News

Microsoft, HP Singled Out in Senate Panel for Tax-Avoidance Measures

• By Kurt Mackie
• September 24, 2012

Microsoft and Hewlett-Packard were spotlighted as case-study examples in a Senate panel hearing on Thursday regarding individuals and U.S.-based multinational corporations that regularly avoid paying U.S. taxes.

As part of a hearing at the U.S. Senate Permanent Subcommittee on Investigations, the two companies' tax avoidance details were spelled out in a memo by Sen. Carl Levin, subcommittee chairman, and Sen. Tom Coburn, ranking member. The hearing and testimony can be viewed at here.

According to one common scheme associated with "transfer pricing," Microsoft and HP regularly transfer intellectual property assets to offshore companies and exploit loopholes in U.S. tax laws to avoid paying U.S. taxes. Profits associated with intellectual property from U.S. operations go to overseas tax havens to avoid paying a U.S. tax rate of 35 percent, which is one of the highest tax rates on the globe, according to a KPMG tax table. This practice isn't new. The memo points to a similar complaint by President Kennedy 50 years ago about the corporate offshoring of dollars. However, it's come to such a state that "today, U.S. multinational corporations have stockpiled $1.7 trillion in earnings offshore," Levin explained, in an announcement.

The offshoring problem is particularly flagrant with U.S.-based IT technology companies. Many of them now report the bulk of their cash revenues as being located abroad. For instance, the following U.S.-based IT companies, having foreign cash balances of more than $5 billion, were described in the memo (based on JP Morgan estimates):

U.S. Subpart F tax law has a loophole, described as "check the box," that allows corporations to specify that their controlled foreign corporations aren't associated subsidiaries for tax purposes. In such cases, so-called "passive income," such as dividends and royalties, do not get taxed. This tactic has held back millions in U.S. tax revenue.

"The loss to the U.S. Treasury is enormous," Levin explained in his announcement. "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."

How Microsoft Evades U.S. Taxes
Microsoft uses its foreign subsidiaries to shift revenue generated from U.S. operations, thereby avoiding U.S. taxes. For instance, in 2011, it used this scheme to shift "$8 billion in income offshore," according to Levin. "Yet, over 85% of Microsoft's research and development is conducted in the United States."

Microsoft's basing of U.S. product distribution from Puerto Rico has saved the company more than $4.5 billion over three years' time, according to Levin.

"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 wrote.

Microsoft evades U.S. taxes by setting up foreign companies that are located in low-tax-rate countries, which then do business with subsidiaries that aren't liable to pay taxes under U.S. Subpart F "check-the-box" rules. Microsoft began constructing this complex foreign subsidiary arrangement in the 1990s, according to the memo, setting up "regional operating centers" in Ireland, Singapore and Puerto Rico. The Ireland center sells to Europe, the Middle East and Africa. The Singapore center supports sales in Asia. Microsoft's Puerto Rico regional operating center is concerned with retail sales in North and South America. These regional centers then work with other companies, which are set up specifically to exploit a tax loophole. For instance, Microsoft has one entity, based in Bermuda, that works with the Singapore center. It has no employees, according to Levin.

Microsoft hasn't exactly been hiding this arrangement. A rough sketch is provided in its 103-page fiscal-year 2012 Form 10-K report, on page 32:

"Our effective tax rates for fiscal years 2012 and 2011 were approximately 24% and 18%, respectively. Our effective tax rates were lower than the U.S. 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 centers in Ireland, Singapore, and Puerto Rico, which have lower income tax rates."

In prepared remarks for the senate panel, William J. Sample, corporate vice president for worldwide tax at Microsoft, confirmed that the location of the regional centers was chosen based on tax considerations.

"While the primary objective of our regional structure is to improve our competitiveness and efficiency in each of the three regions, we evaluated available tax incentives when deciding where to locate the ROCs," Sample stated. He claimed that Microsoft has made "very limited use" of some exceptions in the U.S. tax laws, including the controlled foreign corporation "look through" rule, which allows companies to discount its subsidiaries for tax purposes, and an exception associated with foreign-controlled companies loaning back money to Microsoft in the United States.

This latter loophole, which exploits a clause in Section 956 of the Internal Revenue Service code on short-term loans, was championed by HP, according to Levin. HP uses controlled foreign corporations to loan back money to its U.S.-based entity within 30-day intervals to avoid paying taxes on the income. It's a "de facto repatriation" scheme that taps HP's subsidiaries in Belgium and the Cayman Islands.

"Over the years, loans by these two entities have provided billions of dollars to fund general operations for HP in the United States, including payroll and HP share repurchases," the memo explains. It added that this "staggered loan" scheme got a sign-off by HP's auditor, Earnst & Young.

Seeking Another Way?
Levin's memo pointed to an earlier Congressional report showing that corporations have been paying less and less tax over the years. Companies paid 32.1 percent of all U.S. federal tax revenue in 1952, but they currently just contribute 8.9 percent. Meanwhile, the rate of federal tax contributions by individuals has stayed about the same at 42.2 percent in 1952 and 41.5 percent today.

Microsoft and HP voluntarily cooperated with the senate investigation. It doesn't appear that they are being accused of breaking the law. Republican Senator Coburn put the blame on Congress.

"Tax avoidance is not illegal," Coburn said, according to a Reuters report. "Congress has created this situation."

Companies that violate the spirit of the law, like HP and Microsoft, potentially face cash shortages in the United States as a result of these foreign subsidiary tax-routing schemes. So, it's possible that they may want to reform the system, too, but on their own terms. Levin simply said that the Senate panel was convened to "generate some enthusiasm" to fix the system, which has devolved into the regular use of "legal contortions" and "gimmicks" by U.S. corporations.