The Senate Permanent Subcommittee on Investigations held a hearing on offshore profit shifting and the U.S. tax code, examining in particular the practices of Microsoft and Hewlett-Packard, while questioning an Ernst & Young tax partner who services HP.
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“U.S. multinational corporations benefit from the security and stability of the U.S. economy, the productivity and expertise of U.S. workers and the strength of U.S. infrastructure to develop enormously profitable products here in the United States,” Sen. Carl Levin, D-Mich., said in his opening statement at Thursday’s hearing. “But, too often, to many of these corporations use complex structures, dubious transactions and legal fictions to shift the profits from those products overseas, avoiding the taxes that help support our security, stability and productivity. The share of federal tax revenue contributed by corporations has plummeted in recent decades. That places an additional burden on other taxpayers. The massive offshore profit shifting that is taking place today is doubly problematic in an era of dire fiscal crisis.”
Levin noted that U.S. multinational corporations have stockpiled $1.7 trillion in earnings offshore. “We will examine the actions of two U.S. companies – Microsoft and Hewlett-Packard – as case studies of how U.S. multinational corporations, first, exploit the weaknesses in tax and accounting rules and lax enforcement; second, effectively bring those profits to the United States while avoiding taxes; and third, artificially improve the appearance of their balance sheets,” he added.
Levin displayed a chart showing how Microsoft uses transfer pricing agreements with two of its main offshore groups. In 2011, he noted, the two offshore groups paid Microsoft $4 billion for certain intellectual property rights. Microsoft Singapore paid $1.2 billion, and Microsoft Ireland $2.8 billion. “But look what those offshore subsidiaries received in revenue for those same rights: Microsoft Singapore group received $3 billion; and Microsoft Ireland, $9 billion,” he said. “So Microsoft USA sold the rights for $4 billion and these offshore subsidiaries collected $12 billion. This means Microsoft shifted $8 billion in income offshore. Yet, over 85 percent of Microsoft’s research and development is conducted in the United States."
Levin also called attention to Microsoft’s transfer pricing agreement with a subsidiary in Puerto Rico. “Generally, transfer pricing agreements involve the rights of offshore subsidiaries to sell the assets in foreign countries,” he said. “The U.S. parent generally continues to own the economic rights for the United States, sell the related products here, collect the income here, and pay taxes here. However, in the case of Microsoft, it has devised a way to avoid U.S. taxes even on a large portion of the profit it makes from sales here in the United States. Microsoft sells the rights to market its intellectual property in the Americas (which includes the U.S.) to Microsoft Puerto Rico. Microsoft in the U.S. then buys back from Microsoft Puerto Rico the distribution rights for the United States. The U.S. parent buys back a portion of the rights it just sold. Why did Microsoft do this? Because under the distribution agreement, Microsoft U.S. agrees to pay Microsoft Puerto Rico a certain percentage of the sales revenues it receives from distributing Microsoft products in the United States. Last year, 47 percent of Microsoft’s sales proceeds in the U.S. were shifted to Puerto Rico under this arrangement. The result? Microsoft U.S. avoids U.S. taxes on 47 cents of each dollar of sales revenue it receives from selling its own products right here in this country. The product is developed here. It is sold here, to customers here. And yet Microsoft pays no taxes here on nearly half the income. By routing its activity through Puerto Rico in this way, Microsoft saved over $4.5 billion in taxes on goods sold in the United States during the three years surveyed by the subcommittee. That’s $4 million a day in taxes Microsoft isn’t paying.”
Levin noted that Microsoft’s U.S. parent paid significantly more for just the U.S. rights to this property than it received from the Microsoft Puerto Rico for a much broader package of rights.”
Microsoft Defends Tax Strategies
Bill Sample, corporate vice president of worldwide tax at Microsoft, testified in defense of the software giant’s tax strategies. “Microsoft complies with the tax rules in each jurisdiction in which it operates and pays billions of dollars each year in total taxes, including U.S. federal, state, and local taxes and foreign taxes,” he said in his prepared testimony. “The tax rules that we follow in the U.S. generally provide for the deferral of U.S. tax on the earnings of foreign subsidiaries until those earnings are repatriated in the form of dividends. Anti-deferral rules in the Internal Revenue Code, such as Subpart F, also can operate to eliminate deferral and impose current U.S. tax on certain types of income earned by those foreign subsidiaries. Exceptions to Subpart F, such as the “controlled foreign corporation” (CFC) “look through” rule in Internal Revenue Code Section 954(c)(6), in certain cases permit continued deferral on transfers of foreign earnings between foreign subsidiaries. Microsoft has made very limited use of this exception. Similarly, Internal Revenue Code Section 956 generally ends deferral and imposes U.S. tax on foreign earnings when they are loaned by Microsoft’s foreign subsidiaries back to Microsoft, but those rules permit U.S. companies to preserve deferral on certain short-term loans from foreign subsidiaries to their U.S. affiliates. Microsoft has made very limited use of this exception."
Sample also defended the tax treatment of Microsoft’s regional operating centers, or ROCs, in Singapore, Puerto Rico, Ireland, Bermuda and other parts of the world. “Our foreign ROCs pay tax locally in the jurisdiction in which they operate, and Microsoft pays U.S. tax on the earnings of the foreign ROCs when those earnings are repatriated back to the U.S. in the form of dividends or included in income under Subpart F,” he said. “Microsoft also pays U.S. tax on royalties and cost sharing payments that are received from the foreign ROCs. Our worldwide OEM business, consisting primarily of licensing PC operating systems to computer manufacturers for pre-installation on PCs, departs from this regional model and is, with very limited exceptions, operated and supplied from our operations center in Reno, Nevada. The resulting income is reported on our consolidated U.S. income tax return as taxable in the U.S. without regard to the location of the customer.”
However, Sample was questioned closely by Levin and admitted that the company does not have any employees in Bermuda even though it claims to generate $3 billion in royalties there.
Tax Deferral and Check-the-Box
Levin noted that transfer pricing is only one strategy used by corporations to shift profits abroad. He also highlighted the use of tax deferrals and the so-called “check-the-box” rules.
“If a company earns income from an active business activity offshore, it owes no U.S. tax until the income is returned to the United States,” he said. “This is known as deferral. However, as established under Subpart F of the tax code, deferral is not permitted for passive, inherently mobile income such as royalty, interest, or dividend income. Subpart F should result in a significant tax bill for a U.S. parent company’s offshore income. Once the offshore subsidiaries acquire the rights to the assets, they sublicense those rights and collect license fees or royalties from their lower tier related entities – exactly the kind of passive income that is subject to U.S. tax under the anti-deferral provision of Subpart F. But this straightforward principle has been defeated by regulations, exclusions, temporary statutory changes and gimmicks by multinational corporations, and by weak enforcement by the IRS."
Levin noted that on Jan. 1, 1997, the Treasury Department implemented the “check-the-box” regulations, which allow a business enterprise to declare what type of legal entity it wanted to be considered for federal tax purposes by simply checking a box. “This opened the floodgates for the U.S. multinational corporations trying to get around the taxation of passive income under Subpart F,” he said. “They could set up their offshore operations so that an offshore subsidiary which holds the company’s valuable assets could receive passive income such as royalty payments and dividends from other subsidiaries and still defer the U.S. taxes owed on them. The loss to the U.S. Treasury is enormous. During its current investigation, the subcommittee has learned that for fiscal years 2009, 2010 and 2011, Apple has been able to defer taxes on over $35.4 billion in offshore passive income covered by Subpart F. Google has deferred over $24.2 billion in the same period. For Microsoft, the number is $21 billion.”