The U.S. Internal Revenue Service has won a significant court victory in a dozen year effort to have Microsoft pay taxes on at least $39 billion in income that it shifted to Puerto Rico, where the profits were not taxed at all or taxed no more than two percent — contributing to the territorial government’s bankruptcy.
The case has major implications for the practices of 30-odd companies that similarly shift income derived from work in the States to the territory to avoid Federal income tax. Most of the companies are pharmaceuticals and similar firms in the health products field.
In a decision on admitting evidence related to Microsoft’s accounting firm that took three years to obtain, Chief Judge Ricardo Martinez of the U.S. District Court for Western Washington State ruled that, “The Court finds itself unable to escape the conclusion that a significant purpose, if not the sole purpose, of Microsoft’s transactions was to avoid or evade federal income tax.”
Encouraged by the KPMG, Microsoft engaged in what a senior executive wrote was a “pure tax play” involving “very aggressive tax structuring.” It required ostensibly transferring the ownership of intellectual property for top-selling software to a foreign subsidy that it established to do minimal work on the products in the islands.
KPMG — which has also audited for the Government of Puerto Rico — wrote in July 2004 that it had “previously advised several U.S. clients on migrations of this type and successfully negotiated significant tax holidays for U.S. companies with the Puerto Rican government.”
In preparation for a meeting, a Microsoft executive wrote that, “This needs to be a verbal briefing with no handouts and no e-mail.”
The IRS contended that the deal was “illusory in nature, serving no economic purpose except to shift income to Puerto Rico” where it would not be taxed by the Federal government and only very lightly taxed by the territorial government.
The IRS audit also found that Microsoft had understated the income involved by $15 billion and that, while it told investors the revenue would grow 10% to 12%, it told the IRS that the growth rate would be only four percent.
The company also set up similar arrangements with foreign subsidiaries in Ireland and Singapore.
A U.S. Senate Permanent Subcommittee on Investigations hearing in 2012 found that Microsoft had shifted about $4.5 billion in profits each year in 2009, ’10. and ’11 to its Puerto Rico subsidiary and paid the insular government about $40 million a year. Its tax payments were closer to six percent in Ireland and three percent in Singapore than the one percent in Puerto Rico.
It had a maximum of 129 employees in the U.S. territory.
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