Plenty of tech companies have tangled with the IRS before, but a recent tax battle between the agency and Intel (NASDAQ:INTC) could generate a $3.5 billion windfall for Google's parent company Alphabet (NASDAQ:GOOG) (NASDAQ:GOOGL).
Back in 2003, chipmaker Altera challenged an IRS rule which states that foreign subsidiaries of U.S. companies must help cover the costs associated with the stock-based compensation of U.S. employees. For example, if a U.S.-based engineer builds a product which is sold through a foreign subsidiary, the subsidiary must pay a portion of the engineer's salary.
Intel acquired Altera last year, before a Tax Court judge decided to overturn the IRS rule in a 15-0 ruling. The IRS subsequently appealed the ruling, which now makes it Intel's fight. However, this isn't Intel's first clash with the IRS -- the agency hit Intel with $600 million in extra taxes over a decade ago over its 1999 and 2000 tax bills.
How does this affect Alphabet?
The legal battle between Intel and the IRS directly impacts other major companies' tax bills. That's because multinational companies generally try to maximize costs in the U.S., where taxes are higher, while minimizing them abroad, where taxes are lower.
The IRS claims that this strategy enables U.S. companies to claim the entirety of an employee's compensation as a tax deduction to lower its domestic tax bill, while letting it accumulate more profits in an offshore subsidiary located in a country with lower tax rates. Intel argues that two unrelated companies shouldn't share that expense. The IRS claims that since a parent company funds a subsidiary, the two companies' businesses are related.
Alphabet's overseas subsidiaries pay a large portion of the stock-based compensation of the company's stateside employees. If the IRS' appeal fails, Alphabet has disclosed that it could receive a tax benefit of $3.5 billion -- more than the $3.3 billion it paid in income taxes in 2015. It's unclear how much Intel stands to gain from the ruling, but Altera's dispute involves about $80 million in accumulated expenses between 2004 and 2007.
Are Alphabet and Intel paying their fair share?
Receiving a $3.5 billion windfall would certainly be a positive development for Alphabet investors, but it also raises questions about fair taxation. Alphabet's total effective tax rate for 2015 was just 17%, less than half the U.S. corporate tax rate of 35%.
Like many multinational companies, Alphabet reduces it tax bill by keeping its cash overseas, since overseas income can't be taxed by the IRS until it is repatriated. Since interest rates are at historic lows, many companies finance dividends, acquisitions, or other investments with debt instead of bringing cash back to the U.S. Many companies also funnel their profits through low-tax countries like Ireland -- which has a 6.5% corporate tax rate -- enabling them to retain a much larger slice of their profits.
By holding foreign subsidiaries responsible for their parent companies' stock-based compensation, the IRS is trying to prevent companies like Intel and Alphabet from maximizing domestic expenses to minimize their U.S. tax bills. Multinational companies argue that the practice is perfectly legal, and that the U.S. should lower its corporate tax rate to encourage companies to repatriate their earnings.
The "largest unresolved tax issue"
If Intel wins, it wouldn't just be a victory for the chipmaker and Alphabet. About 20 other companies, including Microsoft (NASDAQ:MSFT), have recently disclosed an interest in the case's outcome.
Microsoft has also been targeted by the U.S. government for using Irish subsidiaries to reduce its taxes. Back in 2012, the Senate accused Microsoft of using those subsidiaries to avoid paying $6.5 billion in taxes between 2009 and 2011. The IRS has also been running a long-term probe into Microsoft's tax strategies. At the end of 2014, the agency sued former Microsoft CEO Steve Ballmer and several executives to force the company to turn over more tax-related documents and submit additional testimonies. Intel's potential victory wouldn't solve all of Microsoft's tax problems, but it could lower its tax bill in the same way as Alphabet's.
Eric Ryan, partner at the law firm DLA Piper, recently told The Wall Street Journal that the foreign stock-based compensation tax issue has become "the largest unresolved tax issue that high-technology companies now have."
The key takeaway
Investors should follow this case carefully, because it could have long-term implications for any U.S. based company which generates a large portion of its revenue overseas while paying its employees large amounts of stock-based compensation. It also highlights the ongoing problems between the IRS and U.S. multinational companies, which have caused many major companies to relocate their headquarters to lower-tax countries to permanently reduce their tax bills.