U.S. v. Microsoft Corp., 2020 U.S. Dist. LEXIS 8781 (W.D. Wash 1/17/2020)
Cost-sharing arrangements heavily promoted by Big-4 accounting firms nearly 20 years ago are in the tax news. The Government is conducting an examination of Microsoft’s federal income tax liabilities for the years 2004-2006. A primary focus of the examination relates to cost-sharing arrangements by which ownership of intellectual property occurred between Microsoft’s foreign and domestic subsidiaries. Such transfers are required by federal tax laws to meet an arm’s length standard such that trades between related affiliates are on comparable terms to trade among unrelated parties. The Government is of the view that Microsoft’s cost-sharing plans did not meet this standard; with the result that it impermissibly shifted revenue out of the U.S., through more favorable foreign tax treatment.
Microsoft asserts in the case that certain documents requested to be produced by the Government must be protected and are privileged.
Microsoft sought for years to use a foreign subsidiary in Puerto Rico, obtaining favorable foreign tax credits. The credit was eliminated from the Code, and Microsoft was ready to shut down this country’s operations. KPMG recomended that these Puerto Rico operations get restructured to create a new deferral structure, through a cost-sharing arrangement. Microsoft claims that it employed KPMG to help the lawyers provide legal advice and to give its own tax advice. Also, that materials were prepared in anticipation of litigation with the IRS.
Microsoft had the burden of proving that documents sought by the Government were protected, as work product. Documents serving dual purposes–supporting litigation preparation and ordinary conduct of business–raises the issue as to whether the documents were created “because of litigation.” On that, courts look at whether their creation, their litigation purpose so permeates any non-litigation purpose that the two purposes cannot be discretely separated from the factual nexus as a whole. None of the documents sought were protected by the work product doctrine.
7525 (federally authorized tax practitioner privilege) was also asserted. However, communications made primarily to assist in implementing a business transation are not protected under this privilege. The primary purpose of the communication must be the provision of tax/legal advice.
The court also held that a significant purpose, if not the sole purpose, of Microsoft’s transactions was to avoid or evade federal income tax. The court noted that the only explanation Microsoft gave is that it entered into these cost-sharing arrangements to replace annual disputes over its licensing and royalty scheme. The tax savings appear to have driven the decision-making process.
The court employed in camera proceedings to determine that all of the requested documents were created by KPMG “promoted” the transactions. KPMG originated and drove the structuring of the transactions and that but-for its promotion, Microsoft may not have pursued the same or similar transactions. The outcome serves the public interest because the advice given by KPMG as to FATP strayed from compliance and consequences to promotion of tax shelters. The FATP simply does not apply.
