Former Microsoft Attorney Supports Microsoft Privilege Claims

1. I hold a law degree from Creighton University School of Law (J.D., 1983), a graduate law degree from Boston University School of Law (LL.M. Taxation, 1984), and an undergraduate business degree from Creighton University (B.S.B.A., 1979). I was admitted as a member of the Bar of the State of Nebraska on February 25,1985, in Massachusetts on May 23,1984, and remained an active member of the Nebraska Bar in good standing at all times while employed by Microsoft.

2. I joined Microsoft Corporation ("Microsoft") in 1986 as an attorney in Microsoft's tax department. From 1986 to my October 31, 2006 retirement from Microsoft, I held a series of positions of increasing legal and management responsibility.

3. Immediately prior to my retirement, I served as Microsoft's Corporate Vice President of Finance and Tax Counsel. I held this position from 2003 to 2006. Prior to this position, I served as Vice President, Tax and Audit and Tax Counsel.

4. As Microsoft's Corporate Vice President of Finance and Tax Counsel, I worked closely with senior management and held a number of roles, including overseeing Microsoft's Tax Department, Microsoft's Internal Audit group, and acting as the senior Microsoft lawyer within the Tax Department advising on legal issues relating to tax. In my role overseeing the Tax Department and as Tax Counsel, I oversaw worldwide tax policy, global and domestic tax planning, audits, tax litigation, and final resolution of complex tax issues and disputes.

5. Over the course of my career, I have also held a number of leadership positions within the national and international tax communities. I was honored to serve as the International President of the Tax Executives Institute, Inc. ("TEI"), the foremost association of senior tax executives globally, during 2005 and 2006. I was appointed by the IRS to serve from 1998 to 2000 on its Electronic Tax Administration Advisory Council ("ETAAC"). I was also appointed by the Internal Revenue Service ("IRS") to its IRS Advisory Council ("IRSAC") in March 2007 and served for two years.

6. As part of my role overseeing the Microsoft Tax Department and as Tax Counsel, my job was to defend Microsoft against claims by the IRS that Microsoft had underpaid its taxes. Microsoft, like most large, profitable multinational corporations in the United States, is under continual audit by the IRS.

7. As described below, based on the IRS' practice of challenging transfer pricing issues at a variety of different companies leading to litigation, and Microsoft's own experience in litigating with the IRS, it was abundantly clear to me that the IRS would challenge Microsoft's transfer pricing, including particularly its cost sharing arrangements. Faced with this real threat of litigation, I made the decision to hire outside counsel and tax accountants to assist both in planning our tax structure in a way that was consistent with the tax law, and in preparing Microsoft to defend itself from IRS litigation.

8. Microsoft, like nearly all multinational corporations, transfers goods, services and intellectual property among its related affiliates around the world. These goods, services and intellectual property are often sold or licensed by one related party to another. Depending on the price at which these goods, services and intellectual property are sold or licensed, the related party in a given country will earn more or less income. The local country's tax authority, for example, our IRS, wants the related parties in its country to earn more income so that the local tax authority can collect more tax. Determination of the price at which goods, services and intellectual property are transferred between related parties is thus of great importance to taxpayers and tax authorities. Largely at the insistence of the U.S., countries around the world have agreed that the price at which related parties transfer goods, services, and intellectual property across national boundaries should be based on the arm's length standard. The arm's length standard essentially says that these items should trade among related affiliates upon the comparable terms and prices as those items would trade among unrelated parties. The United States imposes the arm's length standard upon taxpayers under the transfer pricing rules of 26 U.S.C. § 482 ("Section 482") and the hundreds of pages of regulations thereunder.

9. Beginning about the time I started my legal career in the 1980s, the IRS began to focus increasing attention upon transfer pricing issues. This trend continued through the 1990s, the 2000s, and continues even today. Large disputes in the 1980s that involved millions of dollars grew to be hundreds of millions and then billions of dollars of tax disputes for individual companies. The IRS litigated case after case, imposing great cost and uncertainty even upon prevailing taxpayers. The IRS endeavored to change the law and regulations, and poured more and better resources into audits and litigation of transfer pricing cases.

10. Through my participation in and leadership positions at TEI, I saw that these transfer pricing disputes were not limited to Microsoft, but were endemic across profitable industries in the United States, particularly in the high tech sector. In addition to the many high profile transfer pricing cases in litigation, I was aware through my discussions with peers at TEI as well as other similar professional and industry associations that transfer pricing disputes with the IRS were the rule rather than the exception. The tax subscription services, such as the BNA and Tax Notes publications, also covered the transfer pricing developments, including detailed reporting on cases, positions being taken by the IRS, and, due to the extreme size of many of the IRS adjustments, SEC financial statement footnote disclosures by various companies of administrative transfer pricing disputes that were not otherwise yet public. There was so much interest by companies in these transfer pricing disputes that publications dedicated solely to transfer pricing issues appeared, like BNA's Transfer Pricing Report. Microsoft subscribed to these services and publications and I read them. By 2004, I knew from these industry contacts that Microsoft faced a real threat of litigation with the IRS over its global transfer pricing.

11. Moreover, I experienced these battles over transfer pricing first hand at Microsoft. During my tenure at Microsoft, Microsoft had multiple disputes with the IRS over taxes, many of which involved transfer pricing under Section 482. To the best of my recollection, Microsoft had disputes with the IRS over transfer pricing for royalties with the IRS seeking very large adjustments in virtually every single year since Microsoft first established its international manufacturing operations in roughly 1986.

12. In addition to these annual transfer pricing disputes, Microsoft also was embroiled in tax disputes on two different issues arising out of its 1990 and 1991 tax years that ended up in actual litigation with the IRS, first in the United States Tax Court and later in the Ninth Circuit. Although Microsoft ultimately prevailed, the litigation dragged on through 2002. I appeared as one of the counsel of record and was active in the case.

13. The first issue in the Tax Court litigation involved the IRS asserting that our manufacturing subsidiary in Puerto Rico did not "manufacture" software within the meaning of 26 U.S.C. §§ 936 and 954. This was an underlying issue in determining the transfer pricing between the Puerto Rican affiliate and Microsoft. The IRS also challenged the underlying transfer pricing determination, but this issue was tossed out based on expiry of the statute of limitations to raise this issue. Microsoft Corp. v. Comm'r, T.C. Memo. 1998-54,1998 Tax Ct. Memo LEXIS 56 (1998). The manufacturing issue was one of national importance to the IRS, and carried potentially billions of dollars of tax exposure to Microsoft over time. The IRS designated the case for litigation, refusing to enter into any settlement negotiations; this meant that the case would proceed to trial absent complete concession by Microsoft. Microsoft stood by its position and filed the case in Tax Court. After years of audit and litigation, the IRS ultimately "de-designated" and then conceded the Puerto Rican manufacturing issue.

14. In the second issue in the Tax Court litigation, the IRS also claimed that Microsoft had wrongfully overstated the tax benefits received from its Foreign Sales Corporation ("FSC"). The FSC tax benefits were a statutory incentive put in place by Congress to boost export sales by U.S. taxpayers. Microsoft's FSC case involved a highly technical reading by the IRS to limit the FSC tax benefits granted by Congress. The case involved millions of dollars of tax for Microsoft for the years at issue and far more for future years. The issue was again one of national importance to the IRS. After a lengthy Tax Court trial, the Tax Court ruled in favor of the IRS. In 2002, however, Microsoft ultimately prevailed when the Ninth Circuit reversed the Tax Court ruling. Microsoft Corp, v. Comm'r, 311 F.3d 1178 (9th Cir. 2002), rev'g 115 T.C. 228 (2000).

15. Thus, by 2004, I was well aware of the IRS challenging numerous companies' transfer pricing, particularly those of high tech companies, had experienced the IRS annually challenging Microsoft's transfer pricing issues, and had just finished years of tax litigation with the IRS. I knew with certainty that Microsoft's transfer pricing would be under attack by the IRS. Despite this fact, Microsoft still needed to conduct its business around the globe and would thus necessarily continue to move goods, services and intellectual property around the world.

16. Congress had long granted incentives to U.S. companies to put jobs in Puerto Rico. The principal incentives were tax benefits under 26 U.S.C. § 936. These rules allowed Puerto Rican affiliates to produce goods and sell the goods back to their U.S. parents. Microsoft long ago established a Puerto Rican affiliate to manufacture software for sale to Microsoft in the United States under this 26 U.S.C. § 936 incentive regime. Over time, the incentives were curtailed. As noted above, Microsoft had transfer pricing disputes with the IRS relating to the Puerto Rican manufacturing operations, and those disputes for the 1990-91 tax years ended up in Tax Court, with the IRS conceding the litigated issues nearly a decade later.

17. By the end of the 1990s, I began to look for a way to reduce our contentious disputes with the IRS.

18. In the 1960s, the IRS recognized that disputes over royalty payments for use of intellectual property could become very large and contentious. In order to avoid or lessen disputes, the IRS in 1968 published regulations that allowed taxpayers to enter into "cost sharing arrangements" whereby offshore affiliates agreeing to fund a pro rata portion of research and development would be considered, for tax purposes, to be the owner of the intellectual property developed. Essentially, with an eye on the fact that international issues can be exploited by its treaty partners, the IRS recognized that substantial fairness could be achieved by all related entities using intellectual property and throwing their money into a hat to fund that development. If one party came to the table with intellectual property already developed or in a partial state of development, the other cost sharing entities would make that entity whole economically by paying for the market value of that technology, which came to be known under the regulations as a "buy-in payment." That basic construct, of paying all costs of intellectual property (or more broadly, product) development and making buy-in payments for pre-existing intellectual property used in the cost sharing effort, was enshrined and remained in the 26 U.S.C. § 482 cost sharing regulations from 1968 until after my retirement. By the late 1990s, I was aware through my contacts at TEI and other similar organizations that many of my peers at other high technology companies had already implemented cost sharing agreements in an attempt to minimize disputes with the IRS. In the late 1990s, in order to avoid Microsoft's annual fights with the IRS over transfer pricing royalties, I began to consider switching Microsoft's international operations from a royalty structure to a cost sharing structure. I believed this would place Microsoft in a better position to defend against the IRS's challenges to its royalty structure. But for the IRS's annual attack on the prior licensing structure, Microsoft would have maintained its prior licensing structure and not switched over to a cost sharing structure.

19. Nonetheless, I expected the IRS to attack the buy-in amounts to be paid by the offshore affiliates for pre-existing intangible property used for purposes of research and development as part of these cost sharing arrangements. In addition to attacking the buy-ins, I expected the IRS to raise every issue they could find to attack the cost sharing arrangements, including raising non-transfer pricing related issues. I fully expected that the IRS challenge could be in the billions of dollars. However, I was of the view that once the buy-in disputes were resolved, disputes going forward over transfer pricing for intellectual property would be largely eliminated. But I first had to defend and prevail in the inevitable fight with the IRS.

20. Having worked with and been challenged by the IRS for my entire legal career, I recognized that I needed to ensure that Microsoft was as ready as it could be to defend against this IRS challenge. Accordingly, I hired the best available legal and tax advisors to prepare our position. I hired Baker & McKenzie, a well known international law firm that had successfully tried many of me leading transfer pricing cases, a firm I have used for years in both tax planning and litigation of the tax cases and transfer pricing disputes mentioned above. I also engaged the accounting firms of Arthur Andersen, KPMG and EY to assist with tax advice. My intent was to prepare the best possible position in order to stave off the IRS attack.

21. We, that is, I and my Tax Department, began with two cost sharing arrangements relating to Europe, the Middle East, and Africa ("EMEA") -- one relating to the retail market and one relating to the original equipment manufacturer ("OEM") market. I hired Arthur Andersen to advise on the EMEA retail market cost sharing arrangement. This was completed and executed in May 1999. I hired KPMG to advise on the EMEA original equipment manufacturer ("OEM") market cost sharing arrangement. This was completed and executed in January 2003. I knew Microsoft would face certain disputes with the IRS over these cost sharing arrangements, particularly the buy-in aspects. Accordingly, I also asked Arthur Andersen and KPMG to assist me in preparing Microsoft's defense of these issues. The IRS, in fact, challenged both EMEA cost sharing arrangements upon audit. I understand that Microsoft and the IRS settled their dispute on these cost sharing arrangements and entered into a closing agreement memorializing that settlement in April 2008.

22. We next set up a cost sharing arrangement in the Asia-Pacific region ("APAC"). We hired EY to advise us. I knew that the IRS would challenge the arm's length value we determined for the buy-in for pre-existing intellectual property contributed by Microsoft to the APAC cost sharing arrangement, as well as other aspects of the transaction. I asked EY to help me prepare Microsoft's defense. The materials prepared and analyses performed by EY at my request were prepared in anticipation of the administrative dispute or litigation that I anticipated with the IRS over the APAC cost sharing agreement. In short, I intended analyses performed and the materials prepared by EY to be protected by the work product doctrine. As evidenced by these proceedings, and as I anticipated, the IRS has challenged the APAC cost sharing agreement and asserted potential adjustments in the billions of dollars.

23. We next set up a cost sharing arrangement in the Americas region with our Puerto Rican operations. We hired KPMG to advise us. I knew that the IRS would likely challenge whatever buy-in amount we determined for the arm's length value of the pre-existing intellectual property to be contributed by Microsoft to the Puerto Rican cost sharing arrangement. I also recognized that the IRS would challenge the sales prices of software sold back to Microsoft in the United States, as well as other aspects of the transaction. Accordingly, I wanted to ensure that our best position and defense was prepared on the sale of software to Microsoft as well. I asked KPMG to help me prepare Microsoft's defense. To be clear, the materials prepared by KPMG for me were prepared at my request, and were prepared in anticipation of an administrative dispute or litigation with the IRS over the Puerto Rican cost sharing arrangement, the pricing of the software sales to Microsoft, and other issues expected to be in dispute relating to those transactions. In short, I intended the analyses performed and materials prepared by KPMG to be covered by the work product doctrine. As evidenced by these proceedings, and as I anticipated, the IRS has challenged the Puerto Rican cost sharing arrangement and the pricing of sales of software back to Microsoft in the United States, and is asserting adjustments in the billions of dollars.

24. We also hired PricewaterhouseCoopers LLP ("PwC") to provide tax advice on certain discrete issues related to the Puerto Rican cost sharing arrangement. This PwC tax advice was prepared for the same reasons, and the associated documents were maintained by Microsoft in the same manner, as the KPMG tax advice and documents.

25. As a tax lawyer, I was keenly aware of Congress's adoption of an accountant-client privilege in 26 U.S.C. § 7525 ("Section 7525"), which confers upon federally authorized tax practitioners a privilege co-extensive in many respects with the attorney-client privilege. I asked both EY and KPMG to ensure that their tax advice to me (other than advice relating to Section 6662 Transfer Pricing Reports intended to be provided to the IRS, as described in the next paragraph) met the foundational requirements of Section 7525, and that such analyses and advice were to be kept confidential so as to not waive the privilege. My request for non-Section 6662 tax advice and provision of factual information and materials to EY or KPMG or PwC constituted a confidential communication by a client (Microsoft) to its federally authorized tax practitioners for the purpose of seeking tax advice.

26. If a taxpayer's valuations used for Section 482 purposes are successfully challenged by the IRS, and if the adjustments exceed certain relatively low thresholds, the taxpayer can be liable for 20% or 40% penalties under 26 U.S.C. § 6662 ("Section 6662"). To avoid these penalties, the taxpayer must prepare transfer pricing reports supporting its Section 482 valuations and positions ("Section 6662 Transfer Pricing Reports") prior to submission of the tax return and provide those reports and related documents to the IRS upon request during audit. I asked both EY and KPMG to prepare Section 6662 Transfer Pricing Reports for their respective transactions. As these reports were intended to be provided to the IRS upon request, these reports could not be privileged under Section 7525. The EY Section 6662 Transfer Pricing Report was principally authored by Dr. John Wills, an economist, and a team working under his direction. The KPMG Section 6662 Transfer Pricing Report was principally authored by Dr. Anne Welsh, an economist, and a team working under his direction.

27. Documents that Microsoft believed were privileged or protected from disclosure, including documents from EY, KPMG, and PwC (other than the Section 6662 Transfer Pricing Reports and related documents), were kept secure by storing them in locked offices or on Microsoft's secure information systems. Moreover, such documents or information were not disseminated beyond those in the Tax Department or counsel with a need to know. As part of my Department's practices and procedures, these documents were kept in a manner intended to maintain confidentiality. To the best of my knowledge and throughout my tenure at Microsoft, these documents were kept in confidence and the associated privileges or protections were not waived.

28. I hired EY, KPMG, and PwC to give me the best independent, critical tax advice possible on cost sharing agreements and, in the case of Puerto Rico, on the sale of software back to Microsoft. Due to the complexities of U.S. corporate tax, particularly U.S. corporate taxation of international activities, I asked EY and KPMG to advise upon a wide range of tax issues relating to these transactions. As a relatively simple example, as discussed above, the IRS previously challenged Microsoft's software manufacturing activities in Puerto Rico, arguing that those activities did not constitute manufacturing within the meaning of 26 U.S.C. §§ 936 and 954. It took me nearly a decade and the filing of a suit in Tax Court to get the IRS to concede this issue. As part of its case against Microsoft, the IRS argued about various nuances of the manufacturing process in Puerto Rico, including what was done and by whom, as well as about the content of various contracts among related and unrelated entities. I say this by way of example to explain that the provision of tax advice in the corporate international context depends as much upon the facts as upon the law. In order to provide their tax advice, EY and KPMG had to understand the nuances of all aspects of the proposed transactions and operations and to be able to advise what activities or contractual arrangements would be acceptable under the law, as well as which arrangements would not satisfy these legal requirements.

29. I did not want EY, KPMG or PwC to have, nor did EY, KPMG or PwC have, any interest in the transaction. I wanted them to be free to give me their best advice, regardless of whether that was the advice I wanted to hear. I knew that these arrangements would be scrutinized by the IRS, and I knew from past experience that the IRS would end up challenging these transactions. But I wanted Microsoft prepared as best it could for the fight to come. Accordingly, other than being paid on their regular hourly basis for their work on these issues, EY, KPMG and PwC had no financial or proprietary interest in these transactions. Nor could they: these proposed transactions had been conceptualized by Microsoft. I engaged EY, KPMG and PwC to advise on these Microsoft concepts. At bottom, although the international tax provisions are highly complex, the work performed by EY, KPMG, and PwC was routine international tax analysis and advice regularly performed by their colleagues and peers in the Big Four accounting firms. This tax advice is indistinguishable from the legal advice provided by law firms working in the international tax field, as recognized by Congress in Section 7525.

30. I did not hire KPMG, EY or PwC to provide business advice, nor would I have ever hired them for that purpose. To the extent that KPMG's, EY's, or PwC's tax advice on the APAC or Americas Cost Sharing Arrangements addressed nuances of and contractual provisions relating to Microsoft's business operations, the tax advice addressed those items that had tax consequences under applicable United States tax laws.

I declare under penalty of perjury that the foregoing is true and correct.

Executed on this 12^th day of September, 2016 in Seattle, Washington.