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How Microsoft avoided billions in taxes, and what the GOP says it will do about it

Rep. Paul D. Ryan (R-Wis.) and Sen. Mitch McConnell (R-Ky.) watch President Trump deliver his inaugural address Jan. 20. (Chip Somodevilla/Getty Images)
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On paper, Microsoft’s facility in Puerto Rico was wildly profitable. With just 177 workers, the plant recorded $4 billion in earnings in 2011, a Senate investigation found.

The gimmick was entirely legal. According to the Senate’s report, the software company’s lawyers were channeling its profits from sales all over the country through the Puerto Rican operation, getting Microsoft out of about $1.5 billion in taxes a year.

It was the kind of scheme that designers of congressional Republicans’ tax proposal hope to eliminate. The vast sums Microsoft saved hint at how much money is at stake for corporations that rely on similar strategies to reduce their taxes, which are especially common among technology firms and other companies with valuable brands, patents and copyrights.

Understanding the uncertain and potentially disruptive consequences of the GOP plan, known as a “border adjustment tax,” has become an urgent priority for U.S. firms — not just in Silicon Valley, but throughout the corporate sector, said John Gimigliano, a principal at KPMG in Washington.

“It is a pretty significant departure from the current system of taxation,” he said. “It’s almost impossible to talk about anything else.”

From Redmond to Puerto Rico

The Senate investigation into Microsoft’s taxes in 2012 described this kind of legal strategy in detail. First, Microsoft had sold a share of its brands and copyrights to its subsidiary in Puerto Rico. The U.S. territory’s rules for taxes are different from those that apply to businesses in the 50 states.

The Puerto Rican subsidiary made an impressive profit on that investment over the years — profits that would otherwise have accrued to Microsoft’s main office in Redmond, Wash., where they would have been subject to ordinary federal taxes.

Microsoft’s practices were typical, experts say. Many multinational firms set up subsidiaries in jurisdictions with minimal taxes — whether in Europe, Asia or the Caribbean — and then pay those subsidiaries for goods and services. Those payments come out of the income taxed in the United States.

In 2011, for example, the Puerto Rican entity paid $1.9 billion to the main U.S. company as an installment on its initial purchase of the intellectual property. Microsoft then manufactured copies of its software in Puerto Rico and imported it back onto the mainland for sale.

In 2011, the Puerto Rican subsidiary’s $4 billion in earnings were taxed at a rate of 1 percent.

“This structure is not designed to satisfy any specific manufacturing or business need,” the committee's report concluded. “Rather, it is designed to minimize tax on sales of products sold in the United States.”

Microsoft cooperated with the congressional investigation, according to the Senate report, which presented no evidence of wrongdoing or lawbreaking.

“In conducting our business at home and abroad, we abide by U.S. and foreign tax laws as written,” Microsoft vice president William Sample told the Senate Permanent Subcommittee on Investigations. “That is not to say that the rules cannot be improved — to the contrary, we believe they can and should be.”

A spokesman for Microsoft declined to comment on whether the company would support the GOP proposal or on whether the company's practices had changed.

Across oceans

Similar maneuvers are particularly prevalent among firms with patents, trademarks, copyrights and other valuable intellectual property. By signing a few contracts, a chief executive can move these assets across oceans. The profits associated with them go, too.

Firms that avoid taxes this way cost the U.S. government at least $100 billion a year, by one estimate. Alan Auerbach, an economist at the University of California at Berkeley predicted that the situation will worsen as the economy becomes more reliant on hip brands and lucrative patents.

“Companies with a lot of intellectual property are doing this,” he said. “It’s one of the main problems of our tax system — especially going forward.”

Auerbach is one of the most vocal proponents of the border adjustment tax. Under the proposal, it could be more difficult for these companies to avoid U.S. taxes this way.

The plan would prevent companies from deducting any payments to foreign vendors from their income. Consequently, companies would not be able to reduce the taxes they owe through payments to subsidiaries abroad.

The investigation found that this system allowed Microsoft to shift 47 percent of its U.S. revenue to Puerto Rico in the form of payments for imported software.

A Republican bill could treat Puerto Rico similarly to a foreign jurisdiction for purposes of the tax, in which Microsoft would not be able to shift any of that revenue by paying its subsidiary to import software. It is also possible that Puerto Rico would be treated more like a state, in which case the Puerto Rico subsidiary would presumably have to pay regular federal taxes.

American brands

Yet while the GOP proposal could force some companies to pay up, the plan also includes an exemption for exports — so some businesses could pay less. Microsoft, for example, does extensive business overseas. As a result, the company could come out ahead.

Whether companies would pay more or less under the plan would depend on how many customers they have at home and abroad, where their intellectual property is legally located and to what degree exchange rates fluctuate once the plan is implemented.

“It really depends on each company’s individual profile,” said Kathy Michael, a tax partner at PricewaterhouseCoopers.

Microsoft is holding $109 billion in cash and equivalent reserves overseas from its sales in foreign countries. Under the current system, Microsoft would have to pay federal taxes on that money if the firm returns the cash to the United States. Under the Republican proposal, Microsoft’s future sales abroad would be free from U.S. taxation — and the company might even get a break on its existing pile of cash in the bargain.

Several multinational technology companies, including Dell, Google, Oracle and IBM, are supporting the Republican plan as part of an industrial coalition called the Alliance for Competitive Taxation.

The group’s other members include Abbott and Pfizer, which depend on their patented drugs, and iconic American brands such as Coca-Cola and Walt Disney.

“They basically think this is good for them,” said Reuven Avi-Yonah, a legal scholar at the University of Michigan.