, would not pay referral fees to Amazon US on revenues derived from the initially referred European customers once those individuals had “converted” to AEHT customers and purchased items by coming directly to AEHT’s sites. Dr. Higinbotham agreed with this proposition.

To ascertain the “conversion” rate, Dr. Wills relied on analyses performed by Dr. Moe and Mr. Wentland. Using Associates program data from January 2004 through April 2006, Dr. Moe analyzed subsequent spending by European customers who had originally arrived at an Amazon website via referral. To the extent these customers made future purchases by coming to an Amazon site directly, rather than by referral from a partner’s site, she deemed them to have

“converted.”

Her analysis shows a very rapid rate of conversion, with 83.5% of referred customers becoming direct Amazon customers within one year. After eight years, only 10% of customers who had initially been referred from a partner’s site continued to return to Amazon by referral, thus generating additional referral fees. - 167 -

These additional fees, while less numerous, tended to be more lucrative because these customers spent above-average amounts on each Amazon shopping trip.

Dr. Wills concluded that the future revenue stream on which AEHT would have to pay referral fees equaled the sum of: (1) the initial purchases that the referred European customers made from AEHT and (2) subsequent purchases those individuals would make from AEHT upon referral from a mirror site rather than as

“converted” AEHT customers. Dr. Moe’s analysis provided an estimate of the median and average amounts that customers would spend, per visit to AEHT’s sites, during the 10-year period following the business transfer. Dr. Wills used the median amounts in his analysis and concluded that AEHT, operating at arm’s length, would agree to pay referral fees only for six years.

Combining the customer retention and conversion analyses with the median estimated spending per customer, Dr. Wills calculated the revenue that AEHT would derive from customers inherited from Amazon US who were expected to arrive at AEHT’s websites by referral during the six years following the business transfer. Multiplying the estimated annual customer spending by the 5.9% referral fee and discounting this revenue stream at 18%, he opined that the arms-length buy-in payment for the customer information was $51.9 million. - 168 -

Respondent challenges Dr. Wills’ $51.9 million valuation on several grounds, the first of which concerns the cutoff date for paying referral fees. Dr.

Wills acknowledged that there was a long “tail” of unconverted customers in the

Associates program; indeed, 10% of customers initially referred from a partner’s site continued to return to Amazon by referral eight years later. Dr. Wills admitted that there was no obvious “bright line” dictating when referral fees should stop.

Although he had data from the Associates program going out 10 years, he opined that a term of 6 years would be generous.

We agree with respondent that Dr. Wills’ selection of a truncated six-year period was arbitrary. Although he assumed that AEHT would refuse to pay for the long “tail” of customer referrals, Amazon did just that in its Associates program.

Second, respondent contends that Dr. Wills understated the revenue stream for computing referral fees by using the median rather the average amounts that customers were expected to spend per visit. Dr. Moe’s analysis showed that a small subset of customers was responsible for a disproportionate dollar amount of sales. Thus the average spending per customer was significantly higher than the median spending per customer.57

Dr. Wills testified that using the median was appropriate because using the average would likely overestimate future customer spending. Extrapolating customer spending out a decade resulted in a subset of customers with very high spending. Dr. Wills reasoned that customers would not increase their spending year after year indefinitely, and he used Dr. Moe’s median figures to reduce the impact of outliers caused by the extrapolation.

Respondent’s expert Dr. Wilcox opined that use of average spending was more appropriate. He noted that retailers often expect to earn a significant portion of their profits from a small subset of their customers. A desire to reduce the im-

57A simplified example may illustrate this difference. Assume that 1,000 customers are referred to Amazon’s website from mirror sites, with 900 making purchases of $20 and 100 making purchases of $100. The median spending per customer would be $20, but the average spending would be $28. - 170 - pact of high-spending customers, he opined, was not a sufficient justification for rejecting the use of average data.

We agree with Dr. Wilcox. High-spending customers are the customers a retailer most desires to have. We see no reason why AEHT, operating at arm’s length, would insist on paying referral fees calculated to exclude these customers.

Petitioner did not show that high-spending customers tend to “convert” to direct

Amazon customers at a different rate from low-spending customers. Nor did petitioner offer any other persuasive reason for minimizing their impact on projected future revenue streams. Dr. Wills may be right that extrapolating customer spending out 10 years ultimately yields very high spending by the biggest hitters. But we do not find it illogical to assume that these fortunate individuals will keep spending more money each year. In any event, discounting out-year spending at

18% will tend to mitigate the effect of any distortion.

In his rebuttal report Dr. Wilcox revised Dr. Wills’ calculations by using average spending levels and a 10-year cutoff for payment of referral fees. He thus derived a value of $129 million for the customer information. We find this to be the arm’s-length buy-in payment for this group of intangibles.

Respondent contends that Dr. Wills’ approach, even if modified as we have done above, does not capture the full value of Amazon’s customer information. - 171 -

Forrest Oswald, one of respondent’s experts, opined that Dr. Wills erred by valuing solely the customer referral, rather than the complete universe of customer data

(including purchase history, addresses, and credit card information) that Amazon

US made available to AEHT. Mr. Oswald opined that the latter information would enable AEHT to provide a more streamlined and personalized user experience, even after the referred customers had become regular AEHT customers.

While Mr. Oswald is correct that Amazon’s customer information had uses apart from customer referral, the trial established that this value had a very short life. Amazon US used customer information to power its “Similarities” and “Rec- ommendations” software, as well as to improve the customer experience through one-click shopping and email marketing. But Amazon itself regarded this historical data as having limited utility; stored addresses and credit card information rapidly become outdated, and customers’ buying habits change significantly over time. For its Similarities software, Amazon uses only relatively recent data because it regards older data as having little or no value. Indeed, older data may have negative value because they yield irrelevant or inappropriate recommendations.

Dr. Wilcox offered a different critique of Dr. Wills’ approach by emphasiz- ing the strength of Amazon’s brand. The customer information that Amazon US - 172 - made available to AEHT concerned individuals who had previously purchased from Amazon. These customers presumably had a favorable opinion of Amazon; arguably, this “brand loyalty” would predispose them to keep patronizing AEHT.

Dr. Wilcox urged that the customers thus referred were more valuable than the customers referred to Amazon through the Associates and Syndicated Stores programs, some of whom may never have visited an Amazon site previously.

We conclude that Dr. Wills’ overall analysis adequately accounts for the strength of Amazon’s brand. Although he looked to the Associates and Syndicat- ed Stores agreements to derive an arm’s-length commission rate, he used Ama- zon’s experience to estimate customers’ future spending. Those spending levels presumably reflect the value of Amazon’s brand.

As discussed previously, customers’ willingness to return to Amazon’s websites depended chiefly on their satisfaction with Amazon’s execution of the “three pillars,” not on their impression of Amazon’s “brand.” See supra p. 12. Dr. Wills’ methodology, in which Dr. Higinbotham ultimately concurred, reasonably captures the arm’s-length value of the customer referrals that Amazon US made to

AEHT. We conclude that any value associated with the customer information in excess of the value of customer referral was short-lived and immaterial or was adequately accounted for in Dr. Wills’ valuation of the marketing intangibles and - 173 - website technology, on which the strength of Amazon’s brand was based. We accordingly find that Dr. Wills’ approach, as modified in the two respects discussed above, yields an appropriate arm’s-length buy-in payment of $129 million for the customer information.

IV. Cost Sharing Payments

Where parties have entered into a QCSA, they share the cost of developing intangible property. A participant’s “costs of developing intangibles * * * mean all of the costs incurred * * * related to the intangible development area.” Sec.

1.482-7(d)(1), Income Tax Regs. “Costs incurred related to the intangible development area” generally consist of operating expenses (other than depreciation or amortization expense), plus charges for use of certain tangible property. Ibid. “If a particular cost contributes to the intangible development area and other areas or other business activities, the cost must be allocated between the intangible development area and the other areas or business activities on a reasonable basis.” Ibid.

Once the total pool of IDCs is determined, these costs must be allocated to each QCSA participant “based on factors that can reasonably be expected to reflect that participant’s share of anticipated benefits.” Id. paras. (b)(2), (f)(1). In the CSA, Amazon US and AEHT used a revenue-based formula to determine their respective benefit shares. That formula is not in dispute. - 174 -

What is in dispute is the total volume of IDCs that Amazon US incurred; the larger the volume, the larger the cost sharing payments that AEHT must make.

The parties refer to this issue as the “cost pool” issue. For this issue, as for the issues discussed previously, we will uphold respondent’s determination unless petitioner shows it to be arbitrary, capricious, or unreasonable. Seagate Tech., 102

T.C. at 164; Sundstrand Corp., 96 T.C. at 353.

A. Respondent’s Position

Petitioner tracked expenses in six high-level cost centers: (1) Cost of Sales,

(2) Fulfillment, (3) Marketing, (4) Technology and Content (T&C), (5) General and Administrative (G&A), and (6) Other. The parties agree that none of the costs accumulated in the “Cost of Sales” and “Other” categories are allocable to IDCs.

Respondent accepts petitioner’s formula-based allocation to IDCs of costs accumulated in the “Fulfillment” and “Marketing” categories, and he accepts petitioner’s decision to allocate G&A costs to IDCs on the basis of the IDC outcomes for the other five categories.

The parties’ dispute focuses on the T&C category. In the notice of deficiency respondent determined that 100% of the costs accumulated in T&C cost centers constitute IDCs. Petitioner challenges this determination, contending that these costs are “mixed costs,” that is, costs that “contribute[] to the intangible - 175 - development area and other areas or other business activities.” See sec. 1.482-

7(d)(1), Income Tax Regs. According to petitioner, therefore, the regulations require that T&C category costs, like Fulfillment and Marketing costs, “be allocated between the intangible development area and the other areas or business activities on a reasonable basis.” Ibid.

In May 2014 petitioner filed a motion for partial summary judgment on this issue. See Amazon.Com, Inc. & Subs. v. Commissioner, T.C. Memo. 2014-149,

108 T.C.M. (CCH) 87. We denied that motion, finding material facts in dispute at that time. Specifically, we ruled that, “[u]ntil petitioner establishes that the T&C category contains a nontrivial amount of ‘mixed’ costs, we cannot rule as to whether respondent abused his discretion in determining that 100% of T&C category costs constitute IDCs.” 108 T.C.M. (CCH) at 88.

The evidence at trial established that T&C cost centers do indeed contain

“mixed costs.” Employees whose time was captured in T&C cost centers engaged in substantial non-IDC activities, such as helping vendors list their products on

Amazon’s websites, making minor adjustments to how website content is displayed, and managing third-party digital content that is viewed on or downloaded from Amazon.com. Some employees whose time was captured in T&C cost centers negotiated contracts with vendors and documented routine activities for them; - 176 - other employees were responsible for Sarbanes-Oxley compliance. Petitioner’s

SEC Form 10-K notes that T&C category costs included costs involved in

“merchandising selection, category expansion and buying, and ordering products.”

These activities, when conducted by brick-and-mortar stores, are not likely to create intangible property.

Both parties’ experts recognized that T&C category costs include mixed costs. Roman Weil, one of petitioner’s experts, reached this conclusion on the basis of interviews with Amazon employees. Dr. Higinbotham, one of respondent’s experts, agreed that substantial non-IDCs were accumulated in the T&C cost centers, and he used a modified version of petitioner’s cost-allocation method when determining his buy-in payment for the website technology. Indeed, Dr.

Higinbotham agreed that, if he were to treat 100% of T&C costs as IDCs as determined in the notice of deficiency, AEHT’s future cost sharing payments would be so large as to produce a negative buy-in payment under his income method analysis.

Notwithstanding his expert’s conclusions and trial testimony, respondent argues that petitioner cannot use an allocation methodology until it first establishes, on a cost-by-cost basis, which particular costs relate only partially to intangible development. We addressed this very point in our prior opinion, stating: - 177 -

“It is not necessary that the parties painstakingly examine each cost in the 200- plus baseline cost centers in order to determine whether a nontrivial portion of

T&C category costs are ‘mixed.’” 108 T.C.M. (CCH) at 89. Respondent’s audit team did not require this level of granularity when accepting petitioner’s allocation method with respect to the Marketing and Fulfilment categories. We see no logical reason for imposing harsher requirements on petitioner before allowing it to allocate costs within the T&C category.58

In sum, we agree with petitioner that respondent abused his discretion in determining that 100% of the costs accumulated in the T&C cost centers constitute

IDCs. Petitioner has established through documentary evidence and expert testimony that substantial non-IDCs were captured in these cost centers. By deeming

100% of T&C category costs to be IDCs, respondent’s position as set out in the notice of deficiency violates the regulatory command that “[c]osts that do not contribute to the intangible development area are not taken into account.” Sec.

1.482-7(d)(1), Income Tax Regs.

58Respondent’s position would apparently require evaluation of 500 general- ledger accounts and 100 general-ledger account rollups for each of the T&C cost centers. Because petitioner had between 162 and 221 T&C cost centers during 2005 and 2006, this would necessitate several hundred thousand discrete evaluations. This would plainly be overkill; the regulations require only that the allocation be made “on a reasonable basis.” Sec. 1.482-7(d)(1), Income Tax Regs. - 178 -

B. Petitioner’s Position

We have described supra pp. 62-65 the methodology petitioner used for

2006, and urges here, for determining the subset of T&C category costs properly allocable to IDCs. Respondent’s expert, Dr. Higinbotham, examined this methodology carefully when preparing his expert report. Under his income method, he was required to estimate petitioner’s future IDCs in order to calculate a buy-in price for the website technology. He therefore needed to employ a method for allocating costs to IDCs. He spent a “significant amount of time” developing an appropriate method, because his ultimate conclusion necessarily depended on the

IDCs’ being calculated properly.

In estimating future IDCs, Dr. Higinbotham used petitioner’s allocation methodology, as described above, with two significant modifications. Petitioner has accepted the cost-pool results thus reached by Dr. Higinbotham, with one further adjustment (discussed below) to which Dr. Higinbotham assented at trial.

We agree with Dr. Higinbotham’s two modifications subject to this further adjustment, and we reject respondent’s contention that further modifications are required.59

59Respondent argues that Dr. Higinbotham, when preparing his expert reports, did not have enough evidence to decide upon an accurate allocation method. (continued...) - 179 -

Dr. Higinbotham’s first adjustment concerned petitioner’s use of the

“T-ratio.” Using the QRE survey results compiled by PwC, petitioner determined an “adjusted QRE percentage” or “A-ratio” for each person who recorded time in

T&C cost centers. Petitioner multiplied this “A-ratio” by the applicable “T-ratio” to yield a “development ratio” for the T&C category. See supra p. 64. Petitioner then multiplied “modified T&C category costs” (as determined previously) by the

“development ratio” to determine the dollar volume of T&C category costs properly allocable to IDCs.

Dr. Higinbotham opined that petitioner’s insertion of the “T-ratio” into this calculus artificially diluted the cost allocation to IDCs. Petitioner derived the “T- ratio” by dividing the number of T-coded employees in the T&C category by the total number of employees in that category. Petitioner added this step to its allocation formula on the assumption that only T-coded employees were likely to engage in intangible development activity.

We agree with Dr. Higinbotham in rejecting this assumption. During 2005-

2006 there were almost as many T&C cost centers with no T-coded employees as

59(...continued) But the parties conducted very extensive discovery in this case; if Dr. Higin- botham believed he lacked certain necessary information, respondent was free to request it. In any event, respondent stands behind Dr. Higinbotham’s ultimate conclusion, which necessarily includes his underlying calculations. - 180 - with all T-coded employees. In compiling its data, PwC surveyed most employees who recorded time to T&C cost centers, regardless of their job classifications, and it computed a QRE percentage for each employee thus surveyed. Since there were non-T-coded employees whose efforts directly or indirectly furthered intangible development, the use of the T-ratio resulted in understating petitioner’s IDCs.60

To remedy this flaw, Dr. Higinbotham significantly reduced or eliminated the role of the T-ratio. For cost centers in the 7000 series, he set the T-ratio at

100%, effectively eliminating it. He did the same for cost centers in the 5000 series with at least an 80% response rate to the QRE survey and for certain other

5000-series cost centers with “a logic behind doing it.” For the remaining 5000- series cost centers, he assigned the same T-ratio that Amazon had assigned, but made modifications to better capture the cost of interns as if they were T-coded employees. Dr. Higinbotham described these adjustments as his “most important” change to petitioner’s cost-allocation formula. Petitioner has accepted all of these adjustments, and we find them to be appropriate.

60A corollary to this flaw was the exclusion of time spent by paid interns. They completed QRE surveys and recorded time to T&C cost centers, but they did not have a T-coded job classification. Use of the T-ratio effectively eliminated their time from the cost pool even if they did 100% intangible development. - 181 -

Dr. Higinbotham’s second adjustment to petitioner’s formula involved the treatment of certain indirect costs. The QRE survey data compiled by PwC captured time devoted to “direct supervision and support” of qualifying research activity. However, petitioner’s formula did not capture the costs of “indirect supervision” (e.g., time spent by a higher level supervisor) or “indirect support” (e.g., time spent by a supervisor’s executive assistant). Because the CSA defined IDCs to include “all direct and indirect costs” of intangible development, Dr. Higin- botham concluded that an additional modification to petitioner’s cost-allocation formula was necessary.

To implement this modification, Dr. Higinbotham recalculated the A-ratio for employees in the T&C category. He did this chiefly by reallocating to IDCs a portion of the time that employees had reported on their QRE surveys as spent on

“human resources/training,” which PwC had excluded for section 41 credit purposes. The impact of this adjustment was to increase the A-Ratio for certain individuals and the corresponding A-ratio for the cost center in which those individuals were assigned. Petitioner has accepted this adjustment, and we find it to be appropriate.

These two modifications by Dr. Higinbotham were significant, increasing petitioner’s IDCs by more than $50 million for each year at issue. At trial Dr. - 182 -

Higinbotham agreed with Dr. Weil that, whereas salary weighting was appropriately applied to employee costs, headcount weighting was more appropriately applied to the remaining costs. This further adjustment reduced Dr. Higin- botham’s results by $3 million and $5 million for 2005 and 2006, respectively.

We conclude that Dr. Higinbotham’s results, as thus adjusted, yield a formula that allocates costs “between the intangible development area and the other areas or business activities on a reasonable basis.” Sec. 1.482-7(d)(1), Income Tax Regs.

We do not accept three further modifications to petitioner’s allocation formula that respondent has urged at various times. First, in the notice of deficiency respondent contended that petitioner erred in eliminating from the T&C cost centers all costs captured in 26 general ledger accounts that petitioner deemed unrelated to intangible development. See supra p. 63. Examples of the eliminated accounts include 64168 (Pallet Expense), 64712 (Warehouse Supplies), 64715

(Safety Supplies), 64331 (Depreciation: Heavy Equipment), and 64332

(Depreciation: Vehicles). Drs. Weil and Higinbotham agreed that it was reasonable to exclude from IDCs the costs captured in these accounts solely on the basis of the account description, without investigating the subsidiary costs in detail.

Respondent in his post-trial briefs largely abandoned any challenge to this conclusion, which we believe to be correct. - 183 -

Second, respondent urges a further adjustment to the PWC survey data.

Petitioner recognized that certain costs ineligible for the section 41 credit may nevertheless constitute IDCs. Petitioner accordingly added back two types of costs reflected on the QRE survey forms--“reverse engineering” costs and costs of non-U.S. activities--that are ineligible for the R&E credit. Respondent contends that two other types of costs--those of “routine engineering” and “routine data collection”--should also be added back for purposes of determining the IDCs pool.

Neither Dr. Weil nor Dr. Higinbotham believed that these two species of costs should be added back. In support of a contrary view, respondent points to an example in the regulations indicating that “field testing costs” for a new invention may constitute IDCs that must be shared. See sec. 1.482-7(d)(3), Example (2), In- come Tax Regs. We find this analogy inapposite. The costs of field testing a new invention are not comparable to costs of routine data collection and routine engineering. Petitioner agrees that field testing new software generates IDCs and notes that the QRE survey properly captured such costs.61

61Petitioner’s version of field testing is called Weblabs. The QRE survey administered by PwC required employees to report such activity under category 5, captioned: “Testing: Design and execution of plans to test the concepts and software. Includes code sequence testing, unit testing, system testing, and the use of Weblabs. Also involves redesign and re-testing as a result of initial testing results.” - 184 -

Finally, respondent challenges the reliability of the PwC survey data, noting that petitioner’s employees did not record their time contemporaneously. While we agree that contemporaneous time records are always preferable, PwC apparently secured its data within a year of the periods in which the employees rendered their services. The regulations required petitioner to devise a formula that would allocate costs “on a reasonable basis,” id. subpara. (1), and we think petitioner acted logically in using the best data it had.

For purposes of claiming section 41 credits, it was in petitioner’s interest to have its employees show the highest possible percentage of their time as allocable to R&E activities. All time allocated to R&E activities in the QRE surveys will necessarily be allocated to IDCs. To the extent that petitioner’s employees, lack- ing contemporaneous time records, made approximations in reporting how their time was spent, it seems unlikely that the results, as applied here, would be biased in petitioner’s favor.

In sum, we conclude that petitioner’s cost-allocation methodology, as adjusted by Dr. Higinbotham and further modified by him at trial, yields a formula that allocates costs “between the intangible development area and the other areas or business activities on a reasonable basis.” Sec. 1.482-7(d)(1), Income Tax Regs. Dr. Higinbotham needed an accurate allocation methodology for his own - 185 - valuation exercise, and he carefully considered and modified petitioner’s formula for this purpose. Petitioner accepts that result, and so do we.62

C. Stock-Based Compensation

The CSA executed by Amazon US and AEHT defined IDCs to “include all direct and indirect costs (including Stock-Based Compensation Costs)” relating to intangible development. The parties further elected to take into account “all stock- based compensation in the form of stock options in the same amount, and as of the same time, as the fair value of the stock options reflected as a charge against income” in either party’s financial statements. Id. subpara. (2)(iii)(B). This election was made “without prejudice to the Party’s right to challenge the validity” of the regulation.

In filing its 2005 and 2006 returns, petitioner thus complied with the regulation requiring that stock-based compensation be included in the cost pool. Like many technology companies, petitioner questioned the validity of this regulation.

62Respondent notes that the regulation requiring costs to be allocated “on a reasonable basis” states, in the next sentence, that “it is necessary to estimate the total benefits attributable to the cost incurred.” Sec. 1.482-7(d)(1), Income Tax Regs. While urging that petitioner has not satisfied the latter requirement, respondent has not advanced a coherent theory as to how a taxpayer would go about estimating the “total benefits” attributable to costs accumulated within each of several thousand cost centers. We conclude that a properly constructed allocation formula, such as that approved in the text, will accomplish the desired result in petitioner’s case. - 186 -

The CSA accordingly included a “clawback” provision that will apply in the event section 1.482-7(d)(2), Income Tax Regs., is

held to be an invalid regulation by a final decision in a court of law with respect to pending litigation involving another taxpayer, including a U.S. Supreme Court decision, U.S. Court of Appeals decision upon denial of a writ of certiorari or lapse of time for filing such writ, or a decision by a federal trial court upon lapse of time for filing a notice of appeal, or * * * [is] revised or withdrawn by the Treasury Department such that the costs of stock-based compensation are not required to be included as costs for qualified cost sharing arrangements.

In the event this regulation is ultimately invalidated or withdrawn, the CSA provides that “stock-based compensation shall not be included in the determination of * * * [IDCs] in any Year to which this Agreement applies.” For any year for which stock-based compensation turns out to have been “improperly” included in IDCs, “the Cost Share shall be recomputed without the inclusion of stock-based compensation in [IDCs],” and “the Cost Share less the Recomputed Cost Share shall be refunded [to the proper party].” The CSA provides that any such refund shall be “treated as an adjustment to the Cost Share for the Year in which the

Triggering Event occurs * * *, and to the extent that such adjustment exceeds the

Cost Share, the adjustment shall be applied to subsequent Years until fully exhausted.” - 187 -

In Altera Corp. v. Commissioner, 145 T.C. 91, this Court invalidated section 1.482-7(d)(2), Income Tax Regs., the provision that requires stock-based compensation costs to be included in the IDC pool. Our decision in that case was appealed to the U.S. Court of Appeals for the Ninth Circuit on February 19, 2016.

The case remains pending on appeal, and the CSA’s clawback provision is not yet operative.

The parties agree that the CSA is a “qualified cost sharing arrangement.”

This agreement requires petitioner to adhere to section 1.482-7(d)(2), Income Tax

Regs., until such time as that regulation is withdrawn by the Department of the

Treasury or finally invalidated by judicial decree. If and when either of those

“Triggering Events” occurs, the CSA states that appropriate adjustments will be made to the parties’ respective cost shares in the relevant future years. Because there is no scenario in which an adjustment would be required to AEHT’s cost sharing obligation for 2005 or 2006, the years before the Court, we conclude that both petitioner on its original returns and respondent in the notice of deficiency correctly included stock-based compensation in the cost pool. - 188 -

To implement the foregoing,

Decision will be entered under

Rule 155. - 189 -

APPENDIX

Petitioner’s Expert Witnesses

1. Lorenzo Alvisi

Dr. Alvisi is a professor of computer science at the University of Texas at

Austin. He received his undergraduate degree in physics from the University of

Bologna and his M.S. and Ph.D. in computer science from Cornell University. He has been a visiting professor at various institutions around the world, including schools in Italy, China, Germany, and the United States. His research has focused on security issues in computer systems. He has written 21 published articles in addition to book chapters and conference papers relating to the security of computer systems. For purposes of this case, he co-drafted a report with Ken Birman regarding the useful life of Amazon’s eCommerce software technologies and retail websites. However he did not testify at trial.

2. Ken Birman

Dr. Birman is a professor of computer science at Cornell University. His research has focused on distributed computing, fault tolerance, security, and scalability. He received his B.A. in computer science from Columbia University and his M.S. and Ph.D. in computer science from the University of California, Berkeley. In addition to teaching, he has founded three companies in the comput- - 190 - ing systems space and has written 150 research papers and 5 books in the field of computer science. For purposes of this case, he co-drafted a report with Lorenzo

Alvisi regarding the useful life of Amazon’s eCommerce software technologies and retail websites. The Court recognized Dr. Birman as an expert in computer science.

3. Bradford Cornell

Dr. Cornell holds a Ph.D. in financial economics and is a visiting professor of financial economics at the California Institute of Technology. He received his

CRA and Compass Lexecon, and a managing director for San Marino Business

Partners. The Court recognized Dr. Cornell as an expert in financial economics and valuation. - 191 -

4. Robert Dolan

Dr. Dolan is a Baker Foundation professor of business administration at

Harvard Business School. He received his B.A. in mathematics from Boston Col- lege and an M.B.A. and a Ph.D. in business administration from the University of

Rochester in New York. He previously taught at the University of Michigan

Stephen M. Ross School of Business and the University of Chicago Graduate

School of Business. He has extensive teaching and consulting experience in the areas of customer purchasing decisions and building brand awareness. He has published numerous books and articles on marketing, product pricing, and brands.

The Court recognized Dr. Dolan as an expert in marketing.

5. David Franklyn

Professor Franklyn is a professor of intellectual property law at the Univer- sity of San Francisco School of Law. He received his B.A. in history, philosophy, and religion from Evangel College and his J.D. from the University of Michigan

Law School. He is also the executive director of the McCarthy Institute for Intel- lectual Property and Technology Law at the University of San Francisco and the director of the Center for Empirical Study of Trademark Law at the McCarthy In- stitute. He has experience working as a consultant, advising companies on issues relating to trademarks and management of trademark portfolios. He is also the co- - 192 - author and editor in chief of McCarthy’s Desk Encyclopedia of Intellectual Pro- perty, and he has written numerous articles on trademark law. The Court recognized Professor Franklyn as an expert in international trademark law and empirical evaluation of trademarks.

6. Peter Golder

Dr. Golder is a professor of marketing at Tuck School of Business at Dart- mouth College. He received his B.S. in mechanical engineering from the Uni- versity of Pennsylvania and his Ph.D. in business administration (marketing) from the University of Southern California. Before teaching at Dartmouth, he taught at the Stern School at New York University. His research and publications focus on the history of markets and brands, specifically on using the historical method to remove survival bias from marketing analyses, global marketing, and product life cycles. The Court recognized Dr. Golder as an expert in marketing, market leader- ship, duration, and survival time.

7. Marco Iansiti

Dr. Iansiti is the David Sarnoff Professor of Business Administration at

Harvard Business School. He holds an A.B. in physics and a Ph.D. in physics from Harvard University and has taught there for over 25 years, where he was the first faculty member to focus on the computer industry. His research focuses on - 193 - innovation of the Internet and technology companies. In addition to teaching and researching, Dr. Iansiti is an eCommerce entrepreneur, founding Model N, an eCommerce technology provider, and a technology strategy consultant, founding

Keystone Strategy, a consulting firm providing both business and litigation-related technology advice. The Court recognized Dr. Iansiti as an expert in innovation and eCommerce technology.

8. Michael Lasinski

Mr. Lasinski is a managing director and chief executive officer of 284

Partners, LLC, an intellectual property valuation, strategy, consulting, and transactional firm. He holds a B.S. in electrical engineering and an M.B.A. from the

University of Michigan. He is also a certified public accountant with a special certification in financial forensics. He has worked in intellectual property for approximately 20 years. He was formerly the president at the Licensing Exec- utives Society of the United States and Canada. Mr. Lasinski’s work has focused primarily on reviewing and analyzing hundreds of intellectual property license agreements. He has reviewed thousands of license agreements and has negotiated between 50 and 100 license agreements. The Court recognized Mr. Lasinski as an expert in intellectual-property licensing. - 194 -

9. Alan MacCormack

Dr. MacCormack as an expert in the management of innovation, the management of technology and new product development, including the software industry, and the management and evaluation of software code, architecture, and evolution.

10. Haim Mendelson

Dr. Mendelson is the Kleiner Perkins Caufield & Byers professor of electronic business and commerce and management at the Stanford Graduate School of Business. He previously taught business administration at the University of

Rochester. He received his B.S. in mathematics and physics from Hebrew Uni- versity in Jerusalem, his M.S. in management sciences from Tel Aviv University, - 195 - and his Ph.D. in mathematical sciences from Tel Aviv University. A scholar of eCommerce, he has written a number of case studies on eCommerce companies and brick-and-mortar retailers with an online channel. He has also helped build

Internet and eCommerce companies both as a professor assisting student entrepre- neurs and as a paid adviser. The Court recognized Dr. Mendelson as an expert in electronic business.

11. David Parkes

Dr. Parkes is the area dean for computer science and the George F. Colony

Professor of Computer Science and Harvard College Professor at Harvard Univer- sity. He received his master’s degree in engineering and computer science from

Oxford University and a Ph.D. in computer and information science from the Uni- versity of Pennsylvania. He teaches courses related to eCommerce, artificial intel- ligence, machine learning, multi-agent systems, and economics at Harvard. He is currently the chair of the ACM Special Interest Group on Electronic Commerce, the leading computer eCommerce professional organization. He also serves as the chair of the ACM Special Interest Group on Electronic Commerce and has published over 80 papers related to eCommerce. The Court recognized Dr. Parkes as an expert in computer science and eCommerce technology. - 196 -

12. Robert Reilly

Mr. Reilly is a managing director of Willamette Management Associates, a firm that provides financial advisory services relating to business and intangible asset valuation. He received his B.A. in economics and his M.B.A. in finance from Columbia University. He was previously a partner and national director at

Deloitte and Touche, vice president of Arthur D. Little Valuation, Inc., a valuation services firm, director of corporate development for Huffy Corporation, and a senior consultant for Booz, Allen & Hamilton. He has published 12 valuation textbooks and over 300 journal articles in the field of valuation. He has also valued trademarks over 500 times. The Court recognized Mr. Reilly as an expert in valuation.

13. James Roper

Mr. Roper is the chairman and founder of the Interactive Media in Retail

Group (IMRG), a United Kingdom eCommerce industry association. During his time at IMRG, Mr. Roper has advised governments about eCommerce and given numerous presentations on eCommerce. He previously worked as a business development director for New Media Productions and Convergent Communications.

The Court recognized Mr. Roper as an expert in eCommerce. - 197 -

14. Sanjay Unni

Dr. Unni holds a Ph.D. in economics and is currently the director of the

Berkeley Research Group, an expert services firm specializing in economics and financial analysis. He received his B.A. in economics from the University of

Delhi in India and his master’s degree and Ph.D. in economics from Southern

15. Roman Weil

Dr. Weil holds a Ph.D. in economics and is currently the V. Duane Rath professor emeritus of accounting at the Chicago Booth School of Business. He received his B.A. in economics and mathematics from Yale University and his M.S. in industrial administration and a Ph.D. in economics from Carnegie Mellon Uni- versity. He has served on the faculties of nearly a dozen other schools, including - 198 - as a visiting professor of accounting at the Rady School of Management at the

University of California San Diego. He has also served on the Financial Account- ing Standards Advisory Council and the Public Company Accounting Oversight

Board. He has focused his research on accounting and has written numerous books and articles on cost accounting. The Court recognized Dr. Weil as an expert in cost accounting.

16. Robert Wentland

Mr. Wentland is a managing director at Navigant Consulting. He received his B.B.A. in accounting from the University of Wisconsin Madison. He is a

C.P.A. and is also certified by the AICPA in financial forensics. He previously worked for Arthur Anderson as an accounting and consulting partner and for

Huron Consulting as a Managing Director. Mr. Wentland has provided forensic accounting and data analysis services related to international tax controversies, including transfer pricing disputes, for nearly 20 years. The Court recognized Mr.

Wentland as an expert in financial statement analysis and forensic accounting.

17. Robert Willig

Dr. Willig holds a Ph.D. in economics and is a professor of economics and public affairs at Princeton University. He received his A.B. in mathematics from Harvard University, his M.S. in operations research from Stanford University, and - 199 - his Ph.D. in economics from Stanford. While teaching at Princeton, he also served as a principal external advisor at the Inter-American Development Bank, a Deputy

Assistant Attorney General at the U.S. Department of Justice, and a supervisor at

Bell Laboratories, among other consulting roles. His research and publications focus on asset decay, how markets work, how markets influence economic outcomes, and how the forces of economics affect the marketplace. The Court recognized Professor Willig as an expert in microeconomics.

18. John Wills

Dr. Wills holds a Ph.D. in economics and is the principal of Wills Consult- ing, a consulting firm specializing in transfer pricing economics. He received his

B.A. in economics from Claremont Men’s College (now Claremont McKenna

College) and his M.A. and Ph.D. in economics from the University of Washington.

He was previously the head of Ernst & Young’s transfer pricing practice in the

Western region of the United States, an economist in Deloitte & Touche’s Nation- al Tax Office, and a Legislative Assistant at the United States Senate. He has worked in transfer pricing economics for more than 25 years. Most of his work has focused on transfer pricing associated with technology companies, particularly intangibles transactions and cost-sharing arrangements. The Court recognized Dr. Wills as an expert in economics and transfer pricing economics. - 200 -

Respondent’s Expert Witnesses

1. Geoff A. Cohen

Ph.D. in computer science from Duke University. Before working at Elysium, he was a principal at Coherence Engine and a senior consultant and manager at the

Cohen as an expert in computer science and software.

2. James G. Conley

University of Virginia and his master’s in management and Ph.D. in materials science and engineering from Northwestern University. He is also a director at the - 201 -

Global Economics Group LLC. He was previously a principal at Chicago Part- ners, an intellectual capital management and litigation consulting firm, and a founder of Syndia Corporation, a product development and intellectual property licensing firm. He was also an appointed member of the Trademark Public Ad- visory Committee to the U.S. Patent and Trademark Office. He has researched and published extensively in the areas of intellectual property management and process management. The Court recognized Dr. Conley as an expert in intellectual property management.

3. Jorge Luis Contreras

Professor Contreras is an intellectual property law professor at the American

University, Washington College of Law and the founder of Contreras Legal Stra- tegy, LLC, a boutique legal advisory firm. He received his B.A. in English and

B.S. in electrical engineering from Rice University and his J.D. from Harvard Law

School. He was previously an associate and partner at Wilmer, Cutler, Pickering,

Hale, and Dorr LLP where he advised clients on transactions involving intellectual property, including licensing, technology development, and product manufactur- ing, distribution, and sale. He has published extensively in the areas of intellectual property, technology licensing, technical standards, patent litigation, and regula- - 202 - tion of science. The Court recognized him as an expert in U.S. and foreign intellectual property law, domain name law, and intellectual property licensing.

4. Edward W. Felten

Dr. Felten is the director of the Center for Information Technology Policy and the Robert E. Kahn professor of computer science and public affairs at Prince- ton University. He received his B.S. in physics from the California Institute of

Technology and his M.S. and Ph.D. in computer science and engineering from the

University of Washington. He has held numerous other positions in the area of computer science, including chief technologist at the Federal Trade Commission, consulting computer scientist at Elysium Digital LLC, and consultant at Electronic

Frontier Foundation, in addition to serving on various advisory and consulting boards. He has written two books and over 100 articles relating to computer science and intellectual property policy. The Court recognized Dr. Felten as an expert in computer science.

5. Daniel J. Frisch

Dr. Frisch holds a Ph.D. in economics specializing in transfer pricing analysis and is the managing director at Horst Frisch, Incorporated, an independent economics consulting firm. He received his A.B., M.A., and Ph.D. in economics from Harvard University. He previously worked as a principal at KPMG Peat - 203 -

Marwick and as a director for international taxation and international economist at the U.S. Treasury Department’s Office of Tax Analysis. He also worked as a senior staff economist at the Council of Economic Advisers and an assistant professor of economics at the University of Washington in Seattle. His practice has focused on consulting for U.S. and foreign multinational companies with regard to transfer pricing policies. He has published extensively in the area of transfer pricing. The Court recognized Dr. Frisch as an expert in economics and transfer pricing.

6. Paul A. Gompers

Dr. Gompers is the administration and faculty chair of the elective curric- ulum at the Harvard University Graduate School of Business Administration. He received his A.B. in biology from Harvard College, his M.Sc. in economics from

Oxford University, and his Ph.D. in business economics from Harvard University.

He has researched and written extensively in the areas of venture capital, private equity industries, and entrepreneurial finance. He has also served as a consultant and adviser to numerous companies with regard to fundraising, future projections, investments, and valuation. The Court recognized Dr. Gompers as an expert in financial economics, valuation of businesses and assets, private equity, and entrepreneurial finance. - 204 -

7. David Haigh

Mr. Haigh is a chief executive at Brand Finance, a United Kingdom brand consultancy firm specializing in brand valuation, evaluation, research, and strategy. He received his B.A. in English literature from Bristol University. He thereafter joined PwC as an auditor and later worked as a management consultant.

While there he became qualified as a chartered accountant. After leaving PwC he worked as a consultant at various firms during which time he earned a post- graduate diploma in marketing. He has written extensively on brand valuation and brand strategy and has also lectured on the subjects at schools in the United States, the United Kingdom, Singapore, and Switzerland. The Court recognized him as an expert in brand evaluation and brand valuation.

8. Harlow Higinbotham

Dr. Higinbotham holds a Ph.D. in economics and is a chartered financial analyst currently serving as the senior vice president of National Economic Re- search Associates (NERA). He received his A.B. in applied mathematics from

Harvard University, completed graduate studies at the London School of Econom- ics, and received his Ph.D. in economics from the University of Chicago. Before joining NERA, he served as A.T. Kearney’s chief economist, leading its transfer pricing practice. He has published extensively on transfer pricing and has also - 205 - served as an expert witness in prior proceedings related to cost determination. The

Court recognized him as an expert in transfer pricing.

9. Thomas Hoeren

Professor Hoeren is a foreign intellectual property law professor at the Uni- versity of Münster in Germany. He received his first degree in theology and philosophy, his doctorate in theology, and a law degree from the University of Mün- ster. He has been a professor in intellectual property law for over 20 years, lec- turing at universities around the world. He has written extensively on intellectual property and trademark law. The Court recognized him as an expert in trademark law, domain name law, and intellectual property.

10. Forrest Oswald

Mr. Oswald is a senior IRS economist in the transfer pricing practice group.

He received his B.A. in economics and a minor in mathematics from Pepperdine

University. Before working at the IRS, he worked for KPMG and FTI Consulting in their transfer pricing groups. He has participated in transfer pricing evaluations for various intercompany transactions, including intellectual property, services, goods, and loans, and for a variety of industries, including retail, software, financial services, automotive, and entertainment. The Court recognized Mr. Oswald as an expert in transfer pricing and valuation. - 206 -

11. Jim Timmins

Mr. Timmins is an investment banker and valuation analyst and currently the managing director of Teknos, a financial services advisory firm focused on technology-driven businesses. He received his B.A. from Trinity College, Uni- versity of Toronto and an M.B.A. from the Stanford University Graduate School of Business. Before joining Teknos, he was a managing director of Pagemill Part- ners (now a Duff & Phelps Business), an investment bank, managing director of the Daiwa Securities Group, NIF Ventures (now NIF Sumitomo Mitsui Banking

12. Ronald T. Wilcox

Dr. Wilcox holds a Ph.D. in economics, is the Ethyl Corporation professor of business administration at the University of Virginia’s Darden School of Busi- ness, and associate dean of the M.B.A. for executives program at Darden. He received his B.A. in economics from Xavier University and his Ph.D. in business administration from Washington University in St. Louis. Before Darden, he was - 207 - an assistant professor of industrial administration at the Graduate School of

Industrial Administration (now Tepper School of Business) at Carnegie Mellon

University. He was also an economist at the U.S. Securities and Exchange Com- mission from 1999 to 2000, in addition to serving as a marketing consultant for various organizations. He has published extensively on the topic of marketing.

The Court recognized Dr. Wilcox as an expert in marketing, marketing modeling, and consumer behavior.