Microsoft, IRS going to court over longtime tax scrutiny

The IRS’ investigation into Microsoft books centers on how the company uses its overseas subsidiaries for tax purposes. The company says the IRS audit has gone on long enough and the federal agency improperly hired an outside law firm to help in the investigation.

Microsoft and the federal government have squared off in court over the years, and this week another high-stakes match is in the offing, this time involving the Internal Revenue Service.

The case is part of the IRS’ campaign to ensure that U.S. companies, particularly those in the tech sector, follow the law when they make moves involving overseas subsidiaries that have tax consequences. Such practices have been the subject of congressional hearings and are a hotly debated political topic.

At issue in the case, to be heard Tuesday in U.S. District Court in Seattle, is a long-running investigation into whether the Redmond company improperly shifted software code worth billions of dollars offshore in a way that illegally evaded its U.S. tax bill.

The IRS in court papers says it’s examining intracompany deals Microsoft struck a decade ago with subsidiaries in Bermuda and Puerto Rico that had billions of dollars of impact on the company’s taxable income.

The investigation is among the highest-profile examples of the tax agency’s effort to scrutinize overseas tax practices by U.S. corporations.

Microsoft, on the other hand, portrays the audit as an example of government overreach and abuse of power.

The IRS, Microsoft’s lawyers say, has dragged the probe out for years without delivering a final estimate of whatever taxes it thinks Microsoft owes. Microsoft also accuses the IRS of violating the rules of its own process.

The two sides take to district court this week in a preliminary hearing to argue over whether the tax agency overstepped its bounds when it hired Quinn Emanuel Urquhart & Sullivan, a Los Angeles business-litigation firm, to assist in the audit of Microsoft’s books.

Microsoft argues that the IRS improperly delegated a governmental function to outside lawyers, while the government contends the deal was a legal use of outside help for a complex investigation.

Since 2007, government auditors have been looking at Microsoft records for tax years 2004 to 2006, focusing on practices that transferred some rights to its software among its international subsidiaries.

After years of document requests and interviews with Microsoft employees and outside experts, the IRS last year took the rare step of hiring Quinn Emanuel.

“The IRS is adopting extraordinary measures to combat Microsoft, above and beyond what you’d usually see,” said Andy Grewal, a law professor at the University of Iowa.

The IRS in December sued Microsoft, former Chief Executive Steve Ballmer, and a slate of former and current executives to force the company to turn over more documents and testimony that it said the company had failed to provide.

Microsoft said the lawsuit amounted to a last-minute effort to force the company to the negotiating table and extend an audit that should have been wrapped up years earlier.

Microsoft also contends that the IRS’ latest requests for information should be thrown out because the use of Quinn Emanuel lawyers amounts to an abuse of the audit process. The company’s lawyers also raise questions about the legality of a temporary regulation, which took effect last summer without the typical public comment. The rule paved the way for the use of outside counsel in audits.

U.S. District Judge Ricardo Martinez granted Microsoft’s request for this week’s hearing to determine whether the hiring of Quinn Emanuel and the regulation’s implementation warrant further investigation.

Stuart Bassin, a lawyer who formerly worked as a tax attorney with the Justice Department, said the $2.2 million contract to hire Quinn Emanuel was unprecedented. “It’s just never been done with anything that mattered before,” he said. “We’ve got a government [agency] that claims it can’t answer the phones, and is paying millions to do stuff” it can do with its own lawyers.

It isn’t uncommon for the IRS to audit large companies, and the agency has looked at Microsoft’s taxes for every year from 1990 to 2006.

But the current Microsoft audit came as political pressure mounted on how big companies use international subsidiaries for tax purposes. Congressional committees have raised questions about the tax arrangements of U.S. corporate giants, from Apple to Hewlett-Packard and Microsoft.

The scrutiny isn’t limited to the U.S. Australia’s senate in April held a hearing in which members questioned representatives of Google, Apple and Microsoft about corporate arrangements that essentially taxed revenue generated in Australia in Singapore.

Microsoft, for its part, says it follows tax law in the U.S. and other countries in which it operates.

Microsoft’s effective tax rate for its most recent fiscal year was 21 percent, which, like that of most multinational corporations, falls below the 35 percent federal corporate tax rate. Microsoft says its taxes are lower than the statutory rate because international earnings are taxed at lower rates in the company’s sales and distribution hubs in Ireland, Singapore and Puerto Rico.

“It’s not obvious to me that Apple or Microsoft owes the U.S. anything for its active business operations in Europe, South America, and so on,” Grewal, the law professor, said. “The hard part is when they create something here in Redmond and shift it offshore. That’s where the [IRS’] concerns come into play. But the mere fact that they’re making money offshore doesn’t make them a bad corporate citizen.”

The IRS in 2011 established a dedicated unit to investigate cases involving transfer pricing, or the accounting behind sales among a company’s international arms. Transfer-pricing law holds that companies should charge fair-market rates for goods shipped among subsidiaries, rather than applying discounts to expensive goods just to lower their tax bill.

The IRS Transfer Pricing Operations unit decided the Microsoft audit, among the largest on the IRS’ plate, was worth a closer look.

“The IRS is fighting very hard to get the correct amount of profits recorded in the U.S.,” said Keith Fogg, director of the Federal Tax Clinic at the Villanova Law School and a former senior counsel with the IRS. “The Microsoft case would be a very logical case for the IRS to push, because the dollars at stake are so much bigger.”

The IRS declined to comment, saying it doesn’t discuss pending audits or litigation.

Tuesday’s hearing in Seattle likely won’t decide the outcome of the audit, say lawyers who are following the case.

Should the judge find the participation of Quinn Emanuel renders the latest rounds of summonses invalid, that could force the IRS to quickly wrap up its audit and deliver an estimate to Microsoft of any taxes it thinks are owed.

A victory for the IRS, meanwhile, could extend a probe that’s been under way for nearly a decade.

Fogg said the legal wrangling could go on for years more should the dispute ultimately wind up in tax court. “There’s a principle at stake,” he said. “Whatever happens to these [tax] years is going to carry forward.”