Government

IRS Wants Microsoft To Pay $28.9B For Using Transfer Pricing To Avoid Taxes

Let’s look at what transfer pricing is, how it can be used for tax avoidance, and what problems this presents.

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971179Last week, Microsoft, in its Form 8-K filing with the Securities and Exchange Commission, reported that the IRS has issued a Notice of Proposed Assessment of tax years 2004 to 2013. In the notice, the IRS is seeking additional payment from the company of $28.9 billion plus penalties and interest.

The IRS is contesting Microsoft’s transfer pricing strategies.

Let’s look at what transfer pricing is, how it can be used for tax avoidance, and what problems this presents.

Transfer pricing is very complicated, but in a nutshell, it is how two or more subsidiary companies with a common parent sells goods and services to each other. Since both entities are controlled by the parent, the parent can dictate the prices. Because of this, the parent can avoid income taxes by manipulating prices to shift profits from a high tax jurisdiction to a tax haven.

In one example, suppose the parent company is in a 25% income tax jurisdiction. Parent owns Subsidiary A in a no income tax jurisdiction and Subsidiary B in a 25% tax jurisdiction. Parent sells a box of product “X,” which has a market value of $300 with a $100 manufacturing cost. Parent, ideally, in its tax home would realize a profit of $200 for every box of X sold and thus pay $50 in corporate income tax. Parent, being unhappy with the tax bill, instead sells its box of X to Subsidiary A for $120 leaving it with only $20 profit and thus $5 is paid in income tax. Subsidiary A then sells that box of X to Subsidiary B for $280. Subsidiary A would realize a $160 profit ($280 sales price minus $120 purchase price) which is income tax free. Subsidiary B then sells the box of X to the public for $300. Subsidiary B realizes $20 in profit ($300 market price less $280 purchase price) and $5 is paid in income tax to its home country. Parent, by paying $10 in taxes as opposed to $50, saves 80% in income taxes through this transfer pricing structure.

Another example of transfer pricing involves intellectual property. Suppose again that the parent company is in a 25% income tax jurisdiction and owns Subsidiary A, which is located in a no income tax jurisdiction. Parent invents product Y which can be sold for $300 with a manufacturing cost of $100. Parent in its tax home would realize a profit of $200 for every Y sold and thus pay $50 in corporate income tax. Parent’s tax attorney advises them to sell their intellectual property rights in product Y to Subsidiary A. Parent, in their licensing agreement, has to pay Subsidiary A $160 royalties for every product Y sold. In this case, for every product Y sold for $300, after taking into account the $100 manufacturing cost and $160 royalty payment, the parent company realizes a profit of $40 which means that it pays only $10 in income tax. Subsidiary A pays no income tax on its royalty payments. Parent saves 80% in income taxes through this structure.

The IRS (as well as other developed countries) have complex transfer pricing rules and regulations that ban or recharacterize the above transactions. But generally, they require all related parties to buy or sell at market rates or by using arm’s-length transactions.

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The astute will wonder whether the costs of implementing the above tactics will eat up the tax savings to the point where it will make little sense to do it. For the little people, this will either be too expensive or too complicated. But transfer pricing strategies are common in cross-border transactions. And when billions of dollars are at stake, the administrative costs, while large, could still be relatively minuscule.

While companies save taxes through transfer pricing, they are stuck with a practical problem — their money is stuck overseas. Any repatriation to the home country will be subject to its income taxes. But every once in a while, usually when Republicans control the government, a law is passed where repatriated income is subject to little or no taxes. For example in 2004, the American Jobs Creation Act allowed multinational corporations to take a one-time 85% deduction of any dividends received from their foreign subsidiary corporations. In 2017, the Tax Cuts and Jobs Act completely exempts foreign subsidiary income from taxation although it was required to pay taxes on prior earnings are a lower tax rate. The repatriated funds were supposed to be used for job growth but several large companies were accused of using the repatriated funds for stock buybacks.

Microsoft published a statement explaining their side of the story. The company also stated that it will appeal the proposed assessment and that a resolution may take several years. If there is no resolution with IRS appeals, this may be litigated in the U.S. Tax Court, the Court of Federal Claims, or a local federal district court. At that point, more details about the transactions will be revealed in discovery.

Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolve tax disputes. He is also sympathetic to people with large student loans. He can be reached via email at stevenchungatl@gmail.com. Or you can connect with him on Twitter (@stevenchung) and connect with him on LinkedIn.

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