Microsoft’s Cost-Sharing Arrangement: Frankenstein Strikes Again

“These provisions are necessary . . . to prevent foreign controlled entities from being established simply to participate in cost sharing arrangements.”¹

“This was a pure tax play.”²

“We want to beat the regs, so the sooner we get the structures in place the better. . . . Product flow does not change. Only structure of IP ownership will be altered.”³

“There are a lot of security issues around the ‘Crown Jewels’ and [Microsoft] will likely freak out if we ask them to move it [to a tax haven], but could possibly ‘duplicate.’”⁴

“The [cost-sharing arrangements] did not appear necessary to satisfy Microsoft’s operational needs. . . . The Court concludes that all of KPMG’s written communications were ‘in connection with promotion’ of a tax shelter.”⁵

I. Introduction

Microsoft Corp. is a global business whose worldwide revenue-generating operations have always been entirely managed, controlled, and substantially performed by Microsoft US from Redmond, Washington. According to facts developed in this report, virtually none of Microsoft’s key commercial exploitation activities were substantially performed, managed, or controlled outside the United States around January 5, 2009, as defined by reg. section 1.482-7(m)(1). That failure subjects Microsoft to a periodic trigger test under reg. section 1.482-7(i)(6) starting from that date.

Beginning around 1999, Microsoft began laying the groundwork to shift large amounts of its U.S. pretax income offshore to mostly low-substance tax haven affiliates, according to internal documents referenced later in this report. SEC filings show that in 1999 Microsoft’s foreign revenue and pretax income as a percentage of the U.S. figures were around 44 percent and 10 percent, respectively. By 2004 these figures reached 47 percent and 50 percent, and by 2008 they grew to 68 percent and 88 percent. Microsoft’s foreign pretax income was closing in on parity with U.S. figures despite the fact that in 2008 foreign employees and long-lived assets remained only a fraction of those in the United States — at 65 percent and 6 percent, respectively. By June 2009, just months after the 2008 cost-sharing arrangement (CSA) regulations took effect, Microsoft’s annual foreign revenue had increased by only $893 million from the prior year, but foreign pretax income exploded by multiples of this — around $3.2 billion. This strange result caused Microsoft’s foreign pretax income to exceed its U.S. income by about 60 percent. The offshore profit shifting continued to increase until Microsoft’s foreign pretax income as a proportion of U.S. income reached 1,292 percent in 2012, when its U.S. pretax income fell to 7 percent of its total, despite foreign personnel and long-lived assets remaining below the U.S. numbers.

Figures 1 and 2 depict Microsoft’s exponentially growing foreign income in 1999, 2004, 2008, 2009, and 2012, showing that foreign income overtook Microsoft’s declining U.S. income despite strong revenue growth in both locations and greater U.S. revenues in all years. These results on their face — but especially in the context of the company’s far greater productive capacities in the United States — raise substantial questions about Microsoft’s transfer pricing arrangements.

Microsoft has continued to shift what appears to be most of its U.S. profits offshore, with no apparent enforcement impact by the IRS, despite continuous audits of Microsoft’s returns for tax years that remain under examination after almost two decades, including partial settlements for years through 2013.⁶ As late as 2021, filings in Ireland showed that Microsoft Ireland Operations Ltd. (MIOL) reported about $28 million in revenue per employee — a remarkable figure that is about 3,435 percent times the U.S. figure reported in SEC filings.⁷ These fantastical foreign results appear to have been generated mostly by activities occurring in the United States.

Since January 2009 (the effective date of the 2008 transition regulation, discussed below), Microsoft has reported $319 billion in pretax income offshore, or around 62 percent of its total pretax income in the period. This figure is so much greater than the estimated cost-sharing payments by its foreign participants that these results could not fail to exceed the commensurate with income (CWI) limitation reflected in the 2008 reg. section 1.482-7(i)(6) cost-sharing periodic adjustment rule.

Treasury’s transition regulation, detailed below, sought to make it difficult, if not impossible, for taxpayers with preexisting sham-type, low-substance CSAs to be grandfathered and exempt from the accompanying periodic adjustment rule, which was also introduced in the 2008 CSA regulations. This transition rule, along with the periodic adjustment rule, were clearly intended to prevent further abuse of the CSA regulations and reflected an unambiguous congressional mandate in the Tax Reform Act of 1986 to implement a CWI mechanism into the statute and regulations for intellectual property transfers. The periodic adjustment mechanism for CSAs was implemented in reg. section 1.482-7(i)(6). A more general periodic adjustment mechanism applicable to all intangible transfers was already in place, in reg. section 1.482-4(f)(2).

Microsoft’s CSA, which had existed since around 1999, was considered a preexisting CSA for purposes of the 2008 cost-sharing regulations and was thus subject to the transition rules under reg. section 1.482-7(m)(1). When satisfied, the transition regulation would exempt a preexisting CSA from the newly introduced CSA periodic adjustment mechanism. However, the transition regulation could be satisfied only if specific technical requirements were met. Among them was the requirement that the arrangement comply with former regulations that existed more than a decade earlier: the reg. section 1.482-7A cost-sharing regulations (T.D. 8632), as they existed on January 1, 1996. These former regulations contained an individual exploitation requirement, together with onerous participation rules at reg. section 1.482-7A(c)(1)-(3).⁸ Those rules referenced reg. section 1.367(a)-2T(b)(2) (rules that now appear in reg. section 1.367(a)-2(d)(2)), which required that the foreign CSA participant “perform every operation which forms a part of, or a step in [the] . . . process by which an enterprise may earn income or profit . . . outside the United States.”

The January 1, 1996, date of the former regulations chosen by Treasury was no mistake. These participation requirements under reg. section 1.482-7A(c)(1)-(3), which were effective January 1, 1996, were removed only a few months later, in May 1996. However, Treasury’s reference to these regulations as they existed on January 1, 1996, precluded consideration of any later amendments, even if they were retroactive to that date.

This report finds that Microsoft’s preexisting CSA did not comply with the 2008 transition regulation. This is because Microsoft US has historically performed, managed, or controlled the key exploitation functions that generated its foreign territory revenue and profits throughout the period under review but most importantly on January 5, 2009. This means that Microsoft’s foreign CSA affiliates booked substantial nonroutine profits for (1) performing only routine activities that in any case did not meet the thresholds for qualifying exploitation-type activities required by the transition rules; and (2) contractually assuming risks that were fully managed and controlled by Microsoft US. These foreign entities had neither the capability nor the capacity to manage or control themselves beyond their routine activities. Such facts apparent in January 2009 would subject Microsoft’s CSA to a periodic adjustment trigger test under reg. section 1.482-7(i)(6) beginning in January 2009 (midway through Microsoft’s June 30, 2009, fiscal year).

This report is based on limited information and assumes that since 2009, there was one CSA that included three Microsoft foreign participants — in Puerto Rico, Ireland, and Singapore — up to 2017, when Microsoft changed its CSA to include only one foreign participant, in Ireland.⁹ According to facts presented in this report, each of Microsoft’s foreign CSA participants individually failed the reg. section 1.482-7(m)(1) transition regulation in January 2009, and Microsoft’s entire CSA therefore did not comply with the transition regulation. Accordingly, Microsoft’s CSA would have technically been invalid on January 5, 2009. However, the IRS continued to respect Microsoft’s CSA even to the present. As a result, Microsoft’s CSA is treated by that regulation as having started over on January 5, 2009, as a new CSA covered by all provisions of the 2008 reg. section 1.482-7 regulations effective on that date.

Such a periodic adjustment applied from 2009 through 2022 could result in a tax charge of about $83 billion or more for those years (net of repatriation taxes paid because of the Tax Cuts and Jobs Act of 2017). Microsoft could also be subject to the 40 percent gross valuation misstatement penalties under section 6662(h), together with interest, which has been calculated in this report assuming a 2017 adjustment year and a 2022 determination date.

II. Congress Mandates, IRS Ignores

According to the conference report for TRA 1986, CSAs must distribute profits between the participants in a manner that reasonably reflects the actual economic activities undertaken by each participant. Under this standard, if the principal expense of a foreign tax haven participant is the cost-sharing payment itself with few other nonroutine economic activities — as has been the case with many a sham, low-substance, or tax-motivated arrangement, as well as Microsoft’s — this violates the CWI provision. The conference report states: “The objective of these [CWI] provisions [is] that the division of income between related parties reasonably reflect the relative economic activity undertaken by each.”¹⁰ (Emphasis added.)

Those provisions forced CSA participants to not only undertake actual economic activities associated with the exploitation of the CSA-covered IP in their defined territories but to also contribute their separately owned intangibles to the cost-shared intangible development program. This was accomplished in the 2008 regulations by setting limits on the returns to the CSA investments made by a participant. For example, periodic adjustments could be imposed on a foreign participant if it experienced an actual return on its CSA investments that exceeded 150 percent in any of the first 10 years of a new CSA under the 2008 regulations. If triggered, the periodic adjustments would be applied using a residual profit-split method (RPSM) that split nonroutine profits between the participants based on the relative value of their nonroutine contributions (intangible and services) to the joint endeavor. As such, if a foreign CSA participant provided no platform contributions or other relevant nonroutine contributions to the CSA and its return exceeded the 150 percent CWI threshold at any time in this 10-year period, effectively all the nonroutine profit booked by these foreign affiliates from the point of trigger would become taxable in the hands of the relevant U.S. group member participant. This would then continue for not only the adjustment year but for every year thereafter for the life of the arrangement.

Recent developments have shown that the periodic adjustment regulations are consistent with the legislative history and statutory text invoking them. For instance, the court in Altera¹¹ concluded that the periodic adjustment rule in reg. section 1.482-7 comports with the arm’s-length standard for purposes of U.S. tax law. Any taxpayer facing a periodic adjustment would presumably find it extremely difficult to overcome this relatively objective adjustment, which is based on a rote calculation. This would be even more so in situations in which a foreign CSA participant has provided no platform contributions or other relevant nonroutine contributions to the CSA. Taxpayers using CSAs agreed to follow and be bound by reg. section 1.482-7, including its periodic adjustment provisions, when they voluntarily elected cost-sharing treatment for their IP transactions over the conventional methods, such as a licensing fee method, found in reg. section 1.482-4.

We are unaware of the IRS having ever enforced either of the two periodic adjustment regulations (reg. sections 1.482-4(f)(2) and 1.482-7(i)(6)) despite Congress’s clearly stated intent that the IRS give ”primary weight” to “the profit or income stream generated by or associated with intangible property” — a view recently supported in a three-part article by Ryan Finley, a contributing editor at Tax Notes who focuses on transfer pricing.¹² The blue book for TRA 1986, echoing an earlier House Ways and Means Committee report,¹³ summarized some of the congressional guidance included in the legislative record:

Congress intended that consideration also be given to the actual profit experience realized as a consequence of the transfer. Thus, Congress intended to require that the payments made for the intangible be adjusted over time to reflect changes in the income attributable to the intangible . . . [I]t will not be sufficient to consider only the evidence of value at the time of the transfer. . . . [T]he profit or income stream generated by or associated with intangible property is to be given primary weight.¹⁴ [Emphasis added.]

Rather than applying profit-based periodic adjustments ex post and giving them primary weight in the enforcement of CSAs, the IRS has in fact avoided periodic adjustments under both of the above periodic adjustment regulations and instead continued to apply ex ante transactional methods to value only buy-in payments. By all accounts, this has been an enforcement disaster. Indeed, the CWI standard itself was “reworked” by the IRS to fit into its preferred ex ante approach in a March 2007 advice memorandum by the Office of Chief Counsel, which said:

The word “income” in the phrase “commensurate with the income attributable to the intangible” in section 482 should generally be construed as operating profits attributable to the intangible the taxpayer would. . . have projected at the time it entered into the controlled transaction.¹⁵ [Emphasis added.]

The IRS, in its discretion, provisionally may treat actual profits as evidence of projected profits and make periodic adjustments as if such results were projected at the time of the controlled intangible transfer.¹⁶ [Emphasis added.]

This seems inconsistent with both the “primary weight” guidance expressly intended by Congress for testing actual ex post income from exploiting the IP and for the periodic adjustment regulation (reg. section 1.482-7T(i)(6)) that became effective less than two years after this memorandum.

In ongoing litigation with the IRS, Facebook Inc. has argued that its compliance with the ex post trigger mechanism in reg. section 1.482-7(i)(6) in the initial years after a 2010 intangible transfer means that the original pricing of Facebook’s intangible transfer under reg. section 1.482-7(g) must be respected.¹⁷ The IRS disagrees, maintaining that Facebook’s actually experienced return ratio (AERR) is irrelevant in the case. Whether its AERR for 2010 is inside or outside the periodic return ratio range (PRRR) “has no bearing on the outcome of this case,” according to the IRS.¹⁸

We believe the IRS is applying a technical argument based on the structural separation and different coverages within reg. section 1.482-7: paragraphs (g) (ex ante pricing of intangible transfers) and (i)(6) (application of periodic adjustments based on ex post income). While the IRS may have a technical argument for its approach, it is clear that the AERR calculation and its being within the PRRR can legitimately be raised by Facebook as evidence of the reasonableness of its 2010 intangible transfer pricing and its compliance with the statute. Perhaps the Tax Court will be swayed by that claim.¹⁹

It is hoped that this Facebook controversy, which has focused so much attention on the periodic adjustment mechanism, will give the IRS an understanding that it should be actively using the two periodic adjustment regulations as the regulatory tools they were meant to be.

The IRS’s chosen ex ante approaches have in some cases created so-called reverse-enforcement outcomes because the agency challenged what appeared to be compliant arrangements while not challenging flagrantly obvious noncompliant ones. For instance, the IRS issued an advance pricing agreement for at least one sham CSA with a tax haven shell company²⁰ while challenging multiple arrangements that appeared to be completely compliant. This latter category included CSAs in which the U.S. participant booked 100 percent of the profits of the arrangement and the foreign participant earned only losses. Those situations would presumably result in an AERR within or below the PRRR, meaning that there would be no trigger under the reg. section 1.482-7(i)(6) trigger mechanism. Again, this is one item of evidence suggesting that the taxpayer’s pricing may have been compliant — at least for the years under exam. Both Amazon.com and Facebook Inc. exhibited exactly this fact pattern in most or all of the years under challenge in the Tax Court. The IRS lost the Amazon CSA dispute in 2017 and is defending its challenge to Facebook in the Tax Court.²¹ Concurrent with its failed challenge against Amazon.com, the IRS approved an arrangement (with U.S. tax refunds) at an Amazon competitor in which all profit-generating activities were located in the United States but the foreign participant, a tax haven shell company, recorded almost 100 percent of the CSA-related IP profits — or around 87 percent of the company’s total profits.²² This, of course, continues a long history of IRS failures to detect or successfully challenge violations of U.S. transfer pricing laws by corporations, as one of us noted in 2020:

Between 1979 and 1994, the IRS consistently lost every major transfer pricing case it litigated, including those against U.S. Steel Corp., Bausch & Lomb Inc., HCA Healthcare, Eli Lilly and Co., G.D. Searle LLC, Ciba-Geigy AG, Sundstrand Corp., and Merck & Co. Inc. After the new transfer pricing regulations were issued in 1994, there was a hiatus in transfer pricing litigation. When cases resumed, the IRS continued losing, including against DHL Corp. (1998), UPS (1999), Compaq (1999), Xilinx Inc. (2005), Veritas Software Corp. (2009), Medtronic Inc. (2016), and Amazon.com Inc. (2017).²³

Importantly, as this report and the previous five reports in this series show,²⁴ the subject taxpayers actually ramped up their CSA-related profit shifting even more dramatically after the 2008 regulations became effective in January 2009, contributing to a record $3 trillion of profits located by U.S. multinationals in low-tax jurisdictions.²⁵

Given the size of some of these adjustments and the almost certain prevalence of violations by many other taxpayers, initiating enforcement of the periodic adjustment under reg. section 1.482-7(i)(6) could have a substantial impact on outbound profit shifting and the U.S. tax gap. That is because the cost-sharing regulation’s periodic adjustment trigger test is almost totally prescriptive and often involves no unreliable or contestable analyses of comparables — unlike previous IRS enforcement efforts, which mostly targeted only buy-in payments under ex ante approaches. These approaches involved purely speculated results whose reliability is by definition more contestable than the ex post analyses of actual profit results inherent in the congressionally mandated CWI approach. It may be difficult for taxpayers to even challenge the trigger test of the periodic adjustment regulations because taxpayers voluntarily elected to choose CSA treatment over conventional licensing methods, a choice that could be interpreted as a contract with the IRS (an explicit contract if covered by an APA). Contesting a contractual provision, or the remedy prescribed for violating the provision, that the taxpayer considered, agreed to, and then promptly violated would appear to be a non-starter in almost any unrelated contractual relationship, according to this view.²⁶

The IRS has yet to enforce the existing CSA periodic adjustment regulation against any offending taxpayer in the many years since its promulgation; however, the agency could do so at any time. The regulation operates in a way that effectively suspends the statute of limitations by accumulating the relevant violations over time and accounting for them in an “adjustment year,” which can be any open tax year. Based on the published reviews of the six large taxpayers in this series (including Microsoft), this must be a widespread problem.

This series documents how the “Frankenstein” U.S. cost-sharing regulations have completely thwarted and in some cases reversed the arm’s-length standard by enabling a disastrous “externality” of gargantuan foreign nonroutine profits for only small, routine contributions that often consist of only round-tripped cash payments for research and development by tax haven shell companies. In short, on the surface, a CSA represents a simple election to divert a portion of the funding for often exclusively U.S.-conducted R&D to a foreign group member for no apparent business purpose. At the same time, through this election, the CSA effectively relocates to this foreign group member — which, in at least some cases, lacks any economic substance — the entirety of revenue and profits economically earned by a U.S. group member from foreign customers.

Practitioners and academics have repeatedly called for the repeal of the U.S. cost-sharing regulations.²⁷ Several attempts have been made to fix their many decades-old gaping holes, of which the 2008 regulations were the latest installment. In some ways, the 2008 regulations — that is, the “current” regulations — were both a step forward and a step backward. The step forward was the introduction of the CWI standard in the new CSA-specific periodic adjustment rule. The step backward was the elimination of the long-standing express requirement that a participant individually exploit the CSA-related IP assigned to it, thereby arguably making it much easier to set up sham and low-substance arrangements compared with earlier regulations. That change implies that aggressive structures must often be challenged using other IRS tools, such as other transfer pricing rules, the sham transaction or economic substance doctrines, or the effectively connected income rules, if not the CSA periodic adjustment rule.

Speaking of ECI, some of Microsoft’s pre-2009 foreign affiliates appear to have been engaged in a U.S. trade or business. If Microsoft’s foreign affiliates haven’t filed Form 1120-F, “U.S. Income Tax Return of a Foreign Corporation,” for relevant years, the statute of limitations has not begun to toll on those early tax years, meaning that the IRS could impose ECI taxation on relevant pre-2009 income after accounting for periodic adjustments to all tax years back to 2009. This is further investigated in Section IX.

It is difficult to see how Microsoft might defend itself against a cost-sharing periodic adjustment. The regulatory thresholds are clear, and, as noted earlier, courts have upheld the regulation. Further, the recent Tax Notes series found no apparent obstacles (including any tax treaties) that would prevent application of the periodic adjustments, which the statute and congressional intent explicitly require:

The House Ways and Means Committee report (H.R. No. 99-426) on TRA 1986 was explicit that its intent was to require the IRS to adjust the consideration charged in a controlled intangible transfer over time based on realized profitability — regardless of what the parties could have foreseen at the time of the transfer.²⁸

. . .

Regardless of their standing under the arm’s-length standard, retrospective periodic adjustments are what Congress intended and what the statute requires.²⁹

The IRS’s statutory authority to apply these adjustments therefore appears ironclad, especially when the foreign CSA participant provided no platform contributions or other relevant routine or nonroutine contributions to the CSA. The argument most anticipated to be used by taxpayers like Microsoft might be a defense of their platform contribution transactions (PCTs) based on unrelated comparables (especially in light of the IRS’s failed track record using this method). But that argument can be quickly dispatched:

Taken together, the statutory text and the legislative history make clear that the actual income attributable to the transferred intangible takes precedence over other considerations when pricing a transfer of a controlled intangible — especially transactional comparables data. The statute’s explicit reference to “income,” reinforced by Congress’s clearly expressed intent to deemphasize comparables’ role in pricing intangible transfers, all but rules out any defensible argument that periodic adjustment provisions should give way to transactional evidence. . . .

As long as there is no uncontrolled transfer of the same intangible under the same (or substantially the same) circumstances as the controlled transaction, which there rarely will be, neither the blanket exemption from periodic adjustments nor the preference for the [comparable uncontrolled transaction] method takes hold. . . .

And nothing in the statutory text or legislative history suggests that transactional evidence has any role whatsoever in the periodic adjustment analysis. . . . Not only are Treasury and the IRS not required to offer exceptions to periodic adjustments or anoint the CUT method as the presumptive best method under specific conditions, their statutory authority for doing so is doubtful.³⁰ [Emphasis added.]

These conclusions are all the more powerful when one considers that Microsoft does not have just one PCT that is subject to a periodic adjustment but probably dozens or even hundreds (noting that every acquisition involving acquired IP is a likely PCT). The CSA periodic adjustment rule is an income-based method that applies to all PCTs in aggregate, in alignment with congressional intent. Simply put, an almost purely objective, congressionally mandated and Tax Court-certified periodic adjustment determination based on internal tax accounting data should be difficult to defend against.

It is unknown whether the IRS will enforce the periodic adjustment rule or ECI taxation against Microsoft or any of the other five taxpayers whose violations were investigated in this series of reports. That’s anyone’s guess. However, there appear to be no justifiable obstacles for the IRS to do so, and there is a congressional mandate that it in fact do so.

III. A Trove of Documents

The IRS has been examining Microsoft’s 2004-2006 tax years since 2007. As part of that exam, the IRS filed a petition in the U.S. District Court for the Western District of Washington on December 11, 2014, to enforce a “designated summons” that it served on Microsoft for documents connected to the Puerto Rico tax planning. (Apparently, it was the first time that type of summons had been used since 1996.³¹)

As part of the litigation, a multitude of internal planning documents were disclosed publicly on October 12, 2016. These documents provided a treasure trove of information on Microsoft’s internal planning and structure of its CSA. This report draws in part on analysis of those internal documents. The court eventually ruled in favor of the IRS on January 17, 2020, finding that specified additional documents were not privileged by virtue of their having been prepared in connection with a tax shelter promoted by KPMG. The court said:

This reasoning guides the Court’s determination that KPMG strayed into promotion of a tax shelter. As noted previously, the transactions did not appear necessary to satisfy Microsoft’s operational needs. . . . KPMG worked to make the transaction fit both Microsoft’s existing operations and the relevant tax laws. . . . But it did so only to promote Microsoft’s avoidance of tax liability and the Court concludes that all of KPMG’s written communications were “in connection with promotion” of a tax shelter. 26 U.S.C. section 7525(b).³²

Microsoft disclosed additional information in a hearing before the Senate Permanent Subcommittee on Investigations (PSI) on September 20, 2012. Those two disclosures — together with in-depth analysis of Microsoft’s SEC filings and websites, reporting by various reputable news agencies, and information from Microsoft employees — provide enough information to develop and perform an indicative periodic adjustment test. Table 1 lists some of the more important internal planning documents reviewed for this report.

Table 1. United States v. Microsoft Corp., No. 2:15-cv-00102, Document Disclosures

Document	Description	No. of Pages	Date Filed
107	Order Granting Enforcement of Summons, No. 2:15-cv-00102 RSM	17	11/20/2015
146	Statement by IRS examiner Eli Hoory	19	10/12/2016
146-8	KPMG email — attached Puerto Rico proposal presentation	19	10/12/2016
146-9	MSFT-KPMG emails — no handouts or emails at meeting	1	10/12/2016
146-10	KPMG-MSFT scheduling meeting emails	4	10/12/2016
146-11	KPMG-MSFT scheduling email	1	10/12/2016
146-12	Email and presentation — KPMG Microsoft	15	10/12/2016
146-13	Email and KPMG contract — tax assistance to Microsoft	14	10/12/2016
146-14	KPMG email — questions on KPMG cost-sharing proposal	3	10/12/2016
146-15	KPMG email	1	10/12/2016
146-16	Draft Americas cost-share project timeline	4	10/12/2016
146-17	Email and Americas cost-sharing tables	10	10/12/2016
146-18	Email and spreadsheet excerpt	2	10/12/2016
146-19	KPMG email — project update	4	10/12/2016
146-20	KPMG email — PR MOU revisions	2	10/12/2016
146-21	Draft Microsoft MOU	23	10/12/2016
146-22	Microsoft pre-planning meeting notes	2	10/12/2016
146-23	Microsoft PR planning meeting	6	10/12/2016
146-24	Microsoft PR cost-sharing structure	6	10/12/2016
146-25	KPMG engagement letter	12	10/12/2016
146-26	KPMG examination email	12	10/12/2016
146-27	Draft MOPR intracompany services agreement	13	10/12/2016
146-28	Draft PR intracompany services agreement	13	10/12/2016
146-29	MSFT-KPMG emails and draft technology license agreement	12	10/12/2016
146-30	Emails — cost-share April update	12	10/12/2016
146-31	KPMG email — contingent purchase price question	2	10/12/2016
146-32	KPMG-Microsoft process narrative	17	10/12/2016
146-33	KPMG email chain — potential PR tax treaty	3	10/12/2016
146-34	KPMG cost-sharing call agenda	4	10/12/2016
146-35	MOPR project status update	12	10/12/2016
146-36	KPMG Weaver email — digital distribution	1	10/12/2016
146-37	KPMG email — call agenda	2	10/12/2016
146-38	KPMG to MSFT draft Americas buy-in memorandum	26	10/12/2016
146-39	KPMG to Microsoft mail-draft review	2	10/12/2016
146-40	KPMG KPMG buy-in CWI discussion	4	10/12/2016
146-41	Tax issues related to buy-in structure	7	10/12/2016
146-42	KPMG Microsoft emails — draft cost share	3	10/12/2016
146-43	KPMG emails — cost-share marketing discussion	2	10/12/2016
146-44	MSFT-KPMG PR payroll transition discussion	4	10/12/2016
146-45	Estimation of market value of Microsoft entities — redacted	37	10/12/2016
146-46	Performance review — MOPR	2	10/12/2016
146-47	KPMG email buy-in report	1	10/12/2016
146-48	KPMG memo — explanation of Microsoft PR model components	10	10/12/2016
146-49	KPMG email and spreadsheet — Microsoft model assumptions	3	10/12/2016
146-50	Arthur Andersen 1999 memo — royalty rate	19	10/12/2016
146-51	Cost-share memo and org structure	33	10/12/2016
146-52	KPMG to MSFT email — intercompany interest	1	10/12/2016
146-53	Emails and attachment	4	10/12/2016
146-54	Email and charts	4	10/12/2016
146-55	KPMG emails — IBE discussion	2	10/12/2016
146-56	MSFT email — cost of capital assumptions discussion	1	10/12/2016
146-57	KPMG to MSFT email — IP buy-in discussion	2	10/12/2016
146-58	KPMG memo and email	20	10/12/2016
147	Order requiring Microsoft to provide documents to the IRS	3	1/17/2020

IV. Microsoft US’s Control

The IP development phase of Microsoft’s CSA-related operations generally consists of activities that produce the source code and object code for the Windows operating systems (OSs) and apps and related software.³³ Performing a transfer pricing analysis of the exploitation phase of this CSA can be tricky because the object code IP (and occasionally the source code) — the final output of the IP development phase — is shipped directly to both unrelated and related parties, each of which exploits the software in similar (including highly routine) ways.³⁴ This exploitation primarily involves the mere copying of images of the object code software onto devices and media or using it to create apps. At least in the original equipment manufacturer (OEM) market, the foreign cost-sharing participants don’t appear to participate in the exploitation process at all. In the retail market, only routine portions of the exploitation functions appear to be conducted outside the United States, with some or most production-type functions being outsourced to unrelated parties. This factual situation would have negated participation by Microsoft’s foreign CSA participants according to the 2008 CSA transition regulation for preexisting arrangements, discussed later.

The text that follows focuses on Microsoft’s Windows OS software and related apps software, such as its suite of Microsoft Office and Dynamics software that runs on the Windows OS. Microsoft’s reported client segment revenue in 2009 consisted exclusively of Windows revenue; its server and tools segment consisted primarily of licenses for Windows and SQL server; and its business division segment consisted primarily of Office and Dynamics app software that runs on the Windows platform. Combined, these Windows-related divisions represented around 81 percent of total revenue in fiscal 2009 — that is, the overwhelming majority of Microsoft’s worldwide revenue that year.

A. Windows Legacy IP

Microsoft’s Windows OS is the world’s most prevalent system software. As of July 2020, Windows was estimated to have about 78 percent of the global market share for desktop OSs versus Apple Inc.’s Mac OS with 17 percent and Linux with approximately 2 percent.³⁵ According to Microsoft, Windows 10 is made up of about 50 million lines of code.³⁶ The Windows OS was first launched in 1985 as a successor to Microsoft’s original OS MS-DOS, which was first developed for IBM personal computers. However, the original code for the modern Windows used today was created around 1988:

The earliest version of 16-bit Windows was released in 1985, but modern versions of Windows are based on NT, which was developed from scratch by Dave Culter’s team at Microsoft, starting in 1988. That code base was first released in 1993 as Windows NT. It does not depend on or include any of the Microsoft 16-bit code that was written before that, from MS-DOS or from Windows. Although the 32-bit versions of Windows still support some 16-bit DOS and Windows apps, the code which accomplishes this is not actually 16-bit DOS or Windows. All desktop versions of Windows since XP in 2001 and all server versions of Windows, from 1993 to present, are based on NT.³⁷

The size, complexity, and “path dependency” of the Windows software makes it nearly impossible to replace with new code to accomplish the same functions because the current code contains decades of code layered on top of each prior version. Any new version of Windows must be interoperable with more recent versions of Windows that came before it and incorporate all the drivers, past post-launch modifications, and patches for prior recent versions.³⁸

B. Windows IP Development

The development of new versions of Windows is accomplished by widely distributed teams of developers and programmers dedicated to individual components of the Windows environment. These are the building blocks of the Windows system. These components are assembled into larger components, and the larger components are combined and so on until the source code is complete, at which time it is prepared for testing.

The development process occurs within the company at locations worldwide in a highly secured environment. One team within Microsoft may wish to leverage a piece of code from another division to accomplish a similar function in its module, and that code is shared freely between divisions anywhere in the world. Inside Microsoft, obtaining shared code often takes little more than a phone call or email request. However, the process is managed and controlled by personnel in Redmond in the United States, such that any foreign operations are largely compartmentalized components of larger workstreams over which only Microsoft US has full visibility and control.

One of the most important processes in the development and launch of new versions of Windows is maintaining “order of the IP” as it evolves. Microsoft US controls this key process and maintains the versioning of the code throughout the development and launch process. When the source code is ready to compile into object code for testing and launch, this process is performed, managed, and controlled by Microsoft US. Therefore, management and control over thousands of developers all over the world working on different versions of the Windows source code simultaneously occurs under the management and control of Microsoft US, as does the key exploitation function of compiling the code into the object code that is sent to licensees and customers around the world (related and unrelated).

Importantly, the Windows source code has all the required translation, unitization, and localization functions already built in where these functions are important. Once the new version of Windows is launched, no further changes are allowed to the post-launch source code, except for patches and updates.

The location of the source code is a tightly kept secret. The source code has been kept under lock and key, generally in partnership with Perforce Software Inc. in recent years. Perforce is a private company whose software enables secure development, operation, and internal testing of software, enabling the running of apps in test mode, with version control and web-based repository management, and functionality for developer collaboration and app life cycle management. The firm also provides app servers, debugging tools, and Agile planning software. When a developer within Microsoft anywhere in the world accesses the source code for their development work, they do so through a tightly secured portal hosted by Perforce with tracking and protections against unauthorized access or disclosure. Controls are set by Microsoft US.

As detailed above, the size of the source code for Windows and its dependence on pieces of legacy code originally developed for long-obsoleted OSs make it effectively impossible to replicate or steal the code. Windows operates flawlessly for most users with each successive version because the new version consists only of new programming added to the prior versions with a continuous rolling process of development, testing, launch, and patching. In other words, any new version of Windows is basically the previous version with new features layered onto it in a rigorous testing environment.

As a result, the Windows source code has an extremely long decay rate for transfer pricing purposes — perhaps on the order of decades versus the much shorter decay periods of perhaps 10 years, five years, or even shorter periods that might be assumed in a typical cost-sharing buy-in PCT valuation model. This is one of the ways in which substantial IP-based profits have been shifted offshore, through underpriced buy-in payments (often structured as declining royalties) whose payments decay too quickly and over too short a time. The complexity of this process and long decay rates are reasons that the periodic adjustment regulation is so important. The adjustment accounts for these attributes and for other underpriced and unpriced PCTs that otherwise might never be caught by overworked IRS examiners who may lack the specific skills and industry knowledge necessary to identify them.

Once the development of the source code is completed for a new edition of Windows, that source code then reenters the development phase, and the process described above starts all over again. Importantly for transfer pricing cost sharing, source codes and object codes can be protected by copyright, and they generally meet the regulatory definition of controlled IP. The fact that this IP is provided in substantially the same form to both unrelated customers and related affiliates for similar internal or external exploitation-type functions does not appear to cause any problems under the cost-sharing regulations. For instance, foreign affiliates can sub-license the object code to unrelated vendors for use in production operations.

Making this even more complex is that the development of the Windows OS and other software applications in a rolling development and launch process also involves a feedback loop between development and exploitation. For instance, upon the launch of a new Windows OS, that OS becomes the base programming for the next version, which will include new features to accommodate future processing and user needs. However, while new programming work is proceeding on the next version, Microsoft is still developing patches and updates for the existing launched version, as well as for prior versions, often to fix issues discovered after launch and new security concerns. These patches and updates for the current and past launched software must then be modified as necessary and simultaneously implemented in the new version under development as well as in the prior launched versions.

Moreover, during the development of one product (whether the OS or an app), a so-called forking process occurs, in which developers might take code from one product or component and adapt it to another product or component and/or use it to begin programming new features. This “fork” can become a new feature or component.

The internal testing of the pre-launch software is commonly referred to as “dogfooding.” This process takes place after initial testing, whereby a pre-launch version of the source code is tested internally in a controlled environment until it operates as intended and is deemed ready for launch. During this process, the new software is operational within the company for general use and testing by employees. The goal of the dogfooding is to find exception cases or broken sections of code at each level of operation. This process involves several substages, including cleanup, debugging, and new features. The pre-launch testing involves testing the execution of the functions caused by the object code compiled from the source code. Once the pre-launch testing is complete, the process moves to commercialization or exploitation of the CSA-covered IP.

C. Windows IP Exploitation

1. Microsoft Windows exploitation functions.

Exploitation of the Windows IP begins with the imaging of the object code created by Microsoft US. Images of the object code are provided by Microsoft US in a similar form to related and unrelated parties. Importantly, the key exploitation activity at this point is merely the copying of these images to new equipment or media. Crucially, Microsoft US substantially manages and controls the exploitation process in several ways that undermined the ability of foreign affiliates to comply with the 2008 cost-sharing participation rules in January 2009.

For instance, consider how Microsoft US tightly managed and controlled every aspect of how its software could be used by customers and affiliates worldwide by building restrictions into the software images it produced in the United States before delivery to U.S. and foreign customers and related parties. A Microsoft document from 2011 titled “OEM Software Licensing: Rules & Restrictions”³⁹ provided details of the types of limitations and controls built into the software by Microsoft US that severely restricted how related and unrelated parties could use or exploit the IP:

• OEM Software may not be transferred to another machine.

• OEM versions of Microsoft Office cannot be deployed in a Terminal Services or remote desktop services environment.

• Re-imaging rights are a benefit granted only to Microsoft Volume Licensing customers.

• The motherboard is the component that determines whether or not a new Microsoft Windows Desktop Operating System license is required.

• Windows desktop operating system licenses purchased through Microsoft Volume Licensing Programs are upgrades and require an eligible underlying Windows license (generally purchased as an OEM license pre-installed on a computer system).

• OEM Microsoft Office licenses do not grant downgrade rights.

• OEM Microsoft Windows Server licenses do grant downgrade rights.

• OEM Software may not be transferred to another machine . . . [e]ven if the original laptop, PC or server is no longer in use, or if the software is removed from the original hardware, the OEM licenses are tied to the device on which the software is first installed.

• If an OEM license has SA [Software Assurance] coverage, although the SA coverage may be transferred, the underlying OEM license may not.

• Microsoft Volume Licensing customers may use Volume Licensing media to re-image software (including OEM Software licenses) under the following conditions: The copies re-imaged from the Volume Licensing media are identical to the originally licensed product (the same product and version, contain the same components, and are in the same language). The customer must purchase at least one unit of the product required to be re-imaged through their Volume Licensing agreement in order to obtain access to the product media and receive a key. Volume Licensing media must be used for re-imaging (OEM media may not be used). [Emphasis in original.]

Microsoft’s foreign CSA participants appeared to play little if any role in the production side of the exploitation activities for the OS and app software and primarily performed marketing, sales, and support functions (which were considered only one of two required components of exploitation under the former (January 1, 1996) regulations cited by the transition rules in the 2008 CSA regulations). One support function cited as a primary activity of foreign affiliates concerns “localization” of Microsoft’s software, according to The Wall Street Journal:

Microsoft has just over 1,000 full-time employees in three suburban Dublin buildings. . . . About half of the Irish employees work on software “localization,” translating and modifying for local markets the programs produced by some 29,000 employees of Microsoft in the Puget Sound region of Washington state.⁴⁰

This statement describes how Microsoft US creates the CSA-related IP and how foreign affiliates don’t perform functions that would be considered exploitation under the 2008 transition rules. Microsoft itself describes localization as “quick and easy” activities that rely on “editor tools,” “localization processes,” and capabilities already built into the software images by Microsoft US and provided to foreign affiliates for routine preference selections within the software:

Localization of a product requires that the product be adapted to both the language and the culture of a particular market. . . . There are many elements that are modified in both software and content localization. These elements include text, layout, graphics and multimedia, keyboard shortcuts, fonts, character sets and locale data, as well as the product’s build process and packaging. . . . Using the proper resource editor tools can make the localization of product resources quick and easy. Effective localization tools should also be able to create the localized version of the corresponding original file, which can be a resource file or a compiled file, depending on the localization team’s choice of tools and localization process. . . . Content localization includes UA [user assistance] documentation, which consists of printed documentation, online content, and Help files. Content can be actual pieces of the software product or an online product by itself.⁴¹ [Emphasis added.]

Within Microsoft, these foreign related-party activities are not an IP development activity that adds to R&D expenses but rather an operating activity akin to packaging or customizing the product for the local market as part of the distribution process. Also, it appears that Microsoft’s internal programmers located offshore are performing localization functions that are similar to those performed by unrelated developers using the same tools produced by Microsoft US that are already built into the software.

2. Exploitation in the OEM segment.

In 2009, when Microsoft’s preexisting CSA was required to comply with the 2008 cost-sharing regulations, its largest segment by revenue was the Business Division, according to the company’s fiscal 2009 Form 10-K. In that segment, Microsoft transfers images of its apps software to OEMs that manufacture computers, servers, and other equipment so that they can copy the images to the equipment they are building. Unlike sales of the OS software to these OEMs — which are recorded primarily in the United States — sales of the applications software (and all other non-operating-system sales) to OEMs and non-OEM users appear to be booked in either U.S. or foreign jurisdictions according to the location of the user. Note that the same or similar images for apps are also provided to both related and unrelated parties in the retail segment, including images for the purpose of copying by related parties onto CDs or other media that were packaged for individual sale. It appears that Microsoft considered the OEM business to be only the license and installation of the Windows OS software by OEMs on the computers and devices that they manufactured. On the other hand, apps software appears to be accounted for as retail sales, whether the apps were installed by an OEM or by a retail customer after purchase of the computer or other device. Those OEM sales refer only to sales of the OS by Microsoft US, according to testimony by Microsoft’s vice president of worldwide tax before the PSI in 2012:

Our worldwide Original Equipment Manufacturer (OEM) business, consisting primarily of the licensing of the Windows operating system to computer manufacturers for pre-installation on PCs, is primarily supplied from our regional operating center in Reno, Nevada.⁴² [Emphasis added.]

In the OEM market, the OS software loaded on a given device is essentially identical for all devices of the same make and model, based on a common core program for the OEM’s desired version of Windows. Microsoft’s OS software is licensed on a per-device basis, under which the OS will not work until the user inputs a required unique license key into the start-up program on first use. The license keys are unique combinations of letters and numbers that are retrieved from Microsoft automatically during OEM production (and included separately with a CD image of the software in packaged retail products). For computers, the motherboard is what links the device to the license.⁴³

3. Non-OEM exploitation.

Microsoft also makes the images of its software and OS available to smaller unrelated companies and developers, which can customize the software for unique applications or nonstandard uses. They can also obtain interoperability with apps designed to work with the OS together with relevant developer kits necessary to develop apps for the Microsoft Windows and.NET frameworks. For instance, the Windows assessment and deployment kit is a collection of tools and technologies produced by Microsoft US for developers to customize Windows for large-scale deployments, whereas a software deployment kit is a collection of software development tools in one installable package containing the latest headers, libraries, metadata, and tools for building Windows apps (such as Universal Windows Platform and Win32 apps) for current and some earlier Windows releases.⁴⁴

It appears that Windows software apps were sold separately to foreign customers who purchased products from an OEM or through a non-OEM channel (such as a retail store), and those app sales were booked offshore to the extent that the customers were located outside the United States, even though the app software may have been installed by the OEM when it produced the machines — a process that was managed and controlled by Microsoft US. Therefore, these foreign Windows app licenses appear to have been credited to Microsoft’s foreign affiliates for tax purposes, even if those affiliates weren’t directly involved in the sales, production, or delivery of the licensed software by Microsoft US in their territories. This is true regardless of whether the payment for those apps was made by an OEM or by a foreign user who purchased the OEM-produced device (on which the OEM may have pre-installed the apps software).

Regarding the development and exploitation of Microsoft’s software, the following anecdote was conveyed to us by one former Microsoft developer: “Anyone doing technical work at Microsoft only got significant tasks to work on if they were based at Headquarters [in Redmond]. Anyone based at any other location were assigned only trivial work.” This may be a bit extreme and possibly U.S.-centric; however, as a corollary, establishing the authenticity of Microsoft’s U.S.-built software sold around the world by retail establishments, authorized resellers, and online resellers through certificates of authenticity affixed to the product or device has been an important initiative for years. These certificates often involve color-shifting and holographic features signifying that the software is an authentic Microsoft-produced copy of U.S.-built software. In other words, the certificates are essentially assurances by the U.S. company that software copied offshore (typically for the retail market, which appears to include pre-installed app software) can be trusted the same way as if it came from Microsoft US directly. Microsoft most recently deployed these certificates for retail software produced (that is, copied) by its controlled affiliates in Southeast Asia, India, and South Korea.⁴⁵

4. At least some foreign exploitation looked like a sham.

Although Microsoft executives described to a congressional committee in 2012 that the OEM business was primarily the imaging of the Windows OS software to OEM machines, one OEM contract, which was labeled as such and disclosed to the SEC not long before this testimony, covered both the Windows Mobile OS and embedded apps. That contract described the apps as follows:

“Embedded Application” means an industry- or task-specific software program and/or functionality with all of the following attributes: (a) It provides the primary functionality of the Device. (b) It is designed to meet the functionality requirements of the specific industry into which the Device is marketed. (c) It offers significant functionality in addition to the Product software. “Device” means OEM Customer’s computing system or device with an Image that (a) is designed for and distributed with an Embedded Application; and (b) is not marketed or useable as a general purpose personal computing device (such as a personal computer), a multi-function server or a commercially viable substitute for one of these systems.⁴⁶

This is only one OEM contract that originally began on November 1, 2009, or around 10 months after the transition requirements took effect, and it may not be representative of all OEM contracts at the time, in particular the OEM contracts covering the Windows OS. However, the activities of Microsoft’s foreign affiliates described in that contract would clearly fail the transition rules of the 2008 CSA regulations, for reasons described below.

This OEM contract was a Microsoft Windows Mobile OEM license contract with Bsquare Corp., which Bsquare filed with the SEC in connection with operations during its annual financial reporting period ending December 31, 2010.⁴⁷ This was one of four similar contracts, each of which covered a different geographic region. Microsoft Licensing GP was the contracting party for three of the agreements — those covering the Americas, Japan, and Asia. For the fourth, which covered Europe, the Middle East, and Africa (EMEA), MIOL was the contracting party.

Contracts like this one, which is with a multinational customer using Microsoft products in multiple locations around the world, appear to have been drafted, negotiated, and executed by Microsoft US. Further, it would appear that the products would all be delivered to licensees by Microsoft US, with the use of the products in foreign territories being managed and controlled by Microsoft US through the imbedded restrictions discussed earlier. The only involvement by Microsoft Ireland in the entire commercial process appears to have been the signing of the document by a Microsoft Ireland executive.

Only the contract for the Americas was included in the SEC disclosure. However, Microsoft noted that the terms of the separate EMEA contract were “substantially identical” to that of the one disclosed contract:

The Company has also entered into three additional distribution agreements, as amended, with Microsoft that are substantially identical in all material respects to the Distribution Agreement except as to the parties thereto, the dates of execution and other details, including the territories covered (the “Additional Agreements”).⁴⁸ [Emphasis added.]

Table 2 replicates the information shown on the first page of this disclosure.

Table 2. Information on Microsoft Worldwide OEM Distribution Agreement

Name of Agreement	Licensee	Licensor	Territory	Microsoft Signatory
Microsoft OEM Windows Mobile Distribution Agreement, as amended by Amendment No. 1 dated as of September 1, 2010, and Amendment No. 2 dated as of November 1, 2010	Bsquare Corp.	Microsoft Licensing, GP, Nevada USA	Americas	Microsoft eSign Team
Microsoft OEM Windows Mobile Distribution Agreement, as amended by Amendment No. 1 dated as of September 1, 2010, and Amendment No. 2 dated as of November 1, 2010	Bsquare Corp.	Microsoft Licensing, GP, Nevada USA	Japan	Microsoft eSign Team
Microsoft OEM Windows Mobile Distribution Agreement, as amended by Amendment No. 1 dated as of September 1, 2010, and Amendment No. 2 dated as of November 1, 2010	Bsquare Corp.	Microsoft Ireland Operations Ltd.	Europe, Middle East, Africa	Cristina Gregorin (Ireland)
Microsoft OEM Windows Mobile Distribution Agreement, as amended by Amendment No. 1 dated as of September 1, 2010, and Amendment No. 2 dated as of November 1, 2010	Bsquare Corp.	Microsoft Licensing, GP, Nevada USA	Asia	Microsoft eSign Team
aSource: OEM contract with Bsquare Corp., available through the SEC archives.

Focusing on the third row, the licensor is MIOL, the Irish affiliate 100 percent owned by Microsoft Ireland Research (MIR),⁴⁹ which was the Irish cost-sharing participant. MIR was a disregarded entity subsidiary of Microsoft Round Island One Unlimited Co. in Ireland (indicating a “double Irish” type tax arrangement designed to eliminate Irish taxes).⁵⁰ MIOL appears to have recorded the revenue for the EMEA territory as a signatory to the contract and a (possibly disregarded) wholly owned subsidiary of MIR, the CSA participant. A credit report for MIOL showed that as late as 2021, it recorded $56 billion in revenue, or about $28 million in revenue per employee.⁵¹ According to MIOL’s income statement included in the credit report, it expensed 82 percent of that revenue as operating costs separate from the cost of sales and administrative expenses. This expense is believed to consist primarily of a royalty to MIR for the license of the OEM-related technology IP it obtained through the CSA.

The important point here is that revenue is being reported by MIOL based on an OEM contract for which MIOL will have conducted, managed, or controlled few to none of the required exploitation functions under the 2008 CSA transition rules, which would have prevented MIR’s CSA from qualifying for transition as a valid preexisting CSA after January 5, 2009.

5. Microsoft’s U.S.-managed and -controlled software supply chain.

Microsoft’s vice president of worldwide tax said the following in testimony before the PSI in September 2012, citing Microsoft’s fiscal 2011 financial results:

Approximately 75 percent of total Windows & Windows Live Division revenue comes from Windows operating system software acquired by original equipment manufacturers, which they pre-install on hardware equipment they sell. . . . The U.S. entities . . . are responsible for substantially all aspects of our OEM business . . . The profits from these activities are taxable in the U.S.⁵²

This statement asserts that Microsoft US was responsible for “substantially all aspects of” its OEM (Windows) business and that in 2011 the Windows OS business alone represented fully 75 percent of the Windows and Windows Live division revenue. Microsoft provided segmented (non-geographic) results by division as well, by product and service, in which the “PC Operating System” product revenue aligned closely with that of the “Windows & Windows Live” division. It also provided revenue for the app software products. The latter segmentation is shown in Figure 3, based on a screenshot of the results from Microsoft’s fiscal 2011 Form 10-K.

Finally, Figure 4 shows which Microsoft entity controlled its worldwide long-lived assets and the pretax return reported in the controlling entities’ jurisdiction divided by the long-lived assets under its control.

Figures 3 and 4 lead to the following conclusions about Microsoft’s operations in 2011:

• Microsoft US pretax profit margins were only about half the margins earned by foreign operations. Foreign revenue primarily related to sales of non-Windows OS products and services, whereas most U.S. revenue related to Windows OS sales (based on the 2012 PSI testimony), indicating that OS software licenses likely generate much lower margins than other software.

• Microsoft’s U.S. sales of products and services not based on Windows OS were around $20 billion, whereas foreign sales were $31.9 billion — or 1.5 times larger than the U.S. figure.

• Microsoft US appears to have licensed and distributed Windows OS to OEM customers whose devices were later sold to foreign users. And based on its control of over 86 percent of global long-lived assets, the U.S. company appears to have also physically produced and distributed the apps software that runs on the Windows OS to both U.S. and foreign end-users.

• The much higher profitability in foreign jurisdictions when Microsoft US controlled, managed, or executed substantially all development, exploitation, sales, and distribution functions for the foreign Windows market (when total foreign revenue was less than U.S. revenue) suggests aggressive offshore profit shifting (hence Microsoft’s invitation to testify before the PSI in 2012).

• Based on these results, Microsoft US appears to bear an inordinately large proportion of foreign-benefiting exploitation and commercialization expenses for the foreign app sales, inflating the foreign profits on those sales far in excess of what Microsoft US earned on its own app and OS sales — the latter product making the foreign app sales possible and being the primary driver of that revenue.

To better understand how Microsoft US produced, sold, and delivered both the Windows OS and related apps software to foreign licensees and/or users while virtually all of its income was booked offshore by the following year in 2012, it is necessary to delve into the mechanisms and assets used to accomplish what might otherwise appear to be a sham-like transaction under U.S. tax law.

First, the OEM licensing of the Windows OS is conducted by a separate business unit from the apps business unit, which also sells retail copies of the Windows OS. Despite this separation, the basic technology underlying the licensing processes is substantially the same for both the OEM OS and app software sales and the retail Windows OS and app software sales. All these supply chain operations appeared to be managed and controlled by Microsoft US.

Although there are different versions of any given software, both the OS and apps are distinguished entirely by function and not by jurisdiction. Every version of a given piece of software is globalized (configured to allow customization according to geographic region based on built-in functionalities) and localized (provided with specific information and formatting appropriate to a given region). This allows for a given copy of the Windows OS or an app like Office to be set to work in a language- and culture-specific context without any additional installation. A computer user can have a device that was purchased in the United States and configured for U.S. English language to change a few easily accessible settings and configure the Windows OS, as well as any Microsoft apps, to function as if set up for use in a non-English language. This built-in functionality includes unique keyboard settings based on the desired language, with the ability to change back to English if desired. In fact, there are third-party companies that sell rubber and plastic keyboard overlays to facilitate these operations, and many users involved in language translation rely on this functionality.

Although these language-specific settings are sometimes generated outside the United States, Microsoft US performs and manages the creation of the built-in globalization capabilities and the integration of the localization files. Microsoft’s U.S.-built software therefore supports all geographic regions with customization capabilities built in (together with built-in restrictions), and this facilitates the control by Microsoft US of the worldwide sales and distribution processes.

6. Current Windows sales channels.

There are now more channels through which a user or company might acquire a license to use Microsoft software than there were in 2009. Knowledge of these channels is important for understanding the contributions of foreign affiliates to the exploitation process for offshore sales. The OEM channel remains the most common for versions of the Windows OS. In this licensing model, a private individual or a company purchases a piece of computing equipment that has the Windows OS pre-installed with a license permanently attached to the device. Microsoft has a contract with the device manufacturer to provide the software to the OEM entity with rights for that OEM to resell those licenses as attached to a device. These contracts are managed and sold exclusively by Microsoft US. In some cases, Microsoft’s apps, such as its Office programs, are also sold through these OEM channels or by arrangement with OEMs for these apps to be pre-installed on an OEM’s computers or other devices at the time of purchase by the computer or device user.

For individuals and small businesses, Microsoft software is also sold through a second channel consisting of various online and physical retail outlets. A customer purchases a general license for an OS or app and installs it on a physical computer or other device. Customers at their discretion may remove the apps software from one device and move it to another. Again, for this channel, the primary manufacturing of any media and its retail packaging and distribution, whether physical or online, is managed by Microsoft US for both OS and apps.

A third distribution channel is similar to the OEM model but involves large corporate customers that license Microsoft’s products in large volumes for use by employees. This is known as volume licensing. In this channel, a corporate licensee contracts with Microsoft or a licensed vendor to purchase a single product key that is attached to a significant number of individual licenses. As the company installs software using that key, the computing devices go through an activation process by which they report back to Microsoft US that an additional individual license from the prearranged set of licenses has been used. If the software is removed from a device as part of the company’s device retirement process, a deactivation process is initiated that also causes an electronic report to be sent to Microsoft indicating that one of the set of licenses is no longer being used.

A fourth primary channel Microsoft uses to license its software has gone by various names (including Microsoft developer network) and is now branded as visual studio subscriptions. This channel allows individuals or companies to pay an annual flat fee per user to access some or all of Microsoft’s catalog of software. This fee includes either one or more retail licenses for specific software titles or bulk license keys (allowing unlimited installs) for other catalog items. These licenses cannot be resold, and bulk licenses may be used only for internal-facing devices. This program is also managed, marketed, controlled, and distributed by Microsoft US.

Through 2009, according to sources in this report, these channels appeared to be the primary way Microsoft provided licenses to OEM and retail customers for Windows and all of its other software product lines. Beginning in late 2010, Microsoft introduced another means to license apps, through Office 365, which allowed individuals and companies to essentially rent app licenses on an annual or monthly basis. In 2017 Microsoft added more features and licensing (including Windows 10 volume licenses) to this cloud-based offering under the Microsoft 365 banner.

In 2010 Microsoft also introduced Azure cloud-based products and services, which enabled use of many of its server products through “software as a service” and “platform as a service” environments. In Azure, the product licensing is included in the fee for use of the various platforms and services. For both Microsoft 365 and Azure, there are duplicate data centers around the world, but they are all managed and controlled by Microsoft US. This allows, for instance, a user with an Azure account to access their account from any data center in the world with no limitations or special considerations. Microsoft US provides its “software as a service” and “platform as a service” products to users worldwide regardless of which Microsoft group member records the revenue, thus continuing the centralized U.S. management and control and/or execution over foreign-benefiting exploitation functions that existed in 2009.

In summary, the licensing and distribution process in 2009 and later years appears to have been entirely managed and controlled and primarily conducted by Microsoft US, with no material observable contributions to the commercialization process by foreign affiliates. Under the 2008 transition rules, foreign cost-sharing participants were required to conduct individual exploitation and to perform or manage and control the exploitation functions associated with the cost-shared IP for sales to unrelated parties in their assigned territories. It was impossible to do so by merely transferring the IP to unrelated contractors that would independently conduct production. The following section focuses more specifically on Microsoft’s foreign cost-sharing participants and their activities related to the CSA around January 5, 2009.

V. Microsoft’s CSA

Microsoft’s CSA was initially set up around 1999 to offshore its retail products segment IP associated with sales outside the Americas, according to internal documents. By July 2005 Microsoft appeared to have a single global CSA, involving three principal foreign participants, whose territories covered the Americas, Asia Pacific (APAC), and EMEA. Note, however, that in an August 2017 hearing in Australia, Microsoft disclosed that it substantially modified its CSA in that year to centralize its foreign-licensed IP into its Irish affiliate.⁵³ Therefore, for purposes of this report, the information presented below describes Microsoft’s CSA between January 2009 and 2017, after which time there appeared to be only one foreign CSA participant for all foreign territories. But this should not affect the overall results of the periodic trigger and periodic adjustment calculations, which are primarily based on U.S. and aggregated non-U.S. CSA territories, which would be appropriate if performing the periodic adjustment in 2017 or later, when there were only the U.S. and Irish participants.

The arrangements under Microsoft’s CSA were somewhat complex, involving the aggregation and transfer out of the United States of both marketing and technology IP rights pertaining to the exploitation and sale of related products in the retail segment and possibly including portions of the OEM segment in the EMEA territory. In the APAC territory, only the technology IP for the retail segment and marketing IP pertaining to unrelated sales was transferred. In Puerto Rico, the CSA involved the license of technology IP to Microsoft Operations Puerto Rico (MOPR) for production of intermediate products for sale back to Microsoft US. This is primarily based on information contained in internal documents:

By way of background, [Microsoft] has engaged in the following IP restructuring transactions: 1) 1999 migration of EMEA retail marketing intangibles . . . 2) 2003 migration of EMEA OEM market intangibles . . . 3) 2004 migration of Asia intangibles . . . The current proposed project is Microsoft’s largest IP migration to date, involving shifting the technology intangibles from the U.S. retail market to Puerto Rico . . . [Puerto Rico] will manufacture 100 percent of the disks for the U.S. market, load them with the software, and sell them to the [Microsoft] U.S. distribution. . . . [Microsoft] Corp in the U.S. will retain the marketing intangibles.⁵⁴

May 99 — EMEA retail buy-in (very granular model), EMEA OEM buy-in [apparently referencing item 2 above in 2003], and then APAC Retail. In EMEA, there was a Tech/marketing split of 59/41. In EMEA OEM 56/44, and in APAC, 70/30 (all projected) but as a look back these turned out as 55/45, 58/42, and 69/31, respectively. . . . if we had done a level rate then it would have been EMEA retail buy-in (9 percent), EMEA OEM buy-in (15 percent), and then APAC Retail (29 percent). . . . EMEA retail buy-in (Channels include FPP, Select, Open, MLP, Enterprise and Other), EMEA OEM buy-in (Including System builder), and then APAC Retail (Includes only Combined Channels).⁵⁵

A. Foreign CSA Participants

1. Microsoft Ireland.

MIR, located in Ireland, is the cost-sharing participant for the EMEA territory. According to registration documents in Ireland, MIR was registered on April 25, 2001, as a wholly owned disregarded entity subsidiary of Round Island One, which was a wholly owned Microsoft controlled foreign corporation registered months later on September 27, 2001. Round Island One operated in Ireland but was headquartered in Bermuda, and its corporate parent was Round Island LLC in Nevada.⁵⁶

MIR (through a predecessor entity) is believed to have joined the global CSA in 1999 and made a $7 billion buy-in payment.⁵⁷ MIR in turn owns MIOL, the lower-tier Irish operating company, presumably part of a double Irish tax avoidance structure that would have eliminated most of the Irish taxes on the CSA-related pretax income. Typically in those arrangements, the lower-tier operating company, such as MIOL, would be checked into its parent (MIR in this case) for U.S. purposes to exclude the royalty payments from MIOL to MIR for the CSA-related IP from being subject to subpart F taxation in the United States. The Microsoft Ireland website says the following about its operations, notably with no indication of any internal production activities or production management capacity:

Microsoft in Ireland. . . 2,000 people. 71 different nationalities. One Campus situated in Leopardstown, Dublin. At Microsoft, our mission is to empower every person and organisation to do and achieve more, not just here in Ireland, but right across the world. From software development, testing and localisation to operations, finance, HR and sales & marketing for Europe, Middle East and Africa, our ambition is to help everyone, through the power of technology, to achieve theirs.

Importantly, Microsoft Ireland conducts no internal production operations and outsources all production for the EMEA market to unrelated parties as a “primary purpose,”⁵⁸ as shown below by a social media post by an executive within Microsoft Ireland:

In this role I am responsible for all Microsoft Software manufacturing in EMEA and its end to end supply chain. This is an outsource model and I therefore manage a large vendor footprint supplying software as physical products to all our customers in EMEA.⁵⁹ [Emphasis added.]

The fact that Microsoft US conducted or managed all internal commercial exploitation activities associated with the CSA-covered IP from the United States in 2009, combined with the total production outsourcing model, means that the CSA with Microsoft Ireland could not have qualified for grandfathering as a valid preexisting CSA on January 5, 2009.

2. Microsoft Singapore.

Microsoft Asia Island Ltd. (MAIL) was the CSA participant in the APAC territory. MAIL was incorporated December 11, 2003, in Bermuda as a disregarded subsidiary of Microsoft Singapore Holdings Pte. Ltd., a Singapore subsidiary created in 1990, which was in turn fully owned by MIR.⁶⁰ MAIL entered into the CSA on April 3, 2004, by making a buy-in payment of $4 billion.⁶¹ MAIL, whose operations were based in Singapore, employed several hundred personnel as late as 2012 and owned and operated data centers. That enabled MAIL to distribute Microsoft’s software to customers in its territory as well as conduct localized regional production, marketing, and administrative functions.⁶² Like MIR, however, MAIL did not appear to conduct, manage, or control any of the qualifying exploitation activities that would have made it a valid participant to Microsoft’s CSA on January 5, 2009.

The APAC website says the following about MAIL’s operations, which appear to represent primarily marketing, sales, localization, customer support, and contract R&D activities:

We have been operating in the region for more than three decades and have a presence in 23 Asian markets today. Our diverse and talented team of some 30,000 people — across sales, marketing, operations, engineering, and developers — serve customers through a market-leading ecosystem of more than 100,000 partners. And, as proof of our commitment to Asia’s future, we have established our two largest research centers outside the United States in China and India. [Emphasis added.]

Though very little public information exists regarding MAIL’s operations in 2009, none of the public information we reviewed would support that this entity performed any internal production activities that would have qualified for transition under the 2008 CSA regulations.

3. Microsoft Puerto Rico.

On July 1, 2005, Microsoft decided to create a new Puerto Rican affiliate to join the existing CSA. This would allow it to replace the existing section 936 possession tax credit structure (the credit was due to expire the next year) with a profit-shifting transaction structured as a CSA. That arrangement had no economic substance, according to internal documents.⁶³ Indeed, a federal district court found that the arrangement constituted nothing more than a tax shelter.⁶⁴ MOPR had rights to the Americas CSA territory only for technology IP and not marketing IP.⁶⁵ Around this time (according to the 2012 PSI testimony), MOPR received $1.6 billion from Round Island One in Ireland to build a new manufacturing plant, distribution facility, and product release lab.

MOPR was a wholly owned subsidiary of Microsoft US, and, as a participant in Microsoft’s CSA, it made a buy-in payment of $17 billion on July 1, 2005.⁶⁶ MOPR had 177 employees in 2012.⁶⁷ Microsoft Puerto Rico supplied its products only to Microsoft US, specifically its legal entity in Reno, Nevada, as confirmed in 2012 testimony given by Microsoft’s corporate vice president of worldwide tax.⁶⁸

The functions of Microsoft’s Puerto Rican affiliate clearly violated the former (reg. section 1.482-7A) CSA regulations invoked by the 2008 transition rules, primarily because those regulations required that a foreign participant sell its output to unrelated customers in its assigned territory, and MOPR sold its products only to Microsoft US (see Section VI.A.1, infra). The ongoing IRS examination of MOPR has revealed that the Puerto Rican entity was created for the exclusive purpose of joining Microsoft’s CSA. The IRS has accused Microsoft of engaging in a sham arrangement with Microsoft Puerto Rico. In particular, the IRS points to a valuation study performed by Duff & Phelps claiming that the newly created Puerto Rican entity was worth around $30.4 billion as soon as the ink was dry on its cost-sharing contract — based largely on the tax savings.⁶⁹ The Microsoft Puerto Rico website contains little information on the MOPR operations.

B. Americas Operations Center

Microsoft’s Americas Operations Center in Reno appeared to play a key role in Microsoft’s CSA-related exploitation operations around 2009. Even today, its Americas website indicates that this center conducts substantial management and control over key foreign operations, as illustrated by this excerpt:

Business divisions we operate and manage:

Commercial Operations supports the fulfillment and revenue processing operations of the company’s multi-billion-dollar Commercial business . . . Commercial Operations has Regional Operating Centers located in . . . Ireland. . . and Singapore. Commercial Operations globally manages channel partner and customer contract management, revenue processing, manufacturing/fulfillment of media, electronic software distribution and volume licensing customer care . . .

Device Partner Operations (DPS) is a global organization with teams located in Redmond, Reno, Dublin and across Asia. The team supports the Device & IoT Partners business(es) and the channel ecosystem that manufactures, markets and sells devices with Microsoft software and services. The DPS Operations team is accountable for core execution of partner licensing and contract management, ordering, billing, fulfillment, financial compliance and revenue recognition.

Global Services Operations (GSO) organization is responsible for managing the contract-to-cash process for Premier Support and Microsoft Consulting Services (MCS) businesses worldwide.

The Xbox Operations team, run by the Windows and Devices Group within Microsoft Corporation, is responsible for performing operational support for Xbox. This includes processing and administering publisher licensing agreements, collecting associated royalties and fees, enforcing contract compliance, and antipiracy program management. This team is also responsible for the manufacturing and distribution of Xbox third-party games through management of authorized replicators, applying supply chain security standards and coordination of product manufacturing and shipping.

The World Wide Credit Services organization is responsible for the management of Microsoft’s global credit risk and accounts receivable portfolio. Oversight for this $12 billion portfolio is carried out by teams based in Redmond, Reno, Fort Lauderdale, Manila, Buenos Aires, Dublin, Budapest, Chennai, Gurgaon, Johannesburg, Singapore, Seoul, and Beijing. World Wide Credit Services provides services for all of Microsoft’s major business segments in support of the order-to-cash cycle and partners with the Treasury Organization to maximize cash flow in support of the lifecycle of the dollar. [Emphasis added.]

Note that the “Device & IoT Partners business(es) and the channel ecosystem that manufactures, markets and sells devices with Microsoft software and services” appears to be a reference to unrelated parties to whom production is outsourced as a principal purpose of the foreign related-party licensing of the CSA-controlled IP. This conclusion is supported by information disclosed by Microsoft personnel responsible for these activities (“This is an outsource model . . . a large vendor footprint supplying software as physical products to all our customers in EMEA”⁷⁰). The information conveys that Microsoft Ireland transfers the licensed IP to unrelated manufacturers as a general rule for all production.

C. 2011 CSA Results

Microsoft has only ever divulged a sliver of detailed financial results for its foreign cost-sharing participants, for only one year (fiscal 2011) as part of the company’s 2012 PSI testimony. However, by combining that information with the internal documents that came to light in 2016 as a result of an IRS summons, as well as additional information from Microsoft’s fiscal 2011 Form 10-K, several interesting insights can be developed. The data extracted from those sources and some associated analytics are provided in tables 3a and 3b, which show the following:

• Microsoft’s foreign pretax return on cost-sharing payments was 260 percent in 2011, while the U.S. return was only 30 percent;

• the indicated reasonably anticipated benefit (RAB) shares of R&D expense for Microsoft’s U.S. and non-U.S. entities approximated the U.S. and foreign shares of pretax income;

• foreign affiliates bore $7 billion less in expenses than should have been borne if basing their share of total costs on their revenue share — an amount that was equivalent to the foreign revenue share of Microsoft’s total general and administrative expenses and cost of revenues combined, equivalent to foreign affiliates bearing approximately none of those expenses;⁷¹

• foreign net income per foreign employee was 476 percent times the U.S. figure;

• foreign CSA pretax income represented about 80 percent of total pretax income;

• the U.S. return on long-lived assets was only 48 percent versus 643 percent for the non-U.S. return; and

• asset intensity per U.S. employee was four times the figure for foreign employees.

On their face, these results appear extreme from a transfer pricing and CWI perspective. They point to the likelihood that foreign affiliates were vastly undercharged for foreign-benefiting exploitation expenses incurred by Microsoft US and that substantial PCTs were missing or undercharged, such as those associated with acquisitions. The “missing” charges to foreign affiliates become apparent when Microsoft’s reported foreign expenses are compared with a revenue-based split of the company’s total expenses by geography.

This would explain at least a portion of what appears to be inflated foreign profit for what is likely only routine offshore activities, while virtually all nonroutine activities were performed, managed, and controlled by Microsoft US with much lower margins. In the next financial report, for 2012, Microsoft reported that U.S. pretax income profits declined even further, to only 7 percent of global pretax income (possibly related to a $6.2 billion goodwill impairment charge primarily concerning a 2007 acquisition). Microsoft appears to have attained the nirvana of performing most, if not all, nonroutine value-generating activities in the United States while reporting virtually all the nonroutine profits of those activities offshore, mostly in low-substance tax haven affiliates.

KPMG LLP’s cost-sharing project in years before January 2009 might have allowed Microsoft to disregard the CWI limitations of the 2008 CSA regulations with impunity, so long as the arrangement with each foreign affiliate qualified for grandfathering under the associated transition regulation, reg. section 1.482-7(m)(1). However, because Microsoft’s CSA failed to comply with those transition rules, all of Microsoft’s foreign CSA results since 2009 are not grandfathered but are subject to a periodic adjustment trigger test. This report shows that this test and a computation of the applicable periodic adjustments would result in the U.S. taxation of Microsoft’s foreign profits since 2009 in almost their entirety. This report also shows that some foreign profits even before 2009 should be taxable due to ECI concerns, discussed in Section IX.

D. 2003-2004 CSA Results vs. 2009

1. Microsoft’s 2003-2004 CSA results.

Microsoft US’s central role in the tightly controlled performance of exploitation functions in the United States is supported by analysis of Microsoft’s SEC filings. Its fiscal 2003 and 2004 filings show an interesting development: Based on the reported changes in U.S. and foreign revenue, long-lived assets, and pretax income, it appears that foreign profits increased by a higher percentage than revenue (both measures increasing by double-digit percentages), while foreign long-lived (exploitation) assets declined by 67 percent. On the other hand, Microsoft US increased its controlled long-lived assets by 42 percent while experiencing a decline in its proportion of pretax income despite similar growth in both U.S. and foreign revenue.

Table 3a. Variables and Calculations From Microsoft Sources (millions of dollars)

Calc	Description	Amount	Source
(a)	Revenues	$69,943	FY2011 Form 10-K
(b)	Pretax income	$28,071	FY2011 Form 10-K
(c)	Cost of revenue	$15,577	FY2011 Form 10-K
(d)	R&D costs	$9,043	FY2011 Form 10-K
(e)	Sales and marketing expenses	$13,940	FY2011 Form 10-K
(f)	General and administrative expenses	$4,222	FY2011 Form 10-K
(g)	U.S. revenues	$38,008	FY2011 Form 10-K
(h)	Non-U.S. revenues	$31,935	FY2011 Form 10-K
(i)	U.S. pretax income	$8,862	FY2011 Form 10-K
(j)	Non-U.S. pretax income	$19,209	FY2011 Form 10-K
(k)	U.S. current federal and state tax provision	$3,317	FY2011 Form 10-K
(l)	Non-U.S. tax provision	$1,602	FY2011 Form 10-K
(m)	U.S. net income provision	$5,545	FY2011 Form 10-K
(n)	Non-U.S. net income provision	$17,607	FY2011 Form 10-K
(o)	Windows and Windows Live Division revenue	$18,778	FY2011 Form 10-K
(p)	Server and tools revenue	$17,107	FY2011 Form 10-K
(q)	Microsoft Business Division revenue	$21,986	FY2011 Form 10-K
(r)	Online Services Division revenue	$2,528	FY2011 Form 10-K
(s)	Entertainment and devices revenue	$8,716	FY2011 Form 10-K
(t)	Unallocated and other revenues	$828	FY2011 Form 10-K
(u)	Windows and Windows Live Division, percentage non-OEM	25%	FY2011 Form 10-K
(v)	Server and tools, percentage non-OEM	30%	FY2011 Form 10-K
(w)	Microsoft Business Division, percentage non-OEM	20%	FY2011 Form 10-K
(x)	Online Services Division, percentage non-OEM	100%	FY2011 Form 10-K
(y)	Entertainment, percentage non-OEM	100%	FY2011 Form 10-K
(z)	Employees	90,000	FY2011 Form 10-K
(aa)	U.S. employees	54,000	FY2011 Form 10-K
(ab)	Non-U.S. employees	36,000	FY2011 Form 10-K
(ac)	Product R&D employees	35,000	FY2011 Form 10-K
(ad)	U.S. R&D employees, percentage total	85%	Senate PSI Report, p. 3
(ae)	Sales and marketing employees	25,000	FY2011 Form 10-K
(af)	Product support and consulting employees	16,000	FY2011 Form 10-K
(ag)	Manufacturing and support employees	5,000	FY2011 Form 10-K
(ah)	General and administrative employees	9,000	FY2011 Form 10-K
(ai)	Long-lived assets	$21,487	FY2011 Form 10-K
(aj)	U.S. long-lived assets	$18,498	FY2011 Form 10-K
(ak) = aj/ai	U.S. share of long-lived assets	86%	Calc
(al) = i/aj	U.S. return on long-lived assets	48%	Calc
(am) = j/(ai - aj)	Non-U.S. return on long-lived assets	643%	Calc
(an) = (aj/aa)/((ai - aj)/ab)	Long-lived assets per U.S. employee / non-U.S.	413%	Calc
(ao) = ac * ad	U.S. R&D employees	29,750	Calc
(ap) = ac - ao	Non-U.S. R&D employees	5,250	Calc
(aq) = aa/z	U.S. employee share	60%	Calc
(ar) = a - b	Total costs	$41,872	Calc
(as) = g - i	U.S. total costs	$29,146	Calc
(at) = h - j	Non-U.S. total costs	$12,726	Calc
(au) = o * u	Windows and Windows Live Div. retail revenue (est.)	$4,695	Calc
(av) = p * v	Server and tools retail revenue (est.)	$5,132	Calc
(aw) = q * w	Microsoft Business Division retail revenue (est.)	$4,397	Calc
(ax) = r * x	Online Services Division retail revenue (est.)	$2,528	Calc
(ay) = s * y	Entertainment and devices retail revenue (est.)	$8,716	Calc
(az) = sum(au:ay)	Total retail revenues (est.)	$25,468	Calc
Note: Est. = Values that were computed based on assumptions by the authors.

Table 3b. Variables and Calculations From Microsoft Sources (millions of dollars)

Calc	Description	Amount	Source
(a1)	MOPR Revenues (are 100% Retail)	$6,300	Senate PSI Report, p. 189
(b1)	MOPR pretax income	$4,015	Senate PSI Report, p. 237
(c1)	MOPR R&D costs paid	$1,900	Senate PSI Report, p. 31
(d1)	MOPR R&D costs paid + PCT payments ($400 million used)	$2,300	Senate PSI Report, p. 31
(e1)	MOPR reported RAB share of R&D costs	25%	Senate PSI Report, p. 32
(f1)	MOPR revenues / Americas retail revenues	47%	Senate PSI Report, p. 32
(g1)	Microsoft Ireland revenues	$9,000	Senate PSI Report, p. 190
(h1)	Microsoft Singapore revenues	$3,000	Senate PSI Report, p. 190
(i1)	Microsoft Ireland pretax income	$8,908	Senate PSI Report, p. 93
(j1)	Microsoft Singapore pretax income	$2,485	Senate PSI Report, p. 93
(k1)	Microsoft Ireland R&D costs paid	$2,800	Senate PSI Report, p. 3
(l1)	Microsoft Singapore R&D costs paid	$1,200	Senate PSI Report, p. 3
(m1) = az/a	Retail revenues / total revenues (est.)	36%	Calc
(n1) = d - c1 - k1 - l1	Microsoft US R&D costs	$3,143	Calc
(o1) = n1/d	Microsoft US R&D costs / global R&D costs	35%	Calc
(p1) =i/b	Microsoft US pretax income / global pretax income	32%	Calc
(q1) = as/ar	Microsoft US total costs / global total costs	70%	Calc
(r1) = g/a	Microsoft US share of global revenues	54%	Calc
(s1) = a1 - b1	MOPR total costs	$2,285	Calc
(t1) = s1 - d1	MOPR total costs minus R&D expenses	($15)	Calc
(u1) = c1/d	MOPR R&D costs / global R&D costs	21%	Calc
(v1) = d1/d	MOPR R&D costs + PCT costs / global R&D costs	25%	Calc
(w1) = d1/s1	MOPR R&D + PCT costs / total MOPR costs	101%	Calc
(x1) = a1/az	MOPR revenues / global retail revenues (est.)	25%	Calc
(y1) = g1-i1	Microsoft Ireland total costs	$92	Calc
(z1) = h1 - j1	Microsoft Singapore total costs	$515	Calc
(aa1) = y1 - k1	Microsoft Ireland total costs excl. R&D costs	($2,708)	Calc
(ab1) = z1 - l1	Microsoft Singapore total costs excl. R&D costs	($685)	Calc
(ac1) = k1/d	Microsoft Ireland R&D costs paid / global R&D	31%	Calc
(ad1) = l1/d	Microsoft Singapore R&D costs paid / global R&D	13%	Calc
(ae1) = 1.2 * g	Americas revenue if equal to 120% * U.S. revenues (est.)	$45,610	Calc
(af1) = a1/f1	Americas retail revenues (est.)	$13,404	Calc
(ag1) = az - af1	Non-Americas retail revenues (est.)	$12,064	Calc
(ah1) = h - a1	Non-Americas revenue (earned by non-CSA participants) (est.)	$25,635	Calc
(ai1) = as - d1 - k1 - l1	Non-Americas total costs (excl. R&D costs) (est.)	$22,846	Calc
(aj1) = ah1 - ai1	Non-Americas pretax income (excl. CSA participant income) (est.)	$2,789	Calc
(ak1) = aj1/ai1	Non-Americas MUTC (excl. CSA participants) (est.)	12%	Calc
(al1) = d1 + k1 + l1	Non-U.S. R&D expenses (actual)	$6,300	Calc
(am1) = al1/d	Non-U.S. share of total R&D expenses	70%	Calc
(an1) = j/b	Non-U.S. share of pretax income	68%	Calc
(ao1) = h/a * c	Non-U.S. share of cost of revenue if same as revenue share	$7,112	Calc
(ap1) = h/a * e	Non-U.S. share of selling expenses if same as revenue share	$6,365	Calc
(aq1) = at - al1 - ao1 - ap1	Non-U.S. total costs diff. from revenue share apportionment	($7,051)	Calc
(ar1) = (i * 1mil)/aa)/1mil	Pretax income per U.S. employee	$0.16	Calc
(as1) = (j * 1mil)/ab)/1mil	Pretax income per foreign employee	$0.53	Calc
(at1) = as1/ar1	Pretax income per foreign employee / U.S. figure	325%	Calc
(au1) = (m * 1mil)/aa)/1mil	Net income per U.S. employee	$0.10	Calc
(av1) = (n * 1mil)/ab)/1mil	Net income per foreign employee	$0.49	Calc
(aw1) = av1/au1	Net income per foreign employee / U.S. figure	476%	Calc
(ax1) = (b1 + i1 + j1)/j	Pretax income of CSA participants / of non-U.S. pretax income	80%	Calc
(ay1) = (b1 + i1 + j1)/(c1 + k1 + l1)	Non-U.S. CSA participant return on total (R&D) costs	261%	Calc
(az1) = i/as	U.S. CSA participant return on total costs	30%	Calc
Note: Est. = Values that were computed based on assumptions by the authors.

Analysis of Microsoft’s fiscal 2004 Form 10-K indicated no material changes in the overall value of long-lived assets or employee headcount. The possible transfer of foreign-controlled, long-lived assets to U.S. control was not explained, and it was noted that long-lived assets are reported by the location of the affiliate that controls the assets. This appeared to be such an extreme movement away from the commensurateness of U.S. and foreign risk bearing and return that this period was used as the baseline with which to measure any movement back toward the CWI standard by January 2009. Such a movement would have certainly been envisioned by the transition rules for preexisting low-substance CSAs such as Microsoft’s. These transition rules were, of course, consistent with, and possibly based on, the existing U.S. transfer pricing regulations at the time, which stated:

In considering the economic substance of the transaction, the following facts are relevant — . . . Whether the pattern of the controlled taxpayer’s conduct over time is consistent with the purported allocation of risk between the controlled taxpayers; . . . The extent to which each controlled taxpayer exercises managerial or operational control over the business activities that directly influence the amount of income or loss realized.⁷²

2. Microsoft’s year-end 2008 CSA results compared with 2004.

For this report, what matters most is whether Microsoft might have modified this tax planning by January 2009 such that it would then have complied with the 2008 CSA transition regulation. To comply, the foreign participants would have to conduct individual exploitation activities and manage and control any foreign-benefiting exploitation activities related to the CSA-related IP that they didn’t conduct through their own employees or agents. Those activities would include internal production and the sale and distribution of products and services to unrelated parties. For the CSA to comply with the transition rules and be valid from January 5, 2009, some appropriate proportion of the productive resources necessary to carry out those activities would have had to have been shifted to the foreign CSA participants by January 2009, as compared with 2004. That such a shift was necessary is demonstrated by Microsoft’s Puerto Rico participant selling only to related parties, Microsoft’s other CSA participants (in Ireland and Singapore) outsourcing all production, and all three participants inexplicably earning nonroutine profits for only routine contributions. To test if these changes might have occurred, Figure 6 compares Microsoft’s fiscal 2004 and fiscal year-end June 30, 2008, results (the latter assumed to accurately describe Microsoft’s operations on January 5, 2009, only six months later).

The results in Figure 6 indicate that Microsoft’s foreign long-lived assets did increase from 2004 to 2008, but (1) the increase didn’t return these foreign assets back to their 2003 levels before their substantial decline in 2004; (2) the foreign proportion of total long-lived assets in fact dropped by nearly 50 percent from 2004’s already reduced level (from 11 percent to 6 percent); while (3) the 2008 foreign pretax income increased by twice as much as long-lived assets, causing the foreign return on long-lived assets to increase proportionally almost by half (46 percent) from 2004 (from 637 percent to 932 percent). In the same period, Microsoft US continued to increase its proportion of long-lived assets by about five times its increase in revenues, which itself increased by almost 50 percent while the proportion of profits declined by double digits.

Quantitatively, these results in 2008 had clearly moved even further in the opposite direction from what one would expect considering the congressionally mandated CWI concept. With the material decline in 2004 and this further decline by 2008, the numbers don’t pass the smell test for transfer pricing or transition under reg. section 1.482-7(m)(1). This is in addition to the qualitative observation that Microsoft’s foreign participants also failed to remedy the technical violations of the former reg. section 1.482-7A exploitation requirements, which called for individual exploitation, sales to unrelated parties, and actual production as a primary purpose of the IP transfer. There is scant evidence that Microsoft’s foreign affiliates complied in any way with the 2008 CSA transition regulation under reg. section 1.482-7(m)(1) by January 5, 2009.

E. The IRS Examines MOPR

The ongoing IRS examination of Microsoft’s 2004-2006 tax years has focused on its Puerto Rican cost-sharing participant. As noted, the IRS pointed to the Duff & Phelps valuation study showing that the newly created Puerto Rican entity was worth around $30.4 billion — based largely on the tax savings — soon after the CSA was executed.⁷³ The IRS prepared the diagram (Figure 7) in 2015 as part of its audit of Microsoft’s CSA, focusing on the addition of the new Puerto Rican affiliate to the arrangement in July 2005 and the absurdly high returns for essentially low-value routine activities performed there.

A simple calculation based on this chart shows that this arrangement would have been in flagrant violation of the CWI provisions of the 2008 cost-sharing regulations, which limited such foreign CSA-related IP returns to 150 percent of the total IP investments (PCTs and R&D cost-sharing payments) (Table 4).

Table 4. Back of Envelope Calculation of MOPR Returns vs. CWI Limitations
(from IRS presentation; millions of dollars)

Revenues
(a)	Technology transfer price	$67,810
(b)	Products transfer price	$1,680
(c) = a + b		$69,490
Expenses
(d)	CSA buy-in payment	$15,560
(e)	Cost-sharing payments	$15,350
(f) = 0.9 * b	Product costs	$1,512
(g) = d + e + f		$32,422
(h) = c - g	Pretax income	$37,068
(i) = a/(d + e)	Return on IP investments	219%
(j)	Limitation on IP investments in 2008 CSA regulations	150%
(k) = i - j	Microsoft Puerto Rico return on IP investments in excess of 2008 CSA limitations for post-January 5, 2009, arrangements	69%

Despite these results, there is no indication that the IRS has tested MOPR’s compliance with the reg. section 1.482-7(m)(1) transition regulation, which this report shows MOPR would have failed. Further, there has been no disclosure that the IRS has considered assessing a periodic adjustment or sought to otherwise invalidate Microsoft’s CSA from January 2009 onward.

Microsoft’s CSA was particularly aggressive. Under typical arrangements involving a U.S.-parented taxpayer, countries in the Americas or the North America territory will be assigned to a U.S. group member’s CSA territory, while the rest of the world is assigned to one or more foreign group member participants. However, Microsoft pushed these boundaries by transferring into MOPR all product and production (that is, non-marketing) intangibles for sales to U.S. customers. There was simply no legitimate business purpose for this, though Microsoft did create a putative purpose through the uneconomic physical manufacturing of CDs within Puerto Rico, a process that factually did not require the transfer of any IP.

Documents released in 2016 show that in 2003, when Microsoft was considering what to do upon the expiration of the section 936 possession tax credit, it was determined that there would be over $5 million of annual pretax savings if the company were to discontinue its own production of CDs in Puerto Rico and instead migrate to available unrelated contract manufacturers. This annual savings, however, paled in comparison to the potential tax benefits of keeping the more expensive production in Puerto Rico under negotiated tax rulings and aggressive transfer pricing.⁷⁴

The Puerto Rican affiliate performed only intermediate routine contract manufacturing functions to produce unpackaged (for retail sale) plastic CDs for sale back to Microsoft US. In the words of Microsoft’s vice president of worldwide tax at the September 20, 2012, Senate hearings:

The Puerto Rico ROC [regional operating center] performs the software production and initial distribution operations for the Americas group. It owns and operates the primary release lab for the creation of Microsoft software masters for our worldwide business operations as well as the data center initiating software product distribution for the Americas market. The Puerto Rico ROC also owns and operates Microsoft’s only media production facility. The Puerto Rico ROC employs hundreds of people to produce masters in the release lab, manufacture media, and distribute digital software copies from the data center. The Puerto Rico ROC delivers software products to our Reno Nevada ROC for final distribution to Americas customers.⁷⁵

Note that according to the internal documents released in 2016, these “software masters” appeared to be unnecessary and redundant CD copies of the app software that were sent to various locations that already had digital access to Microsoft’s software. KPMG even recommended sending Microsoft’s licenses to its OEM customers in disc form and to, later, send server transmissions through Puerto Rico in a purely redundant, tax-driven, sham transaction.⁷⁶ To suggest that distributing copied software under these circumstances justifies MOPR’s earning a major portion of the profit from retail software sales to U.S. customers is simply ludicrous.

By 2012 Microsoft US reported only 7 percent of the company’s global pretax income despite reporting 53 percent of global revenue and control of over 57 percent of Microsoft’s long-lived assets in the United States as well as employing 60 percent of total employees, which included almost all product developers and upper management responsible for its global supply chain.⁷⁷ Given Microsoft’s perennially high profits and U.S.-centric commercialization operations, Microsoft’s CSA-related profit results simply make no sense from a transfer pricing perspective.

VI. CSA Transition Failure

A. The 2008 CSA Transition Rules

The 2008 CSA regulations (T.D. 9441) were released in temporary form on December 31, 2008, and published in the Federal Register January 5, 2009, in final form. Those regulations included, in reg. section 1.482-7T(m)(1), an important set of transition rules for the grandfathering of CSAs that were already in existence as of the regulations’ January 5, 2009, effective date. That was the date Microsoft was trying to “beat,”⁷⁸ though that strategy was rendered obsolete by the provisions discussed below, which required the preexisting arrangement to comply with both an earlier version of the CSA regulations and also with new provisions enacted in the 2008 regulations.⁷⁹

This transition regulation, reg. section 1.482-7t(m)(1), remained unchanged in the 2011 final regulations. It provides:

In general. An arrangement in existence on January 5, 2009, will be considered a CSA, as described under paragraph (b) of this section, if, prior to such date, it was a qualified cost sharing arrangement under the provisions of section 1.482-7 (as contained in the 26 CFR part 1 edition revised as of January 1, 1996, hereafter referred to as “former section 1.482-7”). [Emphasis added.]

This provision of the 2008 CSA regulations stated that the regulations as in existence on January 1, 1996, were the qualifying regulations and not the regulations in effect when Microsoft’s CSA was created. Accordingly, Microsoft’s preexisting CSA — and most importantly, the way in which the CSA participants factually operated — would have had to have been modified to comply with regulations as they had existed almost a decade earlier, on January 1, 1996.

1. Exploitation = internal production + sales to unrelated customers.

Key requirements of former reg. section 1.482-7A, as of January 1, 1996, include both the individual exploitation requirement in reg. section 1.482-7A(a) and the participant requirement found in reg. section 1.482-7A(c) (before amendment by T.D. 8670, May 13, 1996, that removed these provisions).

The individual exploitation requirement read:

A cost sharing arrangement is an agreement under which the parties agree to share the costs of development of one or more intangibles in proportion to their shares of reasonably anticipated benefits from their individual exploitation of the interests in the intangibles assigned to them under the arrangement. [Emphasis added.]

The participant requirement read, in relevant part:

(1) . . . A controlled taxpayer may be a controlled participant only if it —

(i) Uses or reasonably expects to use covered intangibles in the active conduct of a trade or business, under the rules of paragraphs (c)(2) . . . of this section. . . .

(2) Active conduct of a trade or business — . . .

(ii) Active conduct. In general, a controlled taxpayer actively conducts a trade or business only if it carries out substantial managerial and operational activities. For purposes only of this paragraph (c)(2), activities carried out on behalf of a controlled taxpayer by another person may be attributed to the controlled taxpayer, but only if the controlled taxpayer exercises substantial managerial and operational control over those activities. [Emphasis added.]

This guidance includes or implies two important threshold requirements: (1) the foreign affiliates must exercise “substantial managerial and operational control over” the exploitation activities related to their territory; and (2) that control must extend to both the activities of production and commercial sales to unrelated parties.

For Microsoft’s revenue generated in its EMEA and APAC territories through MIR and MAIL, respectively, this report maintains that MIR and MAIL both failed the participant requirement primarily because of their outsourcing of key production activities as a primary purpose as well as their failure to manage and control the key exploitation activities and risks associated with their territory revenue. MOPR’s revenue resulted exclusively from sales to related parties, and this too would have disqualified it from being a CSA participant from January 2009 or from being grandfathered under the 2008 CSA transition rules.

The former regulations (reg. section 1.482-7A) never explicitly defined the terms “exploitation” or “use” in reference to covered IP, but those terms are used interchangeably in the context of individual exploitation in the former regulations. The meaning in the context of a situation such as MOPR’s is made clear, though, through multiple examples that are quite explicit and difficult to interpret any other way. In fact, every example that involves “use” or “exploitation” includes the execution of sales to unrelated parties by the foreign participant together with the execution and/or management and control of production internally by the foreign CSA participant. These examples include the following (with emphasis added).

Example 5 of reg. section 1.482-7A(f)(3)(iii)(E) states:

Foreign Parent (FP) and U.S. Subsidiary (USS) both manufacture and sell fertilizers. They enter into a cost sharing arrangement. . . . Under the cost sharing arrangement, USS obtains the rights to produce and sell the new form of fertilizer for the U.S. market while FP obtains the rights to produce and sell the fertilizer for the rest of the world [that is, for unrelated customers].

Example 1 of reg. section 1.482-7A(c)(3)(ii) (before amendment by T.D. 8670, May 13, 1996, that removed these provisions) states:

Controlled corporations A, B, and C enter into a qualified cost sharing arrangement for the purpose of developing a new technology. . . . A, B, and C have the exclusive rights to manufacture and sell products based on the new technology in North America, South America, and Europe, respectively.

Example 1 of reg. section 1.482-7A(c)(4) (before amendment by T.D. 8670, May 13, 1996) states:

U.S. Parent (USP), one foreign subsidiary (FS), and a second foreign subsidiary constituting the group’s research arm (R+D) enter into a cost sharing agreement to develop manufacturing intangibles for a new product line A. USP and FS are assigned the exclusive rights to exploit the intangibles respectively in the United States and Europe, where each presently manufactures and sells various existing product lines.

Example 2 of reg. section 1.482-7A(g)(8) states:

Example 2. U.S. Subsidiary (USS), Foreign Subsidiary (FS) and Foreign Parent (FP) enter into a cost sharing arrangement to develop new products within the Group X product line. USS manufactures and sells Group X products in North America, FS manufactures and sells Group X products in South America, and FP manufactures and sells Group X products in the rest of the world.

2. Conducting sales alone fails the participation threshold.

The former regulations contain a special example (Example 2 of reg. section 1.482-7A(g)(8)) in which the manufacturing and selling functions have been explicitly separated. This capstone example involves a situation in which, when the IP was being developed, it was expected that a particular participant (USS) would manufacture and sell one-third of the group’s products under development so that it had a one-third RAB share, which was used to calculate its share of intangible development costs. Before initiating any manufacture of these newly developed products, USS discontinued all manufacturing but continued to make product sales by importing products manufactured by FP. Because of this discontinuance of manufacturing, the example concludes that USS ceased to be a participant at the time of cessation. The example stated:

USS earns a return on its resale activity that is appropriate given its function as a distributor, but does not earn a return attributable to exploiting covered intangibles. [Emphasis added.]

This example and another, at reg. section 1.482-7A(c)(2), Example 1 (before amendment by T.D. 8670, May 13, 1996), combined with the requirement of substantial managerial and operational activities, means that any putative CSA participant that performed production or manufacturing merely through contractual structuring and not through, at a minimum, the managerial and operational activities of its own personnel will not qualify as a participant in a CSA. This is made crystal clear in Example 2 of reg. section 1.482-7A(g)(8), in which USS ceases its status as a participant once it no longer earns any CSA-related IP exploitation return in its territory because it does not itself manufacture or manage and control the manufacture of the products using the relevant IP.

3. Widespread outsourcing of production fails the transition rules.

It was noted earlier that Microsoft’s Asian and Irish operations outsourced production of CDs and other products in a comprehensive “outsourcing model” of exploitation. In this regard, a principal purpose of the arrangement (in addition to profit shifting) was to license the CSA-covered IP to foreign affiliates for transfer to unrelated contract manufacturers. Importantly, reg. section 1.482-7A(c)(3)(i) (before amendment by T.D. 8670, May 13, 1996, that removed these provisions) states the following:

A covered intangible will not be considered to be used, nor will the controlled taxpayer be considered to reasonably expect to use it, in the active conduct of the controlled taxpayer’s trade or business if a principal purpose for participating in the arrangement is to obtain the intangible for transfer . . . to [an] . . . uncontrolled taxpayer. [Emphasis added.]

The regulation then illustrates this rule by providing a counterfactual example, in which a lone instance of outsourcing in one small country by exception is allowed as an infrequent and nonstandard occurrence that represents a “relatively insignificant” exception to the primary purpose of licensing the IP only for use in internal production:

Controlled corporations A, B, and C enter into a qualified cost sharing arrangement for the purpose of developing a new technology. Costs are shared equally among the three controlled taxpayers. A, B, and C have the exclusive rights to manufacture and sell products based on the new technology in North America, South America, and Europe, respectively. When the new technology is developed, C expects to use it to manufacture and sell products in most of Europe. However, for sound business reasons, C expects to license to an unrelated manufacturer the right to use the new technology to manufacture and sell products within a particular European country owing to its relative remoteness and small size. In these circumstances, C has not entered into the arrangement with a principal purpose of obtaining covered intangibles for transfer or license to controlled or uncontrolled taxpayers, because the purpose of licensing the technology to the unrelated manufacturer is relatively insignificant in comparison to the overall purpose of exploiting the European market. [Emphasis added.]

By all accounts, MIR and MAIL in 2009 outsourced production on a consistent and widespread basis in the retail market to unrelated contract manufacturers as a principal purpose. Those operations included the use of independent contractors for routine functions such as copying software object codes to CDs for retail distribution, noting that the relevant cost-shared IP is the software itself that is transferred to those contract manufacturers. Those putative participants therefore failed the requirement of the former reg. section 1.482-7A provision that bars participant status when a principal purpose for the arrangement is the transfer of the controlled intangibles to uncontrolled taxpayers (here, the unrelated contract manufacturers).

B. The CSA Failed the Transition Rules

1. Foreign participants failed to comply with the former regulations.

As discussed above, neither MIR, MAIL, nor MOPR produced or manufactured for unrelated parties through their own internal production any product using the CSA-covered software. Further, they did not conduct any major business of installing the CSA-related software on customers’ computer systems. Rather, they (MAIL and MIR) simply marketed and sold the products manufactured by other (unrelated) parties, or in the case of MOPR, didn’t market or sell the product at all to unrelated customers. The functions performed by the foreign CSA participants therefore never qualified them to earn a return attributable to exploiting covered intangibles.⁸⁰ The same is true for revenue from any leasing of software or any provision of cloud services because their return is measured by their distribution function and not any production or manufacturing function that represents the exploitation of the covered intangibles.

With all three foreign putative participants failing to achieve qualified participant status on January 5, 2009, there would have been no valid preexisting CSA as of that date because a CSA must have at least two participants. And with no preexisting CSA, all intangibles remained with Microsoft US so that MIR, MAIL, and MOPR would have earned no more than the arm’s-length returns for the routine functions that they performed beginning January 5, 2009.

To add to the failure of this CSA to be valid, note that the covered IP does not in fact include technology concerning how to place software on CDs, which was the only “production” that MIR, MAIL, and MOPR were purported to have conducted around 2009 (though MIR and MAIL outsourced these functions to unrelated parties). Any claim that the foreign CSA participants were exploiting the rights to the software because of that production must be summarily dismissed. These mere imaging processes are extraordinarily routine in nature and involve no contribution or exploitation of CSA-covered IP. Most, if not all, unrelated contract manufacturers already have know-how regarding those imaging processes; the only intangible being transferred to them by MIR or MAIL should be the right to place Microsoft object code on CDs or other media within the terms of the contract manufacturing agreement.

Even if the IRS mistakenly concluded that the CSA was valid on January 5, 2009 (which appears to be the case), the failure of MIR, MAIL, and MOPR as participants to meet the regulatory requirements for grandfathering their preexisting CSA under the 2008 transition rule means that the reg. section 1.482-7(i)(6) periodic adjustment trigger test would still apply. As demonstrated later in this report, the tax effect of periodic adjustments would be similar to the tax effect if there were no CSA. This means that through the periodic adjustment mechanism, MIR, MAIL, and MOPR would likely earn no more than arm’s-length returns from the routine functions that they perform.

2. Regulatory examples are prescriptive.

The former regulations contain no examples contrary to the examples above, which comprise the only guidance that can be used to identify the thresholds for qualifying individual exploitation activities. Importantly, had the regulations provided one or more examples of exploitation that related only to manufacturing or selling as qualifying activities, one could argue that the examples were not prescriptive and perhaps only descriptive. However, the presentations of mutually exclusive examples in which both manufacturing and selling to third parties qualifies as exploitation, and performance of only one of those activities and not the other fails to qualify, forecloses any interpretation that this regulatory guidance is merely descriptive or in any way ambiguous. The only instance not covered by an example is the absence of both production and third-party sales functions, for which no example is necessary because the absence of only one of those activities would invalidate the preexisting CSA.

VII. Periodic Trigger

Having established in earlier sections that the periodic adjustment rules of reg. section 1.482-7(i)(6) apply as a result of the failure to qualify for grandfathering under the reg. section 1.482-7(m)(1) transition rule, we first determine in this Section VII whether the profitability of the MIR, MAIL, and MOPR CSA participants in the aggregate⁸¹ is sufficiently high that the periodic adjustment mechanism is triggered. Finding that the mechanism is triggered, we calculate the estimated periodic adjustment in Section VIII.

The first step in applying the reg. section 1.482-7(i)(6) periodic adjustment rules is to perform a periodic trigger calculation. In short, this is a calculation that determines whether the cumulative level of profits within Microsoft’s foreign CSA participants is within or outside a range defined in the regulation. If a U.S. taxpayer has made one or more platform contributions to its CFCs in connection with various technology acquisitions contributed to the CSA, and the cumulative level of foreign participant profit is within the defined range, there has been no trigger and no periodic adjustment calculation is required. On the other hand, if the CFC’s cumulative discounted profits are outside (that is, above) the range, a periodic adjustment must be calculated. That computation is in Section VIII.

Consistent with the general premise underlying section 482 that transfer pricing adjustments are a tool of the commissioner, the drafters of the reg. section 1.482-7(i)(6) rules clearly gave the commissioner the discretion, in the event of a trigger, to make or not make a periodic adjustment.⁸² In exercising his discretion, the commissioner “may consider whether the outcome as adjusted more reliably reflects an arm’s length result under all the relevant facts and circumstances, including any information known as of . . . the date of the relevant determination by the Commissioner.”⁸³ This guidance reflects that the periodic adjustment rule is the mechanism that puts the 1986 CWI mandate into effect for CSAs.⁸⁴

Economically, the trigger calculation looks at historical information and determines the actual rate of return that a CSA participant has realized on its investment in the CSA. This rate of return, the AERR, will either be within or outside the above-mentioned range, which is the PRRR in the regulations. With the calculations and the comparison being “as of . . . the date of the relevant determination by the Commissioner,” the IRS may make this trigger determination regarding Microsoft’s new CSA⁸⁵ under the 2008 CSA regulations in any still-open year, such as 2017. The calculations apply on a cumulative basis that includes the relevant information from years that may have already been closed. As such, this determination for Microsoft will include relevant information from 2009 through the determination date applied by the IRS (assumed here to be Microsoft’s fiscal year ending on June 30, 2022).

Because the calculations in this and the following sections derive from publicly available information, they necessarily involve some assumptions and estimation. Perhaps the most important input to be estimated for this calculation involves acquisitions from January 5, 2009, by Microsoft that include intangible assets and/or personnel and facilities that will contribute to the intangible development activity under the CSA. This analysis incorporates information in Microsoft’s Forms 10-K regarding the value of those acquisitions, as shown in its statement of cash flows.

Generally, an acquisition or portions thereof would give rise to a PCT only if the acquisition involved capabilities, resources, or rights that were “reasonably anticipated to contribute to the intangible development activities.” The value of the platform contribution would be estimated according to methods in reg. section 1.482-7(g)(1)(i) through (vi) (which include unspecified methods). However, in appropriate circumstances, the entire adjusted acquisition value can be the platform contribution value according to reg. section 1.482-7(g)(5)(iii). Under this method, the full acquisition price, plus any assumed liabilities and minus the value of any tangible assets, would be the adjusted acquisition value.

Because the use of the acquisition price method would normally be assumed to be rare, its use here for all acquisitions is expected to produce the most conservative estimates possible. This is because the acquisition price method represents the maximum possible platform contribution and resulting maximum PCT payment that could be paid by Microsoft’s foreign CSA participants, and the periodic adjustment calculations treat PCT payments as investments on which these affiliates are entitled to earn an appropriate return. By assuming that the foreign participants made all required PCT payments and by using an estimation method that likely overvalues the amount of the PCT payments in total, the total investment amount is assumed to be the maximum possible, thereby minimizing the calculated periodic adjustment. Therefore, this approach is in effect a threshold test. If acquisition-related PCT payments were not made or were smaller than the acquisition price, the AERR would be higher than estimated here. If the threshold test results in a periodic adjustment, it would appear to be highly unlikely that Microsoft would not have a periodic adjustment and also highly likely that the actual periodic adjustment calculated with internal tax accounting data would be larger than the threshold result.

The calculations in this report also assume that all acquisitions were made by Microsoft US and contributed to the CSA activity as platform contributions, requiring PCT payments by foreign CSA participants.⁸⁶

The periodic trigger calculation, described in reg. section 1.482-7(i)(6)(i) through (iv), is performed on Microsoft’s aggregate foreign results and triggers a periodic adjustment for the aggregate result if the aggregate AERR is above the PRRR. The AERR is the present value of the total foreign pretax profits from 2009 through the adjustment year (PVTP), divided by the present value of the CSA-related investments made by the foreign CSA participants over that same period (essentially, the sum of the foreign PCT payments and cost-sharing payments, which is referred to as PVI).

The upper bound of the PRRR limitation is 1.5. However, if the taxpayer has not substantially complied with the documentation requirements referenced in reg. section 1.482-7(k), the PRRR threshold is reduced to 1.25. In this report, we conservatively assume that Microsoft has met the requisite documentation requirements so that the higher 1.5 PRRR threshold applies.

Because Microsoft is publicly traded, the applicable discount rate is Microsoft’s weighted average cost of capital in the year in which the trigger PCT occurs, under reg. section 1.482-7(i)(6)(iv)(B).

The calculations that follow use Microsoft’s fiscal 2017 as the adjustment year. According to Microsoft’s fiscal 2022 Form 10-K filing made on July 28, 2022, the IRS had concluded its examinations of all tax years through 2003. Because the triggering PCT occurred in 2009, Microsoft’s 2009 applicable discount rate, which is reported on a financial website⁸⁷ to have been 9.86 percent, must be used. All the following tables use that applicable discount rate.

The calculations of the indicative periodic trigger are based on estimates derived primarily from Microsoft’s SEC filings as well as other information, including information disclosed in the 2012 PSI hearings and exhibits disclosed in the 2016 litigation. The figures used are anticipated to be close estimates of the internal tax accounting figures, such as third-party revenue, or U.S. and foreign pretax income. As such, the calculations may differ to some extent from calculations using the actual tax accounting information, but those differences are not anticipated to be substantial enough to materially change the indicative results calculated here. This is particularly true in light of the conservative nature of the calculations and the high probability that they have undervalued the actual periodic adjustments that Microsoft could be required to recognize as additional U.S. taxable income.

The principal information used as inputs to the periodic trigger calculation are shown below. As described earlier, Microsoft’s CSA is assumed to have split its participants’ respective territories into three regions, with the Americas territory (for technology IP) assigned to MOPR, excepting Microsoft’s U.S. marketing profits.

The periodic trigger calculation, shown in Table 6, follows the process and formatting shown in reg. section 1.482-7(i)(6)(vii), Example 1. Interestingly, in several years the calculation of the “Non-CC/Non-IDC” expenses (all participant expenses other than cost contributions and intangible development costs, both of which are defined in reg. section 1.482-7) resulted in negative expenses (possibly because Microsoft US bore excessive amounts of foreign-benefiting exploitation expenses). To cure these inappropriate results, Table 6 calculates those expenses in those cases as 30 percent of the sales figure in column (b). This produced results consistent with the other years exhibiting more conventional outcomes. Note that this adjustment was only made to the year 1 results and two other years, and a periodic adjustment is triggered in every year to the present.

Based on this trigger result, an indicative periodic adjustment calculation is performed in the next section based on aggregate foreign CSA participant results using public information. As can be seen in the last three columns of Table 6, a periodic trigger (AERR > 1.5) is indicated by this calculation for all years beginning in year 1 of the January 5, 2009, “new” CSA. Importantly, it only takes a periodic trigger in just one year to invoke a periodic adjustment that applies to every year thereafter. The fact that a periodic trigger is indicated in every year from 2009 through 2022 — and by a substantial amount (more than 200 percent in at least one year), using the most conservative assumptions — is persuasive that this violation would likely be confirmed using internal tax accounting information.

Table 5. Key Inputs to Microsoft Periodic Trigger and Periodic Adjustment Calculations (millions of dollars)

Year (June 30 YE)	Calendar Year No. (Yr 1 is a Half Year)	Discount Rate	Discount Factors	(a)	(b)	(c) = a - b	(d)	(e)	(f)	(g) = f/e	(h) = d * g	(i)
				Total Revenues (per SEC Filings)	U.S. Revenues (per SEC Filings)	Foreign Revenues (per SEC Filings)	Total R&D Costs (per SEC Filings)	Total Pretax Income (per SEC Filings)	Foreign Pretax Profits (per SEC Filings)	Est. Foreign RAB Share (Based on Share of Pretax Income)	Est. Foreign R&D payments	Acquisitions Net of Liabilities Assumed Minus Tangible Assets Acquired Since Jan. 2009 (per SEC Filings)
FY2009	1	9.86%	0.95	$58,437	$33,052	$25,385	$4,437	$19,821	$14,292	72%	$3,199	$329
FY2010	2	9.86%	0.87	$62,484	$36,173	$26,311	$8,714	$25,013	$15,438	62%	$5,378	$245
FY2011	3	9.86%	0.79	$69,943	$38,008	$31,935	$9,043	$28,071	$19,209	68%	$6,188	$71
FY2012	4	9.86%	0.72	$73,723	$38,846	$34,877	$8,911	$22,267	$20,667	93%	$8,271	$10,112
FY2013	5	9.86%	0.65	$77,849	$41,344	$36,505	$10,411	$27,052	$20,378	75%	$7,843	$1,584
FY2014	6	9.86%	0.60	$86,833	$43,474	$43,359	$11,381	$27,820	$20,693	74%	$8,465	$5,937
FY2015	7	9.86%	0.54	$93,580	$42,941	$50,639	$12,046	$18,507	$11,144	60%	$7,254	$3,723
FY2016	8	9.86%	0.53	$91,154	$46,146	$45,008	$11,998	$25,639	$20,514	80%	$9,600	$1,393
FY2017	9	9.86%	0.49	$96,571	$51,078	$45,493	$13,037	$29,901	$23,058	77%	$10,053	$25,944
FY2018	10	9.86%	0.44	$110,360	$55,926	$54,434	$14,726	$36,474	$24,947	68%	$10,072	$888
FY2019	11	9.86%	0.40	$125,843	$64,199	$61,644	$16,876	$43,688	$27,889	64%	$10,773	$2,388
FY2020	12	9.86%	0.37	$143,015	$73,160	$69,855	$19,269	$53,036	$28,920	55%	$10,507	$2,521
FY2021	13	9.86%	0.33	$168,088	$83,953	$84,135	$20,716	$71,702	$36,130	50%	$10,439	$8,909
FY2022	14	9.86%	0.30	$198,270	$100,218	$98,052	$24,512	$83,716	$35,879	43%	$10,505	$22,038
Source: This table was created based on analysis of taxpayer filings and other sources, to create estimates of the aggregated foreign CSA participant legal entity tax accounting information that Microsoft or the IRS would use to perform this calculation. These figures, based on disclosures of book accounting results, have been adjusted for this purpose. It is common for taxpayers to use book accounting information as inputs for the RAB share and other calculations used to apportion, for instance, research and development expenses between U.S. and foreign CSA participants. Note: The shaded 2011 figure in column (g) is an actual percentage derived from the Senate PSI report on September 20, 2012, which reported both the pretax income in the foreign CSA participants, as well as cost-sharing payments in the same year. The RAB share was calculated for all other years based on the indicated actual calculation in 2011 reported in testimony before the U.S. Senate.

Table 6. Estimated Microsoft Foreign Territory Periodic Trigger Calculation per Reg. Section 1.482-7(i)(6) for All PCTs (millions of dollars)

	(a)	(b)	(c)	(d)	(e)	(f) = d + e	(g) = b - c	(h) = g/f	(i)	(j)
Year	Year No.	Foreign CSA Territory Related Sales	Non-CC/Non-IDC Costs (Est.)	CC/IDCs (Est.)	PCTs (Est.)	PVI = Est. Total Investment Costs	PVTP = Est. Divisional Profit (Loss)	AERR = PVTP/PVI	AERR > 1.5	“Excess” AERR vs. 1.5 Limitation
FY2009	1	$12,693	$3,808	$1,600	$237	$1,837	$8,885
FY2010	2	$26,311	$5,344	$5,378	$151	$5,529	$20,967
FY2011	3	$31,935	$6,489	$6,188	$49	$6,237	$25,446
FY2012	4	$34,877	$10,463	$8,271	$9,385	$17,656	$24,414
FY2013	5	$36,505	$7,091	$7,843	$1,193	$9,036	$29,414
FY2014	6	$43,359	$9,785	$8,465	$4,416	$12,881	$33,574
FY2015	7	$50,639	$30,000	$7,254	$2,242	$9,495	$20,639
FY2016	8	$45,008	$13,780	$9,600	$1,115	$10,714	$31,228
FY2017	9	$45,493	$13,648	$10,053	$20,007	$30,060	$31,845
FY2018	10	$54,434	$18,808	$10,072	$607	$10,679	$35,626
FY2019	11	$61,644	$21,457	$10,773	$1,524	$12,298	$40,187
FY2020	12	$69,855	$29,053	$10,507	$1,375	$11,882	$40,802
FY2021	13	$84,135	$33,077	$10,439	$4,489	$14,928	$51,058
FY2022	14	$98,052	$42,223	$10,505	$9,445	$19,950	$55,829
Yr 0 NPV thru Yr 1		$12,115	$3,635	$1,527	$227	$1,754	$8,481	4.8	Yes	222%
Yr 0 NPV thru Yr 2		$34,965	$8,275	$6,198	$358	$6,556	$26,690	4.1	Yes	171%
Yr 0 NPV thru Yr 3		$60,209	$13,405	$11,089	$396	$11,486	$46,804	4.1	Yes	172%
Yr 0 NPV thru Yr 4		$85,305	$20,934	$17,041	$7,150	$24,190	$64,372	2.7	Yes	77%
Yr 0 NPV thru Yr 5		$109,215	$25,578	$22,177	$7,931	$30,108	$83,637	2.8	Yes	85%
Yr 0 NPV thru Yr 6		$135,065	$31,412	$27,224	$10,564	$37,788	$103,653	2.7	Yes	83%
Yr 0 NPV thru Yr 7		$162,546	$47,692	$31,160	$11,780	$42,941	$114,854	2.7	Yes	78%
Yr 0 NPV thru Yr 8		$186,591	$55,053	$36,289	$12,376	$48,665	$131,537	2.7	Yes	80%
Yr 0 NPV thru Yr 9		$208,713	$61,690	$41,178	$22,105	$63,283	$147,023	2.3	Yes	55%
Yr 0 NPV thru Yr 10		$232,808	$70,015	$45,636	$22,374	$68,010	$162,793	2.4	Yes	60%
Yr 0 NPV thru Yr 11		$257,646	$78,661	$49,977	$22,988	$72,965	$178,985	2.5	Yes	64%
Yr 0 NPV thru Yr 12		$283,266	$89,316	$53,830	$23,492	$77,323	$193,949	2.5	Yes	67%
Yr 0 NPV thru Yr 13		$311,353	$100,359	$57,315	$24,991	$82,306	$210,994	2.6	Yes	71%
Yr 0 NPV thru Yr 14		$341,149	$113,189	$60,508	$27,861	$88,369	$227,960	2.6	Yes	72%

VIII. Periodic Adjustment

A. Exceptions

Subparagraphs (1) through (4) of reg. section 1.482-7(i)(6)(vi)(A) identify four exceptions that could prevent a periodic adjustment. In Microsoft’s case, the applicable period when these exceptions could apply would start on January 5, 2009. This is because of Microsoft’s earlier-described noncompliance with the reg. section 1.482-7(m)(1) transition rule of the 2008 regulations, which caused a new CSA as of that date.

The first exception concerns when a taxpayer has transferred the cost-shared IP to an unrelated party under similar conditions to that of the contribution to the controlled CSA participant, and the unrelated transfer price was used as the basis for pricing the PCT. No instances of this can be found in the public domain, and it seems patently doubtful that any such situations would exist.

The second exception occurs when the indicated periodic trigger was the result of extraordinary events, beyond the control of the controlled participants, that could not reasonably have been anticipated at the time of the trigger PCT. Note that this exception assumes that the taxpayer otherwise complied with the CSA regulations in all other respects. This seems unlikely with Microsoft because no extraordinary events can be identified that would qualify for this exception.

The third exception appears to apply when the periodic trigger occurs as the result of contributions other than platform contributions, such as operating contributions made by the PCT payer; for example, the creation of exploitation IP. It is quite clear that platform contributions contribute significantly to Microsoft’s extremely high foreign pretax profits, but there could certainly be operating and other contributions by foreign participants that are impossible to discern based on public information. However, that is not a major concern in this analysis because the periodic adjustment trigger test in this report incorporates all foreign revenue and profit results. To the extent that Microsoft has substantial foreign operating and other contributions (that are nevertheless assumed here to be less profitable than its Windows IP), removing them from the analysis (as prescribed by the regulation for a periodic trigger test before applying this exception) would be expected to increase the AERR above the indicative results shown in this report.

The fourth exception would apply if a periodic trigger would not have occurred if anticipated profit and losses in future years were taken into account in the current year. For example, this would occur if, in a year after the triggering event, the foreign CSA participant experienced a loss that was substantial enough to reduce the cumulative AERR to below the PRRR upper range in that future year, in effect reversing the initial periodic trigger. No such future year results would change the results of this analysis, primarily because a periodic trigger occurs in each and every reported year of the CSA since January 5, 2009.

There are also five- and 10-year safe harbors. Under the five-year safe harbor, if the CSA-related results of Microsoft’s foreign participants are so low in the first five years that they fall below the periodic trigger range, no periodic trigger would be allowed for these first five years of the CSA (which, in our analysis, is from January 5, 2009). Under the 10-year period safe harbor, if the taxpayer has no periodic trigger in the first 10 years of its CSA under the 2008 regulations, it will be exempt from a periodic adjustment for the remaining life of the CSA. Microsoft qualifies for neither of these safe harbors because it appears to trigger a periodic adjustment in every year since the initial year, 2009.

In summary, Microsoft does not appear to qualify for any of the exceptions or safe harbors, or if so, in a way that would prevent a periodic adjustment under reg. section 1.482-7(i)(6).

B. Overview of Periodic Adjustment Steps

The five steps described below are formulaic. The background to them, though, is the CWI concept inserted into section 482 (and section 367(d) as well) in TRA 1986. In short, the concept behind these formulaic steps is to allow a CSA participant to earn a return only to the extent of two factors.

The first factor is the routine functions performed. Normal transfer pricing concepts and applicable regulations under section 482 will determine the return for these functions. For Microsoft’s foreign CSA participants, these functions include the sales and marketing, customer support, and any other routine activities performed. The models assume (based on research of public information) that Microsoft’s foreign affiliates do not perform any nonroutine activities.

The second factor is the nonroutine contributions that each CSA participant has brought to the table at the initiation of the CSA. For Microsoft US, MIR, MAIL, and MOPR, this would be any IP that each brought to the new CSA as of January 5, 2009. Under the rules detailed in reg. section 1.482-7(i)(6)(v), the RPSM is used by applying the relative value of each participant’s nonroutine contributions to determine, for each period from 2009, that participant’s share of actual profits exceeding the calculated routine returns.

The position taken in this report is that Microsoft’s CSA was invalid from its 1999 inception because all putative foreign participants failed to conduct individual exploitation of the cost-shared IP, a required condition under reg. section 1.482-7A(a) at the time of formation. As a result, at the time the new CSA started on January 5, 2009, neither MIR, MAIL, nor MOPR owned any legacy IP. Accordingly, these calculations assume that only Microsoft US brought any nonroutine contributions to the “new” CSA in 2009 for purposes of applying the RPSM. This leaves Microsoft US with 100 percent of any residual profit for all periods from 2009.

The five formulaic steps to calculate the periodic adjustment are set out in reg. section 1.482-7(i)(6)(v) as follows:

1. As of the date of the trigger PCT, determine the present value of the PCT payments using the adjusted RPSM as described in paragraph (i)(6)(v)(B) of the CSA regulations. Note that for this purpose, those PCT payments are primarily those related to Microsoft acquisitions, reported in its Form 10-K, which represent the source of Microsoft US platform contributions to the CSA reflected in the models shown in this report. The values of acquisitions, net of cash acquired and of purchases of intangible and other assets reported in the statement of cash flows, were used for this purpose. Note that in this step, a residual profit split is determined, and when only the U.S. CSA participant has made nonroutine contributions to the CSA, the residual profit split attributes 100 percent of the residual profits to the U.S. participant under reg. section 1.482-7(i)(6)(vii), Example 1, para. (vi).

2. Convert the present value of the PCT payments determined in the first step into a level royalty rate as a percentage of the reasonably anticipated divisional profits or losses over the entire duration of the CSA activity.

3. Multiply the step 2 royalty rate by the actual divisional profit or loss for tax years preceding and including the adjustment year to yield a stream of contingent payments in each year and convert those payments to a present value as of the CSA start date. In the event of a loss in any particular year, the result will be a negative contingent payment for that year.

4. Convert any actual PCT payments through the adjustment year to a present value as of the CSA start date (January 5, 2009) and subtract this present value from the present value result determined in step 3. This difference is the amount in present value terms of the participant’s deficiency in PCT payments. Then convert that present value payment to a nominal amount in the adjustment year. This nominal amount is the periodic adjustment to be recognized by the U.S. taxpayer as additional taxable income in the adjustment year. (Note that this fourth step actually includes three substeps. In the tables below, this is separated into steps 4a, 4b, and 4c for clarity.) After a periodic adjustment has been calculated for a particular adjustment year, every subsequent year will automatically be subject to a periodic adjustment in accordance with the following guidance found at reg. section 1.482-7(i)(6)(v):

In the event of a periodic trigger, subject to paragraph (i)(6)(vi) of this section, the Commissioner may make periodic adjustments with respect to all PCT Payments between all PCT Payors and PCT Payees for the Adjustment Year and all subsequent years for the duration of the CSA Activity pursuant to the residual profit split method as provided in paragraph (g)(7) of this section, subject to the further modifications in this paragraph (i)(6)(v). A periodic adjustment may be made for a particular taxable year without regard to whether the taxable years of the Trigger PCT or other PCTs remain open for statute of limitation purposes.

5. Apply the step 2 royalty rate to the actual divisional profit or loss for each tax year after the adjustment year to calculate amounts for each year. Then subtract from each year’s amount any actual PCT payment made for the same year. The differences are the periodic (income) adjustment for each respective post-adjustment tax year.

Reg. section 1.482-7(i)(6)(v)(B)(2) contains the following guidance regarding the determination of the applicable royalty:

Projected results for the balance of the CSA Activity after the Determination Date, as reasonably anticipated as of the Determination Date, shall be substituted for what otherwise were the projected results over such period, as reasonably anticipated as of the date of the Trigger PCT.

The detailed guidance, as reflected in reg. section 1.482-7(i)(6)(vii), Example 1, paragraphs (v) through (vii), requires that the entire projected life of a CSA be included in the calculation of the level royalty rate. The calculation steps described above as applied to Microsoft’s CSA, together with relevant assumptions, are shown below.

C. Detailed Calculations

1. Periodic adjustment calculation step 1.

Table 7 calculates the residual profit from transactions recorded by Microsoft’s foreign affiliates for each year based on the difference between the foreign revenue and the non-CSA-related expenses as marked up by the routine return. This difference is the nonroutine return. The nonroutine return is additive by year, and the sum of each year and prior years is determined and converted to a net present value as of the CSA start date (January 5, 2009). The calculations are based on several assumptions, as noted earlier:

• Microsoft’s foreign affiliates perform only routine activities.

• Microsoft’s foreign CSA participants owned no IP, including legacy IP, at the outset of the new 2009 CSA and made no nonroutine contributions to the CSA at that time that would have provided these affiliates anything more than a 0 percent residual profit split under the periodic adjustment rules that require application of a modified RPSM.

• The applied arm’s-length return for foreign routine activities is an 8 percent markup on its associated expenses. Based on experience, this was deemed by us to likely be a generous arm’s-length profit for what are clearly routine functions, including marketing and sales activities, customer support, logistics, etc.

• Future years included in these calculations, as described in reg. section 1.482-7(i)(6)(v)(B)(2), to determine the terminal value for the IP, were based on the 2022 results repeated for 10 years (that is, no growth or decline) and discounted back to the 2022 tax year.

Table 7. Periodic Adjustment Step 1 Results per Reg. Section 1.482-7(i)(6) for All PCTs (millions of dollars)

Year	(a)	(b)	(c)	(d)	(e)	-	(f)	(g) = (d - e - f)
	Year No.	Foreign Territory CSA-Related Sales	Non-CC/Non-IDC Costs (Est.)	Est. Divisional Profit (Loss)	Reported CC/IDCs (Est.)	Routine Return %	Routine Return (MUTC) = (c) * Routine Return	Residual Profit (100% to U.S.)
FY2009	1	$12,693	$3,808	$8,885	$1,600	8%	$305	$6,980
FY2010	2	$26,311	$5,344	$20,967	$5,378	8%	$427	$15,162
FY2011	3	$31,935	$6,489	$25,446	$6,188	8%	$519	$18,738
FY2012	4	$34,877	$10,463	$24,414	$8,271	8%	$837	$15,306
FY2013	5	$36,505	$7,091	$29,414	$7,843	8%	$567	$21,004
FY2014	6	$43,359	$9,785	$33,574	$8,465	8%	$783	$24,326
FY2015	7	$50,639	$30,000	$20,639	$7,254	8%	$2,400	$10,986
FY2016	8	$45,008	$13,780	$31,228	$9,600	8%	$1,102	$20,526
FY2017	9	$45,493	$13,648	$31,845	$10,053	8%	$1,092	$20,700
Yr 0 NPV thru Yr 9		$208,713	$61,690	$147,023	$41,178	8%	$4,935	$100,910

2. Periodic adjustment calculation step 2.

Table 8 is used to calculate the residual return to Microsoft US for its exploitation of the cost-shared intangibles. This return is stated as a level royalty rate percentage of divisional profit or loss.

Table 8. Step 2 Royalty Rate Determination per Reg. Section 1.482-7(i)(6) for All PCTs (millions of dollars)

Year	(a)	Foreign Territory CSA-Related Sales	Non-CC/Non-IDC Costs (Est.)	(b)	(c)	-	(d)	(e) = (b - c - d)	(f) = e/b
	Year No.			Est. Divisional Profit (Loss)	Reported CC/IDCs (Est.)	Routine Return %	Routine Return (MUTC) = Est. Non-CC/Non-IDC Costs * Routine Return	Residual Profit	Royalty Calc
FY2009	1	$12,693	$3,808	$8,885	$1,600	8%	$305	$6,980
FY2010	2	$26,311	$5,344	$20,967	$5,378	8%	$427	$15,162
FY2011	3	$31,935	$6,489	$25,446	$6,188	8%	$519	$18,738
FY2012	4	$34,877	$10,463	$24,414	$8,271	8%	$837	$15,306
FY2013	5	$36,505	$7,091	$29,414	$7,843	8%	$567	$21,004
FY2014	6	$43,359	$9,785	$33,574	$8,465	8%	$783	$24,326
FY2015	7	$50,639	$30,000	$20,639	$7,254	8%	$2,400	$10,986
FY2016	8	$45,008	$13,780	$31,228	$9,600	8%	$1,102	$20,526
FY2017	9	$45,493	$13,648	$31,845	$10,053	8%	$1,092	$20,700
FY2018	10	$54,434	$18,808	$35,626	$10,072	8%	$1,505	$24,050
FY2019	11	$61,644	$21,457	$40,187	$10,773	8%	$1,717	$27,697
FY2020	12	$69,855	$29,053	$40,802	$10,507	8%	$2,324	$27,970
FY2021	13	$84,135	$33,077	$51,058	$10,439	8%	$2,646	$37,973
FY2022	14	$98,052	$42,223	$55,829	$10,505	8%	$3,378	$41,946
Terminal Value		$606,128	$261,007	$345,120	$64,941	8%	$20,881	$259,299
Yr 0 NPV thru Yr 14		$245,010	$113,189	$227,960	$60,508		$7,496	$159,956	70%

3. Periodic adjustment calculation step 3.

Table 9 calculates the nominal value of the royalty payment representing the residual profit as calculated in Table 8 on a rolling basis from the beginning of the CSA to the adjustment year. The table calculates the nominal royalty in the adjustment year based on the sum of the net present value of the payments in each year and the years before it. This table therefore uses a royalty rate applicable to the adjustment year, 2017.

Table 9. Step 3 Nominal Royalty Calculation per Regulation Section 1.482-7(i)(6) (millions of dollars)

Year	(a)	(b)	(c)	(d) = b * c
	Year No.	Est. Divisional Profit and Loss	Royalty Rate	Nominal Royalty Due Under Adjusted RPSM
FY2009	1	$8,885	70%	$6,234
FY2010	2	$20,967	70%	$14,713
FY2011	3	$25,446	70%	$17,855
FY2012	4	$24,414	70%	$17,131
FY2013	5	$29,414	70%	$20,639
FY2014	6	$33,574	70%	$23,559
FY2015	7	$20,639	70%	$14,482
FY2016	8	$31,228	70%	$21,912
FY2017	9	$31,845	70%	$22,345
Yr 0 NPV thru Yr 9		$147,023		$103,164

4. Periodic adjustment calculation steps 4a, 4b, and 4c.

Table 10 combines several steps. Step 4a calculates a series of nominal adjustments by subtracting the nominal PCT payments from the nominal royalty payments calculated in Table 9. Step 4b converts these results to a net present value payment at the beginning of the first year of the CSA (year 0). Step 4c takes the step 4b amount and converts this amount through compounding to a nominal payment in the adjustment year (2017).

Table 10. Step 4 Periodic Adjustment Calculation per Reg. Section 1.482-7(i)(6) (millions of dollars)

Year	(a)	(b)	(c)	(d) = b * c	(e)	(f) = d - e	(g) = f/(Det Year ADR)
	Year No.	Est. Divisional Profit and Loss	Royalty Rate	Nominal Royalty Due Under Adjusted RPSM	Est. Nominal Payments Made (PCTs)	Additional PCT Owed	Present Value of the Owed PCT in Adjustment Year (2017)
FY2009	1	$8,885	70%	$6,234	$237	$5,997	Convert Year 0 Amounts to PV in 2017 Determination Year
FY2010	2	$20,967	70%	$14,713	$151	$14,561
FY2011	3	$25,446	70%	$17,855	$49	$17,806
FY2012	4	$24,414	70%	$17,131	$9,385	$7,745
FY2013	5	$29,414	70%	$20,639	$1,193	$19,446
FY2014	6	$33,574	70%	$23,559	$4,416	$19,143
FY2015	7	$20,639	70%	$14,482	$2,242	$12,240
FY2016	8	$31,228	70%	$21,912	$1,115	$20,798
FY2017	9	$31,845	70%	$22,345	$20,007	$2,339
Yr 0 NPV thru Yr 9		$147,023		$103,164	$22,105	$81,059	$166,688

The amount in year 9 is considered additional U.S. taxable income to be reported related to the 2017 tax year. This income would be taxed at the U.S. federal tax rate in effect in 2017, which was 35 percent.

5. Periodic adjustment calculation step 5.

Table 11 applies the royalty rate established for the adjustment year to the years after the adjustment year for which information is available (fiscal 2018 through fiscal 2022) to calculate the periodic adjustments for each of these years net of the nominal PCT payments made in those years. These figures are not discounted because these adjustments occur within each subsequent examination cycle after the 2017 adjustment year examination and pertain only to the nominal results on a year-by-year basis.⁸⁸

Table 11. Step 5 Periodic Adjustment Calculation Through Determination Date per Regulation Section 1.482-7(i)(6) (millions of dollars)

Year	(a)	(b)	(c)	(d) = b * c	(e)	(f) = d - e
	Year No.	Est. Divisional Profit and Loss	Royalty Rate in Adjustment Year	Nominal Royalty Due Under Adjusted RPSM	Assumed Nominal Payments Made (PCTs)	Additional Periodic Adjustment to be Made
FY2018	10	$35,626	70%	$24,999	$607	$24,391
FY2019	11	$40,187	70%	$28,198	$1,524	$26,674
FY2020	12	$40,802	70%	$28,630	$1,375	$27,255
FY2021	13	$51,058	70%	$35,826	$4,489	$31,337
FY2022	14	$55,829	70%	$39,175	$9,445	$29,730

6. Calculation of taxes owed.

The calculation in Table 12 of taxes owed multiplies the first periodic adjustment for the adjustment year (2017) by 35 percent, which was the tax rate in effect for that year. Fiscal 2018 was calculated using a blended rate of 28 percent as a result of the TCJA’s change to the federal tax rate, which was applied on a calendar-year basis. Later years reflect the still-current rate of 21 percent.

The calculated periodic adjustment of almost $167 billion for adjustment year 2017 reduces the accumulated foreign earnings that are the base for the TCJA transition tax because of the change from a deferral taxation system to a territorial taxation system (section 965). This report therefore appropriately assumes in Table 12 that the taxes on periodic adjustments will be reduced by the amount of transition taxes previously paid, which, as Microsoft stated in its fiscal 2022 Form 10-K, amount to about $6.2 billion⁸⁹:

As a result of the TCJA, we are required to pay a one-time transition tax on deferred foreign income not previously subject to U.S. income tax. Under the TCJA, the transition tax is payable in interest-free installments over eight years, with 8 percent due in each of the first five years, 15 percent in year six, 20 percent in year seven, and 25 percent in year eight. We have paid transition tax of $6.2 billion, which included $1.5 billion for fiscal year 2022. The remaining transition tax of $12.0 billion is payable over the next four years, with $1.3 billion payable within 12 months.

Table 12. Est. Total Federal Taxes Payable for 2017 Through Determination Date

Description	Applicable Year	Periodic Adjustment	Statutory Federal Rate	Estimated Federal Taxes Net of Repatriation Taxes
Initial Periodic Adjustment	2017	$166,688	35%	$58,341
FY2018 Periodic Adjustment	2018	$24,391	28%	$6,830
FY2019 Periodic Adjustment	2019	$26,674	21%	$5,602
FY2020 Periodic Adjustment	2020	$27,255	21%	$5,724
FY2021 Periodic Adjustment	2021	$31,337	21%	$6,581
FY2022 Periodic Adjustment	2022	$29,730	21%	$6,243
TCJA repatriation taxes paid, 2018-2022				$(6,200)
Total				$83,119

It is believed that interest would apply to this payment because periodic adjustments are applied at the discretion of the commissioner, though the regulation allows for taxpayers to offset the tax underpayment from the periodic adjustment in a later year by increasing payments from the foreign CSA participant sufficient to eliminate the periodic adjustment by the later year, taking advantage of one of the exceptions. Here the taxpayer did not do this, and the values computed here are as of 2017. If payment of the periodic adjustment was made in early 2023 and incurred interest representing the period from 2017 to the end of 2022, because the amount exceeds $100,000, the applicable interest rate would be the federal short-term rate plus 5 percentage points, compounded daily.⁹⁰ This total rate would be around 9.5 percent at the time of this report (January 2023). If applicable, the interest payment on the tax adjustment could be substantial — around $52 billion.

Reg. section 1.4827(k)(2)(iii)(A) of the 2008 regulations notes that penalties could apply to the periodic adjustment, in accordance with section 6662(e) and (h). A 40 percent penalty of about $33 billion could be added to the sum of all tax imposed on the periodic adjustments. All in, the tax, interest, and penalty due from a periodic adjustment could be (rounded) $83 billion + $50 billion + $33 billion = $168.7 billion.

D. Effect of Grandfathering

Assume as a counterfactual that Microsoft’s CSA had been validly grandfathered such that the reg. section 1.482-7(i)(6) periodic adjustment rule did not apply from January 5, 2009. In such a case, reg. section 1.482-7(m)(3), which reads as follows, is relevant:

The periodic adjustment rules in paragraph (i)(6) of this section (rather than the rules of section 1.482-4(f)(2)) shall apply to PCTs that occur on or after the date of a material change in the scope of the CSA from its scope as of January 5, 2009. A material change in scope would include a material expansion of the activities undertaken beyond the scope of the intangible development area, as described in former section 1.482-7(b)(4)(iv). [Emphasis added.]

The regulation further defines such an expansion as consisting of one event or multiple events on a cumulative basis. As a result, even if Microsoft’s preexisting CSA was grandfathered, it could still owe a periodic adjustment beginning as early as 2010. One event in particular that appeared to materially change the scope of the CSA activity was Microsoft’s 2010 entry into the rapidly developing market for cloud-based services with its launch of the Azure cloud platform. That led to quickly growing R&D needs for new cloud-based products and services that by 2022 represented almost half of Microsoft’s total revenue. Other possible material expansions could be Microsoft’s acquisition of Skype Technologies SARL for $8.5 billion in 2011 and/or its acquisition of Nokia Corp. for $7.2 billion in 2013, both of which represented entry into new market segments. If any or a cumulation of these acquisitions and expansions caused a material change in the scope of CSA activities, a material periodic adjustment could still occur.

Taxpayers like Microsoft had an opportunity to be grandfathered by simply complying with the reg. section 1.482-7(m)(1) transition rules of the 2008 regulations, but Microsoft appears to have made no attempt to do so. Taxpayers agreed to abide by the cost-sharing regulations when they elected CSA treatment as an exception to the conventional comparables-based license arrangements described by reg. section 1.482-4. Further, taxpayers were required by reg. section 1.482-7(k)(2)(ii)(J) to maintain documentation showing that their results complied with the 2008 CSA regulations, which implies that taxpayers with CSAs should be performing periodic trigger calculations regularly to ensure their compliance with the CWI standard.

IX. Alternative Approach

Regardless of whether the IRS chooses to apply a periodic adjustment under reg. section 1.482-7(i)(6), the publicly available facts strongly support an additional approach that the IRS should apply to Microsoft’s CFCs: ECI taxation. ECI taxation is applied directly to Microsoft’s CFCs⁹¹ as taxpayers rather than to Microsoft Corp., which, along with other U.S. affiliated group members, files a consolidated U.S. corporate tax return. ECI taxation can be pursued either on its own or simultaneously with transfer pricing adjustments, including both the periodic adjustment discussed in this report as well as adjustments under other transfer pricing regulations.

ECI taxation is applied directly to foreign persons, including CFCs such as MIR, MAIL, and MOPR. It requires as a threshold that the foreign person factually conducts a trade or business within the United States. Earlier sections of this report have documented how, through the actions of U.S.-based personnel and assets, Microsoft US has conducted the bulk of actual day-to-day exploitation operations of Microsoft’s foreign business. This was most explicitly established with disclosure of the contracts to provide Bsquare with the Windows Mobile OS on an OEM basis. All foreign revenue was generated from sales efforts and other exploitation operations occurring in the United States. Despite this, revenue related to the EMEA territory was recorded in the name of MIOL by virtue of an Irish executive’s signature on the customer license contract.

A principal portion of revenue-generating activities in the years when Microsoft’s CSA was initiated (1999) and expanded to additional foreign group members involved the sale of software, including both the Windows OS and stand-alone apps, such as Office. Further, the trove of documents mentioned in Section III that was made available in 2016 related mostly to that early period. As a result, much of the focus of this report concerns how Microsoft generated revenue through the sale of those products.

Despite this primary focus on software sales, Microsoft has also generated increasing amounts of revenue and profits from the leasing of software and from cloud and other services, including advertising. While Microsoft’s high profits have primarily come from software and services, it has manufactured and sold over the years various devices in the gaming, smartphone, and computer/tablet areas (it is understood that the actual manufacturing is normally performed by third-party contract manufacturers). Some significant portion of the revenue from these sources has been generated through Microsoft’s online store, which is accessible throughout the world. It is understood that with the exception of the OEM sales of Windows OS, third-party revenue for all these sources from customers physically located outside the Americas has generally been recorded within MIR and MAIL. This is in contrast to MOPR’s revenue, which is primarily or solely from its intercompany sales to U.S. group member distributors.

For these other areas that involve software leasing, cloud and other services, and sales of manufactured products, the relevant exploitation activities that generate the revenue also occur primarily within the United States. For example, consider the internet-based platforms through which software is leased, services are provided, and the Microsoft online store reaches customers accessing and paying for products and services. It is understood that the managers and the personnel who operate these platforms day to day are located primarily within the United States. Those are the people who decide what products and services to offer, the terms on which to offer them, and at what prices. As noted earlier, there may be some localization of products and services that occurs outside the United States, but these are mere adjustments to standardized products and services (with the localization options already built in) that are being provided by one central management and operational groups to Microsoft’s customers worldwide through standard platforms.

This constitutes the management and operation by U.S. group members of MIR, MAIL, and MOPR’s businesses.

Microsoft may have intercompany agreements in place that label Microsoft US as an independent contractor merely performing services for MIR, MAIL, and MOPR. Despite any such label, it is clear that Microsoft US’s role goes far beyond what any independent contractor would do on behalf of its client. Further, it is extremely doubtful that any foreign management personnel from any office of MIR, MAIL, or MOPR outside the United States would have the authority, or even the knowledge or competence, to be able to direct Microsoft US’s actions in its labeled capacity as an independent contractor. Rather, Microsoft US acts in the capacity of a de facto agent on behalf of its CFCs.

The focus of most fact-finding in this report has been on the period 1999-2009, but the relevant facts likely remain unchanged for later years. This fact pattern causes Microsoft’s foreign CSA participants to be engaged in a trade or business within the United States, likely for all years from 1999 through the present.⁹²

The application of ECI taxation is procedurally easier when there is a partnership. Accordingly, the way in which Microsoft US and its CFCs have conducted Microsoft’s worldwide business must be examined in light of the entity classification rules of reg. sections 301.7701-1 and -3. In short, with one management and operational structure that conducts the worldwide businesses of Microsoft Corp. and MIR, MAIL, and MOPR, there is clearly a joint business being conducted that constitutes an entity for federal tax purposes that, under the default rule of the entity classification regulations, will be treated as a partnership in the absence of an active election.⁹³ With MIR, MAIL, and MOPR thereby being treated as partners in a partnership that conducts the joint worldwide business of the Microsoft group,⁹⁴ they would be treated by statute (section 875) as being engaged in a trade or business within the United States.

Once MIR, MAIL, and MOPR are found to be engaged in a trade or business in the United States (whether directly or through a partnership), each item of gross income must be considered under the applicable sourcing and ECI rules to determine the ECI that will be directly taxable in the hands of those foreign affiliates. Given that it is primarily personnel in the United States who conduct exploitation activities for the various classes of the CFCs’ income (sales, services, etc.), with personnel outside the United States being primarily involved in routine sales, marketing, and customer support activities, it seems certain that there will be significant U.S.-source income under sections 861, 863, and 865(e)(2) that will be treated as ECI under section 864(c)(3).⁹⁵

Note that ECI taxation may be applied in conjunction with transfer pricing adjustments. Assume that the IRS chooses to apply and eventually sustains periodic adjustments under reg. section 1.482-7(i)(6) and/or other transfer pricing adjustments, such as intercompany service fee adjustments under reg. section 1.482-9. Following those adjustments, CFC profits will have been reduced to some extent under the correlative adjustment rules of reg. section 1.482-1(g)(2). It is the post-correlative adjustment profits of MIR, MAIL, and MOPR to which ECI taxation will be applied.

The status of open and closed years for the application of ECI taxation to a CFC does not follow the status of the Microsoft U.S. affiliated group’s open and closed years. This is because any CFC is a separate taxpayer with its own filing requirements on Form 1120-F. If a CFC has never filed a Form 1120-F for a prior year, under section 6501(c)(3), that CFC’s prior year will still be open for adjustment.⁹⁶ Therefore, relevant years may still be open going back to the 1999 initiation of Microsoft’s CSA.

ECI taxation includes not only the normal corporate tax at the rate applicable for the particular tax year but also the section 884 branch profits tax. Further, when a tax return has not been timely filed,⁹⁷ the section 882(c)(2) denial of deductions and credits will increase the amount of ECI.⁹⁸ This can create effective tax rates much higher than the normal 35 percent rate for 2017 and prior years and 21 percent for 2018 and later years.

Microsoft’s income comes from the sale and lease of software, the provision of services, and the sale of manufactured products. To the extent that any of Microsoft’s foreign income from that revenue is foreign-source and escapes ECI taxation, it might still be subject to U.S. taxation in the hands of its U.S. shareholder under subpart F. For example, the branch rule of section 954(d)(2) and reg. section 1.954-3(b) may apply to some portion of Microsoft’s sales transactions.⁹⁹ Because subpart F results in taxation in the hands of the U.S. shareholder and not the applicable CFC, this additional tax can apply only to Microsoft’s open years.¹⁰⁰

X. Conclusion

The conclusions of this report are based primarily on information provided directly or indirectly by Microsoft in various contexts (internal planning documents, testimony before the Senate, SEC filings, comments by executives in the press and social media, Microsoft’s website, and former employees and developers familiar with Microsoft’s IP and internal operations). The report finds that Microsoft’s CSA did not comply with the transition rule in reg. section 1.482-7(m)(1) of the 2008 CSA regulations, which would have otherwise allowed grandfathering of its preexisting CSA under those regulations. This is because Microsoft’s foreign CSA participants met neither the individual exploitation requirement nor the participant requirement, which are imbedded in the transition rules through their reference to reg. section 1.482-7A — the former regulations published in 1996. The IRS’s apparent acceptance of Microsoft’s CSA since 2009 means that it must be considered a new CSA effective from January 5, 2009, with no benefit of any of the grandfathering provisions included in reg. section 1.482-7(m)(1) or (2). As a result, Microsoft is unable to qualify under this regulation for exemption from the 2008 periodic adjustment rules in reg. section 1.482-7(i)(6).

An indicative calculation of this periodic adjustment based on conservative assumptions shows that Microsoft should be subject to a substantial periodic adjustment that would result in tax payments materially exceeding its deferred tax liabilities for the TCJA deemed repatriation taxes and reserves for uncertain tax positions. Either in conjunction with, or as an alternative to, a periodic adjustment, the IRS has a particularly strong basis for assessing ECI taxation directly on some of Microsoft’s CFCs. Importantly, the apparent recognition within these CFCs of significant profits that should have been reported within the United States potentially also affects state taxes, especially for any states that apply their state income tax on a water’s-edge or other approach that excludes Microsoft’s foreign profits from the allocable tax base. These findings should provide a basis for state tax auditors to recoup significant amounts of underpaid taxes to the extent they enforce transfer pricing laws in the state. The evidence provided in this report raises the possibility that this could be yet another spectacular tax enforcement failure produced by the Frankenstein cost-sharing regulations.