Veritas Software Corporation & Subsidiaries, Symantec Corporation (Successor in Interest to Veritas Software Corporation & Subsidiaries.) v. Commissioner

133 T.C. No. 14

UNITED STATES TAX COURT

VERITAS SOFTWARE CORPORATION & SUBSIDIARIES, SYMANTEC CORPORATION
(SUCCESSOR IN INTEREST TO VERITAS SOFTWARE CORPORATION &
SUBSIDIARIES), Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 12075-06. Filed December 10, 2009.

P entered into a cost-sharing arrangement with S,
its foreign subsidiary, to develop and manufacture
storage management software products. Pursuant to the
cost-sharing arrangement, P granted S the right to use
certain preexisting intangibles in Europe, the Middle
East, Africa, and Asia. As consideration for the
transfer of preexisting intangibles, S made a $166
million buy-in payment to P. P employed the comparable
uncontrolled transaction method to calculate the
payment. In a notice of deficiency issued to P, R
employed an income method and determined a requisite
buy-in payment of $2.5 billion and made an income
allocation to P of that amount. In an amendment to
answer, R reduced the allocation from $2.5 to $1.675
billion. R further determined that the requisite buy-
in payment must take into account access to P’s
 - 2 -

research and development team; access to P’s marketing
team; and P’s distribution channels, customer lists,
trademarks, trade names, brand names, and sales
agreements. P contends that R’s determinations are
arbitrary, capricious, and unreasonable and the comparable
uncontrolled transaction method is the best method to
calculate the requisite buy-in payment.

1. Held: R’s determinations are arbitrary,
capricious, and unreasonable.

2. Held, further, P’s comparable uncontrolled
transaction method, with appropriate adjustments, is
the best method to determine the requisite buy-in
payment.

Mark A. Oates, Scott Frewing, Andrew P. Crousore, James M.

O’Brien, Catlin A. Urban, Erika S. Schechter, Paul E. Schick,

Jaclyn Pampel, Jenny A. Austin, Mark T. Roche, Erika L. Andersen,

John M. Peterson, Jr., and Kristen B. Proschold, for petitioner.

Lloyd Silberzweig, James P. Thurston, Kimberley Peterson,

David Rakonitz, Stephanie Profitt, Margaret Burow, and John

Strate, for respondent.

CONTENTS

Background.................................................... 4

I. Storage Management Software Products.................... 6

II. Product Distribution Channels........................... 10

III. Intensely Competitive Market............................ 11

IV. Product Lifecycles and Useful Lives..................... 15

V. Geographic Expansion.................................... 16

VI. The Cost-Sharing Arrangement............................ 17
 - 3 -

VII. VERITAS Ireland’s Operations............................ 21

VIII. Procedural History...................................... 23

Discussion.................................................... 30

I. Applicable Statute and Regulations...................... 33

II. Respondent’s Buy-in Payment Allocation Is Arbitrary,
Capricious, and Unreasonable............................ 35

A. Respondent’s Notice Determination Is Arbitrary,
Capricious, and Unreasonable........................ 37
B. Respondent’s Determination in Amendment to Amended
Answer Is Arbitrary, Capricious, and Unreasonable... 39
1. Respondent’s “Akin” to a Sale Theory Is Specious. 39
2. Respondent’s Allocation Took into Account Items
Not Transferred or of Insignificant Value........ 41
3. Respondent’s Allocation Took Into Account
Subsequently Developed Intangibles............... 44
4. Respondent Employed the Wrong Useful Life,
Discount Rate, and Growth Rate................... 45

III. Petitioner’s CUT Analysis, With Some Adjustments, Is the
Best Method............................................. 50

A. Comparability of OEM Agreements..................... 54
B. Unbundled OEM Agreements Were Comparable to the
Controlled Transaction.............................. 56

IV. Requisite Adjustments to Petitioner’s CUT Analysis...... 64

A. The Appropriate Starting Royalty Rate............... 65
B. The Appropriate Useful Life and Royalty Degradation
Rate................................................ 66
C. Value of Trademark Intangibles and Sales Agreements. 67
D. The Appropriate Discount Rate....................... 69

V. Conclusion............................................... 71

OPINION

FOLEY, Judge: On November 3, 1999, VERITAS Software Corp.

(VERITAS US) and VERITAS Ireland entered into a cost-sharing
 - 4 -

arrangement (CSA), which consisted of a research and development

agreement and a technology license agreement.1 Also on November

3, 1999, VERITAS US, pursuant to the CSA, transferred preexisting

intangible property to VERITAS Ireland and VERITAS Ireland made a

buy-in payment to VERITAS US as consideration for the preexisting

intangible property. After concessions, the issue for decision

is whether, pursuant to section 482,2 the buy-in payment was

arm’s length.

Background

On August 22, 2007, the Court issued a protective order to

prevent disclosure of petitioner’s proprietary and confidential

information. The facts and opinion have been adapted

accordingly, and any information set forth herein is not

proprietary or confidential. VERITAS US is a Delaware

corporation with its principal place of business in Cupertino,

California. During 1999, 2000, and 2001 (years in issue) VERITAS

US was the parent of a group of affiliated subsidiaries.

1
See infra, Background, sec. VI, The Cost-Sharing
Arrangement, for detailed discussion of the research and
development agreement and technology license agreement.
2
Unless otherwise indicated, all section references are to
the Internal Revenue Code of 1986, as amended and in effect for
the years in issue, and all Rule references are to the Tax Court
Rules of Practice and Procedure.
 - 5 -

VERITAS US is in the business of developing, manufacturing,

marketing, and selling advanced storage management software

products. VERITAS US’ products protect against data loss and

file corruption, provide rapid recovery after disk or system

failure, process large files efficiently, manage and back up

systems without user interruption, and provide performance

improvement and reliability enhancement features that are

critical for many commercial applications.

In the mid to late 1990s VERITAS US expanded its business

through corporate acquisitions and the establishment of foreign

subsidiaries. On April 25, 1997, VERITAS US acquired and merged

with OpenVision Technologies, Inc. (OpenVision). With the

acquisition of OpenVision, VERITAS US obtained NetBackup;3 offices

in the United Kingdom, Germany, and France; an engineering team;

and skilled sales and marketing executives. By the end of 1997

VERITAS US had sales subsidiaries in Canada, Japan, the United

Kingdom, Germany, France, Sweden, and the Netherlands. VERITAS

US, on May 28, 1999, acquired Seagate Software Network and

Storage Management Group, Inc. (NSMG). As a result of this

acquisition, VERITAS US became the largest storage software

3
See infra, Background, sec. I, Storage Management Software
Products, for a discussion of NetBackup.
 - 6 -

company in the industry and obtained Backup Exec;4 a distribution

channel in Europe, the Middle East, and Africa (EMEA); and a

sales force that sold Backup Exec to customers in Europe. On

July 2, 2005, VERITAS US was purchased by Symantec Corp.

(Symantec) and became one of Symantec’s wholly owned

subsidiaries. References to petitioner are to VERITAS US, its

subsidiaries, and Symantec (successor in interest to VERITAS US

and subsidiaries).

I. Storage Management Software Products

All computer operating systems have “backup” and “restore”

capabilities.5 Storage management software replaces the portion

of a computer’s operating system that organizes files and manages

data storage devices. Stored data is preserved and protected

against loss or corruption by the use of backup applications that

copy, on secondary storage, the data, its organizational

structure, and its ownership information. Secondary storage

devices may be attached directly to a computer or accessed

through a network server.

4
See infra, Background, sec. I, Storage Management Software
Products, for a discussion of Backup Exec.
5
“Backup” is simply making a copy and moving it to a safe
location. “Restore” takes the copy from the safe location and
makes it available to the end-user.
 - 7 -

Prior to 1999 only one application could access a data file

at any given time. Thus, to back up data on secondary storage,

it was first necessary to shut down all applications using the

data. Most secondary storage was on magnetic tape and directly

attached to a single server. After the CSA, there were important

technological advances relating to the data storage software

industry. In response to 24-hour Web sites, backup technology

advanced significantly, enabling backups to run at any time. In

addition, exponential increases in file size and data volume and

the plummeting cost of disk storage spurred the use of disks as

secondary storage. The switch to disks as the primary backup

medium required the source code6 of backup products to be

rewritten. The advent of storage area networks allowed storage

to be shared by numerous computers, allowed more than one server

to access a particular piece of data, and enabled applications to

run continuously without interruption. Other technological

advances dramatically increased storage capacity and also

facilitated disaster recovery by allowing storage resources to be

replicated several times in different data centers. These

6
Source code is the human readable statement used to write
computer programs and is commonly organized into files, which are
composed of individual lines of code. Complex software, such as
storage management software, often requires thousands of source
code files and hundreds of thousands or millions of lines of
code.
 - 8 -

advances reduced the cost of physical storage and made it

possible for many systems to share storage devices.

During the years in issue, VERITAS US had one primary

commercial product (i.e., a product with a low price point and

high-volume sales), Backup Exec, and five primary enterprise

products (i.e., products with a high price point and low-volume

sales): NetBackup, Volume Manager, File System, Cluster Server,

and Foundation Suite.

Backup Exec, which was targeted to small businesses, was a

data management product that provided backup, archive, and

restore capabilities for a network’s servers and workstations.

NetBackup, Volume Manager, File System, Cluster Server, and

Foundation Suite were purchased by businesses with large

sophisticated information technology systems. NetBackup provided

backup, archive, and restore capabilities for servers and

workstations using complex UNIX, Windows, Linux, and NetWare

operating systems. Volume Manager allowed an administrator to

manage volumes (i.e., physical disks or hard drives that stored

data) and also provided online disk storage management. File

System was a journaling system that provided a directory index of

files and made it easier to find and access files and data. File

System also enabled fast system recovery from operating system

failure or disruption. Cluster Server allowed multiple servers
 - 9 -

to be grouped together as a cluster and, if one server failed,

another server was automatically activated to perform the

functions of the failed server. Volume Manager had Cluster

Server functionality by 1999 and File System had such

functionality by 2000. Foundation Suite combined Volume Manager

and File System to deliver a complete solution for online disk

and file management functions. The consolidated product

facilitated quicker and more efficient data transmission,

storage, and backup. Foundation Suite was also sold in a high

availability version. This version combined Foundation Suite and

Cluster Server and ensured continuous uninterrupted operation in

the event of system failure.

Many of VERITAS US’ products were deemed “sticky” because

after employing them it was difficult, costly, and time consuming

for the user to change to a competing product. These products

communicated with and controlled parts of the computer and its

attached devices without support from standard application

program interfaces (API)7 or device drivers. Consequently, the

software code in these products included code inextricably tied

to the most basic part of an operating system. In 1999 VERITAS

7
APIs, which provide software vendors with access to the
operating system’s features, allow an application written for one
type of operating system to run on a different type of operating
system.
 - 10 -

US software products could run on systems and applications

manufactured by Sun Microsystems, Inc. (Sun); Hewlett-Packard Co.

(HP); Microsoft Corp. (Microsoft); International Business

Machines Corp. (IBM); Red Hat, Inc.; Apple Inc.; Novell, Inc.

(Novell); Oracle Corp. (Oracle); SAP AG; Sybase, Inc.; and

VMware, Inc. After the CSA, VERITAS US released numerous

versions of its aforementioned products. Each version contained

new features. When new features were added to a product, the

source code relating to these features was either added to

existing files or placed in newly created files. While no one

feature modification significantly altered the essential elements

of the code, the cumulative effect of modifying hundreds of

features typically resulted in significant code changes.

II. Product Distribution Channels

A product’s path to market is often referred to as a

distribution channel. In 1999 VERITAS US sold its products

directly to customers and through original equipment

manufacturers (OEMs), distributors, and resellers. From 1997 to

2006 VERITAS US entered into OEM agreements with several entities

including Sun, HP, Dell Products, L.P. (Dell), Compaq Computer

Corp. (Compaq), Ericsson Radio Systems AB (Ericsson), Hitachi,

Ltd. (Hitachi), NEC Corp. (NEC), Microsoft, NCR Corp. (NCR), and

Siemens Nixdorf Informationssysteme AG (Siemens). VERITAS US

provided the OEMs with the product and the OEMs sold the products
 - 11 -

either bundled with their operating systems or unbundled as an

option. Bundled products were installed with, and sold as a part

of, the operating system, while unbundled products were sold as

separate products for customers to install. During the term of

the license, OEMs generally received the current version of the

products plus updates, upgrades, and new versions. After selling

VERITAS US’ bundled products, the OEMs often provided technical,

engineering, and maintenance support. The OEMs’ willingness to

sell and support the bundled products was a tacit affirmation of

the products’ reliability and quality. VERITAS US benefited from

this arrangement because the OEMs had better name recognition and

more customers.

From November 1999 to 2006 OEM licensees paid VERITAS US

$1.327 billion in royalties.8 The calculation of royalties was

based on list price, revenues, or profits and the products were

often sold at a discount off list price. VERITAS US generally

received a one-time license fee upon entering into the agreement

and additional license fees each time the OEM sold VERITAS US

products bundled with an operating system. The royalty rates

8
From 1999 to 2006 Sun, VERITAS US’ largest and most
significant OEM partner, paid VERITAS US $657.4 million in
royalties. During this period VERITAS US also received $292.9
million from HP, $181.6 million from Dell, $23.9 million from
Hitachi, $7.9 million from NEC, and $780,000 from Compaq. In
addition, from 2000 to 2008 VERITAS US received $23.9 million in
royalties from Ericsson.
 - 12 -

relating to VERITAS US’ OEM licenses ranged from 10 to 40 percent

for bundled products and 5 to 48 percent for unbundled products.

Profit potential and sales volume were important factors in

determining royalty rates. VERITAS US could not accurately

predict the amount of its license revenue receipts attributable

to OEM agreements because VERITAS US had no control over delivery

dates or the number of VERITAS US products sold with OEM

operating systems. This uncertainty led VERITAS US to explore

other paths to market (i.e., distributors, resellers, and direct

sales) for its products .

VERITAS US sold Backup Exec through distributors and

resellers. The distributors sold Backup Exec to resellers and

the resellers sold it to customers. VERITAS US sold NetBackup,

Volume Manager, File System, Cluster Server, and Foundation Suite

directly to customers and through resellers. Between 1997 and

2005 VERITAS US entered into reseller agreements with operating

system, hardware, and database vendors including Compaq, Hitachi,

Fujitsu, Ericsson, Dell, HP, NCR, Bull S.A., and EMC Corp. (EMC).

The royalty rates relating to the reseller agreements ranged

between 32.5 and 70 percent.

III. Intensely Competitive Market

Prior to the CSA, VERITAS US products competed intensely

with products manufactured by numerous companies. ARCserve, a

backup product manufactured by Computer Associates, was Backup
 - 13 -

Exec’s major competitor. NetBackup’s primary competitors

included IBM’s Tivoli Storage Manager, EMC’s Legato NetWorker,

HP’s OmniBackup/Data Protector, and CommVault’s Galaxy.

Foundation Suite’s primary competitors were products manufactured

by operating system, hardware, and database vendors (i.e., Sun,

EMC, and Oracle).

VERITAS US products competed with both comparable and free

alternatives. The free alternatives included storage management

products readily accessible on the Internet and those bundled

with operating systems. Vendors sometimes incorporated storage

management capabilities into their operating systems. Some

customers preferred operating systems with built-in storage

management software (i.e., integrated stacks).9 These stacks were

less expensive and easier to deploy because purchasers were not

required to acquire or install costly individual components.

VERITAS US continuously sought to offer products that were faster

and more efficient than comparable products or free alternatives.

The performance advantages of VERITAS US products over free

products decreased, however, as competitors improved their

products’ functionality.

9
The operating system, the applications it supports, and the
software it uses to manage devices attached to the computer are
referred to as a “stack”.
 - 14 -

Between 1996 and 2006 the primary competition for VERITAS US

products was products sold by operating system, hardware, and

database vendors such as Sun and Oracle. Sun and Oracle had a

similar objective--remove VERITAS US from their respective stacks

and provide their respective customers with viable alternatives

to VERITAS US products.

Sun, an operating system manufacturer and distributor, was

one of VERITAS US’ main OEM contractors and competitors. The

relationship between VERITAS US and Sun evolved from a mutually

beneficial partnership in 1997 to mutual tolerance in 1999 and,

ultimately, to outright competition in 2006. Sun was committed

to capturing the funds that its customers were spending on

VERITAS US products. Sun upgraded its operating systems in an

attempt to replicate the functionality of VERITAS US products and

achieved this goal by adding to its operating system a

supplanting product that was provided to customers at no cost.

From 2000 through 2006 Sun released a series of operating systems

that included software products that offered progressively more

functionality. These products took market share from VERITAS US

and closed the technology gap between Sun and VERITAS US.

Oracle, a software manufacturer known for its databases and

applications, was as aggressive as Sun in competing with VERITAS

US. Oracle offered software to directly, and successfully,
 - 15 -

compete with File System, Volume Manager, and Cluster Server. In

an attempt to maximize revenues and customer loyalty, Oracle

embarked on a strategy to build a complete stack and compete not

just with VERITAS US, but also with operating system vendors.

Oracle started with basic level technology and continued to

innovate until it developed products similar, and ultimately,

equal to VERITAS US products.

IV. Product Lifecycles and Useful Lives

In the rapidly changing storage software industry, products

with state-of-the-art function lost value quickly as that

functionality was duplicated by competitors or supplanted by new

technology. Even with substantial ongoing research and

development (R&D), VERITAS US products had finite lifecycles.

Intense competition (i.e., from OEMs offering comparable

products) and the rapid pace of technological advances forced

VERITAS US to innovate constantly. By the time a new product

model became available for purchase, the next generation was

already in development.

At the time of the CSA, VERITAS US products, on average, had

a useful life of 4 years. In 2001 VERITAS US’ board of directors

realized that VERITAS US’ primary products were approaching the

end of their lifecycles and that the product pipeline was not

capable of sustaining business growth. In 2002 and 2003 the

board of directors recognized that revenues relating to Backup
 - 16 -

Exec and NetBackup had ceased to grow and that the revenues

relating to Volume Manager and File System were declining.

NetBackup’s useful life came to an end in 2005 when a major

overhaul was performed. Even as the products approached the end

of their useful lives, they did not lose all of their value.

VERITAS US typically updated its products but, on occasion,

an OEM would pay VERITAS US to build a custom item that would not

be further developed. In these instances, the related OEM

agreements contained a royalty degradation or technology aging

discount provision to account for obsolescence and decay. Some

agreements provided for the royalties to be decreased at a steady

rate while others required royalty rate reductions that increased

during the term of the agreement. Generally, the agreements did

not provide a royalty rate reduction of more than 75 percent over

a 4-year period.

V. Geographic Expansion

Prior to 2000 VERITAS US had limited presence in EMEA and

Asia Pacific and Japan (APJ). While VERITAS US had sales and

service offices and resellers in North America, Europe, Asia

Pacific, South America, and the Middle East, it had no

manufacturing operation in these countries and only small sales

subsidiaries in the United Kingdom, France, Germany, Sweden, the

Netherlands, Switzerland, Japan, and Australia. In 1999 VERITAS

US’ international sales force, excluding Canadian employees,
 - 17 -

consisted of 287 employees: 237 in Europe, 27 in Asia Pacific,

and 23 in Japan. VERITAS US had a total of 33 international

marketing employees: 28 in Europe, 4 in Japan, and 1 in Asia

Pacific.

In the EMEA storage management software market (i.e., in

which VERITAS US sold Foundation Suite, NetBackup, and Backup

Exec), VERITAS US’ market shares in 1998 and 1999 were 8.9

percent and 13.2 percent, respectively. Computer Associates’

ARCserve, Backup Exec’s primary competition, dominated the EMEA

market, holding more than 50 percent of the United Kingdom market

and more than 60 percent of the French, Italian, and Spanish

markets.

In 1999 the EMEA and APJ territories accounted for 92

percent of VERITAS US’ international revenues and 22 percent of

VERITAS US’ total revenues (i.e., EMEA revenue totaled $110

million and APJ revenue was de minimis). VERITAS US’ management

recognized that geographic expansion in EMEA and APJ presented an

opportunity to increase sales. After evaluating the cost of

labor, employment laws, quality of workforce, and tax

considerations, VERITAS US’ management decided to headquarter its

EMEA and APJ operations in Ireland.

VI. The Cost-Sharing Arrangement

In January 1999 VERITAS Software Holding, Ltd. (VSHL) was

incorporated as an Irish corporation. VSHL was a resident of
 - 18 -

Bermuda and a wholly owned subsidiary of VERITAS US. In August

1999 VERITAS Software International, Ltd. (VSIL) was incorporated

as a resident of Ireland and a wholly owned subsidiary of VSHL.

VERITAS Software, Ltd. (VERITAS UK) and VERITAS Software Asia

Pacific Trading PTE, Ltd. (VERITAS Singapore), disregarded

entities for U.S. income tax purposes, were also wholly owned by

VSHL. In 2000 and 2001 VSHL, VSIL, VERITAS UK, and VERITAS

Singapore (collectively, VERITAS Ireland) were subsidiaries of

VERITAS US.

Effective November 3, 1999, VERITAS US assigned to VERITAS

Ireland all of VERITAS US’ existing sales agreements with

European-based sales subsidiaries (i.e., VERITAS UK, VERITAS

Sweden, VERITAS Switzerland, VERITAS France, and VERITAS

Germany). Also effective on that date, VERITAS US, VERITAS

Operating Corp., NSMG, and VERITAS Ireland10 entered into the

Agreement for Sharing Research and Development Costs (RDA), and

VERITAS US and VERITAS Ireland11 entered into the Technology

License Agreement (TLA).12

10
With respect to the RDA, “VERITAS Ireland” refers to VSHL
and VSIL, the two parties who entered into the RDA with VERITAS
US.
11
With respect to the TLA, “VERITAS Ireland” refers to VSHL
and VSIL, the two parties who entered into the TLA with VERITAS
US.
12
As previously stated, the CSA consisted of these
(continued...)
 - 19 -

Pursuant to the RDA, the signatories agreed to pool their

respective resources and R&D efforts related to software products

and software manufacturing processes. They also agreed to share

the costs and risks of such R&D on a going-forward basis. The

RDA provided VERITAS Ireland with:

the exclusive and perpetual right to manufacture
Products utilizing, embodying or incorporating the
Covered Intangibles within VERITAS Ireland’s
Territory,[13] and the nonexclusive and perpetual right
to otherwise utilize the Covered Intangibles worldwide,
including in the marketing, sale, and licensing of
Products utilizing, embodying or incorporating the
Covered Intangibles, and in further research into
similar technology.

The RDA defined “Covered Intangibles” as:

any and all inventions, patents, copyrights, computer
programs (in source code and object code form), flow
charts, formulae, enhancements, updates, translations,
adaptations, information, specifications, designs,
process technology, manufacturing requirements, quality
control standards, and other intangible property rights
arising from or developed as a result of the Research
Program.[14]

Pursuant to the TLA, VERITAS US granted VERITAS Ireland the

right to use certain “Covered Intangibles”, as well as the right

12
(...continued)
agreements.
13
The RDA defined VERITAS Ireland’s Territory as “Europe,
Middle East, Africa, Asia, and the Asia Pacific.”
14
The RDA defined Research Program as “all software research
and development activity and process development activity”.
 - 20 -

to use VERITAS US’s trademarks, trade names, and service marks in

EMEA and APJ. The TLA defined “Covered Intangibles” as:

any and all inventions, patents, copyrights, computer
programs (in source code and object code form), flow
charts, formulae, enhancements, updates, translations,
adaptations, information, specifications, designs,
process technology, manufacturing requirements, quality
control standards, and other intangible property rights
arising in existence as of the Effective Date of this
Agreement, relating to the design, development,
manufacture, production, operation, maintenance and/or
repair of any or all of the Products.

In exchange for the rights granted by the TLA, VERITAS Ireland

agreed to pay VERITAS US royalties. The TLA, which was amended

on three occasions,15 specified the initial royalty rates, as well

as a prepayment amount (i.e., a lump-sum buy-in payment). The

TLA provided that the parties “shall adjust the royalty rate

prospectively or retrospectively as necessary so that the rate

will remain an arm’s-length rate.”

In 1999 VERITAS Ireland paid VERITAS US $6.3 million and

agreed to prepay VERITAS US, in 2000, the remaining consideration

relating to the preexisting intangibles. In 2000 VERITAS Ireland

made a $166 million lump-sum buy-in payment to VERITAS US, and in

2002 VERITAS Ireland and VERITAS US adjusted the payment to $118

million.

15
Amendment No. 1 was effective as of Nov. 3, 1999;
Amendment No. 2 was effective as of Aug. 1, 2001; and Amendment
No. 3 was effective as of July 1, 2002.
 - 21 -

VII. VERITAS Ireland’s Operations

Prior to the establishment of VERITAS Ireland, VERITAS US’

supply chain and distribution channels to the EMEA and APJ

markets were weak and inefficient. NetBackup, Volume Manager,

File System, Cluster Server, and Foundation Suite were

manufactured in Pleasanton, California, and Backup Exec was

manufactured by a contractor in Lisle, France (Lisle contractor).

In 1999 VERITAS Ireland began codeveloping, manufacturing, and

selling VERITAS US products in the EMEA and APJ markets. VERITAS

Ireland’s facility, in Shannon, County Clare, Ireland,

manufactured NetBackup, File System, Volume Manager, Cluster

Server, and Foundation Suite.16 The Ireland location had a

production line, quality control stations, and a CD replication

tower. VERITAS Ireland controlled all aspects of production,

planning, shipping, and logistics. It also processed purchase

orders and bore contractual, credit, and collection risks

relating to transactions in the EMEA and APJ markets. With

VERITAS Ireland in control of the manufacturing process and

managing the Lisle contractor, the supply chain became much more

efficient.

16
In 2001 VERITAS Ireland outsourced the manufacture of
Volume Manager, File System, Cluster Server, and Foundation
Suite.
 - 22 -

VERITAS Ireland developed the EMEA and APJ markets without

significant input from VERITAS US. In 1999 VERITAS US’ customer

base had little or no value because of its minimal market share

and limited presence in EMEA and APJ. At that time there were

two offices in the United Kingdom: One in Chertsey and one in

Reading. The Chertsey office was staffed by direct sales

employees. The Reading office was staffed by two small teams

(i.e., a distribution team and a reseller team) of inept workers.

VERITAS Ireland focused on the basics of building a more

extensive sales business and stronger distribution channels. In

2000 VERITAS Ireland hired a new distribution sales manager who

was responsible for expanding its products’ paths to market.

VERITAS Ireland’s new management totally changed the culture by

continually upgrading VERITAS Ireland’s sales resources;

examining distributor and reseller reports; finding new

customers; initiating interaction with the reseller base;

providing sales incentives for distributors; training and

educating the distributors’ presales teams; and firing

underperforming salesmen, distributors, and resellers. To

further expand its sales presence, VERITAS Ireland accessed and

leveraged its distribution partners’ sales organizations and

customer contacts.

VERITAS Ireland’s operations and its presence in the EMEA

territory grew substantially from 2000 to 2006. By 2001 the
 - 23 -

Ireland facility had increased from 12,000 to 40,000 square feet

and the number of VERITAS Ireland employees had increased from 20

to more than 100. By 2002 VERITAS Ireland had over 25 new

offices and subsidiaries in 19 countries, and by 2004 VERITAS

Ireland had more than 1,500 employees in more than 30 countries.

From 1999 to 2006 VERITAS Ireland spent $1.374 billion on sales

and marketing expenses, $676 million on cost-sharing payments,

$456 million on customer service expenses, $146 million on

administrative expenses, and $124 million on buy-in payments. In

2000 VERITAS Ireland’s first full year of operation, revenues

were approximately $200 million. By 2003 VERITAS Ireland’s

license revenues had doubled, and by 2004 its annual revenues

were five times higher than VERITAS US’ 1999 revenues

attributable to EMEA and APJ.

VIII. Procedural History

VERITAS US timely filed Federal income tax returns for 2000

and 2001. On its 2000 return VERITAS US reported a $166 million

lump-sum buy-in payment from VERITAS Ireland. In response to

VERITAS Ireland’s updated sales figures and forecasts, VERITAS

US, on December 17, 2002, amended the 2000 return reducing the

lump-sum buy-in payment to $118 million.

Respondent examined VERITAS US’ 2000 and 2001 returns and

concluded that the cost-sharing allocations reported did not

clearly reflect VERITAS US’ income. On March 29, 2006,
 - 24 -

respondent issued petitioner a notice of deficiency based on a

report prepared by Brian Becker (Becker). In the notice,

respondent stated:

In accordance with Section 482 of the Internal
Revenue Code, to clearly reflect the income of the
entities, we have allocated income and deductions
as a result of the transfer and/or license of pre-
existing intangible property in connection with the
cost sharing arrangement and technology license
agreement, both effective November 3, 1999.

Becker employed the forgone profits method, the market

capitalization method, and an analysis of VERITAS US’ arm’s-

length acquisitions to arrive at a series of values, ranging from

$1.9 billion to $4 billion, for the lump-sum buy-in payment. He

ultimately decided that a $2.5 billion buy-in payment was

appropriate. In accordance with Becker’s calculations,

respondent, in the notice to petitioner, made a $2.5 billion

allocation of income to VERITAS US and determined deficiencies of

$704 million and $54 million, and section 6662 penalties of $281

million and $22 million, relating to 2000 and 2001, respectively.

On June 26, 2006, petitioner timely filed its petition with

the Court seeking redetermination of the deficiencies and

penalties set forth in the notice. On August 25, 2006, the Court

filed respondent’s answer, and on August 31, 2006, the Court

filed respondent’s amended answer. Respondent, in his statement

of position filed September 6, 2007, stated: “In view of the

fact that information is still being collected and analyzed,
 - 25 -

Respondent cannot state which transfer pricing method(s) he

intends to utilize at trial.” On October 11, 2007, respondent,

in a supplement to his statement of position, notified the Court

and petitioner that he was going to employ the forgone profits

method, but was not going to rely on the market capitalization

method or call Becker as a witness. Respondent, in the October

11, 2007, statement also stated:

Respondent will use the actual income figures and
projections extrapolated from those figures to
determine the value of the intangibles and,
consequently, the total compensation due Petitioner
from VERITAS Ireland for the intangibles. Based on a
preliminary analysis of Petitioner’s actual income
figures, which are less than Petitioner’s projections
relied upon by Dr. Becker, Respondent anticipates that
the resulting value will be less than the amount used
in the notice of deficiency. In that case, Respondent
will not contend that the value is greater than the
amount determined by his experts at trial.

On April 10, 2007, the Court filed the parties’ stipulation

of settled issues relating to stock-based compensation, technical

support services, and section 6662 penalties.17 On May 24, 2007,

the Court filed the parties’ stipulation of settled issues

relating to the RDA. Pursuant to the May 24, 2007, stipulation,

17
The parties stipulated the stock-based compensation costs
at issue and agreed that the determination of whether such costs
must be included in the cost-sharing pool would be “controlled by
the final decision, within the meaning of section 7481 of the
Internal Revenue Code (the ‘Code’), in Xilinx, Inc. and
Subsidiaries v. Commissioner, 125 T.C. 37 (2005), appeals
docketed, No. 06-74246 and 06-74269 (9th Cir., Aug. 30 and Sept.
29, 2006).” In addition, respondent conceded adjustments
relating to technical support services.
 - 26 -

the parties established the 2000 and 2001 arm’s-length values of

VERITAS Ireland’s proportional shares of the cost-sharing

payments.18

On January 11, 2008, the Court filed petitioner’s motion for

partial summary judgment. In the motion, petitioner contended

that respondent had abandoned the $2.5 billion allocation and the

methodologies set forth in the notice; the notice was

fundamentally defective; and respondent’s determination was

arbitrary, capricious, and unreasonable. Petitioner further

contended that, pursuant to precedent governing the Court of

Appeals for the Ninth Circuit (Ninth Circuit), the burden of

proof shifts to respondent. The Court, on February 6, 2008,

filed respondent’s notice of objection to petitioner’s motion for

partial summary judgment.

On March 7, 2008, respondent submitted to the Court an

expert report prepared by John Hatch (Hatch). Hatch, employing a

discounted cashflow analysis, concluded that the requisite lump-

sum buy-in payment was $1.675 billion, and calculated, as an

alternative, a 22.2-percent perpetual annual royalty. In

determining the best method to calculate the buy-in payment,

18
VERITAS Ireland’s shares of reasonably anticipated
benefits, pursuant to section 1.482-7(f)(3), Income Tax Regs.,
were 23.04 percent relating to 2000 and 28.47 percent relating to
2001.
 - 27 -

Hatch rejected the comparable uncontrolled transaction method

(CUT method)19 and the profit split method20. He contended that

prior to November 3, 1999, VERITAS US had made several

acquisitions of software companies that offered complementary,

and in some cases, competing products. Hatch opined that those

acquisitions were comparable to the CSA because VERITAS US

received rights pursuant to the acquisitions that were similar to

those which VERITAS Ireland received pursuant to the CSA. On the

basis of his findings, Hatch characterized the CSA as “akin” to a

sale or geographic spinoff (“akin” to a sale theory) and employed

the income method to determine the requisite buy-in payment.

Hatch defined the buy-in payment as “the present value of

royalty obligations expected to be paid under arm’s length

royalty terms applicable to the rights conferred on a go-forward

basis.” He did not individually value any of the specific items

that were allegedly transferred to VERITAS Ireland. Instead, he

employed an “aggregate” valuation approach that was based on a

three-step analysis. First, Hatch estimated the arm’s-length

royalty amounts that would be due in each period (i.e., each

19
See sec. 1.482-4(c)(1), Income Tax Regs. See also infra,
Discussion, sec. III, Petitioner’s CUT Analysis, With Some
Adjustments, Is the Best Method, for a fuller discussion of the
CUT method.
20
See sec. 1.482-6, Income Tax Regs., for a discussion of
the profit split method.
 - 28 -

calendar year or portion thereof after November 3, 1999) of the

CSA. Second, Hatch chose a discount rate to convert estimated

future royalty payments into November 1999 dollars. Third, Hatch

calculated the buy-in payment as equal to the present value of

the royalty payments estimated in step 1, discounted at the rate

determined in step 2. Hatch concluded that the requisite buy-in

payment was $1.675 billion and that a 22.2-percent perpetual

annual royalty was economically equivalent to the requisite

$1.675 billion payment. In calculating the requisite buy-in

payment, Hatch assumed that the preexisting intangibles have a

perpetual useful life. In addition, he concluded that 13.7

percent was the appropriate discount rate and 17.91 percent was

the appropriate compound annual growth rate.

On March 21, 2008, the Court filed respondent’s motion for

leave to file amendment to amended answer and lodged respondent’s

amendment to amended answer. In the proposed amendment,

respondent alleged that the requisite buy-in payment was $1.675

billion, payable as either a lump-sum payment or a 22.2-percent

perpetual royalty. In paragraph 9.f of the proposed amendment,

respondent asserted an adjustment relating to a transfer of

“certain other intangible rights.” Respondent specifically

alleged a transfer of access to VERITAS US’ marketing team;

access to VERITAS US’ R&D team; and VERITAS US’ trademarks, trade

names, customer base, customer lists, distribution channels, and
 - 29 -

sales agreements (collectively, paragraph 9.f items).

Petitioner, in its notice of objection to respondent’s motion for

leave to file amendment to amended answer filed April 10, 2008,

contended that respondent’s assertion of the paragraph 9.f items

raised a new matter because the issue was not described in the

notice of deficiency and required the presentation of new

evidence.

On May 2, 2008, the Court held a hearing (May 2 hearing)

relating to the aforementioned motions. In an order issued June

13, 2008 (June 13 order), we denied petitioner’s motion for

partial summary judgment and concluded that there was a genuine

issue with respect to whether respondent had abandoned the theory

and methodology set forth in the notice, petitioner had failed to

establish that the notice was fundamentally defective, and

petitioner had therefore failed to establish that the

determination was arbitrary, capricious, or unreasonable. With

respect to whether the burden of proof shifts to respondent, we

concluded that it was premature to rule on the issue. We also

granted respondent’s motion for leave to file amendment to

amended answer and concluded that the notice of deficiency was

sufficiently broad to include the paragraph 9.f items and,

therefore, respondent’s amendment to amended answer did not raise

a new matter. We stated:
 - 30 -

if, after an evaluation of expert and fact witnesses,
we determine that an adjustment relating to such items
is not appropriate, that such items were not in fact
transferred, or that such items are not intangibles
pursuant to section 482, we may conclude that the
notice of deficiency is arbitrary, capricious, or
unreasonable. * * *

On July 1, 2008, the trial commenced.

Discussion

We must determine whether VERITAS Ireland made an arm’s-

length buy-in payment to VERITAS US as consideration for

intangible property transferred to VERITAS Ireland in connection

with the CSA. In addition, we must determine whether

respondent’s allocation is arbitrary, capricious, or

unreasonable.

In essence, respondent’s determination began to unravel with

the parties’ pretrial stipulations of settled issues. After the

parties’ settlement relating to the arm’s-length value of the

RDA, as a practical and legal matter respondent was forced to

justify the $1.675 billion allocation by reference only to the

preexisting intangibles. As discussed herein, he simply could

not. Respondent, in a futile attempt to escape this dilemma,

ignored the parties’ settlement relating to the RDA and

disregarded section 1.482-7(g)(2), Income Tax Regs., which limits

the buy-in payment to preexisting intangibles. In addition,

respondent inflated the determination by valuing short-lived

intangibles as if they have a perpetual useful life and taking
 - 31 -

into account income relating to future products created pursuant

to the RDA.

After an extensive stipulation process, a lengthy trial, the

receipt of more than 1,400 exhibits, and the testimony of a

myriad of witnesses, our analysis of whether respondent’s $1.675

billion allocation is arbitrary, capricious, or unreasonable

hinges primarily on the testimony of Hatch. Put bluntly, his

testimony was unsupported, unreliable, and thoroughly

unconvincing. Indeed, the credible elements of his testimony

were the numerous concessions and capitulations.

Respondent’s predicament was primarily attributable to the

implausibility of respondent’s flimsy determination. In

calculating the $1.675 billion allocation, Hatch used the wrong

useful life for the products and the wrong discount rate and

admittedly did not know precisely which items were valued.

Furthermore, respondent’s trial position reflected sections

1.482-1T through 1.482-9T, Temporary Income Tax Regs., 74 Fed.

Reg. 349 (Jan. 5, 2009)--regulations that were promulgated 10

years after the transaction and 5 months after trial.21 These

regulations include specific examples involving “assembled

21
These regulations, promulgated in December 2008, are
effective for transactions entered into on or after Jan. 5, 2009.
See infra, Discussion, sec. III(A), Comparability of OEM
Agreements, for a more in-depth discussion.
 - 32 -

workforce”22 and prescribe the income method as a specified

method. In fact, after amending his amended answer, respondent

began referring to the intangibles subject to the buy-in payment

as “platform contribution” intangibles (i.e., the term used in

sections 1.482-1T through 1.482-9T, Temporary Income Tax Regs.,

supra) rather than “pre-existing intangibles”23 (i.e., the term

used in the applicable regulations). We further note that the

Administration, in 2009, proposed to change the law, expanding

the section 482 definition of intangibles to include “workforce

in place”,24 goodwill, and going-concern value.25 See Department

of the Treasury, General Explanations of the Administration’s

Fiscal Year 2010 Revenue Proposals 32 (May 2009). For the years

in issue, however, there was no explicit authorization of

respondent’s “akin” to a sale theory or its inclusion of

22
During the May 2 hearing, respondent referred to “access
to R&D team” and “access to marketing team” as “assembled
workforce”.
23
The term “pre-existing intangibles” is not used in secs.
1.482-1T through 1.482-9T, Temporary Income Tax Regs., 74 Fed.
Reg. 349 (Jan. 5, 2009).
24
During trial and on brief, respondent referred to “access
to R&D team” and “access to marketing team” as “workforce in
place”.
25
The Administration stated that the proposed change in law
was simply a “clarification” yet estimated that this change, when
combined with other “clarifications”, would raise nearly $3
billion dollars over 10 years. See Department of the Treasury,
General Explanations of the Administration’s Fiscal Year 2010
Revenue Proposals, Table 1 (May 2009).
 - 33 -

workforce in place, goodwill, or going-concern value. Taxpayers

are merely required to be compliant, not prescient.

Pursuant to the law in effect at the time of the CSA,

respondent’s determination is arbitrary, capricious, and

unreasonable, and VERITAS US’ CUT method, with some adjustments,

is the best method to determine the requisite buy-in payment.

I. Applicable Statute and Regulations

Section 482 was enacted to prevent tax evasion and ensure

that taxpayers clearly reflect income relating to transactions

between controlled entities. This section authorizes the

Commissioner to distribute, apportion, or allocate gross income,

deductions, credits, or allowances between or among controlled

entities if he determines that such distribution, apportionment,

or allocation is necessary to prevent evasion of taxes or to

clearly reflect the income of such entities. Id. 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.” Sec. 1.482-1(b)(1), Income Tax Regs.

Section 482 provides that in the case of any transfer of

intangible property the income with respect to the transfer shall

be commensurate with the income attributable to the intangible.

In a qualified cost-sharing arrangement, controlled participants

share the cost of developing one or more items of intangible

property. See sec. 1.482-7(a)(1), Income Tax Regs. When a
 - 34 -

controlled participant makes preexisting intangible property

available to a qualified cost-sharing arrangement, that

participant is deemed to have transferred interests in the

property to the other participant and the other participant must

make a buy-in payment as consideration for the transferred

intangibles. Sec. 1.482-7(g)(1) and (2), Income Tax Regs. The

buy-in payment, which can be made in the form of a lump-sum

payment, installment payments, or royalties, is the arm’s-length

charge for the use of the transferred intangibles. Sec. 1.482-

7(g)(2), (7), Income Tax Regs.

Section 1.482-7(g)(2), Income Tax Regs., requires buy-in

payments to be determined in accordance with sections 1.482-1 and

1.482-4 through 1.482-6, Income Tax Regs. Section 1.482-4(a),

Income Tax Regs., provides:

(a) In general. The arm’s length amount charged
in a controlled transfer of intangible property must be
determined under one of the four methods listed in this
paragraph (a). Each of the methods must be applied in
accordance with all of the provisions of § 1.482-1,
including the best method rule of § 1.482-1(c), the
comparability analysis of § 1.482-1(d), and the arm’s
length range of § 1.482-1(e). The arm’s length
consideration for the transfer of an intangible
determined under this section must be commensurate with
the income attributable to the intangible. See § 1.482-
4(f)(2) (Periodic adjustments). The available methods
are--
(1) The comparable uncontrolled transaction
method, described in paragraph (c) of this
section;
(2) The comparable profits method, described in §
1.482-5;
 - 35 -

(3) The profit split method, described in §
1.482-6; and
(4) Unspecified methods described in
paragraph (d) of this section.

If the recipient of the intangibles fails to make an arm’s-length

buy-in payment, the Commissioner is authorized to make

appropriate allocations to reflect an arm’s-length payment for

the transferred intangibles. Sec. 1.482-7(g)(1), Income Tax

Regs. The Commissioner’s authority to make section 482

allocations is limited to situations where it is necessary to

make each participant’s share of costs equal to its share of

reasonably anticipated benefits or situations where it is

necessary to ensure an arm’s-length buy-in payment for

transferred preexisting intangibles. Sec. 1.482-7(a)(2), Income

Tax Regs.

II. Respondent’s Buy-in Payment Allocation Is Arbitrary,
Capricious, and Unreasonable

Respondent’s section 482 allocation must be sustained absent

a showing of abuse of discretion. Sundstrand Corp. & Subs. v.

Commissioner, 96 T.C. 226, 353 (1991); Bausch & Lomb, Inc. v.

Commissioner, 92 T.C. 525, 582 (1989), affd. 933 F.2d 1084 (2d

Cir. 1991). Thus, to prevail petitioner first must show that

respondent’s section 482 allocation is arbitrary, capricious, or

unreasonable. Sundstrand Corp. & Subs. v. Commissioner, supra at

353-354 (citing G.D. Searle & Co. v. Commissioner, 88 T.C. 252,
 - 36 -

359 (1987), and Eli Lilly & Co. v. Commissioner, 84 T.C. 996,

1131 (1985), affd. in part, revd. in part and remanded 856 F.2d

855 (7th Cir. 1988)). If petitioner proves that respondent’s

allocation is arbitrary, capricious, or unreasonable but fails to

prove that the allocation it proposes meets the arm’s-length

standard, the Court must determine the proper allocation for the

buy-in payment. See Sundstrand Corp. & Subs. v. Commissioner,

supra at 354.

Respondent’s determination as set forth in the notice of

deficiency is presumptively correct. Id. at 353. Respondent

made two determinations with respect to the requisite buy-in

payment, one set forth in the notice of deficiency and one set

forth in the amendment to amended answer. Because we found in

the June 13 order that the amendment to amended answer did not

raise a new matter, the presumption of correctness that attached

to the determination set forth in the notice carried forward to

the revised determination set forth in the amendment to amended

answer. See Shea v. Commissioner, 112 T.C. 183 (1999). Thus, we

look to both the notice determination and the revised

determination in the amendment to amended answer to decide

whether respondent’s section 482 allocation is arbitrary,

capricious, or unreasonable.
 - 37 -

A. Respondent’s Notice Determination Is Arbitrary,
Capricious, and Unreasonable

In the notice, respondent determined, using Becker’s

valuation, that the requisite buy-in payment was $2.5 billion.

During trial respondent did not call Becker as a witness, place

Becker’s report in evidence, or present any evidence to support

Becker’s findings. Respondent, relying solely on the report

prepared by Hatch, did not address Becker’s $2.5 billion buy-in

valuation but instead asserted a $1.675 billion buy-in valuation.

The $825 million decrease in value with little explanation is

just one of the factors we consider in evaluating the

reasonableness of respondent’s determination. There are other

factors that collectively and convincingly establish that the

notice determination was not only unreasonable but was also

arbitrary and capricious. Using an income method, Becker and

Hatch, respectively, employed a 12.8- and a 13.7-percent discount

rate to calculate the requisite buy-in payment. Beta, a key

component in the formula used to calculate the discount rate, is

a measure of the tendency of a security’s price to respond to

swings in the market.26 In calculating their discount rates,

26
A beta of 1 indicates that the security’s price has tended
to move in step with the market (i.e., a 1-percent increase in
the market has led to a 1-percent increase for the security), a
beta of less than 1 implies that the security is less volatile
than the market, and a beta greater than 1 indicates that the
security is more volatile than the market. See infra,
(continued...)
 - 38 -

Becker and Hatch used essentially the same beta, 1.4 and 1.42,

respectively. Petitioner’s finance expert established that 1.935

was the correct beta. See infra, Discussion, sec. IV(D), The

Appropriate Discount Rate. Hatch ultimately conceded that a 1.42

beta “could not, to a reasonable degree of economic certainty, be

the correct beta.” See infra, Discussion, sec. II(B)(4),

Respondent Employed the Wrong Useful Life, Discount Rate, and

Growth Rate. In essence, Hatch admitted that both he and Becker

employed the wrong beta. Indeed, the beta Becker employed was

even further removed from the correct beta.

In sum, respondent, without meaningful explanation, conceded

$825 million of the buy-in amount set forth in the notice and at

trial failed to offer even a token defense in response to

petitioner’s critique of Becker’s conclusions. Moreover,

respondent cannot convincingly contend that the notice

allocations are reasonable while adopting the opinion of an

expert who admits that a critical factor relating to the

calculation of the allocation is incorrect. Accordingly,

respondent’s notice determination is arbitrary, capricious, and

unreasonable.

26
(...continued)
Discussion, sec. II(B)(4), Respondent Employed the Wrong Useful
Life, Discount Rate, and Growth Rate, for formula using beta.
 - 39 -

B. Respondent’s Determination in Amendment to Amended
Answer Is Arbitrary, Capricious, and Unreasonable

Respondent’s amendment to amended answer set forth a revised

determination of the requisite buy-in payment. The revised

determination, which is based on Hatch’s report, takes into

account certain items (i.e., the paragraph 9.f. items) that

respondent alleges were intangibles transferred to VERITAS

Ireland. Hatch’s valuation was based on the theory that the

collective effect of the RDA, TLA, and conduct of the parties was

“akin” to a sale of VERITAS US’ business. Respondent’s

determination is erroneous for several reasons.

1. Respondent’s “Akin” to a Sale Theory Is Specious

Respondent contends that VERITAS US’ transfer of preexisting

intangibles was “akin” to a sale and should be evaluated as such.

Respondent further contends that because “th[e] assets

collectively possess synergies that imbue the whole with greater

value than each asset standing alone”, it is appropriate to apply

the “akin” to a sale theory and aggregate the controlled

transactions, rather than value each asset. Hatch was certainly

in a position to know whether his valuation method took into

account the collective assets’ “synergies”, yet his defense, of

respondent’s “akin” to a sale theory was akin to a surrender. On

redirect examination, Hatch testified:

Q [Counsel for respondent] Do you believe your
valuation methodology captured synergistic value?
 - 40 -

A [Hatch] I really don’t have an opinion. It
may have. It may not have.

At trial the Court asked respondent’s counsel: “if [we] reject

Dr. Hatch’s approach that [we] should look at this in the

aggregate and he hasn’t valued any of the intangibles separately,

where does that leave the Court?” Respondent’s counsel replied:

“That leaves the Court absolutely nowhere”, and that is precisely

where respondent is with this theory--absolutely nowhere.

Petitioner astutely suggests that “The reason that respondent is

placing an all or nothing bet on his aggregation theory is

simple: software does not last forever, but Respondent’s

valuation approach does.” Indeed, respondent’s assertion of the

“akin” to a sale theory and its assumption that the preexisting

intangibles have a perpetual life are an unsuccessful attempt to

justify respondent’s determination.

Respondent contends that pursuant to section 1.482-

1(f)(2)(i)(A), Income Tax Regs., he was authorized to aggregate

the transactions and treat them as a sale. Transactions may be

aggregated if an aggregated approach produces the “most reliable

means of determining the arm’s length consideration for the

controlled transactions”. Id. (emphasis added). Respondent’s

“akin” to a sale theory (i.e., a theory which encompasses short-
 - 41 -

lived intangibles valued as if they have a perpetual life27 and

takes into account intangibles that were subsequently developed

rather than preexisting)28 certainly does not produce the most

reliable result. Thus, pursuant to section 1.482-1(f)(2)(i)(A),

Income Tax Regs., respondent was not authorized to aggregate the

transactions and treat them as a sale.29

2. Respondent’s Allocation Took Into Account Items
Not Transferred or of Insignificant Value

The parties agree that, on November 3, 1999, certain product

intangibles (i.e., NetBackup, Backup Exec, Volume Manager, File

System, Cluster Server, and Foundation Suite) were transferred

from VERITAS US to VERITAS Ireland but disagree about the

transfer of the nonproduct items alleged by respondent. With the

exception of the trademarks, trade names, brand names, and sales

27
See infra, Discussion, sec. II(B)(4), Respondent Employed
the Wrong Useful Life, Discount Rate, and Growth Rate.
28
See infra, Discussion, sec. II(B)(3), Respondent’s
Allocation Took Into Account Subsequently Developed Intangibles.
29
Even if respondent, pursuant to section 1.482-
1(f)(2)(i)(A), Income Tax Regs., were authorized to aggregate the
transactions, the “akin” to a sale theory may violate section
1.482-1(f)(2)(ii)(A), Income Tax Regs. This regulation provides
that “The district director will evaluate the results of a
transaction as actually structured by the taxpayer unless its
structure lacks economic substance.” The transaction at issue,
which certainly had economic substance, was structured as a
license of preexisting intangibles, not a sale of a business.
 - 42 -

agreements,30 the nonproduct items either were not transferred or

had insignificant value.

With respect to distribution channels, VERITAS US had

relationships with distributors and resellers prior to the CSA,

but those relationships were weak and had little value. In fact,

it was not until VERITAS Ireland hired the channel manager from

Computer Associates that the distribution channels were

strengthened and maximized. Thus, to the extent VERITAS US’

distribution channels were transferred to VERITAS Ireland, they

had insignificant value. With respect to customer lists and

customer base, Hatch agreed that, prior to the CSA, VERITAS US

lacked the data systems needed to generate accurate and

meaningful customer lists and that VERITAS US’ customer base had

no value given VERITAS US’ marginal market share and limited

presence in EMEA and APJ. Thus, to the extent VERITAS US’

customer lists and customer base were transferred to VERITAS

Ireland, they had insignificant value. With respect to “access

to research and development team”, Hatch testified that his

valuation of the buy-in payment did not include access to R&D

team and that access to R&D team “just was not on [his] radar

screen or anything that [he] thought of.” In addition, Hatch

30
The sales agreements were transferred, but the parties
made no attempt to value them. See infra, Discussion, sec.
IV(C), Value of Trademark Intangibles and Sales Agreements.
 - 43 -

conceded that if he assumed that the agreement relating to the

share of R&D expenses was arm’s length, a fact that the parties

stipulated, then access to the R&D team would have zero value.

With respect to “access to marketing team”, Hatch testified that

he did not value VERITAS US’ marketing team, did not know whether

marketing support was provided by VERITAS US, and had no idea

whether the alleged marketing intangibles existed or had been

transferred. Hatch further testified:

if those marketing intangibles did exist -- and
sometimes they don’t, and they just have clauses in
there, I don’t know. But if they did exist, they were
conferred when these related party seller contracts
were assigned. Now did they have any value? I don't
have any opinion on that. I have no idea. [Emphasis
added.]

In short, there is insufficient evidence that access to VERITAS

US’ R&D and marketing teams was transferred to VERITAS Ireland or

had value.31

31
Even if such evidence existed, these items would not be
taken into account in calculating the requisite buy-in payment
because they do not have “substantial value independent of the
services of any individual” and thus do not meet the requirements
of sec. 936(h)(3)(B) or sec. 1.482-4(b), Income Tax Regs.
“Access to research and development team” and “access to
marketing team” are not set forth in sec. 936(h)(3)(B) or sec.
1.482-4(b), Income Tax Regs. Therefore, to be considered
intangible property for sec. 482 purposes, each item must meet
the definition of a “similar item” and have “substantial value
independent of the services of any individual”. Sec.
936(h)(3)(B); sec. 1.482-4(b), Income Tax Regs. The value, if
any, of access to VERITAS US’ R&D and marketing teams is based
primarily on the services of individuals (i.e., the work,
(continued...)
 - 44 -

3. Respondent’s Allocation Took Into Account
Subsequently Developed Intangibles

Hatch’s calculations of the requisite buy-in payment took

into account rights to future codeveloped intangibles transferred

pursuant to the RDA. Petitioner contends that respondent’s buy-

in payment allocation relating to subsequently developed products

violates section 1.482-7(g)(2), Income Tax Regs. We agree.

Section 1.482-7(g)(2), Income Tax Regs., the regulatory

authority requiring a buy-in payment, states:

(2) Pre-existing intangibles. If a controlled
participant makes pre-existing intangible property in
which it owns an interest available to other
controlled participants for purposes of research in
the intangible development area under a qualified cost
sharing arrangement, then each such other controlled
participant must make a buy-in payment to the owner.
* * * [Emphasis added.]

31
(...continued)
knowledge, and skills of team members). Nevertheless, respondent
in support of his contention cites Newark Morning Ledger Co. v.
United States, 507 U.S. 546 (1993), and Ithaca Indus., Inc. v.
Commissioner, 97 T.C. 253 (1991), affd. 17 F.3d 684 (4th Cir.
1994). These cases, however, do not suggest that access to an
R&D or marketing team has substantial value independent of the
services of an individual, do not define intangibles for sec. 482
purposes, and do not even reference sec. 482. We note that in
December 2008, the Secretary promulgated temporary regulations
(i.e., secs. 1.482-1T through 1.482-9T, Temporary Income Tax
Regs., supra) which reference “assembled workforce”. In
addition, the Administration, in 2009, proposed to change the law
to include “workforce in place” in the sec. 482 definition of
intangible.
 - 45 -

The regulation unequivocally requires a buy-in payment to be made

with respect to transfers of “pre-existing intangible property”.

No buy-in payment is required for subsequently developed

intangibles. Yet Hatch unabashedly took such items into account

in calculating the requisite buy-in payment rather than limiting

the valuation to preexisting intangibles as prescribed by section

1.482-7(g)(2), Income Tax Regs. In fact, respondent readily and

repeatedly acknowledged that his valuation took into account

income relating to items other than the preexisting intangibles.

Accordingly, respondent’s allocation violates section 1.482-

7(g)(2), Income Tax Regs.

4. Respondent Employed the Wrong Useful Life,
Discount Rate, and Growth Rate

Respondent, relying on Hatch’s report, employed the wrong

useful life, the wrong discount rate, and an unrealistic growth

rate to calculate the requisite buy-in payment.

In calculating his valuation of the buy-in payment, Hatch

assumed a perpetual useful life for the transferred intangibles,

yet acknowledged that “if you had 1999 products that you left

untouched, that technology would age and eventually become

obsolete” and that the preexisting product intangibles would

“wither on the vine” within 2 to 4 years without ongoing R&D.

The useful life of the preexisting product intangibles was, on

average, 4 years, and certainly was not perpetual. Petitioner
 - 46 -

established that something, however, was perpetual--VERITAS US

was in a perpetual mode of innovation. Before and after the CSA

VERITAS US released numerous versions of its products. Even with

substantial ongoing R&D, VERITAS US products had finite

lifecycles. By the time a new product became available for

purchase, the next generation was already in development.

In determining the discount rate32 for the buy-in payment,

Hatch used a weighted average cost of capital (WACC)33 derived

under the capital asset pricing model (CAPM).34 Employing the

CAPM,35 Hatch used, as the risk-free rate, the yield on 20-year

32
The discount rate (i.e., the cost of capital) is an
adjustment to a determined value to take into account the rate of
inflation, the time value of money, and any attendant risk.
33
The WACC provides the expected rate of return for a
company on the basis of the average portion of debt and equity in
the company’s capital structure, the current required return on
equity (i.e., cost of equity), and the company’s cost of debt.
The equation for calculating the WACC is: WACC = E(re) +
D(rd)(1-T), where D represents the company’s average portion of
debt, E represents the company’s average portion of equity, re
represents the company’s cost of equity, rd represents the
company’s cost of debt, and T represents the company’s marginal
tax rate.
34
Estimating the WACC for a company requires estimating the
company’s cost of equity (re). The CAPM, which seeks to
determine the rate of return for a specific security, is commonly
used to estimate a company’s cost of equity.
35
The CAPM model uses the following equation to determine
the cost of equity: re = rf + $*(rm - rf), where $ (beta) is a
measure of the volatility, or systematic risk, of a security or
portfolio in comparison to the market as a whole, rf is the yield
to maturity for a U.S. Treasury bond (often referred to as the
(continued...)
 - 47 -

U.S. Treasury bonds as of March 31, 2000, without adjustments,

and determined an equity risk premium of 5 percent. The equity

risk premium is the expected long-term yield for the stock market

less the risk-free rate. Hatch applied the 5-percent equity risk

premium and an industry beta of 1.4236 to calculate the

applicable discount rate, which he concluded was 13.7 percent.

Petitioner contends that respondent employed the wrong beta,

the wrong equity risk premium, and therefore the wrong discount

rate. Hatch employed an industry beta to calculate the discount

rate. He opined that using an industry, rather than a company

specific, beta was preferred because, with respect to an

individual company, a beta relating to an earlier period is a

very poor predictor of the beta for subsequent periods. Hatch

ultimately admitted, however, that “to a reasonable degree of

economic certainty, the beta he used could not have been the

correct beta for VERITAS US as of November 3, 1999.”

Hatch’s 5-percent equity risk premium was much lower than

the 1926 through 1999 historic average of 8.1 percent which Hatch

stated was reported by Ibbotson Associates (i.e., the recognized

35
(...continued)
risk-free rate), and rm is the expected long-term yield for the
U.S. stock market as a whole.
36
See supra note 26 for a more detailed discussion of beta.
 - 48 -

industry standard of historical capital markets data).37 There

are several problems with Hatch’s analysis. First, in

determining the equity risk premium, Hatch contended that

employing the Ibbotson Associates’ historic average equity risk

premium, which was based on the expected long-term yield for the

U.S. stock market, was not appropriate because the rights

licensed to VERITAS Ireland were exploited in markets outside the

United States. Rights licensed to VERITAS Ireland were indeed

exploited outside the United States, but Hatch erroneously

assumed that the long-term yield for the U.S. market was higher

than the long-term yield for foreign markets. In fact, the

literature upon which Hatch relied establishes that there was no

difference between the observed risk premium in the U.S. market

and the risk premium in foreign markets. See Brealey & Myers,

Principles of Corporate Finance 159 (7th ed. 2003). Hatch’s

erroneous assumptions led to an underestimate of the appropriate

equity risk premium relating to the buy-in payment.

Second, in determining the equity risk premium, Hatch

applied the 20-year U.S. Treasury bond yield as the risk-free

rate. Petitioner contends that the classic formulation of CAPM

uses the 30-day U.S. Treasury bill rate as the risk-free rate,

37
A lower equity risk premium results in a lower cost of
equity, lower WACC (i.e., discount rate), and larger buy-in
payment.
 - 49 -

not the bond rate, and that if the bond rate is used, duration

risk has to be taken into account. Ibbotson Associates’ Cost of

Capital 2000 Yearbook 34 states: “In all of the beta

regressions, the total returns of the S&P 500 are used as the

proxy for the market returns. The series used as a proxy for the

risk-free asset is the yield on the 30-day T-bill.” Furthermore,

the text Hatch cites as support for his use of the U.S. Treasury

bond rate states that “The risk-free rate could be defined as a

long-term Treasury bond yield. If you do this, however, you

should subtract the risk premium of Treasury bonds over bills”.

See Brealey & Myers, supra at 226 n. 8. Hatch, however, did not

reduce the U.S. Treasury bond rate and, on cross-examination,

acknowledged that he used the wrong risk-free rate. In sum,

Hatch employed the wrong beta, the wrong equity risk premium, and

thus the wrong discount rate to calculate the requisite buy-in

payment.

Hatch also employed large and unrealistic growth rates into

perpetuity. Hatch determined that from 2001 through 2005 VERITAS

Ireland’s compound annual growth rate was 17.91 percent. He

projected that VERITAS Ireland’s revenues would increase 13

percent each year from 2007 through 2010 and beginning January 1,

2011, would increase 7 percent each year into perpetuity.

VERITAS Ireland’s actual growth rate between 2004 and 2006 was

3.75 percent, 14.16 percentage points lower than the 17.91-
 - 50 -

percent growth rate Hatch employed for the same period. In

calculating the buy-in payment, Hatch used VERITAS Ireland’s

actual income relating to 2004 through 2006 but opted not to use

actual growth rates relating to those years. Moreover, he could

not provide a plausible explanation for the growth rate he

employed. Further, petitioner notes that a buy-in payment based

on Hatch’s growth rate would require VERITAS Ireland to allocate

a buy-in payment equal to 100 percent of its actual and projected

operating income to VERITAS US through 2009, resulting in $1.9

billion in losses over that period. Simply put, the growth rate

Hatch employed was unreasonable.

In sum, VERITAS Ireland prospered, not because VERITAS US

simply spun off a portion of an established business and

transferred valuable intangibles, but because VERITAS Ireland

employed aggressive salesmanship and savvy marketing,

successfully developed the EMEA and APJ markets, and codeveloped

new products that performed well in those markets. For the

foregoing reasons, we conclude that respondent’s allocations set

forth in the amendment to amended answer and at trial are

arbitrary, capricious, and unreasonable.

III. Petitioner’s CUT Analysis, With Some Adjustments, Is the
Best Method

Petitioner used the CUT method to calculate the buy-in

payment. The best method rule seeks the most reliable measure of
 - 51 -

an arm’s-length result. Sec. 1.482-1(c), Income Tax Regs.

“[T]here is no strict priority of methods, and no method will

invariably be considered to be more reliable than others.” Id.

Respondent’s income method, riddled with legal and factual

miscalculations, is certainly not the best or most reliable

method. Therefore, we must determine the propriety of

petitioner’s CUT analysis. If petitioner’s CUT analysis does not

meet the arm’s-length standard, we must determine the requisite

buy-in payment. See Sundstrand Corp. & Subs. v. Commissioner, 96

T.C. at 354; see also Eli Lilly & Co. v. Commissioner, 856 F.2d

at 860 (and cases cited thereat).

The CUT method evaluates whether the amount charged for a

controlled transfer of intangible property is arm’s length by

referencing the amount charged in comparable uncontrolled

transactions. If an uncontrolled transaction involves a transfer

of the same intangible under the same, or substantially the same,

circumstances as a controlled transaction, the results derived

from applying the CUT method will generally be the most reliable

measure of the arm’s-length result. Sec. 1.482-4(c)(2)(ii),

Income Tax Regs. If, however, uncontrolled transactions

involving the same intangible under the same circumstances cannot

be identified, uncontrolled transactions that involve the

transfer of “comparable intangibles under comparable
 - 52 -

circumstances” may be used to apply the CUT method, but the

reliability of the results is reduced. Id.

Respondent contends that the CUT method is not the best

method and that petitioner has not presented comparable

uncontrolled transactions to prove that its buy-in payment is

arm’s length. Specifically, respondent asserts that the rights

licensed under agreements between VERITAS US and unrelated

parties are not comparable because they involved either rights

that are not comparable to those licensed under the CSA or

licensees who are not comparable to VERITAS Ireland. Petitioner

contends that the CUT method is appropriate and that the value

determined by its expert, William Baumol (Baumol), was arm’s

length.

Baumol calculated, using the CUT method, a range of

estimates for the value of the transferred intangibles and

concluded that the lump-sum buy-in payment was within or exceeded

the arm’s-length range. Baumol used four parameters to estimate

a value for the buy-in payment: The expected economic life of

the intangibles, the annual rate at which the value of the

intangibles declines as a function of time and new software

replacements (i.e., the rate of obsolescence), the parameter

value selected to determine the value of the licenses (e.g.,
 - 53 -

royalty rates as a percent of revenues, list price, or profits),

and the appropriate discount rate.38

Baumol chose particular agreements (i.e., some involving

bundled products and some involving unbundled products) between

VERITAS US and seven OEMs (i.e., Sun, HP, Dell, Hitachi, NEC,

Compaq, and Ericsson) to determine the appropriate starting

royalty rate for the buy-in payment. Most of the product

licenses that Baumol selected provide royalties as a percentage

of list price (e.g., global list price, international list price,

or U.S. list price). Based on his findings, Baumol derived a

range of starting royalty rates of 20 to 25 percent of list price

and opined that the low end of the range, 20 percent, was the

appropriate starting royalty rate for the buy-in payment.

Baumol determined that the preexisting product intangibles

had a useful life ranging from 2 to 4 years. Having determined

both the starting royalty rate and the useful life, Baumol

adjusted the royalty rate by ramping down (i.e., incrementally

38
Using a value for the intangible license expressed in
terms of revenues, Baumol employed the following formula to
determine the requisite buy-in payment: V=Et=0AC(1-B)t(1-D)tPt,
where A is the expected economic life of the intangibles, B is
the rate of obsolescence, C is the value of the parameter
representing the ratio between the list price and the appropriate
intangible license fee (i.e., the arm’s-length license fee for
the intangibles as a percent of revenue), D is the discount rate,
and P is the revenue for products sold during the product’s
useful life, with the payment for the initial year being C(1-
B)(1-D)P1.
 - 54 -

reducing) the rate over the buy-in period. Baumol analyzed

royalty degradation and technology aging provisions in third-

party agreements as evidence of the appropriate ramp-down rates.

To confirm his ramp-down conclusions, Baumol relied on

petitioner’s source code expert, who opined that new lines of

code noticeably increased after 1999 while the amounts of

unchanged functional 1999 source code and files were virtually

nonexistent within a period of 3 to 4 years.

Using the aforementioned findings, Baumol calculated a

valuation range of $94 million to $315 million for the buy-in

payment and concluded that “the preponderance of the values” fell

between $100 million and $200 million.

A. Comparability of OEM Agreements

Use of the CUT method requires that the controlled and

uncontrolled transactions involve the same or comparable

intangible property. Sec. 1.482-4(c)(2)(iii)(A), Income Tax

Regs. In order for intangibles involved in controlled and

uncontrolled transactions to be comparable, “both intangibles

must--(i) Be used in connection with similar products or

processes within the same general industry or market; and (ii)

Have similar profit potential.” Sec. 1.482-4(c)(2)(iii)(B)(1),

Income Tax Regs.

In his CUT valuation, Baumol referenced, as comparables,

agreements between VERITAS US and certain OEMs (i.e., Sun, HP,
 - 55 -

Dell, Hitachi, NEC, Compaq, and Ericsson). Respondent contends

that the CSA involves the transfer of “platform contribution”

intangibles and broad “make-sell rights”39 with respect to

VERITAS US’ full range of products, while the OEM agreements did

not. We note that the term “platform contribution intangibles”

does not appear in the regulations applicable to the CSA but is

set forth in section 1.482-7T, Temporary Income Tax Regs., 74

Fed. Reg. 352 (Jan. 5, 2009)--regulations effective for

transactions entered into on or after January 5, 2009. Thus,

respondent’s litigating position appears to mirror transfer

pricing regulations promulgated 10 years after VERITAS US and

VERITAS Ireland signed the CSA.40 In essence, respondent

39
Make-sell rights are the licensed rights to manufacture
and sell existing intangible property.
40
Secs. 1.482-1T through 1.482-9T, Temporary Income Tax
Regs., supra, provide “further guidance and clarification
regarding methods under section 482 to determine taxable income
in connection with a cost sharing arrangement in order to address
issues that have arisen in administering the current
regulations.” 74 Fed. Reg. 340 (Jan. 5, 2009). These
regulations include the income method and the price acquisition
method and provide guidance on applying these methods for
purposes of evaluating the arm’s-length amount for platform
contribution transactions (i.e., formerly referred to as
transactions involving preexisting intangibles). The temporary
regulations list the following specified methods: The CUT
method, the income method, the price acquisition method, the
market capitalization method, and the residual profit split
method. The CUT method and the profit split method are the only
two “specified methods” in the temporary regulations that were
listed as “specified methods” in the regulations applicable to
VERITAS US’ transaction.
 - 56 -

contends that, pursuant to section 1.482-4(c)(2)(iii)(A), Income

Tax Regs., the CUT method is not appropriate because the OEM

agreements involve substantially different intangibles. We

disagree.

VERITAS Ireland, pursuant to the TLA, received broad rights

for the full range of VERITAS US products. The rights licensed

under the OEM agreements referenced by Baumol involved Backup

Exec, NetBackup, Volume Manager, File System, Cluster Sever, and

Foundation Suite. While none of the individual OEM agreements

evaluated by Baumol included a license for the full range of

VERITAS US’ product line, collectively the agreements did involve

essentially the same intangibles that were transferred from

VERITAS US to VERITAS Ireland. The OEM agreements Baumol

selected do not, however, provide the most reliable measure for

calculating the requisite buy-in payment.

B. Unbundled OEM Agreements Were Comparable to the
Controlled Transaction

VERITAS US entered into numerous OEM agreements prior to and

during the CSA. Baumol chose to use only a select few of those

OEM agreements (i.e., some involving bundled products and some

involving unbundled products) to calculate the requisite buy-in

payment. His justification for rejecting particular agreements

was simply: “I didn’t find the numbers that I could use.”

Respondent contends that the OEM agreements Baumol selected are
 - 57 -

not comparable to the controlled transaction because the

circumstances surrounding the selected OEM agreements and the

circumstances surrounding the controlled transaction are

different. We conclude that, collectively, the more than 90

unbundled OEM agreements the parties stipulated are sufficiently

comparable to the controlled transaction.

When OEMs sold VERITAS US products bundled with the OEMs’

operating systems, VERITAS US gained credibility and improved

brand identity. The OEMs actively marketed the bundled products;

listed the products on their Web sites; and provided equipment,

technical support, and engineering assistance for those products.

Because of these factors, OEMs paid a lower royalty rate with

respect to bundled products. VERITAS Ireland, on the other hand,

did not have a trade name as widely recognized as the trade names

of the OEMs, guaranteed sales like the OEMs, or an operating

system with which to bundle VERITAS US products. Therefore,

VERITAS Ireland would not be entitled to similar royalty rates.

In contrast to bundled products, unbundled products were not

directly associated with the OEMs’ products and the OEMs did not

provide the same level of assistance (i.e., technical and

engineering support). Thus, customers did not perceive unbundled

products to be more reliable or of greater quality than other

comparable products. The OEMs merely listed the unbundled
 - 58 -

products as an option (i.e., customers could purchase VERITAS US

products or other products). Because such agreements are more

comparable to the transaction between VERITAS US and VERITAS

Ireland, use of the OEM agreements involving unbundled products

provides a more reliable arm’s-length result. Thus, we compare

VERITAS US’ unbundled OEM agreements with the controlled

transaction.

The degree of comparability between controlled and

uncontrolled transactions is determined by applying the

comparability standards set forth in section 1.482-1(d), Income

Tax Regs. Sec. 1.482-4(c)(2)(iii), Income Tax Regs. Section

1.482-1(d)(1), Income Tax Regs., provides that the following

factors shall be considered in determining comparability between

controlled and uncontrolled transactions: Functions, contractual

terms, risks, economic conditions, and property or services. An

analysis employing these factors confirms that VERITAS US’

unbundled OEM agreements are sufficiently comparable to the

controlled transaction.

The first factor, functional analysis, compares the

economically significant activities undertaken, or to be

undertaken, in the controlled transactions with the economically

significant activities undertaken, or to be undertaken, in the

uncontrolled transactions. Sec. 1.482-1(d)(3)(i), Income Tax

Regs. VERITAS Ireland and the OEMs undertook similar activities
 - 59 -

(e.g., manufacturing and production, marketing and distribution,

transportation and warehousing, etc.) and employed similar

resources in conjunction with such activities. See section

1.482-1(d)(3)(i), Income Tax Regs., for a list of functional

analysis comparability factors. Respondent contends, however,

that the OEM agreements and the controlled transactions are not

functionally comparable because R&D is a particularly significant

function in the controlled transactions (i.e., VERITAS US and

VERITAS Ireland agreed to share in ongoing R&D costs relating to

the development of new software products), whereas the OEM

agreements did not involve ongoing R&D activities. Respondent

contends that the R&D function is important because VERITAS

Ireland “received ownership interests in future generations of

technology which germinated from the pre-existing technology.”

Respondent’s functional analysis is misguided. Respondent is

relying on rights involving subsequently developed intangibles to

support his assertion that the OEM agreements are not comparable

to the controlled transaction. As previously determined herein,

VERITAS Ireland was required to make a buy-in payment with

respect to the transfer of “pre-existing intangible property”,

not subsequently developed intangibles. See sec. 1.482-7(g)(2),

Income Tax Regs. Thus, the focus of the buy-in payment analysis

should be on transactions involving preexisting intangibles. For
 - 60 -

the products in existence on November 3, 1999, there are no

significant differences in functionality.

The second factor is the comparability of contractual terms.

Determining the degree of comparability between the controlled

and uncontrolled transactions requires a comparison of the

significant contractual terms that could affect the results of

the transactions (e.g., the form of consideration; the sales

volume; the scope and terms of warranties; the right to updates,

revisions, or modifications; the duration of the agreement;

etc.). Sec. 1.482-1(d)(3)(ii)(A), Income Tax Regs. Respondent

contends that the contractual terms of the OEM agreements are not

comparable to the controlled transaction for two reasons. First,

respondent contends that the OEMs often provided VERITAS US with

APIs, source code, or information about their hardware so VERITAS

US could adapt VERITAS US products to the OEMs’ hardware and

operating systems, whereas VERITAS Ireland did not have an

operating system, APIs, or source code. Some of VERITAS US’

unbundled OEM agreements did contain contractual terms pursuant

to which OEMs provided APIs and source code information to

VERITAS US to assist with adaptation issues, but, unlike the

contractual terms set forth in section 1.482-1(d)(3)(ii)(A),

Income Tax Regs., the contractual terms relating to adaptability

were not significant terms that affected the results of the

transactions. The APIs and source code information did not
 - 61 -

change the essential functions of VERITAS US products but rather

enabled VERITAS US products to run on the OEM’s operating system.

Second, respondent contends that the OEMs provided engineering

assistance to VERITAS US in connection with the development of

VERITAS US bundled products, whereas there is no evidence that

VERITAS Ireland was in a position to provide engineering

assistance to VERITAS US. While it is true that some OEMs did

provide engineering support with respect to bundled products, the

provision of engineering support was not a standard contractual

term in OEM agreements relating to unbundled products. Indeed,

the provision of engineering support was not a significant factor

that affected the results of OEM agreements involving unbundled

products. Thus, there are no significant differences in

contractual terms.41

The third factor compares the significant risks borne by the

parties that could affect the prices charged or the profit earned

in the controlled and uncontrolled transactions. Sec. 1.482-

1(d)(3)(iii), Income Tax Regs. The parties to the controlled and

uncontrolled transactions bore similar market risks, similar

risks associated with R&D activities, similar risks associated

41
We recognize that one of the differences between the
controlled and uncontrolled transactions is that, unlike the
OEMs, VERITAS Ireland was not entitled to product updates,
revisions, or modifications. We have concluded, however, that it
was appropriate to make an adjustment to account for this
difference. See infra, Discussion, sec. IV(B), The Appropriate
Useful Life and Royalty Degradation Rate.
 - 62 -

with fluctuations in foreign currency exchange rates and interest

rates, similar credit and collection risks, and similar product

liability risks. See section 1.482-1(d)(3)(iii)(A), Income Tax

Regs., for a list of risk comparability factors. Respondent

contends, however, that the risks borne by VERITAS Ireland and

the risks borne by the OEMs are not comparable because the OEMs

were subject to the risk that the version of technology they

licensed would not do well in the market. VERITAS Ireland bore

the same risk as the OEMs. In short, there are no significant

differences in risks borne.

The fourth factor compares the significant economic

conditions that could affect prices or profit in the controlled

transaction to the significant economic conditions that could

affect prices or profit in the uncontrolled transactions. Sec.

1.482-1(d)(3)(iv), Income Tax Regs. Respondent contends that the

economic and market conditions affecting the OEM agreements are

not comparable to those affecting the transaction between VERITAS

US and VERITAS Ireland because, unlike VERITAS Ireland, the OEMs

occupied significant positions in the market. Respondent further

contends that the OEMs had established sales forces and

relationships with resellers and distributors, whereas on the

date of the transfer VERITAS Ireland was a startup with no

customer relationships or other assets. We agree with respondent

that the OEMs and VERITAS Ireland were at dramatically different
 - 63 -

stages of development and held different positions in the market.

We note, however, that both the OEMs and VERITAS Ireland competed

in similar geographic markets, incurred similar distribution

costs, marketed products that faced similar competition, and were

subject to similar economic conditions. See section 1.482-

1(d)(3)(iv), Income Tax. Regs., for a list of economic condition

comparability factors. While certain economic conditions (e.g.,

interest rate fluctuations, general vicissitudes of the market,

etc.) affect prices and profits for both startups and established

businesses, the impact on a particular business may certainly

depend on the business’ economic stability and market position.

Our analysis of this factor narrowly weighs against a finding of

comparability.

The fifth factor compares the property or services provided

in the controlled transaction to that provided in the

uncontrolled transactions. Sec. 1.482-1(d)(3)(v), Income Tax

Regs. Respondent contends that under the OEM agreements, VERITAS

US generally contracted to provide only the development work

necessary to ensure its products would work with the OEMs’

products, whereas under the CSA, VERITAS US provided make-sell

rights and preexisting intangibles for research to produce future

generations of technology. Specifically, respondent contends

that “VERITAS U.S. and VERITAS Ireland contracted to share all

the costs of future R&D on future software generations and for
 - 64 -

each to hold separate exploitation rights. * * * Neither the

property nor services were comparable.” Once again, respondent’s

contention is misguided. Respondent is relying on rights

involving subsequently developed intangibles to support his

assertion that the OEM agreements are not comparable to the

controlled transaction. As previously determined herein,

pursuant to section 1.482-7(g)(2), Income Tax Regs., the

requisite buy-in payment need not take into account subsequently

developed intangibles. With respect to the controlled

transaction involving the transfer of preexisting intangibles and

the uncontrolled transactions involving VERITAS US’ unbundled OEM

agreements, there are no significant differences in property or

services provided.

Although VERITAS US’ unbundled OEM agreements are certainly

not identical to the controlled transaction, an analysis of the

comparability factors establishes that the unbundled OEM

agreements are sufficiently comparable to the controlled

transaction and that the CUT method is the best method to

determine the requisite buy-in payment. There are, however,

certain adjustments we must make to petitioner’s CUT analysis to

enhance its reliability.

IV. Requisite Adjustments to Petitioner’s CUT Analysis

Imperfect comparables serve “as a base from which to

determine the arm’s length consideration for the intangible
 - 65 -

property involved in this case.” Sundstrand Corp. & Subs. v.

Commissioner, 96 T.C. at 383, 393. Section 1.482-1(e)(2)(ii),

Income Tax Regs., provides that

Uncontrolled comparables must be selected based upon
the comparability criteria relevant to the method
applied and must be sufficiently similar to the
controlled transaction that they provide a reliable
measure of an arm’s length result. If material
differences exist between the controlled and
uncontrolled transactions, adjustments must be made to
the results of the uncontrolled transaction if the
effect of such differences on price or profits can be
ascertained with sufficient accuracy to improve the
reliability of the results. * * *

A. The Appropriate Starting Royalty Rate

Respondent contends that if the OEM agreements are

comparable to the controlled transaction, petitioner’s

calculation of the starting royalty rate is nevertheless

erroneous. In determining the requisite buy-in payment, Baumol

used 20 percent as the starting royalty rate and acknowledged

that he did not use any “sophisticated calculation” or “higher

mathematics” to arrive at that rate. He based the 20-percent

royalty rate on rates found in select OEM agreements involving

bundled and unbundled products. As previously determined, OEM

agreements involving unbundled products are the appropriate

comparables. As petitioner did not use sufficiently comparable

transactions in determining the starting royalty rate to

calculate the requisite buy-in payment, and respondent has not
 - 66 -

provided a royalty rate other than one based on a perpetual

royalty, the Court must determine the appropriate royalty rate.

The parties provided the Court with the royalty rates for

more than 90 unbundled OEM agreements. Because each unbundled

OEM agreement standing alone does not involve the full range of

intangibles referenced in the TLA, the agreements must be looked

at collectively. The royalty rates relating to VERITAS US

unbundled products range between 25 and 40 percent. The mean

(i.e., the average) royalty rate for VERITAS US’ OEM agreements

involving unbundled products is 32 percent of list price. Thus,

we conclude that the starting royalty rate for the transferred

product intangibles is 32 percent of list price.

B. The Appropriate Useful Life and Royalty Degradation
Rate

The appropriate useful life of the preexisting product

intangibles is 4 years. Indeed, as previously discussed, VERITAS

US products, on average, had a useful life of that duration.42

Licensing parties often agree to ramp down royalty rates to

account for the gradual obsolescence of static technology.43

Petitioner contends that the royalty rates for the preexisting

42
See supra, Discussion, sec. II(B)(4), Respondent Employed
the Wrong Useful Life, Discount Rate, and Growth Rate, and supra,
Background, sec. IV, Product Lifecycles and Useful Lives.
43
While a static product may lose considerable value, the
value of the product need not be zero in the final year of the
product’s useful life.
 - 67 -

product intangibles should be ramped down over the lives of the

intangibles to account for obsolescence and decay of technology.

The majority of VERITAS US’ OEM agreements included provisions

for updates and new versions, but the preexisting product

intangibles transferred pursuant to the TLA did not. Thus, an

adjustment must be made to the starting royalty rate to account

for the static nature of the technology.44 Consistent with

VERITAS US’ other agreements involving static technology,45 the

royalty rates for VERITAS US’ preexisting product intangibles

must be ramped down, starting in year 2, at a rate of 33 percent

per year from the then-current percentage (i.e., 32 percent in

year 1; 21 percent in year 2; 14 percent in year 3; and 10

percent in year 4).46

C. Value of Trademark Intangibles and Sales Agreements

Petitioner contends that VERITAS US’ trademarks, trade

names, and brand names (trademark intangibles) lacked value

because in 1999 “VERITAS” was registered in only a few foreign

jurisdictions and was relatively unknown in the EMEA and APJ

markets. Regardless of the number of foreign jurisdictions in

44
In calculating ramp-down rates, Baumol relied on
petitioner’s source code expert. The source code expert’s
simplistic and mechanical analysis was not convincing.
45
See supra, Background, sec. IV, Product Lifecycles and
Useful Lives.
46
The rates are rounded to the nearest percentage.
 - 68 -

which the “VERITAS” trademark was registered, the “VERITAS”

trademark and the individual product names, especially

“NetBackup” and “Backup Exec”, were well known, respected, and

valuable. Thus, pursuant to section 1.482-7(g), Income Tax

Regs., VERITAS Ireland was required to pay VERITAS US a buy-in

payment as consideration for those trademark intangibles.

Petitioner’s trademark expert found that as of November 3,

1999, VERITAS US had trade names for Backup Exec, NetBackup,

Volume Manager, File System, Cluster Server, and Foundation

Suite, as well as certain other products. He believed that the

value of the trademark intangibles was zero but nevertheless

calculated another value for those intangibles. In calculating a

value petitioner’s trademark expert opined that the useful life

of the trademark intangibles in VERITAS Ireland’s territory

should be no more than 7 years, selected a range of royalty rates

from 0.5 to 1 percent of revenue, and concluded that before taxes

the value for the trademark intangibles was between $1.7 and $3.4

million. He assumed that VERITAS Ireland was entitled to

royalty-free use of the trademark intangibles for the duration of

the TLA and concluded that the TLA, which did not have a

termination date, had a term of November 1999 through October

2003. Thus, his initial valuation included a royalty for only 3

years (i.e., from November 2003 through the end of 2006). During

trial, in response to Hatch’s criticism of his findings
 - 69 -

petitioner’s trademark expert revised his calculations to include

a royalty that covered the entire 7-year useful life that he

projected. He ultimately concluded that the revised upper-end

value for the trademark intangibles was $9.6 million.

Petitioner’s trademark expert was not convincing and when he

was questioned regarding the calculation of his lower range of

values, his response was incoherent. Respondent failed to

estimate a value for these intangibles, and the paucity of

credible evidence relating to this issue is disconcerting.

Nevertheless, we conclude that petitioner’s trademark expert’s

upper-end value of $9.6 million is the best available

approximation of, and thus, the arm’s-length value of the

trademark intangibles.

The buy-in payment must also be adjusted to take into

account the value of the sales agreements transferred from

VERITAS US to VERITAS Ireland. We do not, however, have

sufficient evidence to determine the value of those agreements.

Thus, this matter must be addressed in the parties’ Rule 155

computations.

D. The Appropriate Discount Rate

Petitioner’s financial markets expert Burton Malkiel

(Malkiel) applied the CAPM and concluded that 20.47 percent was a

reasonable estimate of VERITAS US’ WACC. There are two

differences between Hatch’s and Malkiel’s applications of CAPM:
 - 70 -

The estimate of the beta and the equity risk premium. Malkiel,

unlike Hatch, used reliable data to calculate both variables.

Malkiel had two reasons for employing a 1.935 company-

specific beta, rather than a 1.42 industry beta, to calculate

VERITAS US’ WACC. First, the industry beta for VERITAS US’

Standard Industrial Classification (SIC) code47 was skewed

because of the presence and size of Microsoft.48 Microsoft

dominated the personal computer operating system software market

and had a stronger and more established business than VERITAS US.

Thus, the risk level for VERITAS US’ industry SIC group did not

present a portfolio of comparable risk. Second, while betas for

individual companies tend to be unstable, VERITAS US’ betas were

quite stable. Moreover, Malkiel used the historic average risk

premium from 1926 to 1999 as reported by Ibbotson Associates

(i.e., the best available data) to estimate the equity risk

47
The SIC is a U.S. Government statistical classification
system that uses a four-digit numerical code to group businesses
according to industry and subindustry groups. Businesses are
grouped according to their primary economic activity (e.g.,
agriculture, fishing, manufacturing, transportation,
communications, wholesale trade, etc.).
48
Betas relating to industry portfolios typically reflect
the capital structure of the companies included in the particular
industry. Companies that have large market values (i.e.,
determined by multiplying the number of the company’s shares of
stock outstanding by the price of the shares) carry greater
weight in the SIC group’s portfolio.
 - 71 -

premium for 1999. See Brealey & Myers, supra at 157, 179.

Accordingly, the appropriate discount rate is 20.47 percent.

V. Conclusion

With the aforementioned adjustments, the CUT method is the

best method for determining the requisite buy-in payment relating

to VERITAS Ireland’s transfer of intangibles to VERITAS US.

Contentions we have not addressed are irrelevant, moot, or

meritless.

To reflect the foregoing,

Decision will be entered

under Rule 155.