Here’s what’s going on:
-Companies that operate internationally make revenue and incur costs in many different countries.
-As a result, they owe taxes to many different national authorities.
-Each national authority has rules for how costs and revenues are accounted across borders.
-These rules are necessarily complex, because it’s often not clear how costs and asset transfers should be accounted from simple first principles.
-This is particularly important when accounting costs across countries, because taxable income is often based on your costs.
-For example in the US, Federal taxable income equals gross income MINUS the cost of goods sold.
-In a multinational, one critical question in figuring out costs is how to value transfer prices of goods, intangibles, and services among enterprises under common ownership.
-That is, if the U.S. division of company A and a division of company A in another country exchange assets or services, the question of how they price those goods to one another becomes important for tax reasons.
-Typically there’s a lot of accountants with spreadsheets or a software system where all this is calculated, monitored, invoiced, booked, and reconciled.
-Accounting and services for this is typically called “transfer pricing.”
-To determine how to account for these costs, each national regulator has very specific rules.
-The question is whether Microsoft adhered to these rules in how it accounted for costs and revenues between its U.S. and international entities.
-These disputes go through a very long back and forth process that often culminates in litigation, which itself can last years, or settlement.
-Microsoft says, “Because our subsidiaries shared in the costs of developing certain intellectual property, under those IRS cost-sharing regulations, the subsidiaries were also entitled to the related profits.”
-So it looks like the dispute centers around how to account for “the costs of developing intellectual property”, which can be hard if you’re developing software globally.
-Finally, there’s one aspect to consider when you see these $XXB figures. At the size of certain very big corporations like Microsoft or Apple, money does not behave like it does for you, or me, or even Sequoia Capital.
-Microsoft’s market cap is $2.4T. At that scale, money enters a kind of different state of matter.
-Money’s purpose is primarily to coordinate economic activity, especially when you’re talking about non-negligible amounts for multinationals.
-So payments among the revenue agencies of various countries and their very large private multinationals are in kind of a closed loop where they mainly have complex macroeconomic effects.
-For example, the effect of increasing taxes via heightened transfer pricing scrutiny mostly moves production from one sector to another (e.g. from consumer tech to health and defense.)
-The policy and finance folks pulling the levers understand how that works, and often have their own complex set of motives.