The IRS’s intensifying fight over income taxes

The Internal Revenue Service says some of America’s most successful companies have been shuttling money to avoid paying their share of federal income taxes.

Microsoft is fighting IRS attempts to collect more than $2 billion from profit the software giant transferred between foreign affiliates. Amazon.com is fighting to keep $1.5 billion – more than the company’s total profit for the last five years – after it funneled profit to a tax-sheltered European subsidiary.

Smartphone-maker Apple, whose profit now totals a billion dollars a week, has struggled with the IRS over its history of moving earnings to units in such low-tax countries as Ireland.

Malvern-based Vanguard Group is the subject of private complaints to the IRS and state tax agencies by a former Vanguard tax lawyer, David Danon, alleging that it has been improperly transferring money between affiliates, to avoid owing income taxes. Unlike with the other firms, the IRS and Vanguard are not litigating the issue and Vanguard has not reported any effect on its taxes.

Each of these companies has been accused of setting unfairly favorable prices, instead of market-level prices, on billions transferred between their own affiliates, in order to minimize U.S. tax bills.

“The IRS has become a lot more focused on their efforts when it comes to transfer pricing enforcement,” said Samuel Maruca, who joined the Washington law firm Covington & Burling after serving as the IRS’s first transfer pricing director from 2011 to 2014.

The issue “was pretty well in the shadows for the past 50 years,” Maruca said. But it has come to prominence since 2013, when congressional hearings explored why so many large companies are paying so little in taxes.

The IRS is now pursuing more than 1,000 “transfer pricing” cases – in which corporations are accused of transferring income away from higher-tax U.S. operating units to tax-protected affiliates – to collect up to $194 billion in unpaid taxes, according to a memorandum filed as part of the Microsoft case and first reported by Bloomberg BNA in September. The IRS doesn’t discuss cases, though some become public when they land in court.

The Vanguard allegations are unusual for the focus on payments between U.S. affiliates of a company, rather than multinational corporate transfers.

In September, Danon’s lawyers sent the IRS a 10-page “expert opinion” by University of Michigan law professor and tax expert Reuven S. Avi-Yonah, asserting that the government “will succeed” if it were to go to court to force Vanguard to pay up to $35 billion in back taxes for the last six years it avoided by charging its tax-protected mutual funds artificially low fees for stock-picking and other services, and for setting up an untaxed cash reserve.

Vanguard won’t comment on details of Danon’s complaint or the report by Avi-Yonah, whom Danon’s lawyers hired as an expert. The company has said it complies with federal laws.

Danon hopes to collect a whistleblower’s cut of overdue federal and state income taxes, if the IRS and other tax agencies agree he is right and credit him with reporting it.

Tax experts say the critics have the law on their side.

“I am a happy Vanguard customer” because the company, unlike other mutual-fund providers, does not “rip off” investors with high fees, says Lee Sheppard, a prominent tax lawyer and contributing editor of Tax Notes, a widely read accounting newsletter published by nonprofit Tax Analysts in Falls Church, Va.

That’s why Sheppard said it was painful to review the complaints against Vanguard. Danon and his lawyers “are right about the law” – even though the effect would be to “bless high mutual fund fees,” Sheppard said. “Vanguard should be charging [its affiliated funds] what everyone else charges, as a legal matter.”

She cited Section 482 of the Internal Revenue Code, which requires companies to pay market rates for services they buy from affiliates, not lower “at-cost” prices.

In Securities and Exchange Commission filings, Vanguard has noted the SEC gave it permission in the early years after its 1975 founding to charge only “at-cost” distribution fees, not the higher market-level fees the law requires companies to pay when they charge their affiliates for services.

Sheppard and other tax specialists say neither SEC approval nor decades of practice would excuse a company from failing to charge itself properly.

“The IRS is very clear: If it’s anything more complicated than sweeping a floor, you have to bill at market levels,” she said.

New York corporate tax lawyer Robert Willens says he gives similar advice to real estate investment trusts (REITs) when they pay affiliated investment advisers to buy properties. The funds have to pay market-rate fees, not merely reimburse expenses, when they buy those services, Willens says, and so should Vanguard.

Still, “the IRS has a lot of things to think about before bringing this case,” Sheppard said.

After Glaxo SmithKline in 2006 agreed to pay $3.1 billion to settle an IRS transfer-pricing case, tax lawyers say the IRS was unable to get courts to endorse its estimates of how much Veritas Software Corp. and computer chip-maker Xilinx should have valued transfer payments, in other key tax cases.

It’s not enough, said Maruca, the former IRS official, for the tax service to have the law on its side in these high-value cases. After years of budget cuts, “the IRS is obviously very short of resources,” and has to judge each case on whether it is likely to be able to afford what it takes to win in court, he said.

There could be times when it’s more efficient to settle for a fraction of what a big corporation owes. Decisions in the Amazon.com and Microsoft cases may set the tone for future IRS takedowns.

“You may think you are going to win $10 billion. But there’s a time factor. The service is so beleaguered; if they can strike a good deal, they will,” says Mark Everson, who served as commissioner of the IRS under President George W. Bush in 2003 to 2007. “They offer, and they compromise. They will drive a tough bargain with taxpayers, and want them to work it off.” The goal: “to be measured, to be careful, and not to yield on principle.”

He says the IRS takes whistleblower cases especially seriously. Those cases also are important to key members of Congress, such as Sen. Charles Grassley (R., Iowa).

Everson, the former IRS commissioner, is so concerned about the difficulties in nailing down income tax obligations that he is running a longshot Republican campaign for president. His platform would reduce all income taxes in favor of European-style consumption taxes.

Of Vanguard, he says, “I can’t help but think this matter will be looked at very seriously.”