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Microsoft's audit woes mirrored worldwide


Microsoft may be worth $1 trillion, but it still has plenty of unfinished business with the IRS and there is no sign of a final resolution this year. It is far from the only company suffering from lengthy audit procedures.

Despite years of back and forth on its transfer pricing methodology, Microsoft is still working through several TP-related IRS audits. This covers business operations in multiple jurisdictions from 1996 to 2018. The US multinational has put aside $15.7 billion for income tax contingencies.

Microsoft has said in its 10-K filing for the second quarter of 2019 that it does not expect these issues to be resolved in the next year.

“While we believe our allowances for income tax contingencies related to the unresolved issues are adequate, the final resolution of these issues, if unfavourable, could have a material impact on our consolidated financial statements,” the company said in its financial statement.

The IRS has been running audits on Microsoft’s cost-sharing arrangements and other tax practices for many years. The company and the revenue service have settled on most of issues. Microsoft continues to produce and distribute products through operation centres in Ireland, Singapore and Puerto Rico.

As part of its battles with the IRS, the company challenged the tax authority’s use of an outside law firm for advice. The IRS turned to Quinn Emanuel Urquhart & Sullivan for advice, but the firm was also the primary outside counsel to Google at the time. After the challenge, the IRS said it would not use outside law firms for other audits.

Global problem

Microsoft’s audits are far from unusual in an increasingly uncertain world and many taxpayers are concerned about the length of tax audits in the US and overseas. The norm seems to be more audits and more disputes.

As one tax director at a European financial company told TP Week: “We’re facing audits on a regular basis and an increasing number of audits are actually on taxes not even covered by existing treaties.”

“A lot of countries have fairly awful finances at the moment and governments want to find more revenue from somewhere,” the director said.

At the same time, the tax system is getting more complicated in many jurisdictions and the US is no exception. The Tax Cuts and Jobs Act (TCJA) has introduced new levels of complexity to the tax code and the US authorities are still issuing guidance.

This has raised fears that there will only be more audits in the future and more disputes to follow. Yet the chances of the IRS catching-out businesses may have fallen to an all-time low. After years of funding cuts, the revenue service is facing the dual challenge of doing more with less.

The IRS audit rate has fallen by half since 2011 due to the loss of funding and more than 24,000 staff. The revenue service has seen its budget cut by 16% in this period. The number of IRS auditors has fallen from almost 14,000 in 2010 to fewer than 10,000 in 2017 – the lowest figure since 1953.

However, the IRS has been busy working to close the data gap with the business community. The shortage of staff and resources has forced the revenue service to adjust.

“The IRS has spent hundreds of millions of dollars on getting up to speed on big data,” said Kim Boylan, head of the global tax practice at White & Case. “We’ve not seen the impact trickle down to audits yet, but we will in the near future.”

“You have to rethink your documentation for every deal in case you get audited,” Boylan said. “So you have to keep an ‘audit ready’ file on every deal you do now.”

Getting audit-ready

What was best practice in the past may have been acceptable and legal, but the times have changed. The US has seen a big push to get companies up to scratch on their audits and, in some TP cases, this involves examining agreements going back 15 or 20 years.

Companies like Microsoft have to be prepared for every eventuality and the risk of a dispute has to be factored into standard practices. This is especially true for US multinationals operating in Europe, where the tax authorities seem to be increasingly aggressive.

“There has been a change of mindset post-BEPS and this has shown up in the rise of audits and an increased focus on control from the tax authorities,” one head of tax at an energy group said. “It’s also more difficult to claim treaty benefits.”

“We may have been spared the tax scandals that have plagued other companies, but we have had our fair share of tax audits and disputes,” the head of tax said. “In my first year with the company, we had 25 audits and a third of those were launched in my first week.”

Likewise, the fact that Microsoft’s TP arrangements were all perfectly above board historically did not save the company from facing challenges during the past 10 years. The US company routes its licensing agreements for its signature products through a chain of subsidiaries in low-tax jurisdictions.

The company’s European operations are all booked through its subsidiaries in Ireland - where it keeps its intellectual property (IP), thereby wiring cash from the rest of the EU from its sales and distribution network.

Yet this is exactly the kind of practice the tax authorities are keen to question. Other tax professionals tell a similar tale. The head of TP at a US healthcare company operating across Europe suggested the BEPS project has turned things upside down.

“It used to be that things got more difficult the further south you go,” the head of TP said. “It used to be that France, Spain, Italy and Greece were the toughest jurisdictions. But that’s all changed.”

“Now the more north in Europe you go you face more challenges than you did in the past,” he continued. “German tax audits are very tiresome, difficult and precise. Likewise, audits in Denmark are a nightmare.”

Not only are the tax authorities more aggressive, the auditors don’t always grasp the full picture of the business model and its objectives. The level of scrutiny towards transfer pricing in particular has forced some taxpayers to reconsider arrangements old and new.

“The key issue is risk, but what kind of risk? It could be financial or reputational,” Boylan said. “Today, companies are more concerned with their reputation at the end of the day.”

“The flipside of reputational risk might not be financial risk,” said Brian Gleicher, head of the global TP practice at White & Case. “Your reputation can still take a serious hit even if your arrangements are in line with the arm’s-length principle.”

Even though an arrangement might be above board, multinational companies are not safe from facing a trial by public opinion and there is no presumption of innocence in this courtroom.

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