By Lynnley Browning
FAIRFIELD, Connecticut (Reuters) - If you want to know why tax from surging corporate profits isn't making much of a dent in the United States' crippling budget deficit, a glance at Microsoft Corp's recent results provides some clues.
Things were rosy in the giant software company's just-ended fiscal fourth quarter, which produced record sales of nearly $17.4 billion, a 30 percent increase in after-tax profit, and a 35 percent gain in earnings per share.
But for the Internal Revenue Service and foreign tax authorities, things weren't so rosy. Microsoft reported only $445 million in taxes in the U.S. and other foreign countries, just 7 percent of its $6.32 billion in pre-tax profit.
Partly it was because the company had a one-time refund of $461 million from the IRS for previous overpayments and because of its over-estimation of tax rates in previous quarters. There may be increased sales of products to consumers overseas, though it is not clear from company disclosures how much of a factor this might be.
But Microsoft is straightforward about the core reason for its lower tax bill: It is increasingly channeling earnings from sales to customers throughout the world through the low-tax havens of Ireland, Puerto Rico and Singapore.
Microsoft's pre-tax profits booked overseas nearly tripled over the past six years, to $19.2 billion in the fiscal year that just ended, from $6.8 billion in the year ended in June 2006, according to company filings. By contrast, its U.S. earnings have dropped, to $8.9 billion from $11.4 billion in the same period. Foreign earnings now make up 68 percent of overall income.
The change is fueling its shrinking tax bills. According to its 2010 annual report, by keeping a good chunk of foreign earnings away from the U.S., Microsoft has accumulated $29.5 billion overseas -- and that is before the impact of its last financial year.
In theory, the company has saved $9.2 billion in U.S. federal taxes on that figure, though if it brought the entire $29.5 billion back home tomorrow its tax bill would be lower because of credits for foreign taxes paid and other U.S. deductions.
Microsoft's effective worldwide tax rate fell to 17.5 percent in the last fiscal year, down from 25 percent the previous year and 31 percent in the year to June 30, 2006. The company said it expects to owe tax at an effective rate in the next year of between 19 percent and 22 percent.
Few companies, including Thomson Reuters, pay the standard U.S. corporate rate of 35 percent thanks to loopholes and deductions but the Microsoft tax rate is still at the low end when compared with other large technology companies.
In their last reported fiscal years, Google Inc's <GOOG.O> effective tax rate was 21 percent, Apple Inc's <AAPL.O> 24 pct, and IBM's <IBM.N> was 25 percent.
A TWIN SHIFT
Concern about the use of tax-reducing measures now used by many major U.S. corporations has been a big issue for President Obama and the Democrats as they race to hammer out a deal with Republicans by August 2 that would allow the United States to avert imminent default on its debt.
Some Congressional leaders are calling for a "repatriation holiday" that would allow corporations to bring back money held offshore at a lower rate of 5.25 percent, similar to a one-off deal in 2005 through which corporations brought back $312 billion.
Nearly $1.2 trillion of accumulated U.S. corporate profits, are now held in overseas subsidiaries.
The U.S. government taxes U.S. businesses on income earned worldwide but allows them to defer taxes on the money until brought back to the U.S., so corporations like to keep the money abroad, particularly as they increase investment overseas. Critics argue the U.S. system also encourages businesses to move jobs overseas at a time of high unemployment -- now at a 9.2 percent rate -- in the U.S.
Obama and the Treasury Department oppose a "repatriation holiday" while Microsoft, along with other multinationals, including Apple, Cisco Systems <CSCO.O> and Pfizer Inc <PFE.N>, backs the repatriation idea, through Win America, a Washington, D.C., lobbying group.
Most industrialized nations tax businesses only on income earned within their borders. U.S. corporations argue the U.S. worldwide system is anti-competitive and forces money overseas.
But critics such as Richard Murphy of Tax Research LLP, an anti-poverty and tax research firm based in Britain, argue the U.S. system allows companies to park profits in places where the tax obligation largely disappears. He called Microsoft "a giant tax-planning exercise."
LOWER RATES ABROAD
Microsoft said its lower taxes in the recent quarter were "primarily due to a higher mix of earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore and Puerto Rico, which are subject to lower income tax rates."
The details of precisely how it does this have not been disclosed.
U.S. companies do not have to break out earnings in foreign subsidiaries, making it hard to determine from financial filings how much tax they are saving through each jurisdiction. "We're in the land of guesswork here," said Professor James Hines Jr., a tax scholar at the University of Michigan.
What is clear is Microsoft's increasingly sophisticated use of the havens. Foreign earnings taxed at lower rates reduced Microsoft's U.S. rate by 16.3 percentage points to 18.7 percent, for the just-ended year. That compares with a lowering by just 4.6 percentage points to 30.4 percent in 2006, according to SEC. filings.
Ireland taxes corporate profits at 12.5 percent. Singapore taxes them at anywhere from 0 percent to 17 percent. Puerto Rico, a U.S. territory but a foreign country in the eyes of the IRS, offers U.S. multinationals an unusual credit for taxes paid there as well as tax credits for production.
Microsoft operates a 123,000 square-foot factory in Puerto Rico that makes up to 80 million disks a year for sale in the Americas, according to its Spanish-language website -- its only company-owned plant in the world.
A Microsoft spokeswoman declined to answer questions on how it records revenue and earnings in certain jurisdictions, adding, "Microsoft complies with the tax laws of every jurisdiction in which we do business."
Legislation introduced this month by Senator Carl Levin, a Michigan Democrat, would require large U.S. corporations to report results country-by-country.
The Securities and Exchange Commission earlier this year asked the company to do the same, citing what it called the "disproportionate relationships among domestic and foreign revenues, pre-tax income and tax rates."
Microsoft told the SEC it would supply additional information in future filings. The company says it will provide the requested information in its 2011 annual 10K financial report due to be filed on Thursday.
By finding ways to minimize its taxes, Microsoft can argue that it is only behaving in the interests of its shareholders.
Shifting income to low-tax jurisdictions "is not illegal," said Robert Willens, a tax and accounting expert in New York. "It behooves companies to do this."
(Additional reporting by Dena Aubin, David Cay Johnston, Scott Malone and Bill Rigby, editing by Martin Howell)