Microsoft’s Cost Sharing Audit Moves to the Courts at Year-end
On December 11, 2014, the IRS filed a petition in the United States District Court for the Western District of Washington to enforce a summons served on Microsoft Corporation (“Microsoft”) to produce certain data and documents that the IRS has requested in connection with an audit of Microsoft for the tax years 2004 – 2006. The audit concerns two regional cost-sharing agreements entered into by Microsoft with certain foreign affiliates. This petition, as well as other public documents, illuminate the government’s attack on these cost-sharing arrangements, which have significantly reduced Microsoft’s U.S. income tax liability. The Microsoft audit is but one example of the IRS’s attack on cost-sharing arrangements entered into by major U.S. technology companies.
Overview of Cost Sharing Arrangements
In simple terms, a cost-sharing arrangement is a written agreement between two or more related parties to share the cost of developing intangible property in a defined development area in exchange for each party receiving specified rights in any intangible property developed as a result of the joint effort. In U.S. tax law, the concept has a long history, dating to at least 1966. The IRS first issued comprehensive regulations addressing cost-sharing arrangements in 1995.
In the United States, a cost-sharing arrangement is usually between a U.S. company in the group and a foreign affiliate, which often is resident in a low-tax jurisdiction. Under the terms of the cost sharing agreement, the U.S. company typically owns the U.S. rights to any developed intangible asset and the foreign affiliate owns the rights to the developed intangible in the rest of the world.
At the outset, new intangible property often is developed by using existing intangible property owned by the U.S. members of the group. Assuming a U.S. affiliate owns the existing intangible property, the 1995 regulations required the foreign affiliate to make a “buy-in payment” to the U.S. affiliate to compensate that affiliate for the foreign rights to that intangible property. The IRS came to view the 1995 regulations as too favorable to taxpayers (the buy-in payment permitted by those regulations was too small it believed) and in 2005 the IRS issued proposed regulations to address those concerns.
In 2008, the IRS issued temporary cost sharing regulations and withdrew the 1995 regulations. Final cost-sharing regulations were issued at the end of 2011. The temporary and final regulations are lengthy and complex. These regulations effectively attribute a significant and continuing portion of the return on any intangible developed under the cost-sharing arrangement to the existing intangible property.
The IRS views the valuation methods of the temporary and final regulations as economically sound and as applicable to cost-sharing arrangements entered into during the years the 1995 regulations were in effect – even though such methods were not described in the 1995 regulations. Taxpayers often disagree with the IRS on both points. In one case, the U.S. Tax Court has rejected the government’s position as arbitrary and capricious. The IRS has not relented, however, and continues to take this position during audits and in the courts.
Microsoft’s Cost Sharing Arrangements
According to a report issued in 2012 by the Permanent Subcommittee on Investigations, of the U.S. Senate Committee on Homeland Security and Governmental Affairs,  and an IRS petition filed in United States District Court for the Western District of Washington on December 11, 2014, Microsoft entered into several key cost-sharing arrangements with foreign affiliates in 2004 and 2005.
For example, the IRS petition refers to a cost-sharing agreement effective July 1, 2005 between Microsoft and a Puerto Rican company, Microsoft Operations Puerto Rico, LLC (“MOPR”) relating to rights to technology supporting Microsoft’s Americas’ retail business. According the Subcommittee report, MOPR produces digital and physical copies of Microsoft products in Puerto Rico and sells those copies to certain U.S. subsidiaries of Microsoft for resale to retail customers. The Subcommittee report also states: “Microsoft shifts about 47 percent of the gross revenues from U.S. sales to its operations in Puerto Rico, which is not subject U.S. tax laws and instead levies a tax of just 1-2 percent on Microsoft.”
In fact, MOPR is a controlled foreign corporation (CFC) and is subject to the Internal Revenue Code’s subpart F rules. Based on the Subcommittee Report, it appears that through planning employed by many U.S. multinationals, U.S. tax on the earnings of MOPR is deferred. MOPR is subject to tax in Puerto Rico. As the Subcommittee report points out, MOPR apparently avails itself of Puerto Rican tax incentives to pay a low rate of tax in Puerto Rico, so the overall structure is quite favorable.
MOPR’s profits are due to its manufacturing activity and its ownership of valuable technology obtained under the cost-sharing arrangement with Microsoft. Thus, should the IRS successfully attack the cost-sharing arrangement using the valuation methods set forth in the 2009 cost-sharing regulations, income booked in MOPR could be reallocated to Microsoft and taxed currently by the United States. The amounts at stake appear to be significant.
The IRS’s Audit of Microsoft
The IRS does not disclose whether a particular taxpayer is under audit for any taxable year, because disclosure of taxpayer return information is barred by statute. However, U.S. accounting rules require public companies to disclose their “uncertain tax positions.” Microsoft has acknowledged that it is under audit by the IRS for the years 2004-2006.
Microsoft’s 10-K for the period ended June 30, 2014 filed with the Securities and Exchange Commission reports uncertain tax positions (unrecognized tax benefits) of $8.7 billion. A note to the financial statements includes the following statement:
“During the third quarter of fiscal year 2011, we reached a settlement of a portion of an I.R.S. audit of tax years 2004 to 2006, which reduced our income tax expense by $461 million. While we settled a portion of the I.R.S. audit, we remain under audit for these years. . . . As of June 30, 2014, the primary unresolved issue relates to transfer pricing, which could have a significant impact on our consolidated financial statements if not resolved favorably. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved issues and do not expect a final resolution of these issues in the next 12 months.”
Based on public information, it does not appear to be possible to determine the portion of the $8.7 million that Microsoft attributes to the audit of its cost-sharing arrangements.
As noted above, the IRS petition filed in the District Court on December 11 seeks documents and data with respect to the cost-sharing agreement with MOPR and another cost-sharing agreement with a Bermuda affiliate of Microsoft. The government’s summons was a “designated summons” which tolled the statute of limitations with respect to the audit. The statute of limitations with respect to the Microsoft audit was about to expire, which explains, at least in part. of the government’s action.
Subsequent to filing the designated summons, the IRS filed nine other petitions to enforce summonses relating to the Microsoft audit. Microsoft responded by filing a motion with the District Court requesting a “status conference” with the IRS. The IRS, on December 24, filed a motion in opposition to the request for a status conference arguing that such a conference is not warranted at this time and urging the district court to enforce the summons. On December 31, Microsoft file a motion to consolidate all of the summons cases. Consolidating these cases probably makes it easier for Microsoft (and other respondents) to raise any affirmative defenses it has to complying with the IRS’s summonses.
The IRS’s audit of Microsoft’s cost-sharing arrangements has been ongoing since 2007 and has yet reach the IRS Appeals Office. Judging from the year-end filings, litigation over enforcement of the IRS summonses also should be lengthy. Thus, settlement discussions with Appeals and any potential litigation of the key issue in this matter is years away. In the meantime, the government will likely bring other cost-sharing cases to trial. For example, the IRS’s challenge of Amazon’s cost-sharing arrangement is currently being heard by the Tax Court. How those cases are resolved in the courts will undoubtedly influence Microsoft and the IRS in any settlement negotiations when that day finally arrives.
 W.D. Wash., Docket No. 2:14-mc-00117-RSM, motion filed 12/18/14. Veritas Software Corp. & Subsidiaries, et al. v. Comm., 133 T.C. No. 14 (2009). Available at http://www.hsgac.senate.gov/subcommittees/investigations/hearings/offshore-profit-shifting-and-the-us-tax-code/. Microsoft also has entered into a cost sharing arrangement with a subsidiary in Bermuda relating to its Asia-Pacific retail business and with a subsidiary in Ireland with respect to its retail business in Europe, the Middle East and Africa. Section 6103. Amazon.com, Inc. & Subsidiaries v. Commissioner of Internal Revenue, Docket No. 31197-12.
Tax Insights Blog