In May, the IRS asserted $340 million in transfer pricing penalties in Western Digital Corporation v. Commissioner. If the IRS prevails, these would appear to be the largest transfer pricing penalties sustained in US Tax Court history.

The penalties are notable not only for their amount, but also for the way the IRS raised them. The IRS did not apply penalties in its notices of deficiency or in its initial Tax Court pleadings. Instead, the IRS asserted the penalties in amended pleadings over a year after the case began.

The penalty dispute. In the amended pleadings, the IRS argues that penalties apply because Western Digital did not prepare adequate transfer pricing documentation. Although the company did provide the IRS with a valuation report from an accounting firm during the audit, the IRS argues that the report was unreliable, undated, and unsigned. It also argues that the company’s engagement letter with the accounting firm said that the report would not be used for penalty protection under section 6662.

The penalties here may reflect a push by the IRS to assert more transfer pricing penalties. In 2018, the IRS issued a directive warning exam teams that “[f]ailure to apply penalties when appropriate has adverse consequences.” And, just recently, the IRS issued Q&As on transfer pricing documentation for taxpayers. In the wake of this guidance, we may see more big-ticket transfer pricing penalties like the ones in Western Digital.

The amended pleadings touch on another timely penalty issue: the rule that an IRS supervisor must approve penalties in writing under section 6751(b). The supervisors here apparently approved the penalties by signing the amended pleadings. Yet the IRS also indicates that it sent Western Digital drafts of the pleadings before the supervisors gave their approval. Since the supervisor must approve the “initial determination” of the penalties—and that term is deeply ambiguous and the subject of lots of recent litigation—it is unclear whether the IRS approved the penalties in time. So a procedural fight over the approval could be in the offing.

The transfer pricing case. Even before the penalties, the Western Digital case was worth watching because it is one of only a handful of major transfer pricing cases pending in the Tax Court.

The case involves classic transfer pricing facts. Affiliates in the United States licensed pre-existing hard drive technology to a related manufacturing entity in Ireland in exchange for a per-unit royalty. In accordance with the license agreement, the Irish entity prepaid $141 million in royalties forecasted to accrue. In a separate agreement, the US affiliates agreed to perform R&D for the Irish entity for new intellectual property that Ireland would own in return for cost-plus service fees and other cost reimbursements.

Invoking section 482, the IRS challenged the royalty rate and the amount of the royalty prepayment, applied its own discounted-cash-flow analysis, and allocated billions of dollars in income from Ireland to the United States. While the IRS has often argued transferred or licensed intangibles have a perpetual or very long life, here the IRS adopted a more modest useful life. Specifically, the IRS apparently accepted Western Digital’s five-year decay curve for the licensed technology, but applied a two-year lag to it, effectively refashioning it into a seven-year curve.

The transfer pricing issues will likely hinge on the location of Western Digital’s value drivers. In its pleadings, the company argued that its “success, or failure, in the [hard-drive] industry depended on [its] . . . highly efficient manufacturing operations” in Ireland. The IRS responded that manufacturing was merely one of “numerous factors” that drove the company’s success—and that another important factor was R&D performed in the United States.

Related issues. The case raises other issues related to transfer pricing. There is a pending motion for partial summary judgment on the interaction between Subpart F and section 482. And there is a dispute over whether Western Digital can reduce the IRS’s transfer pricing adjustment with its own adjustment removing the value of stock-based compensation from its R&D services cost base.

The case is currently scheduled for trial in late 2021. The IRS’s amendments to answer and Western Digital’s replies are available below.

Amendment to Answer – Docket No. 18984-18

Amendment to Answer – Docket No. 4818-19

Reply to Amendment to Answer – Docket No. 18984-18

Reply to Amendment to Answer – Docket No. 4818-19