[In the largest audit in U.S. history, the IRS rejected
Microsoft’s attempts to channel profits to a small factory in Puerto
Rico that burned Windows software onto CDs.]
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HOW A MANEUVER IN PUERTO RICO LED TO A $29 BILLION TAX BILL FOR
MICROSOFT  
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Paul Kiel
October 13, 2023
Propublica
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_ In the largest audit in U.S. history, the IRS rejected
Microsoft’s attempts to channel profits to a small factory in Puerto
Rico that burned Windows software onto CDs. _

, Michael Kappeler/Picture Alliance via Getty Images

 

_ProPublica is a Pulitzer Prize-winning investigative newsroom. Sign
up for The Big Story newsletter
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to receive stories like this one in your inbox_.

Series: Gutting the IRS:Who Wins When a Crucial Agency Is Defunded

A multiyear campaign to slash the IRS budget has left it understaffed
and on the defensive. That’s been good news for tax cheats, the
rich, and big corporations — but not for the poor.

In a long-awaited development, the largest audit in the history of the
IRS has finally taken its next step. On Wednesday, Microsoft announced
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the agency had notified the company that it owes $28.9 billion in back
taxes, plus penalties and interest.

The case is epic not only in dollars but in scope. As ProPublica
reported in an in-depth narrative in 2020
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the IRS saw the case as a chance to prove the agency’s
effectiveness. Often cowed by the prospect of facing off against
corporations with endless resources, the IRS set out to be bolder and
more aggressive. It took the unusual step of hiring a corporate law
firm to represent the agency, a step that incensed Microsoft. The
company, along with others in its industry, responded by rallying
allies in Congress to rein in the IRS.

The audit is already well over a decade old and figures to grow older,
since Microsoft is allowed to appeal the IRS’ conclusions and says
it plans to. The audit focused on a deal the agency would later
describe as “illusory in nature, serving no material economic
purpose except to shift income.” In 2005, ProPublica wrote
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Microsoft “sold its most valuable possession — its intellectual
property — to an 85-person factory it owned in a small Puerto Rican
city.” Having struck a favorable tax deal with Puerto Rico,
Microsoft then channeled its profits to the facility, which burned
Windows and Office software onto CDs.

At the time, some Microsoft executives celebrated this “pure tax
play,” and they had reason for optimism. Initially, the IRS did not
take an aggressive tack. An early audit resulted in a much more modest
change in 2011.

But earlier that same year, the IRS had set up a new unit to audit
intra-company deals that sent U.S. profits to tax havens — deals
that were especially common among tech companies like Google, Facebook
and Apple. The leader of the new unit decided that Microsoft’s deal
in Puerto Rico was worth a much closer look. The IRS withdrew its
initial finding and dug in to build a deep, comprehensive case.

By the time ProPublica published its story on the audit in 2020, the
two sides had sued each other, and one case had long been stuck in
court. Almost three years after the last motions in the case, a
federal judge still had not ruled on whether the IRS should receive
documents it was seeking. Shortly after ProPublica asked the court for
an update, the ruling finally came down.

The judge sided with the IRS, writing “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.” He agreed with the IRS’ characterization of the deal
as a tax shelter.

For the next three years, the case disappeared from public view until
Microsoft’s announcement.

“We believe we have always followed the IRS’ rules and paid the
taxes we owe in the U.S. and around the world,” wrote Daniel Goff, a
senior Microsoft executive, in a blog post on the company’s site
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that revealed the IRS’ determination.

The $29 billion that the IRS was seeking, he wrote, covered 2004 to
2013. He asserted, however, that the total, were the IRS to ultimately
prevail, would be reduced by about $10 billion in taxes that Microsoft
has already paid on its overseas profits. A major feature of President
Donald Trump’s 2017 tax bill was a requirement that companies
repatriate those profits, though they paid a special, low tax rate
when they did. Microsoft had stored up $142 billion in offshore
profits by 2017.

The conclusion of the audit sends the fight to a new phase. The IRS
has an internal appeals division, and Microsoft said it would pursue
its arguments there. It’s a significant development since the IRS
had once signaled that it would bar Microsoft’s access to an appeal,
a stance that led to blowback in Congress from the company’s allies.
IRS appeals officers, who are independent of the auditors, often
settle cases for steep discounts out of fear that the agency will lose
a court battle. The appeals process is secret.

If Microsoft does not get the result it wants there, it can take its
case to the U.S. Tax Court. Each step is likely to take years, meaning
the case could easily stretch into the late 2020s.

The IRS attorneys who worked on the case believed it to be, by far,
the largest U.S. audit ever, and the amount the IRS is seeking from
Microsoft is several times larger than in any other publicly disclosed
audit in the agency’s history. The case, in a way, is the last,
great vestige of the IRS before it was gutted by budget cuts over the
course of the 2010s
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corporate audits plummeted. While the recent infusion of billions from
the Inflation Reduction Act will allow the agency to rebuild itself in
the coming years, the Microsoft case shows the fruit of those efforts
could take a long, long time to reap.

* IRS
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* corporate tax dodgers
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* Microsoft
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