In a long-awaited development, the largest audit in the history of the IRS has finally taken its next step. On Wednesday, Microsoft announced that the agency had notified the company that it owes $28.9 billion in back taxes, plus penalties and interest.
The case is epic not only in dollars but in scope. As ProPublica reported in an in-depth narrative in 2020, in a story co-published with Fortune, the IRS saw the case as a chance to prove the agency’s effectiveness. Often cowed by the prospect of facing off against corporations with endless resources, the IRS set out to be bolder and more aggressive. It took the unusual step of hiring a corporate law firm to represent the agency, a step that incensed Microsoft. The company, along with others in its industry, responded by rallying allies in Congress to rein in the IRS.
The audit is already well over a decade old and figures to grow older, since Microsoft is allowed to appeal the IRS’ conclusions and says it plans to. The audit focused on a deal the agency would later describe as “illusory in nature, serving no material economic purpose except to shift income.” In 2005, ProPublica wrote, Microsoft “sold its most valuable possession—its intellectual property—to an 85-person factory it owned in a small Puerto Rican city.” Having struck a favorable tax deal with Puerto Rico, Microsoft then channeled its profits to the facility, which burned Windows and Office software onto CDs.
At the time, some Microsoft executives celebrated this “pure tax play,” and they had reason for optimism. Initially, the IRS did not take an aggressive tack. An early audit resulted in a much more modest change in 2011.
But earlier that same year, the IRS had set up a new unit to audit intra-company deals that sent U.S. profits to tax havens — deals that were especially common among tech companies like Google, Facebook and Apple. The leader of the new unit decided that Microsoft’s deal in Puerto Rico was worth a much closer look. The IRS withdrew its initial finding and dug in to build a deep, comprehensive case.
By the time ProPublica published its story on the audit in 2020, the two sides had sued each other, and one case had long been stuck in court. Almost three years after the last motions in the case, a federal judge still had not ruled on whether the IRS should receive documents it was seeking. Shortly after ProPublica asked the court for an update, the ruling finally came down.
The judge sided with the IRS, writing “the Court finds itself unable to escape the conclusion that a significant purpose, if not the sole purpose, of Microsoft’s transactions was to avoid or evade federal income tax.” He agreed with the IRS’ characterization of the deal as a tax shelter.
For the next three years, the case disappeared from public view until Microsoft’s announcement.
“We believe we have always followed the IRS’ rules and paid the taxes we owe in the U.S. and around the world,” wrote Daniel Goff, a senior Microsoft executive, in a blog post on the company’s site that revealed the IRS’ determination.
The $29 billion that the IRS was seeking, he wrote, covered 2004 to 2013. He asserted, however, that the total, were the IRS to ultimately prevail, would be reduced by about $10 billion in taxes that Microsoft has already paid on its overseas profits. A major feature of President Donald Trump’s 2017 tax bill was a requirement that companies repatriate those profits, though they paid a special, low tax rate when they did. Microsoft had stored up $142 billion in offshore profits by 2017.
The conclusion of the audit sends the fight to a new phase. The IRS has an internal appeals division, and Microsoft said it would pursue its arguments there. It’s a significant development since the IRS had once signaled that it would bar Microsoft’s access to an appeal, a stance that led to blowback in Congress from the company’s allies. IRS appeals officers, who are independent of the auditors, often settle cases for steep discounts out of fear that the agency will lose a court battle. The appeals process is secret.
If Microsoft does not get the result it wants there, it can take its case to the U.S. Tax Court. Each step is likely to take years, meaning the case could easily stretch into the late 2020s.
The IRS attorneys who worked on the case believed it to be, by far, the largest U.S. audit ever, and the amount the IRS is seeking from Microsoft is several times larger than in any other publicly disclosed audit in the agency’s history. The case, in a way, is the last, great vestige of the IRS before it was gutted by budget cuts over the course of the 2010s and corporate audits plummeted. While the recent infusion of billions from the Inflation Reduction Act will allow the agency to rebuild itself in the coming years, the Microsoft case shows the fruit of those efforts could take a long, long time to reap.
