More than a decade ago, Microsoft acquired Danish software firm Navision A/S and integrated the company's product into its enterprise resource planning platform, Microsoft Dynamics NAV. But today, Denmark is saying it’s owed 5.8 billion Danish kroner ($1.011 billion) in back taxes.

According to a Monday report (Google Translate) by Danish public broadcaster DR, the Danish Ministry of Taxation is currently in negotiations with Microsoft and the Internal Revenue Service (the tax authority in the United States). The Ministry hopes to gain back the money that the Danish government claims it’s owed.

Representatives from both Microsoft and the Internal Revenue Service declined to comment on this story. The Danish Ministry of Taxation did not respond immediately to a request for comment.

“If [the tax authority] were to get their hands on the money, that would amount to financing a new super hospital, the next Silkeborg Motorway between Herning and Aarhus, or 15,000 teachers in primary schools.” DR reported.

Transfer pricing

Redmond acquired Navision A/S in 2002 in a $1.45 billion deal. But immediately after the deal closed, Microsoft apparently sold these intellectual property rights to its Irish subsidiary through what’s called “transfer pricing.”

As we’ve reported before, this means that foreign profits can be attributed to the offshore subsidiary rather than to the actual corporate headquarters. While subsidiaries are supposed to pay “arm’s length” prices, there’s an incentive to set those prices as low as possible as a way to shift profits overseas, where tax rates are lower.

DR reported that Danish authorities believe Microsoft paid itself far too little for this second deal, effectively transferring huge amounts of money out of Denmark. Currently, Microsoft has 11 subsidiaries, including three in Ireland: "Microsoft Ireland Research," "Microsoft Global Finance," and "Microsoft Ireland Operations Limited."

Companies can arrange for secret deals with the Internal Revenue Service that dictate the terms of such transfer pricing under what’s called an “advanced pricing agreement.” Google got its approval in 2006.

It's likely Microsoft could have used a legal technique known as a "Double Irish." Many other large companies (including Amazon, Apple, Google and others) use this tactic to create complicated shell companies and tax loopholes that allow them to minimize their tax burden in the United States, Ireland, the Netherlands, and elsewhere.

The beginnings of a crackdown?

Governments worldwide are now starting to look more closely at their own tax law, trying to shut down the effectiveness of such techniques.

“It seems like the biggest problem here will be the one that tends to plague these transfer pricing problems: finding a comparable transaction or otherwise figuring out an objective price for the transaction,” Samuel Brunson, a professor of tax law at Loyola University Chicago, told Ars.

“If the software is sui generis—and I suspect Microsoft would argue that it is—what goes into the price is a whole lot harder to figure out. The survey data I've seen says that corporate tax directors generally consider transfer pricing one of the most pressing international tax concerns they have, and it doesn't surprise me that governments are looking to it to increase their revenues, too.”