Microsoft revealed in its 10-K annual report that its use of low-tax countries to shift some of its foreign income has subjected it to an IRS review that could have a significant impact on its financial statements.

“We are subject to income taxes in the U.S. and many foreign jurisdictions,” said the software giant in its SEC filing. “Significant judgment is required in determining our worldwide provision for income taxes. In the ordinary course of our business, there are many transactions and calculations where the ultimate tax determination is uncertain. We regularly are under audit by tax authorities. Although we believe our tax estimates are reasonable, the final determination of tax audits and any related litigation could be materially different from our historical income tax provisions and accruals. The results of an audit or litigation could have a material effect on our financial statements in the period or periods for which that determination is made.”

The company noted that it earns a significant amount of its operating income from outside the U.S., and any repatriation of funds currently held in foreign jurisdictions may result in higher effective tax rates for the company.

“In addition, there have been proposals to change U.S. tax laws that would significantly impact how U.S. multinational corporations are taxed on foreign earnings,” Microsoft noted. “Although we cannot predict whether or in what form this proposed legislation may pass, if enacted it could have a material adverse impact on our tax expense and cash flow.”

Microsoft said later in the filing that its effective tax rates for fiscal years 2011 and 2010 were approximately 18 percent and 25 percent, respectively, far lower than the statutory tax rate of up to 35 percent on corporate income. The company explained that was the case because it used several low-tax jurisdictions to produce and distribute its products.

“Our effective tax rate was lower than the U.S. federal statutory rate and our prior year effective rate primarily due to a higher mix of earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico, which are subject to lower income tax rates,” said the company. In fiscal years 2011 and 2010, Microsoft’s U.S. income before income taxes was $8.9 billion and $9.6 billion, respectively, and comprised 32 percent and 38 percent, respectively, of its income before income taxes.

In contrast, in fiscal years 2011 and 2010, the foreign income before income taxes was $19.2 billion and $15.4 billion, respectively, and comprised 68 percent and 62 percent, respectively, of Microsoft’s income before income taxes. In fiscal years 2011 and 2010, the reduction of the U.S. federal statutory rate as a result of foreign earnings taxed at lower rates was 16 percent and 12 percent, respectively.

Microsoft also noted that its effective tax rate was lower than in the prior year because of a partial settlement with the IRS in the third quarter of fiscal 2011 of an audit of tax years 2004 to 2006. The partial settlement reduced Microsoft’s income tax expense for fiscal year 2011 by $461 million. The partial settlement did not completely resolve matters either.

“While we settled a portion of the IRS audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, we remain under audit for these years,” Microsoft revealed. “During the fourth quarter of fiscal year 2011, the IRS completed its examination and issued a Revenue Agent’s Report (RAR) for the remaining unresolved items. We do not agree with the adjustments in the RAR, and we have filed a protest to initiate the administrative appeals process.”

The adjustments and disagreement with the IRS mainly pertain to the transfer pricing arrangements that Microsoft has set up.

“The proposed adjustments are primarily related to transfer pricing and could have a significant impact on our financial statements if not resolved favorably; however, we believe our existing reserves are adequate,” said the company. “We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months, as we do not believe the appeals process will be concluded within the next 12 months. We also continue to be subject to examination by the IRS for tax years 2007 to 2010.”

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