Microsoft’s $28.9B Tax Battle Highlights Rising Transfer Pricing Risks for GCs

In October, Microsoft announced that it had received a demand for $28.9 billion in back taxes from the IRS, plus penalties and interest. The demand relates to a long-running transfer pricing dispute concerning the use of regional centers in Singapore, Dublin and Puerto Rico to distribute software, reducing Microsoft’s effective tax rate.

Microsoft has stated that it will contest the IRS’s demands, arguing that its existing provisions for tax contingencies are adequate. Nevertheless, the announcement shows the scale of transfer pricing risks and raises the question of how General Counsel should help mitigate those risks.

Other high-profile groups affected by large transfer pricing liabilities include Coca-Cola, which faces a $12 billion tax bill if a 2020 ruling of the U.S. Tax Court in favor of the IRS is not overturned. There is also the case of McDonald’s which, in 2022, agreed to pay €1.245 billion in back taxes and fines to the French tax authorities, in connection with intra-group franchise fees.

Transfer pricing risks are not confined to ultra-large corporates. Every business with cross-border operations should assess transfer pricing risks and put in place appropriate systems to manage them. As a minimum, this should involve documenting the legal and economic substance of related-party transactions through appropriate intercompany agreements. This is an area that requires cooperation between legal and tax functions.

What is transfer pricing?

Transfer pricing (‘TP’) refers to the international set of tax rules that determine the level of intercompany charges (e.g. service fees, royalties, prices for goods, loan interest, etc.) which may be ‘properly’ paid (from a tax perspective) between associated entities, and which in turn affect where profits are made and taxed.

The Organisation for Economic Co-operation and Development (OECD) has adopted the arm’s length principle as the international standard for determining ‘proper’ transfer prices for tax purposes. According to that principle, transactions between associated enterprises have to be priced as if the enterprises were independent entities engaging in comparable transactions under similar circumstances.

In other words, tax authorities can review an entity’s transactions with a related party and tax the entity on the profits it would have made, had that transaction been negotiated between independent third parties. This creates a risk of double taxation, because a TP adjustment demanded by one tax administration may not be approved by the jurisdiction(s) at the other ‘end’ of the transaction. Significant interest and penalties can also apply.

The starting point for TP analysis is to identify the ‘actual transaction’, including functions performed, assets contributed, and the contractual allocation of risk between the parties. Many tax administrations expect intercompany agreements to be entered into in advance, not after the event. Some countries (such as Germany) go further, and expressly state that the arm’s length principle is to be applied on the date when the relevant intercompany agreements are concluded, not when the relevant services, etc. are performed.

Intercompany agreements are often among the first documents requested in a TP audit. If related party transactions are not documented by appropriate intercompany agreements – and if those agreements are not aligned with TP policies – the taxpayer is exposed to unnecessary tax liabilities, as well as the risk of protracted inquiries, audits and disputes. This was the situation in the Coca-Cola litigation mentioned above: the group’s TP policies were directly contradicted by the terms of its intercompany agreements, specifically regarding the ownership of IP rights.

Key takeaways for General Counsel

General Counsel are accustomed to prioritizing and managing risks. The following key steps are suggested to manage TP risks arising from defective intercompany agreements:

1. Ensure that all group entities (including branches/establishments) have been correctly identified.
2. Ensure that the group’s intercompany agreements are stored in a comprehensive central, online repository. This may be ‘owned’ by the tax, legal or compliance function, as appropriate.
3. Carry out a sample review of existing agreements, entities and transactions, to identify any gaps in coverage of intercompany transactions, and any non-alignment between agreements and TP policies.
4. Create a plan to fix gaps and to re-align agreements and policies as needed.
5. Confirm ongoing roles and responsibilities for maintaining intercompany agreements. This should include, as a minimum, an annual review of agreements to reflect any changes in the group and its TP policies.