Case 2:15-cv-00102-RSM Document 146-7 Filed 10/12/16 Page 1 of 18 From: To: Sent: Subject: Attachments: Hoon Kim Glenn Cogswell (TAX) 8/27/2003 4:46:22 PM Puerto Rico Report Puerto Rico Paper - Hoon Kim.doc: Figures and Appendices.xis Hi Glenn, As promised, here is the Puerto Rico report. There are two files: the actual report and supporting appendices. Please take a careful look at the tax sections in the paper, checking for accuracy of data and proper delivery of information. The documents are set to be read-only, but please feel free lo print out the documents and make edits there. I'll be happy to drive up to the main campus to pick up your edted draft. Also, I am planning to schedule a conf call with you, Fred Jordan, and myself either this Friday or ear1y next week to discuss this report. V\Alich time is preferable for you? Thanks, Hoon Government Exhibit 7 _____________ MSTP1253444 Case 2:15-cv-00102-RSM Document 146-7 Filed 10/12/16 Page 2 of 18 File Provided Natively File Name: Flgures and Appendices.xis 2 MSTP1253445 Case 2:15-cv-00102-RSM Document 146-7 Filed 10/12/16 Page 3 of 18 Hoon Kim DRAFT Abstract Microsoft Pueno Rico (MSPR), established in 1989, serves as the primary CD manufacturing facility for North America and Latin America. Producing high revenue FPP, Select, and Enterprise CDs, MSPR takes full advantage ofTRC §936 and saves Microsoft approximately $25 million every year in net taxes. The future of Microsoft Puerto Rico is the concern of this report. Through analysis, three most likely outcomes emerge. First, MSPR can be incorporated as a controlled foreign corporation under the United States. Its benefits include the preservation of 85 FTE positions, protection of Microsoft's local reputation, and added company asset diversity. These benefits, however, may be small compared to the high United States and Latin America tax rates. Second, MSPR can be incorporated as a CFC under a different country. White this outcome can alleviate the high U.S. tax rate ofthc previous possibility, it introduces the cost of having an unfavorable relationship with the U.S. government. Last, MSPR can be shut down, outsourcing all future CD production. Through this outcome, Microsoft can save approximately $5.4 million every year. But, it comes with the cost of d ismissing 85 FTE employees, exposing Microsoft's reputation to bad press, and losing Microsoft's last wholly-owned CD manufacturing facility. Determining the best outcome depends heavily on Microsoft's future business strategy and how much Microsoft values the negative consequences from closing MSPR. If the assumptions are made that Microsoft continues to service both North America and Latin America and that Microsoft puts small value to the negative consequences, the best choice of action is to shut down MSPR and outsource all future CD production. Microsoft Confidential 8/25/03 3 MSTP1253446 Case 2:15-cv-00102-RSM Document 146-7 Filed 10/12/16 Page 4 of 18 Hoon Kim 2 DRAFT Puerto Rico Background Pueno Rico has been part of the United States since 1898. Not until 1952, when it passed its commonwealth constitution, did the lslaad officially become the Commonwealth of Puerto Rico. As a result, Puerto Rico currently governs itself and remains fiscally autonomous with the mainland United States. Puerto Ricans have been considered U.S. citizens since 1917. Puerto Rico's highest executive position belongs to Governor Sila M. Calderon. The Legislative Assembly consists of the Senate and the House of Representatives, and Puerto Rico's highest judicial branch is the U.S. Supreme Court. Close to four million people (July 2002 1 estimate) live on the Island, with nearly an equal number of males and fomales. Puerto Rico's purchasing power parity GDP comes in at $43.9 billion (2001 estimate) with annual growth measured at 2.2%.~ Encouraged by duty-free access to the mainland U.S. and more than 75 years of U.S. tax incentives, many U.S. firms have made substantial investments into Puerto Rico. The largest industries in Puerto Rico cons isl of manufacturing 3 plants for pharmaceuticals, medical devices, biotechnology, and electronics. In 200 I, the total value of exported phannaceutical products reached $28 billion. In doing so, pharmaceutical firms hired more than 26,000 local employecs.4 Tourism also ranks as a top source of income. As a U.S. territory, Puerto Rico obeys U.S. minimum wage laws and uses the U.S. Dollar for its official currency, giving U.S.-bascd firms the added advantage of avoiding currency risks. Microsoft Puerto Rico Background Microsoft Puerto Rico (MSPR) was established in Humacao, Puerto Rico on June 1989. It serves as the primary CD production facility for the Americas Operation Center (AOC). Four rotating shifts working 24 hours. seven days a week produce: Microsoft Confidential 8/25/03 4 MSTP1253447 Case 2:15-cv-00102-RSM Document 146-7 Filed 10/12/16 Page 5 of 18 Hoon Kim 3 DRAFT • 65% of the high revenue full-packaged products (FPP), such as Office and Windows, • all Select/Enterprise CDs (English SKUs only). 5 For FY04, MSPR is budgeted to produce 14.5 million compact disks. Of these, 14.3 million CDs arc targeted for North America and the rest for Latin America. The total cost of producing one CD ranges from $0.44 to $4.09, depending on the product, its target region, and volume of production. Appendix ..Per Unit Matrix" provides a detailed cost/volume breakdown. The higher cost numbers come from the production of low volume CDs for Latin America. Microsoft Puerto Rico employs 85 full-time employees and another 25 for contingent 6 staff. Total budgeted FTE headcount cost for FY04 is $5.4 million. Appendix " Linc item summary." Demographically, 47% arc female, 48% arc between the ages 30 and 40, and 69% of MSPR employees have worked eight or more years. 7 Microsoft Puerto Rico and IRC §936 Perhaps most importantly, MSPR was specifically located in Puerto Rico to take full advantage of the tax benefits outlined in IRC §936: Sectio11 936 possessio11 credit is a11 elective alternative to the Foreign Tat Credi/ (FTC). The possession credit entirely replaces any FTC or deductio11/or laxes paid that are otherwise allowable with re:,pec.:t to possession sourced income. 8 For tax purposes, MSPR statutorily recognizes all revenue and costs associated with the SKUs going through the facility. For Microsoft, Section 936 means that the combined taxable income from MSPR is subject to a tax credit; therefore, to maximize the credit, all high revenue SKUs are routed through Puerto Rico. At the end of FY02, Microsoft's cumulative tax benefit from Section 936 reached $192 million.9 Microsoft Confidential 8/25/03 5 MSTP1253448 Case 2:15-cv-00102-RSM Document 146-7 Filed 10/12/16 Page 6 of 18 Hoon Kim 4 DRAFT However, recent legislative changes have reduced the tax credit amount. When originally fonned in 1954. IRC §936 allowed any income earned from possession corporations to be excluded from federal taxation. In later years, the Tax Reform Act and the Tax Equity and Fiscal Responsibility Act put severe limitations to Section 936. IRC §936(h), adopted in 1982, mandated a 50-50 split between the possession corporation and its United States affiliate on all income derived from intangible property given to the possession corporation. 10 Applying Section 936(h) to Microsoft, half of the profits from MSPR must be reported on the return of a U.S. mainland Microsoft affiliate, thereby eliminating any tax credit on this portion of income. The next major change came with the Omnibus Budget Reconciliation Act of 1993. This legislation reduced the tax credit to just 60% of the possession corporation's U.S. tax liability (previously, tax credit has been at 100% of the possession corporation's U.S. tax liability) with further reduction to 40% in I 998. 11 The Tax Reform Act of 1995 struck the final blow to Section 936 with two measures. First, the Act imposed a cap on the tax benefits after I 998. limit was set at $25 million. 13 11 For Microsoft Puerto Rico, the Second, all tax benefits under Section 936 would terminate after 2005. Microsoft's tax break stops at the end ofFY06. 14 With the changes to IRC §936, it affects Microsoft and MSPR in the following ways: • All tax credits under Section 936 will expire at the end of FY0G, • Half ofMSPR's combined total income must be allocated to a U.S. mainland Microsoft affiliate, thereby exempting this portion of income from Section 936 tax benefits, • Of MSPR's U.S. tax liability on the remaining half, only 40% will equal the tax credit, • Net tax credit is capped at $25 million. Microsoft Confidential 8/25/03 6 MSTP1253449 Case 2:15-cv-00102-RSM Document 146-7 Filed 10/12/16 Page 7 of 18 DRAFT Hoon Kirn 5 Using actual FY02 numbers, Figure 1 illustrates exactly how IRC §936 affects Microsoft and Microsoft Pucno Rico. Figure 1: Example Tax Credit Calculation under IRC §936 MSPR 2 3 4 s 6 7 8 9 Qualified 936 Net Revenue Cost of Goods Sold Gross Profit R&D Expense Other Deductions Total Deductions Combined Taxable Income (CTI) Production Cost Ratio (PCR) PCR Combined Taxable Income U.S. Microsoft 2,567,116,679 {1 32,375,081 ~ 2,434,741 ,598 (535,466,321) {935,017,287) (1,470.483,608) 964,257,990 87% 834,613,503 11 Adjustment to arrive at CTI Limitation CTI Limitation 12 Profit Split 13 CTI Allocation 238,328,066 238,328,066 14 (83,414,823) 33,365,929 (8,341 ,482) (58,390,376) (83,414,823) 17 Gross U.S. Tax (35%) §936 Tax Credit (40% of U.S. Tax) Total Puerto Rico Local Tax (3.5%) Total Tax Liability (83,414,823) n, Net Income 179,937,690 154,913,243 10 15 16 {357,957,371 ) 476,656,132 50% Net benefit from IRC §936: 179,937,690 - 154,913,243 = $25,024,447 Source· Reproduced from Appendi,c I Microsoft Confidential 8/25/03 7 MSTP1253450 Case 2:15-cv-00102-RSM Document 146-7 Filed 10/12/16 Page 8 of 18 Hoon Kirn DRAFT 6 In this example, the calculations to line 7 arc pretty straightforward. In line 8, the Production Cost Ratio (PCR) represents the portion of wexpenscs, losses, or other deductions which cannot definitely be allocated to some item .... " 1s Taking the PCR is permitted under Section 936(h). Multiplying the CTI and the PC'R gives the PCR C"TT (line 9). To this figure , an adjustment is made so that the net tax benefits do not exceed $25 million (line IO). The CTI Limitation, therefore, is the net figure from which the profit split occurs (line 11). As discussed above, half of the CTI is allocated to MSPR, and the other half to a U.S. Microsoft affiliate (line 13). At this point, both MSPR and U.S. Microsoft arc taxed equally at the federal tax rate, i.e. 35% (line 14); however. the benefit of IRC §936 occurs here. For MSPR only, a tax credit is given. equal to 40% of the U.S. tax liability (line I 5), thus reducing MSPR's total tax liability. MSPR must still pay any local Puerto Rican tax, which historically has been very low (line 16). Finally, after computation of net income (line 18), the total net benefits of Microsoft's operating in Puerto Rico and using IRC §936 equal $25 million. Future of Microsoft Puerto Rico Given that the current tax model (and the main reason for manufacturing in Puerto Rico) terminates at the end of FY06. determining what comes next for Microsoft Puerto Rico merits thorough analysis. Three most likely outcomes exist for MSPR: • Make MSPR a Controlled Foreign Corporation under the United States, • Make MSPR a Controlled Foreign Corporation under a country with a more favorable tax system, e.g. Ireland or Singapore, • Shut down MSPR and outsource all CD production.' ; Much credit is given to Glenn Cogswell for providing the direction of these outcomes. Microsoft Confidential 8/25/03 8 MSTP1253451 Case 2:15-cv-00102-RSM Document 146-7 Filed 10/12/16 Page 9 of 18 Hoon Kim 7 DRAFT Which one is best depends on Microsoft's future business strategy. Thus, before deciding on an outcome, it is important to understand the pros and cons of each. Make MSPR a Contmlled Foreign Corpnratio11 under the l /11ited States A controlled foreign corporation (CFC) is defined under IRC §957 as "any foreign corporation if more than 50 percent of (I) the total combined voting power of all classes of stock of such corporation entitled to vote, or (2) the total value of the stock of such corporation, is owned . . ., or is considered as owned,. .. by United States shareholders on any day during the taxable year of such foreign corporation: ' 16 Except for special circumstances, income from a CFC is not taxed by the United States until the CFC repatriates a dividend. With this definition in mind, incorporating Microsoft Puerto Rico into a controlled foreign corporation is a possibility. The benefits of continuing operations on the Island as a U.S. CFC are the preservation ofjobs for the 85 full-time employees in MSPR, the protection of Microsoft's local reputation, and the assurance of wholly owning a CD manufacturing facility., providing added diversification. The dollar value of these benefits is hard to determine. But if these benefits arc not critical and the only reason to keep MSPR running is to profit from a tax break, then incorporating MSPR as a U.S. CFC docs not make sense for two reasons. First, income from products sold to Latin American countries is subject to unacceptably high withholding tax rates.ii A withholding tax is a tax applied by country X against any distributed dividends from country X to country Y. As an example, assume that a Windows CD, which was manufactured in MSPR, is sold in Mexico for $100. Currently, Mexico's withholding u Many Section 9.16 corporations in Puerto Rico, primarily phannaccuticals, have become controlled foreign corporations to extend their tax benefits. Unlike Microsoll, however, these !inns arc not su~jecl to high Latin America withholding tax rates. The tax treatment for medical devices and drugs is different from the treatment for soflware products. Microsoft Confidential 8/25/03 9 MSTP1253452 Case 2:15-cv-00102-RSM Document 146-7 Filed 10/12/16 Page 10 of 18 Hoon Kim DRAFT 8 tax rate is 25%, in addition to a maximum corporate tax rate of 35% . 17 The cash flow from this sale would look like Figure 2. Figure 2: Calculation of After-Tax Income from Mexico Sale Mexico pre-tax earning Local corporate tax (35%) Net Income $100 (35) $65 Dividends distributed from Mexico Withholding tax (25%) (1 6) Net Dividends distributed $49 $65 After all taxes. MSPR would receive only $49 from the $100 sale. This is an effective tax rate of 51 %. The high Latin America withholding tax destroys any chance of a tax break. Assuming that the withholding tax is not a large concern, the second reason against incorporating MSPR as a U.S. CFC is that other countries besides the United States offer better corporate lax structures. If MSPR becomes a U.S. CFC. then the U.S. corporate tax rate still applies to any funds repatriated back into the United States. Recent political pressure by the Puerto Rican government exists to amend lRC §956. Under the proposal, U.S. CFCs in Puerto Rico would be given an incentive to invest in the United States the surplus income earned from 18 the Island; however, the proposal applies only to investments, not repatriations, and it has not been favorably received by U.S. Congress. 19 Furthermore, according to Glenn Cogswell in Microsoft corporate tax. keeping Puerto Rico operations alive under the U.S. would require very aggressive tax structuring and work. Other countries offer substantially lower corporate tax rates for foreign-source income. For example, Ireland enjoys a 12.5% rate. Therefore, it may make Microsoft Confidential 8/25/03 10 MSTP1253453 Case 2:15-cv-00102-RSM Document 146-7 Filed 10/12/16 Page 11 of 18 Hoon Kim 9 DRAFT more sense to incorporate MSPR as a CFC under a d ifferent country. However, even this outcome has its own pros and cons, which will be explored next Make MSPR a C'o111mlled Foreign Cm7mrali x + y + z $5 .4 million < x + y + z Actions Shut down MSPR Preserve MSPR Microsoft Confidential 8/25/03 13 MSTP1253456 Case 2:15-cv-00102-RSM Document 146-7 Filed 10/12/16 Page 14 of 18 Hoon Kim DRAFT Figure 5 summarizes the three most likely outcomes for Microsoft Puerto Rico by listing the pros and cons associated with each possibility. Figure 5: Summary of the Most Likely Outcomes for MSPR Possible Outcome Benefits Costs Make MSPR a U.S. CFC Preservation of85 FTE positions Protection of MS reputation Assurance of owning CD manufacturing facility High Latin America withholding tax Better corporate tax rates outside U.S. Make MSPR a foreign CFC Preservation of 85 FTE positions Protection of MS reputation Assurance of owning CD manufacturing facility Better corporate tax rates than U.S. High Latin America withholding lax Damaging rcla1ionshi1, with U.S. Government Close MSPR & Outsource all CD Procluction S5.4 million savings Dismissal of 85 FTE positions Loss of MS reputation Loss of Microsoft' s only CD manufacturing facility In choosing the best outcome for Microsoft, two assumptions must be made. If neither of these assumptions holds, then more analysis must be done, beyond the contents of this report. The assumptions arc: • Microsoft plans to service both North America and Latin America in the foreseeable future and sell products to both regions, • The value of the 85 FTE positions, Microsoft's reputation in Puerto Rico, and the assurance of owning a CD manufacturing facility is not significant. Microsoft Confidential 8/25/03 14 MSTP1253457 Case 2:15-cv-00102-RSM Document 146-7 Filed 10/12/16 Page 15 of 18 Hoon Kirn 13 DRAFT If both assumptions arc true, then the best outcome is to shut down Microsoft Puerto Rico a11d outsource all CD produc1io11. It is the only outcome that produces a net benefit. Of the other outcomes, preserving MSPR as a controlled foreign corporation under any country would hurt Microsoft's bottom line. The high Latin America withholding tax rates alone would swallow up any benefits received. Plus, if Microsoft even attempted to incorporate MSPR as a non-U.S. CFC, Microsoft's relationship with the U.S. government could be seriously damaged. Thus, given the assumptions above, Microsoft should not consider keeping Microsoft Puerto Rico after FY06. Conclusion Microsoft Puerto Rico was established to serve as the primary CD manufacturing facility for the Americas. Producing high revenue FPP, Select, and Enterprise CDs>MSPR took full advantage oflRC §936 and saved Microsoft over$ I 92 million since 1989. Until Sec Lion 936 expires in FY06, Microsoft will save approximately $25 million every year in net taxes. The future of Microsoft Puerto Rico is of current concern. Through analysis, three most likely outcomes emerge. First. MSPR can be incorporated as a controlled foreign corporation under the United States. Its benefits include the preservation of 85 FTE positions, Microsoft's local reputation, and added company asset diversity. These benefits, however, may be small compared lo the high United Stales and Latin America tax rates. Second, MSPR can be incorporated as a CFC under a different country. While this outcome solves the high U.S. tax rate of the previous possibility, it introduces the cost of having a bad relationship with the U.S. government. Last, MSPR can be shut down, thus outsourcing all future CD production. Without receiving any tax benefits, Microsoft will save $5.4 million every year. But, there is the cost of Microsoft Confidential 8/25/03 15 MSTP1253458 Case 2:15-cv-00102-RSM Document 146-7 Filed 10/12/16 Page 16 of 18 Hoon Kim 14 DRAFT dismissing 85 employees, negative exposure to Microsoft's reputation, and the loss of Microsoft's last CD manufacturing facility. Determining the best outcome depends greatly on Microsoft's future business strategy and how much Microsoft values the negatives from closing MSPR. If the assumptions are made that Microsoft continues to service both North America and Latin America and that Microsoft puts small value to the negative consequences from MSPR' s closure, the best choice of action is to shut down MSPR and outsource all CD production. This analysis of Microsoft Puerto Rico should be followed up with a closer scrutiny as the time gets closer to 2006. Microsoft Confidential 8/25/03 16 MSTP1253459 Case 2:15-cv-00102-RSM Document 146-7 Filed 10/12/16 Page 17 of 18 Hoon Kim 15 DRAFT Endnotes 1 "CIA - The World Factbook - Puerto Rico," The World Factbook, I Aug. 2003, http://www.cia.gov/cia/publications/factbook/geos/rq.html. 2 "CIA -The World Facthook - Puerto Rico" 3 "Puerto Rico's Industry Groups," PRIDCO, 18 Aug. 2003, http://www.pridco.com/cnglish/5.0ind_groups_overview.html. 4 "Pharmaceutical Industry Overview," PRIDCO, 18 Aug. 2003, http://www.pridco.com/cnglish/5. I 0ind_groups_pharma.html. s "Guidelines to Maximize Benefit," MSPR IOI, 14 Oct 2002, MSPR IOI Update for SC Project 021014.ppt, slide number 6. 6 "Overview," MSPR Tax Benefit Update, 7 Jun. 2003, MSPR Tax Benefit 10 I AOC 030607.ppt, slide number 4. 7 "Our People Demographics," MSPR 101, 14 Oct. 2002, MSPR 101 Update for SC Project 021014.ppt, slide number 18. 11 "Internal Revenue Manual," Internal Revenue Service, 1 Jan. 2002, hllp://www .irs.gov/irm/page/0,,id%3D21554,00.hlml. 9 "MSPR Tax Overview," MSPR IOI, 14 Oct. 2002, MSPR IOI Update for SC Project 021014.ppt, slide number 3. 10 "Section 7.1 Possessions Corporations - The Federal Rules," Franchise Tax Board, 7 Nov. 2002, http://www.ftb.ca.gov/manua1s/audit/water/WEMSec7 _ 1a.html. 11 "Internal Revenue Manual," Internal Revenue Service 12 "Internal Revenue Manual," Internal Revenue Service 13 "MSPR Tax Overview," MSPR IOI 14 "MSPR Tax Overview " MSPR 10 I ' 15 "Code Section 936(h)," The Transfer Pricing Network, 18 Aug. 2003, http://www.transfcrpricing.eom/userguidcs/936_ hecon.htm. 16 "Sec. 957. Controlled Foreign Corporations; United States Persons," Asset Protection Corporation, 18 Aug. 2003, http://www.assetprotcctioncorp.com/control1edforeign95.html. Microsoft Confidential 8/25/03 17 MSTP1253460 Case 2:15-cv-00102-RSM Document 146-7 Filed 10/12/16 Page 18 of 18 Hoon Kim 16 DRAFT 17 "Mexican Tax Law; ' Solutions Abroad, 18 Aug. 2003, http://www.solutionsabroad.com/d_ mcxicantaxlaw.asp. 18 Kristin Roberts, "Puerto Rico to Ask for New Business Tax Incentives," Reuters News, 10 Apr. 2003. 19 Ralph J Jr Sierra, "Puerto Rico and the Anti-Inversion Challenge," International Tax Journal, Volume 29, Issue 3, I Jul. 2003, pp. 45-63. Microsoft Confidential 8/25/03 18 MSTP1253461