Microsoft's $29 Billion Tax Bill Highlights the Scale of Transfer Pricing Disputes
Microsoft received a $28.9 billion tax assessment from the IRS due to transfer pricing disputes, underscoring tax risks for multinational corporations. This article analyzes transfer pricing rules, the importance of intercompany agreements, and provides six risk management recommendations for general counsel.
Editor's note:Paul Sutton isLCN Legala partner at LCN Legal, a firm specializing in the implementation of transfer pricing compliance policies. The views expressed in this article are solely those of the author.
Transfer pricing has long been regarded as one of the most significant tax risk areas facing multinational enterprises. Because the management of this risk is closely tied to a company's legal structure, general counsel should take a proactive role in addressing it.
Microsoft announced last year that the U.S. Internal Revenue Service (IRS) required it to pay $28.9 billion in back taxes, penalties, and interest, a case that vividly demonstrates the potential scale of such risks.
The tax dispute involves Microsoft's long-standing practice of distributing software through regional hubs in Singapore, Dublin, and Puerto Rico to lower its effective tax rate. Microsoft stated that its existing tax contingency reserves are sufficient to cover this risk and that it will contest the IRS's demand. The outcome of the dispute remains to be seen; even if Microsoft ultimately prevails, it will need to invest significant time and money in its defense.
Transfer pricing risk is not limited to very large enterprises. Any entity with cross-border operations should assess its own risk and establish a corresponding management system. At a minimum, companies should document the legal and economic substance of intercompany transactions through intercompany agreements, which requires close collaboration between legal and tax departments.
Tax rules
In any multinational group, various intercompany charges occur—such as service fees, royalties, product prices, loan interest, etc.—which affect where profits are generated and where taxes are paid. Transfer pricing refers to the system of international tax rules surrounding these charges.
The Organisation for Economic Co-operation and Development (OECD) has established the arm's length principle as the international standard for determining appropriate transfer pricing. Tax authorities can review related-party transactions and tax entities based on the profits that might have arisen if the transaction had been negotiated between independent third parties. However, a transfer pricing adjustment proposed by one tax authority may not be recognized by the jurisdiction on the other side of the transaction, creating a risk of double taxation, potentially accompanied by substantial interest and penalties.
Many tax authorities require intercompany agreements to be executed in advance. Some countries, such as Germany, go further by explicitly stipulating that the arm's length principle should apply as of the date the relevant intercompany agreement is signed, rather than when the related services are performed.
Intercompany agreements are often among the first documents requested during a transfer pricing audit. Taxpayers must respond promptly, providing intercompany agreements that are consistent with their transfer pricing policies and correctly document the relevant transactions.
Key points for general counsel
General counsel are typically skilled at risk prioritization and management. The following steps can help them address transfer pricing risks arising from deficiencies in intercompany agreements:
- Identify or establish clear ongoing roles and responsibilities for maintaining intercompany agreements, including the allocation of duties between the "tax" and "legal" functions.
- Ensure that the tax and legal departments use the same "central source of information" when identifying all group entities, including branches and permanent establishments. This often involves ensuring that the company secretarial system is properly used and kept up to date.
- Ensure that the group's existing intercompany agreements are stored in a comprehensive central online repository, which may be "owned" by the tax, legal, or compliance department as appropriate.
- Conduct a sample review of existing agreements, entities, and transactions to identify any gaps in intercompany transaction coverage, as well as inconsistencies between agreements and transfer pricing policies.
- Develop a plan to address gaps and realign agreements with policies as needed.
- Identify or establish an ongoing process to review and update the group's portfolio of intercompany agreements as needed. This should include at least an annual review of agreements to reflect any changes in the group and its transfer pricing policies.
Transfer pricing disputes are tax matters, but general counsel play a central role in helping organizations avoid such disputes, with the key being to ensure that intercompany agreements are aligned with transfer pricing compliance policies.