In recent court filings made in various federal district courts in Washington and California, the Internal Revenue Service is seeking to enforce testimonial summonses issued to current or former Microsoft employees, including former CEO Steven A. Ballmer. The summons had been issued earlier this fall. Microsoft’s outside tax counsel responded to the summonses by stating that the various witnesses would not be made available to the Service. The summonses were issued to obtain information relevant to Microsoft’s internal pricing of intangibles transferred under two separate cost-sharing arrangements for tax years 2004-2006.

An earlier summons further directed the company “to appear on November 20, 2014, and to produce for examination books, records, papers, and other data.” Court proceedings were initiated on December 11 to enforce the summons alleging that while Microsoft appeared on the designated date it failed to fully comply in “producing all the books, records, papers, and other data as demanded in the summons.”

Microsoft recently filed a motion to hold a status conference before the applicable court(s) would issue an order to show cause to “enable the Court to gain a clearer understanding of the factual and procedural background and Microsoft’s affirmative defenses, to clarify the potential scope of the enforcement proceeding, to establish a briefing schedule, and to discuss whether an evidentiary hearing would be helpful to the Court.”

The Department of Justice Attorneys, on behalf of the United States, objected to such requests and informed the Court that it had previously filed at least 11 related summons enforcement actions. In addition to the individual summonses mentioned above, two related summons enforcement actions had been filed against Microsoft directly and one against a consultant.

The IRS has to decide on which of two options it must take before the statute of limitations on assessment expires on December 31, 2014. The first option would be to issue a statutory notice of deficiency or, in order to stay the statute of limitations from expiring, to timely petition to enforce the outstanding summonses. Apparantly the government is pursuing the later strategy but it is still possible that the government will move ahead with issuing a stat notice.

Summons Enforcement Filing Against Former Microsoft CEO Steven Ballmer

The enforcement action against Ballmer was filed by the government in the U.S. District Court for the Western District of Washington under 26 U.S.C. Sections 7602, 7609. In its complaint the government stated that the IRS is conducting an examination of the federal income tax liabilities of Microsoft Corporation and includible subsidiaries (“Microsoft”) for the taxable periods ending June 30, 2004, June 30, 2005, and June 30, 2006. Understanding the role of sales and marketing in generating profits, the pleading asserted, is central to evaluating Microsoft’s transfer pricing valuations related to its cost sharing arrangements. This relationship was at the heart of the examination that the Service wanted to conduct from former CEO Ballmer who served in such capacity for 14 years, 2000-2014.

In interviews conducted by the IRS in September and October 2014, current Microsoft employees repeatedly identified Mr. Ballmer as a central decision maker with overall responsibility for sales and marketing priorities and strategies. Microsoft’s 2005 10-K also identifies Mr. Ballmer as the “chief operating decision maker” responsible for “deciding how to allocate resources and in assessing performance.” The testimony sought from Mr. Ballmer may be relevant to the IRS’s consideration of whether the transfer pricing Microsoft adopted for its Asia-Pacific and Americas (the United States, Canada, and Latin America) cost sharing arrangements satisfies the arm’s length pricing standard under 26 U.S.C. § 482 and the regulations thereunder. More specifically, Mr. Ballmer’s testimony may be relevant to evaluating the role of sales and marketing in Microsoft’s operations in the Asia-Pacific and Americas regions, and the relative value of non-technology intangibles in those operations.

Cost-Sharing Arrangements For The Years In Issue In Microsoft: 2004-2006

Congress, in enacting Section 482, wanted to provide the Internal Revenue Service with an appropriate policing statute to prevent affiliates or other related taxpayers from engaging in tax evasive transactions and ensure that taxpayers clearly reflect income relating to transactions between controlled entities. Section 482 therefore authorizes the Commissioner to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among controlled entities if he determines that such distribution, apportionment, or allocation is necessary to prevent evasion of taxes or to clearly reflect the income of such entities. In determining the true taxable income, “the standard to be applied in every case is that of a taxpayer dealing at arm’s length with an uncontrolled taxpayer.” Treas.Reg. Section. 1.482-1(b)(1).

With respect to intangible property, Section 482 provides that in the case of any transfer of intangible property the income with respect to the transfer shall be commensurate with the income attributable to the intangible. In a qualified cost-sharing arrangement, controlled participants share the cost of developing one or more items of intangible property. Treas. Reg. Section 1.482-7(a)(1). When a controlled participant makes preexisting intangible property available to a qualified cost-sharing arrangement, that participant is deemed to have transferred interests in the property to the other participant and the other participant must make a buy-in payment as consideration for the transferred intangibles. Treas. Regs. Sections. 1.482-7(g)(1) and (2).

The buy-in payment, which can be made in the form of a lump-sum payment, installment payments, or royalties, is the arm’s-length charge for the use of the transferred intangibles. Treas. Regs. Sections 1.482-7(g)(2), (7).
Section 1.482-7(g)(2), requires buy-in payments to be determined in accordance with Treas. Regs. Sections 1.482-1 and 1.482-4 through 1.482-6.

Treas. Reg. Section 1.482-4(a) provides: (a) In general. The arm’s length amount charged in a controlled transfer of intangible property must be determined under one of the four methods listed in this paragraph (a). Each of the methods must be applied in accordance with all of the provisions of Treas. Reg. Section 1.482-1, including the best method rule of Treas. Reg. Section 1.482-1(c), the comparability analysis of Treas. Reg. Section 1.482-1(d), and the arm’s length range of § 1.482-1(e). The arm’s length consideration for the transfer of an intangible determined under this section must be commensurate with the income attributable to the intangible. See Treas. Reg. Section 1.482-4(f)(2) (Periodic adjustments). The available methods are — (1) The comparable uncontrolled transaction method, described in paragraph (c) of this section; (2) The comparable profits method, described in Treas. Reg. Section 1.482-5; (3) The profit split method, described in Treas. Reg. Section § 1.482-6; and (4) Unspecified methods otherwise described in the regulations.
Where the recipient of the intangibles fails to make an arm’s-length buy-in payment, the Commissioner is authorized to make appropriate allocations to reflect an arm’s-length payment for the transferred intangibles. Treas. Reg. Section 1.482-7(g)(1). The Commissioner’s authority to make Section 482 allocations is limited to situations where it is necessary to make each participant’s share of costs equal to its share of reasonably anticipated benefits or situations where it is necessary to ensure an arm’s-length buy-in payment for transferred preexisting intangibles. Treas. Reg. Section 1.482-7(a)(2). See Veritas v. Comm’r, 133 T.C. 297 (2009).

Subsequent Years’ Revised Regulations Under Cost-Sharing Arrangements

Although not in issue in the Microsoft audit, the IRS has published temporary regulations in 2009 (T.D. 9441) and then final regulations in 2011 (T.D. 9568) on determining taxable income from cost-sharing arrangements (CSAs) under section 482.

The final regulations provide guidance on the determination of and compensation for all economic contributions by all controlled participants of a CSA in accordance with the arm’s-length standard. For purposes of determining the best method of measuring the arm’s-length results of a CSA and any related controlled transactions, the final regulations employ the same standards used in the temporary regulations in 2009 on assessing the potential applicability of the comparable uncontrolled transaction method. The final regulations also adopt the specified income method, the specified residual profit-split method, the acquisition price method, and the market capitalization method. Additional changes were made in the 2011 regulations with respect to qualified CSAs.