Microsoft Requests Status Conference in Summons Enforcement Action

The Petition seeks enforcement of a summons dated October 30, 2014 (the "Summons"). The Summons is not a typical summons under 26 U.S.C. § 7602; it is alleged to be a "designated summons" described in 26 U.S.C. § 6503(j). Although the Petition characterizes the Summons in passing as a designated summons (see, e.g., Petition, ¶ 7), the Petition and supporting declaration fail to allege all the specific facts necessary for the issuance of a valid designated summons under 26 U.S.C. § 6503(j)(2)(A).² In addition, the Petition fails to advise the Court that the IRS has issued 18 additional, allegedly "related summonses" within the meaning of 26 U.S.C. § 6503(j)(1)(A)(ii) -- to Microsoft, to KPMG LLP ("KPMG"), to Ernst and Young LLP (E&Y), and to current or former Microsoft, KPMG and E&Y employees. (Bernard Decl., ¶ 3) Under 26 U.S.C. § 6503(j), the United States may ask this Court to enforce these related summonses during this proceeding or in separate proceedings.

The IRS's audit of Microsoft's 2004-2006 taxable years began in January 2007, nearly eight years ago. Microsoft has cooperated throughout the audit, producing approximately 1.2 million pages of documents and making over 50 employees available for interviews, in response to 220 Information Document Requests ("IDRs") issued by the IRS. No summonses were issued to Microsoft before October 30, 2014. (Bernard Decl., ¶ 4)

On May 3, 2011, over 3 1/2 years ago, the IRS concluded its field audit and issued a thirty-day letter, a revenue agent's report, and an external economist's report determining the IRS's proposed values for the buy-in royalties required to be paid by foreign participants to Microsoft as arm's length consideration under 26 U.S.C. § 482 for pre-existing intangibles made available in two cost sharing arrangements. These cost sharing arrangements covered the production and distribution of software products in certain Asian and Pacific markets and Western Hemisphere markets (the "APAC Cost Sharing Arrangement" and the "Americas Cost Sharing Arrangement," respectively. (Bernard Decl., ¶ 5)

In response to the thirty-day letter, Microsoft filed a protest brief on June 29, 2011. Microsoft's protest would normally have resulted in the IRS Examination Division's forwarding this dispute to the IRS Appeals Division, which has the authority to settle tax disputes on behalf of the IRS based on the parties' respective litigation hazards. (See Bernard Decl., ¶ 6); 26 C.F.R. § 601.106(f)). But the IRS did not allow the dispute to proceed to the IRS Appeals Division. Rather, the Director of Transfer Pricing Operations ("TPO") within the IRS Large Business & International Examination Division asked for six months to conduct additional field work for the purpose of developing a secondary or alternative buy-in value and a transfer pricing adjustment with respect to the Americas Cost Sharing Arrangement.

The six-month extended audit has now gone on for three years. During that time the IRS engaged over a half dozen additional external experts in economics, finance, software technology, marketing, and the software industry. They created an economic valuation model drafted expert reports, and provided oral advice to the IRS in support of an alternative buy-in valuation and transfer pricing adjustment with respect to the Americas Cost Sharing Arrangement. The IRS presented its alternative buy-in/pricing model, two supporting expert reports and a summary of the experts' oral advice to Microsoft in a meeting on January 14, 2014. (Bernard Decl., ¶ 7)

Throughout the extended audit Microsoft repeatedly asked that, once the IRS completed its secondary valuation, the case move to the IRS Appeals Division for settlement negotiations. At the January 2014 presentation, the TPO asked Microsoft to enter into direct settlement negotiations before the case would be sent to the IRS Appeals Division. After some preliminary discussions, Microsoft declined to negotiate with the TPO, because the TPO wanted to limit such discussions to agreeing upon modifications to its secondary valuation model without any discussion of the parties' respective litigation hazards under 26 U.S.C. § 482, the regulations thereunder, and the decided case law.³ (Bernard Decl., ¶ 8)

On May 19, 2014, unbeknownst to Microsoft at that time, the IRS engaged the law firm of Quinn Emanuel Urquhart & Sullivan, LLP as "an expert in commercial litigation (the 'Contractor') to assist with the evaluation, analysis, presentation and defense of claims or adjustments related to the issues under examination." (Bernard Decl., ¶ 9) On June 14, 2014, less than one month later, the Treasury Department issued in proposed and temporary form an amended regulation, 26 C.F.R. § 301.7602-1T(b)(1). (Bernard Decl., ¶ 10) Prior to this amendment, 26 C.F.R. § 301.7602-1(b) granted authority to "officers and employees" of the IRS to take sworn testimony of witnesses in accordance with 26 U.S.C. § 7602. As amended, the temporary regulation would allow external contractors retained by the IRS to "participate fully in the interview of the witness summoned by the IRS to provide testimony under oath," including specifically "questioning the person providing testimony under oath; and asking a summoned person's representative to clarify an objective or assertion of privilege."

During the summer of 2014, the TPO advised Microsoft, for the first time, that the IRS was considering whether to "designate for litigation" the Microsoft case pursuant to Internal Revenue Manual Part 33.3.6. Designating a case for litigation bars the IRS Appeals Division from settling the case other than by the taxpayer's 100% concession of the designated issue. IRM Part 33.3.6.1(2). The TPO advised Microsoft that it would decide whether to seek designation after taking 32 depositions in September and October 2014. (Bernard Decl., ¶ 11) But following these depositions, the IRS did not advise Microsoft whether it would designate the case for litigation. Instead, on October 30, 2014, it issued the Summons, consisting of 48 separate document requests. Many of these requests are new and seek documents not previously requested in IDRs. The IRS set a response date of November 20, 2014, and refused Microsoft's request for a reasonable extension. Microsoft did respond to the Summons on November 20, 2014, and it is conducting the due diligence necessary to ascertain whether there are additional documents responsive to these requests. (Bernard Decl., ¶ 12)

Microsoft granted eight statute of limitations extensions (IRS Forms 872) during the audit. The statute of limitations under 26 U.S.C. § 6501 is set to expire on December 31, 2014. Microsoft understands that the IRS was prepared to issue a statutory notice of deficiency on or about December 15, 2014, reflecting its primary and/or secondary valuations with respect to the APAC and Americas Cost Sharing Arrangements. (Bernard Decl., ¶ 13) But instead of issuing the statutory notice of deficiency, the United States filed the Petition invoking this Court's jurisdiction.

Microsoft intends to allege one or more affirmative defenses, including that (1) Petitioner has acted in bad faith and with improper purpose and (2) enforcement of the Summons would be an abuse of the Court's process.

• Petitioner already has developed its audit adjustments: the primary APAC and Americas buy-in adjustments were set forth in the May 3, 2011 thirty-day letter and supporting reports, and the secondary Americas buy-in and transfer pricing adjustments were set forth in the January 14, 2014 valuation model and supporting reports. Petitioner was prepared to issue the statutory notice of deficiency on December 15, 2014.

• Petitioner's purpose in issuing an eleventh-hour barrage of summonses after repeatedly assuring Microsoft that the extended audit would be completed after the October depositions is suspect. Is Petitioner attempting to force Microsoft to the negotiating table with the TPO, even though the IRS Examination function has no authority to settle cases based on litigation hazards? Is Petitioner attempting to foreclose IRS Appeals' consideration of this case without formally designating the case for litigation? Is Petitioner no longer conducting a bona fide audit, but instead attempting to conduct pretrial discovery without regard to the U.S. Tax Court's discovery rules or even this Court's electronically stored information discovery rules?

• Until mid-summer 2014, senior IRS executives assured Microsoft that the case would proceed to the IRS Appeals Division for settlement negotiations. But after Microsoft refused to conduct direct settlement negotiations with the TPO in the spring of 2014, Petitioner engaged a commercial litigation firm to assist in developing the case for litigation. The Court may be required to consider whether the IRS is impermissibly delegating inherently governmental functions, such as taking sworn, compulsory testimony and possibly representing the IRS in Tax Court litigation. The Court may be required to decide the validity of 26 C.F.R. § 301.7602-1T(b)(1).

Given counsel's locations, one or both parties may request the ability to participate telephonically as necessary.

WHEREFORE, Microsoft respectfully requests that this Motion be granted, and that the Court issue an order scheduling a status conference before any Show Cause Order is issued.

Respectfully submitted this 18th day of December, 2014.

² Specifically, the Petition does not address the pre-issuance review requirement under 26 U.S.C. § 6503(j)(2)(a)(i).

³ In Veritas Software Corp. v. Commissioner, 133 T.C. 297 (2009), the Tax Court held that the IRS's method for valuing the buy-ins in that case was arbitrary, capricious, or unreasonable under 26 U.S.C. § 482. Although the IRS issued A.O.D. 2010-005, 2010-49 I.R.B. 1, characterizing the Tax Court's factual and legal analysis as erroneous, it chose not to appeal the Tax Court's decision. The IRS currently is relitigating the Veritas ruling in Amazon.com, Inc . v. Commissioner, T.C. No. 31197-12 (trial being conducted in Seattle during November and December 2014).