It’s not an uncommon tax practice for multinational companies to open subsidiaries in low-tax countries to avoid paying higher taxes in the United States. Facebook has got into trouble with the IRS for exactly that.

The IRS claims that Facebook used its Irish subsidiary to avoid paying taxes at the higher tax rate in the U.S. At the time, before the 2017 Tax Cuts and Jobs Act, the corporate tax stood at 35%, one of the highest in the world. Facebook, on the other hand, contends that its Irish subsidiary played a key role in making it a global giant.

If Facebook loses this court battle, it could cost the company $9 billion.

This multi-billion dollar case will set a benchmark for other companies since many multinational companies use this same method to avoid paying taxes in the United States. Market Watch elaborates:

“The case stems from internal transactions Facebook conducted in the period before it went public as it was setting up its global operations. The result will likely hinge on the valuation of intellectual property used by Facebook’s overseas subsidiaries, which pay royalties to the parent company.

Facebook had incentives to set a low value for those assets, such as the user base and the company’s technology. By doing so, Facebook could reduce the stream of royalties paid to the U.S. parent that would be taxed at the 35% rate that applied before the 2017 tax law.

Instead, because of a structure involving a Cayman Islands holding company, the profits would face much lower taxes. Facebook did ultimately owe up to 15.5% on those profits because of a one-time tax imposed under the 2017 tax law. It is the gap between that and the 35% rate that is at stake in the case.

‘Reducing taxes is a key to preserving profits given Facebook’s trajectory toward significant pretax income in 2010 and beyond,’ said a May 2009 presentation to Facebook’s board of directors that is quoted in court records. ‘Shifting international profits to Ireland — this will be the largest source of long-term tax benefits.’

When it filed its tax returns, Facebook put a $7 billion value on the intangible assets in question. But it has recently argued that its subsequent estimates of that value are even lower, so it is entitled to a refund.

Facebook contends that the value should be low in part because the company’s trajectory was uncertain when the transactions were done in 2010 and because the Irish subsidiary did so much work to expand its non-U.S. business.

‘Facebook Ireland and Facebook’s other foreign affiliates — not Facebook U.S. — led the high-risk, and ultimately successful, international effort to sell Facebook ads,’ the company wrote in its pretrial memo. ‘Facebook Ireland is entitled to profits from the foreign business it built.’

The IRS says the components of Facebook’s integrated global business — its user base, technology, and marketing assets — shouldn’t be valued separately and instead must be considered as a package with potentially greater value than the sum of its parts.

The government has ridiculed Facebook’s claims that its Irish subsidiary did substantial work to expand the business. In filings, the IRS cites statements from company officials saying Facebook was already on a strong trajectory in 2010 and suggesting that the transactions were largely tax-motivated.

In its pretrial memo, the government quoted Chief Operating Officer Sheryl Sandberg as saying that Facebook had to call Ireland its international headquarters for ‘tax purposes.’

When it first audited Facebook’s tax returns, the IRS calculated a $14 billion asset value, about double what Facebook determined. But late last year, the IRS said that amount could be as high as $21 billion.

That translates into the $9 billion tax bill, plus interest and penalties, about equal to Facebook’s global tax costs for 2018 and 2019 combined, according to securities filings. That is up from $5 billion before the IRS revised its numbers.

The IRS, depleted after budget cuts, has struggled in similar cases against large companies, losing to Xilinx Inc. and Inc. But last year it defeated Altera Corp., which had become a subsidiary of Intel Corp.”

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