Microsoft Summons Enforcement on Transfer Pricing "Planning" - Mixed on Privilege Claims (1/22/20)

After publishing this blog entry, a new article was published about Microsoft's transfer pricing planning and the audit.  I discuss that article in my comments below (Comment #4.)

In United States v. Microsoft, 2020 U.S. Dist. LEXIS 8781 (W.D. Wash. 1/17/20), here, the district court resolved a contentious summons enforcement proceeding started in December 2014.  (See the CourtListener docket entries, here.)  Summons enforcement proceedings are supposed to be “summary in nature.”  United States v. Clarke, 573 U.S. 248, 254 (2014) (citing United States v. Stuart, 489 U.S. 353, 369 (1989)).

So, why was this summons enforcement proceeding not so summary, taking just over 5 years to resolve?  A hint at the answer is the amount of the tax savings involved (perhaps $5 billion over 10 years, achieved at a cost of $10 million (I don't think that planning included tax professional fees)), the promoter tax shelter context (involving one of the prominent bullshit promoter tax shelter players, KPMG, in the early 2000s), and the sheer number of attorneys appearing in the case (many of whom are amici).  (For the attorneys, see the CourtListener list which may be reviewed by clicking on the “Parties and Attorneys on the CourtListener docket list above; the Government lists 4 attorneys, Microsoft lists 14 (included terminated attorneys), and the amici attorneys are more than I want to count; the relative imbalance between the attorneys for Government and attorneys for the parties opposing the Government reminds me of the old saying about Texas rangers–one mob, one Ranger; in this case one mob, 4 Government attorneys.)

Well, there is not much in the case.  It is, after all, a summons enforcement proceeding where, once the minimal Powell standards are met, the summons is enforced.  United States v. Powell, 379 U.S. 48 (1964).  The Court thus early on ordered the summons enforced.  United States v. Microsoft Corp., 154 F. Supp. 3d 1134 (2015).  But that left the privilege assertions to be thrashed over, hence the delay.

So, what’s the context for this battle?  Not surprisingly, high-dollar transfer pricing cost sharing arrangements that has drawn similar high dollar litigation with loads of attorneys.  E.g., Altera Corp. v. Commissioner, 926 F.3d 1061 17143 (9th Cir. 2019), reh. en banc den. 941 F.3d 1200 (9th Cir. 2019) (with an analogous melange of attorneys, including amici).  As the Microsoft Court said in the most recent opinion (the one linked in the opening paragraph):

Ultimately Microsoft did enter into cost sharing arrangements through technology licensing agreements. Because those cost sharing arrangements were required by law to be arm's length transactions, the design and implementation details are a central focus of the government's examination. The government expresses skepticism that a third party would be likely to enter into the agreements, thereby satisfying the arm's length standard, because the agreements contained several unique provisions. Dkt. #146 at ¶¶ 18-20. While many of the terms changed before and afterward the agreements were to have been formed, they remained favorable for Microsoft's income tax liability. Id. at ¶¶ 9-11. The government believes that the transactions were "designed and implemented for the purpose of avoiding tax." Id. at ¶ 20. n1
   n1 The government expresses further skepticism on the basis that the agreements effectively netted the Puerto Rican entity $30 billion for the "routine" reproduction of CDs containing software and did not otherwise have a significant impact on Microsoft's operations. Dkt. #146 at ¶¶ 15-20. 

Microsoft maintains that nothing was abnormal about its actions. [*7]  Microsoft argues that transfer pricing disputes with the government were prevalent and, "[r]ecognizing the inevitability of an [Internal Revenue Service ("IRS")] challenge, Microsoft was determined to be adequately prepared to defend these cost sharing arrangements." Dkt. #140 at 6; see also Dkt. #143 at ¶ 23. To this end, and because of the complexity of facts relevant to corporate international tax, Microsoft employed KPMG "to help the lawyers provide legal advice" and to give its own tax advice. Dkt. #140 at 1; Dkt. #143 at ¶¶ 7, 10. Mr. Boyle, then Microsoft's Corporate Vice President and Tax Counsel, maintains that the materials at issue were prepared for his use and that they 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." Dkt. #143 at ¶ 23.

In this context, the parties duke it out about whether Microsoft has established its claims of privilege over the set of documents in issue.  Dealing with privilege claims is standard stuff in summons enforcement proceedings.  The court reviewed in camera the contested documents, related to KPMGs promoted tax “planning” and, not surprisingly, sustained some claims of privilege but denied most of them.  The privileges were Work Product Protection (OK, not technically a privilege), and Attorney-Client, Federally Authorized Tax Practitioner Privilege (“FATP”) in § 7525, here.

The most interesting was the Court’s discussion of the exception to the FATP in § 7525(b)(2) which excepts “witten communications * * * in connection with the promotion of the direct or indirect participation of the person in any tax shelter (as defined in section 6662(d)(2)(C)(ii)).”

I cut and paste that discussion to let the opinion speak for itself (rather than through my interpretation).

D. Tax Shelter Exception 

Irrespective of whether [*22]  individual documents are protected by the FATP privilege, the government argues that the privilege does not apply here as the activities fall within the tax shelter exception to the FATP privilege. By statute, the FATP privilege does not apply to written communications "in connection with the promotion of the direct or indirect participation of the person in any tax shelter (as defined in section 6662(d)(2)(C)(ii))." 26 U.S.C. § 7525(b). In turn, a "tax shelter" is defined to include any partnership, entity, plan, or arrangement "if a significant purpose of such partnership, entity, plan, or arrangement is the avoidance or evasion of Federal income tax." 26 U.S.C. § 6662(d)(2)(C)(ii). 

Following the Court's review, 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. The government argues persuasively that the transactions served a primary purpose of shifting taxable revenue out of the United States. Microsoft has not advanced any other business purpose driving the transactions and one does not materialize from the record. The only explanation Microsoft attempts is that it entered the cost sharing arrangements to replace annual disputes [*23]  over its licensing and royalty scheme. But this is not a reason for why Microsoft needed or wanted this arrangement for business purposes. Instead, Microsoft noted favorably that the transaction "should NOT have much impact on how we serve customers" and that, while operational expenses were expected to increase by "$50 million over 10 years," it would result in "tax savings of nearly $5 billion over 10 years." PMSTP0000028. With no real impact on how customers were served, the tax savings appears to have driven the decision-making process. Valero, 569 F.3d at 629 (expressing skepticism that "rigamarole" of transactions was necessary restructuring rather than attempt to "avoid paying taxes"). 

The Court is further left to conclude, after reviewing the records in camera, that all the documents created by KPMG "promoted" the transactions. Other than the unadorned testimony of Mr. Weaver and Mr. Boyle, Microsoft and the record provide no indication that the plans for the transactions originated with Microsoft. Even where testimony is sparse on particulars, the Court does not set it aside lightly. But the record before the Court leads to the conclusion that KPMG originated and drove the structuring of the transactions [*24]  and that but for its promotion, Microsoft may not have pursued the same or similar transactions. Thereafter, and in furtherance of the transactions, KPMG continued to address possible roadblocks and continued to tweak the transactions to maximize—as far as possible—the revenue shifted while minimizing any operational effects of the restructuring. KPMG's advice did not, as Microsoft argues, "merely inform a company about such schemes, assess such plans in a neutral fashion, or evaluate the soft spots in tax shelters that [Microsoft] has used in the past." Dkt. #177-1 at 10 (quoting Valero, 569 F.3d at 629) (quotation marks omitted). 

The obvious protest—and the one that both Microsoft and KPMG raise—is that any adverse ruling by the Court will destroy the FATP privilege. First, Microsoft argues that the transactions at issue were not tax shelters because they were just ordinary and accepted tax structuring. Id. at 8-9; Dkt. #160 at 2. After all, "virtually any taxpayer who seeks tax advice from an accounting firm is looking for ways to minimize his taxes or for assurance that he is complying with the tax law." Doe v. KPMG, L.L.P., 325 F. Supp. 2d 746 (N.D. Tex. 2004) (quotation marks omitted). But the tax shelter exception turns, at least partly, on the purpose for the transaction. [*25]  See 26 U.S.C. § 6662(d)(2)(C)(ii). A tax structure may be a permissible method to achieve a legitimate business purpose in one context and an impermissible tax shelter in another. Valero, 569 F.3d at 632 (noting that "[o]nly plans and arrangements with a significant—as opposed to an ancillary—goal of avoiding or evading taxes count" as tax shelters). The Court's reading is true to the statutory language and does not eliminate the privilege. 

The Court also is not convinced that its common sense reading of "promotion" conflicts with the statutory privilege. Microsoft relies on Tax Court opinions to argue that Congress did not intend to implicate the "routine relationship between a tax practitioner and a client." Dkt. #177-1 at 9-10 (citing Countryside Ltd. P'ship v. Comm'r, 132 T.C. 347, 352 (2009); 106 Ltd. v. Comm'r, 136 TC 67, 80 (2011)). From this, Microsoft puts great emphasis on the Tax Court's conclusion in Countryside that a "FATP was not a promoter, because he 'rendered advice when asked for it; he counseled within his field of expertise; his tenure as an adviser to the [client] was long; and he retained no stake in his advice beyond his employer's right to bill hourly for his time." Dkt. #177-1 at 10-11 (quoting Countryside, 132 T.C. at 354-55). But each case will necessarily turn on its own facts. The Court does not read Countryside as setting forth a static [*26]  test, but as listing relevant considerations for that case. The existence of a routine relationship between a FATP and a taxpayer is certainly a relevant consideration but should not extend the privilege into the impermissible promotion of tax shelters. 

In this regard, the Court finds the reasoning of the Seventh Circuit Court of Appeals in United States v. BDO Seidman, LLP instructive. 492 F.3d 806, 822 (7th Cir. 2007). There the court noted the similarities between the crime-fraud exception to the attorney-client privilege and the tax shelter exception to the tax practitioner privilege. Id. In the crime-fraud context, the Supreme Court has indicated that the need for privilege falls away "where the desired advice refers not to prior wrongdoing, but to future wrongdoing." Id. (quoting United States v. Zolin, 491 U.S. 554, 563, 109 S. Ct. 2619, 105 L. Ed. 2d 469 (1989) (emphasis in original)) (quotation marks and citation omitted). Similarly, the Seventh Circuit viewed the tax shelter exception as vitiating the FATP privilege once the privilege no longer served the goals of assuring full disclosure to counsel and compliance with the law. n7
   n7 Notably, in this regard, this is not an area that Microsoft was required to explore. Consistent with the attorney-client privilege, the FATP privilege's "purpose is to encourage full and frank communication between [FATPs] and their clients and thereby promote broader public interests in the observance of law and administration of justice." Upjohn Co. v. United States, 449 U.S. 383, 389, 101 S. Ct. 677, 66 L. Ed. 2d 584 (1981). Microsoft was not forced to take this position because of its business needs, but rather was strategically positioning itself for a dispute it sought out. KPMG and Microsoft created the legal issue of their own accord and should not gain greater protection merely because they chose to pursue a legally precarious transaction. 

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 [*27]  to satisfy Microsoft's operational needs. n8 KPMG did far more than flesh out or tweak Microsoft's preliminary plans where its expertise reasonably permitted it to do so. KPMG worked to make the transaction fit both Microsoft's existing operations and the relevant tax laws—a task that appeared, at times, to create internal strife. n9 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. § 7525(b).
   n8 See MSTP9007983-MSTP9007995 (Microsoft identifying an after-the-fact business purpose for the transaction but still expressing concern over whether arm's length parties would enter into such an agreement).
   n9 See ESI0023474 (KPMG struggling internally to identify good faith legal arguments and agreeing that its advice to Microsoft was supportable). 

The Court finds that this outcome also serves the public interest. "Our system of federal taxation relies on self-reporting and the taxpayer's forthright disclosure of information." Valero, 569 F.3d at 633. "The practical problems confronting the IRS in discovering under-reporting of corporate taxes, which is likely endemic, are serious." United States v. Textron Inc. and Subsidiaries, 577 F.3d 21, 31 (1st Cir. 2009). "The government's power to compel disclosure of relevant information is the flip side of" of self-reporting. Valero, 569 F.3d at 633. While Congress has provided for certain communications to be treated as privileged, the privilege is not absolute. Where, as here, a FATP's advice strays from compliance and consequences to promotion of tax shelters, the privilege falls away.[*28]  

Lastly, the Court acknowledges that the record before the Court is limited. The Court's conclusions should not be overstated and is in no manner a consideration of the final merits of this tax dispute. Id. at 634 (noting limited scope of opinion as the government was merely seeking information and not yet lodging accusations). The record that is before the Court, however, leads to the conclusion that the government should be afforded additional information as to the nature of the transactions at issue.

JAT Comments:

1.  The opinion does not offer enough information about the "planning"--dare I say scheme--to call it out as a bullshit tax shelter.  (Note the last quoted paragraph that the opinion is not a final resolution of the tax dispute.)  The tenor of the court's discussion, however, does not seem to bode well in the audit.

2.  The audit is for the years 2004-2006.  The KPMG inspired (and surely well-paid) planning presumably occurred in some year prior to 2004.  As tax crimes enthusiasts will recall, in 2003 KPMG was called out for its bullshit tax shelter promotions by the the Permanent Subcommittee on Investigations of the Senate Committee on Homeland Security and Governmental Affairs. (Formerly the Committee on Governmental Affairs.) The investigation produced two reports.  The first, a minority staff report gunned by the minority leader, Senator Carol Levin, was released contemporaneously with the highly touted hearings on November 18 & November 20, 2003.  So, the planning involved was during the period of KPMG aggressive tax planning (at least some of the bullshit category.)  KPMG and other tax professional firms regularly sold bullshit more likely than not tax shelter opinions for client penalty protection for "planning" that crossed the line.  The fees were often calculated as a percentage of the tax savings rather than a time-based fee. Although smart professionals know how to pad hours to achieve a percentage of tax savings, given the tax savings involved the padded time might not be credible particularly for promoted deals where the professionals could not possibly have spent so much time over the various promoted clients who bought the deal.  I do not know whether any such opinions or similar advice or planning was offered to Microsoft.

3.  The summons in issue was a "designated summons."  I don't know that the "designated" status really influenced the court's analysis of the privilege claims.  I offer below the text (but not the footnotes) of my discussion of the designated summons.  Those wanting the footnotes can obtain them from my book, Federal Tax Procedure (2019 Practitioner Edition), pp. 456-457, which can be downloaded here.

4. The Designated Summons.

Section 6503(j) authorizes the IRS to issue a designated summons to a corporate taxpayer under the coordinated issue case program (“CIC”) or a third party with respect to a corporate tax liability under the program.  The designated summons suspends the statute of limitations if (1) the corporate taxpayer or third party does not comply with the summons and (2) the IRS brings a judicial enforcement proceeding before the end of the statute of limitations. The statute of limitations is suspended during the judicial enforcement proceeding plus a minimum of 60 days. 

The designated summons is just a type of summons and therefore must meet the Powell standards.  Further, the IRS can issue the designated summons without any requirement that the taxpayer has been uncooperative or dilatory.  In other words, the IRS can issue the summons when it (the IRS) has itself been dilatory or has not timely allocated adequate audit resources to conclude the audit within the time frame that Congress allowed for audits, and thereby unilaterally keep open the statute of limitations.  The suspension period begins on the date the court proceeding to enforce the summons is commenced and ends on the day the court proceeding is finally resolved.  § 6503(j)(3).  The regulations and the IRM provide guidance as to how the suspension period is calculated and the court proceeding is finally resolved so as to end the suspension period.  The Commissioner or his delegate makes the determination of final compliance as soon as practicable.  A procedure is established for the summoned party to make a statement of compliance that will require that the IRS respond with notice that the IRS takes the position that the party has or has not complied. 

Because it can be used to keep open the statute of limitations unilaterally, Congress required that the designated summons be reviewed and approved in writing by the Commissioner of the operating division and by Chief Counsel and attach a statement of facts establishing that the IRS made reasonable requests for the information subject to the summons. In any court proceeding, the IRS must establish that the IRS made those reasonable requests. Consistent with Congress' purpose, the IRS uses the designated summons only sparingly because, so it is reported, just the threat that the summons might be used has modified taxpayer behavior in response to IRS's requests for information and documents. 

The IRS uses the standard IRS summons for the designated summons but must display prominently at the top of that summons the following: “This is a designated summons pursuant to section 6503(j).”

4. Update 1/22/22 6:30pm:  After I published this, I became aware of a recent article:  Paul Kiel, The IRS Decided to Get Tough Against Microsoft. Microsoft Got Tougher, (ProPublica 1/22/22), here.  (The article indicates that it is co-published with Fortune; I don't have the Fortune link.)  As some background to the parries and thrusts and Microsoft's alleged attempts to hide the ball, I recommend the article to be read in conjunction with this blog entry.  A key excerpt from the article:

The evidence they [the IRS audit team] assembled told a story. It revealed how Microsoft had built a massive Rube Goldberg machine that channeled at least $39 billion in profits to Puerto Rico. It revealed a workshop of outside consultants, economists and attorneys who, as they had with other corporate clients, meticulously planned a structure that seemed to have a basis in the law, even if it violated common sense.

Note the boldfaced language supplied by me.  Readers will recall that my reporting on bullshit tax shelters is that Rube Goldberg schemes were concocted that also "seemed" to have a basis in law (or in the imaginations of their creators reflected in their legal opinions) but when examined did not.  Now, I don't know the Microsoft deal or the legal opinions behind the deal.  But read the ProPublica artcile.  You will see that not only is the IRS very suspicious, as was the judge in the summons enforcement case.