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IRS Takes Facebook to Court, Signaling Start of Tougher Approach

(Bloomberg) -- Signaling a shift in enforcement tactics against big companies that make money from intellectual property, federal tax officials have sought a court order demanding internal corporate records related to one of Facebook Inc.’s offshore tax strategies.

Arguing that the social-media giant missed a deadline last month to turn over such information, the Internal Revenue Service filed a petition July 6 in San Francisco federal court seeking documents and records for the 2010 tax year. That year, Facebook shifted the global rights for many of its intangible assets -- outside the U.S. and Canada -- to a subsidiary in low-tax Ireland. The IRS claims that, for tax purposes, the company understated the value of those assets by billions of dollars.

The agency’s federal court petition represents the latest evidence that it’s applying new, tighter scrutiny to large IP-driven companies. Tax lawyers say the IRS is getting more aggressive as it tries to ferret out their tax-avoidance strategies, which often involve offshore subsidiaries. The agency announced in 2013 that it would begin seeking court orders if companies didn’t fork over documents requested during audits.

‘Enforcement Remedy’

“This is one of the first big cases,” said Laurence Bambino, co-head of the global tax group at Shearman & Sterling LLP in New York. “It appears to be one of the first instances where they’re seeking to pursue the enforcement remedy.”

Facebook, which conducted its initial public offering in May 2012, disclosed this year that the IRS was examining its taxes for 2008 through 2013.

The company “complies with all applicable rules and regulations in the countries where we operate,” Facebook spokeswoman Bertie Thomson said in an e-mailed statement. Matt Leas, an IRS spokesman, said in an e-mailed statement that federal law prohibits the agency’s officials from commenting on any individual case.

In 2010, Facebook transferred rights to valuable intellectual property to Facebook Ireland Holdings Ltd., according to court filings. The rights covered the company’s online platform, which lets users communicate with one another, as well as property that lets advertisers and software developers reach those users and other property, according to the filings.

‘Problematic’ Method

IRS agents believe Ernst & Young LLP, which served as Facebook’s tax adviser in 2010 and now audits the public company’s financial disclosures, used a “problematic” approach for setting the value of the property -- looking at each piece separately, according to court filings. Facebook employees told the IRS that the property was “interdependent,” and that ‘it would be difficult to isolate one from the other,” the government said.

Amy Call Well, Ernst & Young’s global director of external communications, declined to comment.

Like all multinational companies with intellectual property, Facebook creates cost-sharing arrangements with its foreign subsidiaries for use of the property -- and sets prices that the units will pay each other. By transferring its global rights to an Irish subsidiary, Facebook can allocate IP-related income received in higher-tax jurisdictions to lower-tax Ireland, thus lowering its tax bills. Ireland’s corporate income tax rate is 12.5 percent, compared with a statutory tax rate of 35 percent in the U.S.

‘Arm’s Length’

IRS rules require that any company selling goods and services, including use of intellectual property, to a related company must set prices at an “arm’s length” standard -- that is, what the price would be in a transaction between unrelated parties. If the property is undervalued, the prices paid for its use may be as well.

The IRS began examining Facebook’s 2010 tax filing in January 2013, according to the court filing, and presented some preliminary filings to the company last year. The company countered with its own presentation to IRS officials, the court documents say. In response, the agency filed a series of summonses seeking more information to clarify the company’s tax situation.

July Deadline

Facebook’s obligation to comply with the summonses may depend on whether the IRS sends the company new tax bills related to the Irish transfer before the statute of limitations for Facebook’s 2010 tax year expires. That’s due to happen on July 31, according to the filing.

If the IRS beats that deadline with a so-called “notice of deficiency” for underpaid taxes, the company will likely be forced to comply with any court order, said Michael Asimow, a law professor at Stanford University. It’s not clear when the court would rule on the IRS’s petition, which doesn’t mention any notice of deficiency.

Without such a notice, Facebook could successfully dispute the summons, Asimow said. But with one, “the IRS virtually always wins,” he said.

The case is U.S. v. Facebook Inc., 16-cv-03777, U.S. District Court, Northern District of California (San Francisco).

To contact the reporters on this story: Lynnley Browning in New York at [email protected] ;Kartikay Mehrotra in San Francisco at [email protected] To contact the editors responsible for this story: Michael Hytha at [email protected] ;John Voskuhl at [email protected]

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