1.Consider the following fact pattern:

Spacebook, Inc. ("Spacebook"), is a C corporation based in the U.S. which started operations only 10 years ago. Spacebook's main business line is a social media site which is accessible for free to members of the public, not just in the United States but world-wide.Almost all of Spacebook's operations, personnel, and facilities including its headquarters are located in Oklahoma City, Oklahoma.Spacebook does not receive any of its income from the individuals who join Spacebook but earns most of its revenue from marketing fees it charges businesses which posts ads to the site.Since most of the businesses which advertise have a local or regional reach,Spacebook receives advertising income from businesses all over the world.

About 5 years ago, Spacebook's management could foretell that its business model had the potential for becoming wildly successful and decided to proactively engage in tax planning strategies in order to reduce their effective tax rate.At the time, the marginal rate in the United States was 35%, and 12.5% in Ireland.Spacebook therefore formed a wholly-owned Irish subsidiary, Clover PLC ("Clover"), and capitalized it with $100,000.Spacebook then transferred to Clover it all of Spacebook's intellectual property for its then-fair market value, $100,000. The intellectual property included patented processes, logos, franchise marks, and other intangible property.

Clover has only 7 employees in its only office, which is located in Dublin.It does not conduct any significant operations for Spacebook's social media platform.Clover's employees mostly prepare reports, file tax returns, and provide accounting data to Spacebook's U.S. headquarters.

Spacebook and Clover then executed a royalty agreement whereby Spacebook would pay to Clover 42% of all advertising revenue it received world-wide as a royalty in exchange for the use of Clover's intellectual property.Spacebook would then take a deduction for the royalty payment against U.S. income, giving Spacebook a tax benefit of 35%.Clover would recognize the royalty income, paying only a rate of12.5% to the Irish government.For the year 20X1, Spacebook paid $1 billion in royalties.Spacebook and Clover used the CUT method in determining an arm's length percentage for the royalty.The 42% royalty was derived from Table A, which showed other recent transactions.

Over the subsequent years, Clover amassed $3 billion in after-tax royalties in its Irish accounts.It does not intend to expand its operations in Dublin or otherwise directly augment the social media platform which has continuing to be maintained by the U.S. headquarters.Since Clover had no immediate need for this cash, it lent $2.7 billion to Spacebook at a market interest rate.Similar to the royalties, Spacebook deducted the interest expense, and Clover received and reported the interest income.Since Clover and Spacebook considered the transaction a loan, Clover did not treat the $2.7 billion as a dividend and so did not withhold 30% per IRC Sec. 1441.Spacebook paid interest of $200 million during 20X1.

The Internal Revenue Service audited Spacebook for its 20X1 tax return, asserting in its Revenue Agent's Report ("RAR") that the royalty deduction and loan should be disallowed for the following reasons:

a.The initial transfer of the intangibles to Clover lacks any substance, especially since Spacebook essentially gave Clover the money to pay for the intangibles There was no business reason for placing the intangibles in Ireland but for the tax benefits (which alone is not good enough to constitute a business reason).Therefore, the entire transaction should be ignored and Spacebook should be considered the owner of the intangibles.

b.If in the alternative, Clover's ownership of the intangibles is to be respected, then the IRS contends that the use of the CUT method is erroneous.The correct method should be CPM.

c.Under the assumption that the CPM method is the best method of establishing a transfer price, the IRS contends that Clover did not engage in any value-adding activities once it received the intangibles from Spacebook.Therefore, all advertising revenue should be allocated to the United States.The royalty rate should be 0%.

d.The $2.7 billion "loan" is actually a dividend under IRC Section 163(j).

e.The IRS is assessing additional tax of $1.23 billion, consisting of the following components: $350 million for the transfer of the intangibles (35% x $1 billion paid for royalties), $810 million (30% x $2.7 billion) for failure to properly withhold30% per Section 1441 from dividends and $70 million (35% x $200 million) in disallowing the interest expense.

f.The IRS has also imposed a substantial understatement penalty under IRC Sec. 6662 equal 20% of the assessment.Interest will be charged on the $1.23 billion assessment and $246 million Sec. 6662 penalty as a matter of course.

Spacebook disagreed with the RAR and was issued a 30 day letter by the IRS outlining the Service's objections above.You act as Spacebook's representative in their dealings with the IRS.Your task is to respond to the 30 day letter using the format posted to Canvas.

Hint:Sources you may want to consider include, but are not limited to, Section 482, associated Treasury Regulations, and the strategy used by taxpayers (such as Coca-Cola, Medtronic and Amazon) in recent cases.Address the loan issue by starting with Section 163(j) earnings stripping provisions and related sources.Analyze the substantial understatement penalty by looking at Section 6662 and related Treasury regulations.You may need to follow up with additional research after looking at these initial sources.

If you are missing facts in order to answer the questions, you may make assumptions but please put any assumption you are relying upon in your response.You will be graded on completeness, thoroughness and writing style. You will be expected to use complete sentences, good grammar, proper punctuation and write in a professional tone.Do not use bullet points.You will also be graded on the use of proper citation format, as shown on the citation sheet posted to Canvas.Failure to achieve any of these requirements will result in points being deducted.