What Amazon’s Win Means for Facebook

Amazon just won in Tax Court against the IRS. If Amazon would have lost, then it would have owed about $1.5 billion in taxes. The Amazon case is similar and could provide insight into one that Facebook is currently contesting with the IRS. In the Facebook case, if the IRS wins, it could collect between $3 to $5 billion in taxes from Facebook.

More importantly, the IRS is contesting a tax strategy common in the tech field. A company such as Amazon establishes a foreign subsidiary somewhere with low tax rates. Amazon then transfers intellectual property (IP) to the foreign subsidiary and in exchange, the foreign subsidiary makes royalty payments to Amazon.

Amazon pays taxes on the royalties received from the foreign subsidiary. The royalty payments in turn depend on the value of the IP transferred. A higher valuation mean higher royalty income for Amazon and more taxes to be paid. This is what the IRS wants, so it valued the IP Amazon transferred at $4 billion or sixteen times larger than Amazon’s estimate.

The Tax Court didn’t agree with the IRS’s valuation and sided with Amazon, and now Facebook faces the same issue. Facebook established its foreign subsidiary in Dublin, Ireland and also transferred IP which Facebook valued at $4 billion. Unfortunately, the IRS valued Facebook’s IP at $14 billion or three times higher than Facebook’s estimate.

With the higher valuation, the IRS is looking for more royalty income and hence more taxes from Facebook; that will only occur if a Tax Court agrees with IRS’s valuation method, something which did not happen in the Amazon case.


Snap and Amazon Get Lucky?

Snap went down the Amazon on February 8th when it signed an agreement for more cloud services. Recode picked up the change in the amended S-1. At end of the next five years, Snap will have paid in total $1 billion to Amazon.

May be more important is the timing of the payments since it gives clues into Snap’s projected revenue.

Amazon Web Services will provide a back up to Snap. In the amended S-1, Snap said “We have also committed to spend $1 billion with Amazon Web Services over the next five years for redundant infrastructure support of our business operations…”

Over the next five years, Snap is committed to paying $50 million, $125 million, $200 million, $275 million, and $350 million in 2021. Based on the amount sizes, the payments will grow to seven times in the final year.

If cloud services are proxy for traffic, growth, and revenues, then Snap is expecting to grow at least 7X over the next five years.


How Innovation Dies at Apple

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Steve Jobs passed away about five years ago and some question whether innovation passed away at Apple too. Due to its secrecy, it is hard gauging the developments inside Apple, unless you’re an employee or have a golden ticket. From the outside, should Apple’s innovation be measured by new products, new ideas, patents, or spending?

Apple and its competitors have increased spending on research and development since 2011. By looking at Chart I below, you can see that the direction is upward for Apple, Alphabet, Facebook, and Amazon. Apple has nearly quadrupled spending on research and development from $2.4 billion in 2011 to $8.5 billion in 2015.

R D Spending
Source: Annual Reports

So all is well? It difficult to determine the success or failure based solely on money spent. There is no direct connection between research and development spending and the bottom line. Ratios could be used such as research costs to total revenue.  But since there is no causality between the money spent and net income, financial ratios may not be the best measure.

Another way to judge Apple is by the number of patents granted. Chart II shows the number of utility patents granted to Apple and its competitors, per year, for 2011 to 2015. By showing the yearly change, rather than the overall total, one can see that Apple is reversing and Alphabet is speeding  ahead.

Patents Granted
Source: Intellectual Property Owners Association’s Annual Top 300 Organizations Granted U.S. Patents

In addition, you can see the emergence of Facebook during the same period. Since its IPO, Facebook has increased research and development spending from $1.4 billion to $4.8 billion. In the same period, Facebook was granted 127, 279, and 374 patents for 2013, 2014, and 2015 respectively.

Amazon is another surprise. Like Apple, Amazon is very private. Rather than not say anything, Amazon obscures its true actions. For example, Amazon does not report its annual research and development expenses. So the amount shown in Chart I above is somewhat misleading. And it could also be misleading to those outside of Amazon.

Amazon reports its research and development as technology and content. Technology includes primarily research and development expenses, but Content does not. Content includes all the costs associated with “category expansion, editorial content, buying, and merchandise selection.” Technology and Content went from $2.9 billion in 2011 to $12.5 billion in 2015.

Since Amazon buries its  research and development expenses, you really know nothing. You do know from patents granted, that something is happening at the on-line retailer. In 2011, Amazon was granted 180 patents and five years later, it was granted 1,136 patents. In terms of patents granted, Amazon has come from nowhere while Apple is slowing down.

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