The IRS wrongly calculated taxes Amazon.com Inc. owed based on a cost-sharing arrangement that shifted assets from the U.S. to subsidiaries in Europe, a federal appeals court ruled Aug. 16.

The IRS adjusted Amazon’s taxable income by $2.2 billion for 2005 and 2006, arguing the company undercharged for transferred assets. That meant an additional $234 million tax bill for Amazon in those years, but the company’s financial statements estimated the price tag could rise to $1.5 billion for other tax years.

Amazon challenged the agency’s method for valuing the company’s pre-existing intangible assets, which factored in residual-business assets such as the company’s culture of innovation and value of its existing workforce.

A three-judge panel of the U.S. Court of Appeals for the Ninth Circuit held that those residual-business assets didn’t fall within the definition of “intangible” in Section 482 of the tax code.

“Although the language of the definition is ambiguous, the drafting history of the regulations shows that ‘intangible’ was understood to be limited to independently transferable assets,” wrote Judge Consuelo M. Callahan.

The IRS declined to comment. Amazon and its attorney didn’t immediately return requests for comment.

A Cross-Atlantic Transfer

Amazon restructured its European businesses in 2005 and 2006, allowing it to shift income generated by its U.S.-based entities to European subsidiaries. The restructuring meant that the European entities could use Amazon’s intangible assets—developed in the U.S.—to generate income.

Amazon and a holding company for the European entities entered into a cost-sharing arrangement to compensate for shifting these assets to Europe. The holding company had to make a buy-in payment, followed by ongoing payments for its share of future research and development.

Amazon had to pay taxes on this buy-in payment, and it saw smaller U.S. tax deductions for its R&D costs as a result of the holding company’s cost-sharing payments.

Section 482 includes transfer pricing regulations, which require that such payments between related entities—such as a parent company and its subsidiary—reflect the value that unrelated companies would give these intangible assets in a fair market exchange, known as the arm’s-length value.

Amazon reported a buy-in payment of about $255 million for the exchange. The IRS said this wasn’t the arm’s-length price and recalculated, valuing the buy-in at about $3.6 billion.

Congress Changed Definition

The case may only have implications for companies dealing with certain previous tax years.

In 2009, Treasury issued temporary regulations that broadened the range of contributions that must be covered by a buy-in payment. In addition, Congress later amended the definition of “intangible property” within Section 482.

The court drew a sharp distinction between the landscape before and after these changes.

“If this case were governed by the 2009 regulations or by the 2017 statutory amendment, there is no doubt the Commissioner’s position would be correct,” the court wrote.

Other major companies are also in litigation with the IRS over transfer pricing decisions, including Facebook Inc., Altera Corp., and medical device manufacturer Medtronic PLC.

The Ninth Circuit panel upheld a 2017 U.S. Tax Court opinion that the IRS appealed. The IRS’s “determination with respect to the buy-in payment is arbitrary, capricious, and unreasonable,” wrote Judge Albert G. Lauber for the Tax Court.

Callahan was joined in the opinion by Judges William A. Fletcher and Morgan Christen.

The case is Amazon.com Inc. v. Commissioner, 9th Cir., No. 17-72922, 8/16/19.