Minecraft, Nokia, Skype: How Microsoft Buys Overseas Companies To Avoid US Taxes

Nokia, Skype and Minecraft-maker Mojang have more in common than just the fact that they are among Microsoft’s biggest acquisition targets in recent years. They are all also based outside the U.S., and that’s no coincidence.

As the debate over so-called inversions heats up and critics — from President Obama to Democratic Senator Dick Durbin of Illinois — fling allegations of tax dodging at corporate giants like Burger King, Medtronic and Pfizer, American tech companies continue to use offshore profits to expand their portfolios rather than repatriate funds at what they see as punitive tax rates.

Indeed, of the five companies Microsoft has acquired, or agreed to acquire, under CEO Satya Nadella, who took the helm in Redmond in February, four are based outside the U.S. Microsoft earlier this monthsaid it had reached a deal to acquire Stockholm-based Mojang for $2.5 billion.

The strategy predates Nadella. Former CEO Steve Ballmer’s deal to acquire VoIP specialist Skype, which was incorporated in tiny Luxembourg, was “a tax-efficient use of its hoard of offshore cash,” said University of Southern California professor Edward Kleinbard, in an interview.

Kleinbard, whose new book, “We Are Better Than This: How Government Should Spend Our Money,”looks at the country’s taxation system, said companies like Microsoft have built up vast troves of overseas cash and, in today’s low-rate environment, can only realize decent returns by making foreign acquisitions not subject to U.S. taxes. “They’re hoisted on their own petard,” said Kleinberg, who was formerly chief of staff for Congress’ Joint Committee on Taxation.

The process is simple enough. Microsoft and other companies have established subsidiaries in countries, most notably Ireland, with relatively low corporate tax rates. Earnings from overseas operations are parked with the subsidiary and then used to purchase more foreign assets, which also accrue lower tax liabilities than if operated from the U.S.

Corporate taxes in Ireland are 12.5 percent, compared to a tax of 35 percent that the U.S. collects on foreign profits when repatriated.

So how big is Microsoft’s hoard. As of June 20, 2014, Microsoft said it had $92.9 billion in “permanently reinvested” earnings from its offshore subsidiaries. If the company were to repatriate all of those profits, it would get hit with a tax bill from the Internal Revenue Service of a whopping $29.6 billion. Instead, Microsoft paid U.S. income tax of $5.5 billion in 2014, according to its annual report.

Not that the IRS isn’t keeping an eye on Redmond. It’s currently auditing the software maker’s books for the years 2004 to 2006. On a related note, the IRS introduced new rules Monday that seek to limit the tax benefits for companies that “invert” themselves by moving their headquarters overseas.

Microsoft makes no secret of where and why it stows its cash. “The majority of our cash, cash equivalents, and short-term investments are held by foreign subsidiaries,” the company said in its most recent annual report. “We currently do not intend nor foresee a need to repatriate these investments.”

Microsoft is not alone. JPMorgan Chase has estimated that corporate America’s total offshore cash cache is in excess of $1.7 trillion. Google stashes about $30 billion overseas, while IBM and Apple each have more than $50 billion saved abroad.

Critics of the practice say it not only deprives the U.S. government of billions of dollars in revenue but also exerts an undue influence on corporate decision making. “These companies have been letting the tail wag the dog,” forensic accountant Robert Olstein told the New York Times. “They’ve been letting taxes determine their strategy, and that’s a big mistake.”

Former CEO Ballmer has said any effort by the government to make it more difficult to escape taxes on foreign profits would result in job losses. “We’re better off taking lots of people and moving them out of the U.S.,” Ballmer said at a 2009 roundtable.

Tax reasons may explain, in part at least, why Microsoft agreed to pay $2.5 billion for Mojang, which earned $128 million in 2013. The company employs only a few dozen workers, and its flagship game features graphics that would be right at home on a 1980s-era Atari console.

That’s not to say the deal was entirely motivated by financial engineering. Nadella has identified games as core to Microsoft’s future, and Minecraft, with more than 100 million users, may just be the hottest game on the planet right now.

A source familiar with Microsoft’s thinking insisted the company would have acquired Mojang even if it had been based in the U.S.

As for the tax code, Kleinbard believes the U.S. should adopt a rate in the low 20 percent range—which would represent the midpoint of most other countries’ rates. “The U.S. tax system has inadvertently created a powerful incentive for Microsoft and other companies to make foreign acquisitions. That’s no way to run a railroad.”