The IRS is examining whether corporations followed the law in deals that shifted income to countries with lower tax rates, an issue that has drawn scrutiny in the U.S. and abroad.
Lawyers for Microsoft and the Internal Revenue Service (IRS) clashed Tuesday over the hiring of an outside law firm to assist the tax agency in an audit of the software company.
The war of words is a part of the larger effort by the IRS to examine whether corporations followed the law in deals that shifted income to countries with lower tax rates, an issue that has drawn congressional hearings in the U.S. and government scrutiny abroad.
Arguing Tuesday In U.S. District Court in Seattle, Microsoft’s lawyers portrayed the government’s use of Quinn Emanuel Urquhart & Sullivan as an unprecedented step taken in secret and tailored to bring the company to tax court.
They accused the IRS of disclosing to the firm confidential-tax information at the same time as Quinn Emanuel was representing Google and other Microsoft rivals in pending legal disputes with the Redmond company.
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The government’s lawyer defended the hiring, saying the move was in line with IRS use of other outside experts in complex tax cases. The audit, in its ninth year, had dragged on in part because of the complexity of Microsoft’s corporate-tax structure and the company’s failure to provide some information the IRS was seeking, the government said.
District Judge Ricardo Martinez on Tuesday held off on ruling whether the government acted improperly in hiring Quinn Emanuel. He said he would likely ask the IRS and Microsoft for more information before making a decision about whether the move warranted further investigation.
Microsoft had asked for Tuesday’s hearing to make its case for why the use of the Los Angeles business-litigation firm, and a temporary federal regulation that paved the way for the contract, may indicate an abuse of the IRS audit process.
While the hearing focused on a narrow procedural matter, the audit itself is a major issue for both Microsoft and the IRS.
Since 2007 the tax agency has been looking into Microsoft’s 2004 to 2006 tax years, focusing on transactions that shipped the rights to valuable Microsoft property to foreign subsidiaries.
At issue in the audit are a pair of deals that transferred rights to Microsoft’s software code and other assets to subsidiaries in Puerto Rico and Bermuda.
The case is among the largest and most complicated of the IRS’s probes into whether U.S. companies paid the proper amount of tax in accounting for deals with foreign subsidiaries
The IRS’s preliminary assessments of Microsoft’s tax arrangements would have increased Microsoft’s taxable income by billions of dollars, James Weaver, a Justice Department lawyer representing the IRS, said Tuesday.
The IRS in December sued Microsoft to force the company to turn over more documents and make more current and former executives available for interviews. The company challenged the requests, arguing that the use of Quinn Emanuel constituted improper delegation of a government function.
Philip Beck, a lawyer representing Microsoft, spent about three hours Tuesday questioning Eli Hoory, the senior tax adviser with the IRS who is leading the investigation into Microsoft’s big tax deals. The questioning was occasionally heated, with Beck pressing for quick yes or no answers and Hoory offering at times lengthy explanations of the IRS’s reasoning.
Hoory said the decision to hire Quinn Emanuel resulted, in part, from the IRS’s loss in tax court of a prominent transfer-pricing case in 2009. In that case, he said, the IRS relied on a single outside economist. The opposing side used several industry experts.
“In this case we knew that we needed multiple experts” to arrive at a fair assessment of what taxes, if any, Microsoft owes, Hoory said. A commercial litigator like Quinn Emanuel “could bring some value to the table,” he said.
In later questioning, Beck pressed Hoory on why the IRS didn’t inform Microsoft early last year that it was hiring Quinn Emanuel and, in one testy exchange, accused Hoory of deceiving Microsoft about the hiring while at the same time planning for a potential battle in tax court.
“You tricked them,” Beck said. Hoory replied that he didn’t.
Weaver, the government lawyer, said audits sometimes require outside help. A ruling disallowing the use of experts like Quinn Emanuel “would effectively shut down all complex audits in the U.S.,” he said.
During Weaver’s questioning of Hoory, he referred to several documents the IRS obtained in the audit detailing how Microsoft split rights to its software code and marketing relationships among foreign subsidiaries. Weaver said the documents showed that Microsoft and some outside advisers were only now providing information the IRS had been seeking for years.
Among the revelations, Hoory said, were a math error that understated Microsoft’s revenue by about $15 billion over a period of years. Other documents, he said, showed a discrepancy between the upbeat revenue forecasts Microsoft disclosed to shareholders, and lower forecasts the company relied on in structuring its tax arrangements.
In another instance, Hoory cited a Microsoft employee’s statement in an interview that he had no recollection of a specific document used in the company’s tax analysis, only for the document to turn up later in a batch of his own emails as part of a reply to the agency’s requests.
Microsoft’s lawyers challenged the use of some of the documents, saying they were irrelevant to the questions around the Quinn Emanuel hiring. The government, Beck said, is engaging in “a calculated effort to disclose confidential information they think will make us look bad in retaliation for us daring to oppose the IRS.”
Judge Martinez sided with the government, allowing the use of many of the documents.
He didn’t set a timeline for the resolution of the Quinn Emanuel question, but indicated that he would consider more documents obtained by Microsoft on the hiring and the temporary regulation that allowed it to happen.