How reform in the US affects Microsoft’s tax structure

Microsoft’s 2018 10k filing with the Securities Exchange Commission (SEC) shows that the company’s effective tax rate is lower than the US federal statutory rate, but this might have changed due to the Tax Cuts and Jobs Act (TCJA).

As part of its filing, Microsoft reported taking a temporary hit from the TCJA, though the company will see a lower tax rate in the long term thanks to US tax reform.

“Our effective tax rate was 14% and 23% for the three months ended March 31, 2018 and 2017, respectively, and 70% and 21% for the nine months ended March 31, 2018 and 2017, respectively,” the Microsoft report says.

“The increase in our effective tax rate for the year-to-date compared to the prior year was primarily due to the net charge related to the enactment of the TCJA in the second quarter of fiscal year 2018,” the report explains.

Many US companies are costing a short-term rise in their tax liabilities since the TCJA came into force. McDonald’s filed a net tax cost of $1.2 billion on the repatriation of its foreign earnings, though it also reported that the revaluation of deferred tax assets partially offset the cost by $500 million.

This spike in the tax burden is down to US tax reform and its costly transitional rates on foreign earnings. Tax advisers expect this measure to change how many US companies approach tax  planning.

Even so, Microsoft reports an effective tax rate lower than the statutory rate and the company has not followed Apple’s lead in overhauling its Irish structure.

“Our effective tax rate for the three months ended March 31, 2018 was lower than the US federal statutory rate, primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centres in Ireland, Singapore, and Puerto Rico,” the Microsoft report says.

It’s worth noting that the company’s effective tax rate was 26% in 2008, and fell to 18% by 2011. The company’s international structures may be durable, but there are new challenges on the horizon.

Just a two and a half hour flight from Miami, Puerto Rico has long been a desirable location for US multinationals thanks to a range of tax advantages. This includes a special dividend exemption for manufacturing on the island.

Although Microsoft does not manufacture software or hardware on the Caribbean island, the company does meet the standard because of its number of employees. Companies have to employ at least 10 people in Puerto Rico to claim a tax rate of 4% and no tax on dividend distributions.

Under the new rules, Section 951A imposes a 10.5% rate on global intangible low-taxed income ( GILTI ) spread across foreign jurisdictions. This provision directly impacts Puerto Rico, even though the island is a US territory.

ITR speaks to Gabriel Hernandez, head of tax at BDO in San Juan, who has been highly critical of US tax reform and its consequences for Puerto Rico.

“US tax reform impacts Puerto Rico tremendously,” Hernandez says. “While tax reform was intended to promote manufacturing jobs in the United States, Puerto Rico, as a US territory, was not distinguished as part of the US in the reform bill and has been treated as a foreign jurisdiction in the application of the GILTI provisions.”

Around 50% of Puerto Rico’s GDP comes from multinationals basing their manufacturing operations on the island. So the loss of tax advantages in the US territory is no small matter for Puerto Ricans.

“There is a tangible risk multinational operations in Puerto Rico will be scaled back over time,” Hernandez says. “This is a direct result of the material loss of tax arbitrage between Puerto Rico and the US mainland.”

A 2012 US Senate investigation claimed that Microsoft was making tax savings of $4 million a day from its Puerto Rican base. In a 2014 interview, Microsoft co-founder Bill Gates was asked about the Senate report.

“I think that’s about as incorrect a characterisation of anything I’ve ever heard,” says Gates. “It’s simply hogwash.”

The Puerto Rican base is a key part of the US company’s international network, through which it distributes its software worldwide. The subsidiaries buy the intellectual property (IP) rights, and the parent company buys back the distribution rights for the US.

International transfers allow Microsoft to direct profits from US sales to a Nevada subsidiary before redirecting the cash out of the country. Half of the cash goes to the entity in Puerto Rico, before a portion of the remaining cash is passed onto the group in Ireland, only for the money to be sent to RI Holdings in Bermuda.

Microsoft constructed this network of structures over five years. From 2001 to 2006, the parent company shifted the rights to software code and other key assets to a chain of subsidiaries based in low-tax jurisdictions.

Microsoft Operations Puerto Rico (MOPR) pays Microsoft USA for the right to sell its software and other products throughout the Americas. At the same time, the subsidiary is owned by MACS Holdings based in Bermuda, which is in turn owned by Round Island One that also owns the parent company’s Irish subsidiaries.

The US company sells the IP rights to its Puerto Rican subsidiary and buys back the distribution rights for the US mainland. Much like the Puerto Rican subsidiary, Microsoft’s Irish subsidiaries – Microsoft Ireland Research and Microsoft Ireland Operations Limited (MIOL) – have the IP rights to reproduce and distribute Microsoft products across Europe, Africa and the Middle East.

Fintan Clancy, partner at Arthur Cox in Dublin, told ITR that the US multinationals will likely repatriate a lot of cash from Ireland to the US. But this cash was never actually invested in Ireland anyway, so the impact would be marginal.

“Big tech companies often put their non-US IP in Ireland, while the rest stays in the US itself,” Clancy says. “It’s the payments from the rest of the world coming into Ireland irrespective of the US IP.”

On the other side of the world, Microsoft leaves distribution in the Asian markets to two subsidiaries owned by Microsoft Singapore Holdings. These operations have traditionally paid a much lower rate of tax than they would have in the US historically.

Wong Hsin-Yee, international tax partner at EY in Singapore, has been consulting companies on tax planning for more than 18 years. She sees US tax reform hitting some of the structures put in place in the past.

“Many companies are considering the most efficient methods for moving their cash. That could require legal entity restructuring, reviewing the capital structure of subsidiaries, or other manners to repatriate cash in the most efficient manner,” Wong says.

The 2012 Senate report found that the subsidiaries in Ireland and Singapore paid Microsoft $4 billion in 2011 for the IP rights to the software. But the US company shifted $12 billion to these offshore subsidiaries, so $8 billion remained abroad.

Documents from the 2015 court case between the IRS and Microsoft revealed that the tech company had more $108 billion in income stashed offshore. So the company may have a lot to lose if its structures can’t withstand the shock of US tax reform.