Microsoft Receives IRS Notice To Pay $28.9B Due to Transfer Pricing Issue

On Microsoft’s 8-K published in early October, they’ve noted that the IRS has issued a notice of adjustment and is due $26.9 billion in taxes, plus penalties and interest. This issue arrived based on the transfer pricing of intangible goods, royalties, research and development, and many other transactions between the US parent and current Ireland and former Singapore and Puerto Rico subsidiaries.

The proposed adjustments are primarily based on cost-sharing agreements (CSA). CSAs typically arise when several entities pool resources in the development, maintenance, enhancement, or ownership of intellectual property. The agreement then contractually divides and splits profits and costs of the shared and related intellectual or other property amongst the participant entities.

To comply with IRS and OECD transfer pricing guidelines, all profits derived from activity and assets within the agreement must be split on an arm’s length basis. Proper valuation of these agreements ensures that profits are distributed appropriately among the related parties based on their level of contribution.

The appropriate method to determine the arm’s length distribution of profits among participating entities includes understanding the individual facts and circumstances, just like any other transfer pricing transaction.

Typical methods for these agreements include:

• The residual profit split method
• The comparable uncontrolled price method
• The comparable profits methods

Which method to use depends on the business environment, the level of non-routine activity provided or used by participants in the agreement, and the existence or lack of comparable transactions or companies.

A key dispute for the Microsoft case arises from changes in rules for cost-sharing agreements that occurred in 2008, taking effect in mid-2009. The legislation applied a commensurate with income (CWI) mechanism for redistributing profits based on the residual profit method to new CSAs and existing CSAs that didn’t meet specific criteria.

The CWI mechanism applies when a participant receives more than 150% of a return on its non-routine contribution in any year of its first ten years. If this occurs, the IRS commission can split profits based on the non-routine activities provided. Non-routine activities are specialized operations that either only the participant can perform or can only be performed using the intellectual property provided. Simply put, someone else can’t just step in and immediately replicate the work. An example of such activity would include goods manufactured using specialized internally engineered manufacturing equipment. The activities provided by Microsoft’s subsidiary, primarily marketing and distributions, are likely considered routine by the IRS and would require a reduction in their share of profits.

To be considered an existing CSA exempt from the CWI mechanism, participants would’ve needed to use the intangibles to manufacture or produce materials, which would then be sold to unrelated third parties. The Microsoft subsidiaries are primarily used as distribution channels and, therefore, may require having the CWI mechanism applied.

Microsoft contends that they have “acted in accordance with IRS rules and regulations and that [their] position is supported by case law.”

You can find more information about transfer pricing here. For questions about transfer pricing or other international tax matters, contact our Global Business Services team.