How Microsoft and HP avoid corporate taxes

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It’s no secret that some of America’s largest corporations engage in complicated accounting in order to minimize their taxes. However, materials released as part of a U.S. Senate subcommittee hearing last week revealed that technology companies like Apple, Cisco, Microsoft, and Hewlett-Packard are among the companies going to the greatest efforts to shelter their revenues — and some of those efforts seem to violate the intent (if not the letter) of U.S. law.

“Major U.S. corporations are increasingly earning their profits here but shipping them overseas to avoid paying the taxes they owe,” wrote Michigan Senator Carl Levin (D), chairman of the Senate’s Permanent Subcommittee on Investigations. “At a time when we face such difficult budget choices, and when American families are facing a tax increase and cuts in critical programs from education to health care to food inspections to national defense, these offshore schemes are unacceptable.”

Are technology companies paying their fair share in taxes? Or are they just using the system as efficiently as possible so they can stay competitive? The subcommittee looked closely at how two companies — HP and Microsoft — are avoiding tax liabilities — and the results are surprising.

How it works

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The basic dilemma is that most tax codes are enforceable only within particular geographic borders (like a county, a state, or a nation), but most of the largest companies headquartered in the United States do business all over the world — hence, they function in a variety of different tax jurisdictions. In the United States, the base corporate tax rate is 35 percent; however, it’s much lower (or even non-existent) in other parts of the world. It makes sense that companies would try to find ways to take advantage of any difference in tax laws in the different areas where they operate — after all, their competitors are going to do the same thing. Any dollar companies don’t have to pay in taxes is another dollar tacked onto its bottom line.

In pre-Internet days, these differences in tax structure weren’t make-or-break problems for governments. After all, if you build cars — or make raw materials like steel — geographic limitations will effectively limit where you can sell those products. However, in the digital economy, those restrictions have largely vanished. Digital content like music, movies, e-books, apps, and software can largely be sold to anyone in the world from anywhere in the world, making it easy for companies to pick and choose the jurisdictions where — on paper, anyway — they’re conducting business. So subsidiaries in tax-favorable jurisdictions like Ireland, the British Virgin Islands, Singapore, and the Netherlands conduct mammoth amounts of business for technology firms.

Percent of tech companies’ cash
kept overseas
HP 100
Microsoft 89
Cisco 89
eBay 88
Dell 85
Oracle 84
Apple 67      
Qualcomm 62
Google 48

Technology companies have another advantage over traditional businesses because a significant portion of their revenues comes from royalties and intellectual property, like patent and technology licensing. Again, their businesses can be conducted anywhere — and companies based in the U.S. don’t seem to have any problem with taking those transactions out of the country.

The tax code hasn’t evolved to keep up, and tech companies are enthusiastically taking advantage of the situation. For instance, of the 500 companies in the Standard & Poor’s 500 index, 71 would be generally classified as technology companies. Those 71 companies report paying worldwide tax rates as much as a third lower than other S&T companies over the last two years. Senator Levin said U.S. multinationals keep as much as $1.7 trillion offshore.

Microsoft

Microsoft building entrance

The Senate subcommittee specifically took a look at how Microsoft and Hewlett-Packard manage their tax burdens, noting that their practices seem to be representative of the technology industry as a whole. The two firms also seem to be among the most invested in the practices. According to materials compiled for the committee from industry estimates and company reports, Microsoft has almost 90 percent of its total cash overseas, while HP maintains virtually no cash in the United States. The subcommittee issued subpoenas and sent letters of inquiry to both companies to get information that isn’t normally revealed in regulatory filings or investor disclosures.

Microsoft’s basic strategy developed in the 1990s, when the company set up a regional operating center in Ireland responsible for retail sales in Europe, the Middle East, and Africa. The Ireland subsidiary was followed by subsidiaries in Singapore (handling retail sales in Asia) and Puerto Rico (handling retail sales in North and South America). Of the $9.1 billion Microsoft spent on R&D in 2011, some $7.8 billion was spent developing Microsoft product in the United States — and Microsoft reaped $200 million in tax credits for conducting that R&D stateside.

These subsidiaries have the right to profit from sales of Microsoft’s intellectual property, while Microsoft itself retains ownership. Basically, if European sales account for 30 percent of Microsoft’s global revenue, Microsoft collects 30 percent of its revenue back from its Irish subsidiary towards the cost of research and development. The rest of the money stays offshore. From 2009 to 2011, that meant some $21 billion in revenue collected by Microsoft — for products developed and sold in the United States — was not subject to U.S. taxes. That’s about half of Microsoft’s U.S. retail sales net revenue, and about $4.5 billion in taxes successfully dodged.

But that’s not all. Microsoft’s subsidiaries are technically disregarded for tax purposes under look-through regulations for controlled foreign corporations (CFCs), and a “check-the-box” rule instituted in 2004 that enables corporations to declare themselves tax-exempt by, essentially, checking a box on a form. For Microsoft, that’s very handy. It means income that would previously have been immediately taxable — like royalty income from its subsidiaries selling software — becomes tax-exempt because it’s basically just considered a transfer of funds between two disregarded entities. This reduced Microsoft’s U.S. tax burden by another $2.43 billion in 2011 alone.

Hewlett-Packard

hp to combine pc and printer divisions sign

Hewlett-Packard is warehousing almost all its revenue offshore — which is intriguing, considering that HP is a very large employer in the United States. How does it fund its considerable U.S. operations? Through a series of alternating, short-term loans from a pair of foreign subsidiaries.

According to the subcommittee report (PDF): “This loan program, from at least 2008, appears to have been used as a way to de facto repatriate billions of dollars each year to the United States to fund most of HP’s U.S. operations, and provide those operations with the economic use of the company’s foreign earnings without a formal dividend distribution that would be taxable.”

Normally, when a CFC loans money to a related U.S. company or individual, the loan is considered taxable income. However, there are exceptions: One is that if the loans don’t span the CFC’s quarter ends and the loans are repaid within limited time periods. So HP used two subsidiaries — the Belgian Coordination Center and the Compaq Cayman Holding Corp. — which basically just function as separate cash pools for the parent company. The companies would loan HP money during particular windows, and HP would then use the money for payroll, stock repurchases, and even acquisitions. As the tax-related quarterly window came to a close, HP would receive a short-term loan from the other corporation, pay off the previous loan, and continue operating. The pattern of continuous lending spanned at least 2008 through 2011 — and HP paid no U.S. tax on that income.

HP’s auditors, Ernst & Young, knew about HP’s staggered loan program since its inception in 2008, and apparently signed off on the strategy, finding that, technically, the foreign entities were sufficiently independent and HP was meeting time restrictions for avoiding taxation on the loans. Nonetheless, the Senate subcommittee concluded that “it is clear from HP documents that it structured this program in an attempt to circumvent the spirit” of U.S. tax law.

Tech companies aren’t alone

global interonnection (Shutterstock/Toria)

These sorts of tax shenanigans aren’t limited to technology companies. The Senate subcommittee detailed 18 firms that have more than $5 billion stashed away in overseas accounts. Nine of them — half — are technology firms, and the committee noted that the use of foreign subsidiaries to shelter income from royalties and intellectual property is particular common in the industry. Four more — Pfizer, Medtronic, Merck, and Amgen — represent the pharmaceutical industry. The other firms are General Electric, Johnsons & Johnson, Coca-Cola, Walmart, and Devon Energy. Of those, only Pfizer and J&J appear to be in the same pattern as HP in keeping virtually all their cash outside the United States.

Although Senator Levin noted he doubts that HP’s staggered loan program was legal, Oklahoma Senator Tom Coburn (R) described both Microsoft’s and HP’s tax strategies as “properly legal tax avoidance.” Even though Coburn admitted they don’t look great on paper, he noted companies have a fiscal responsibility to do everything they can to minimize their tax burdens — particularly given the overwhelming complexity of U.S. tax code.

Both Microsoft and HP — who each had representatives appearing before the committee — characterized their company’s strategies as legal and in full compliance with U.S. tax code.

“Microsoft complies with the tax rules in each jurisdiction in which it operates and pays billions of dollars each year in total taxes, including U.S. federal, state, and local taxes and foreign taxes,” Microsoft’s VP for worldwide tax William Sample noted in prepared remarks (PDF). At the same time, he noted tax considerations do figure into Microsoft’s decisions on setting up subsidiaries. “The U.S. international tax rules are outdated and are not competitive with the tax systems of our major trading partners.”

Lester Ezrati, HP’s senior VP of tax, defended the company’s staggered loan program as funds that qualified for “indefinitely reinvested” status under U.S. tax law, and HP’s U.S. parent corporation did have enough cash flow so that overseas money wasn’t actually necessary. Moreover, Ezrati noted none of its actions were secret to the IRS: The company outlined the loan program in detail to its auditors, Ernst & Young, and has continually worked with the IRS to establish an advanced pricing agreement that would cover how overseas funds are repatriated. He also noted the IRS didn’t raise any issues with the loans during a recent audit.

Ultimately, the only thing all parties agreed on was that the U.S. tax code needs an overhaul.

“We comply with U.S. and foreign tax laws,” Sample said during the hearing. “That is not to say that the rules cannot be improved.”

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