The U.S. Internal Revenue Service is auditing how Google Inc.avoided federal income taxes by shifting profit into offshoresubsidiaries, according to a person with knowledge of thematter.

The agency is bringing more than typical scrutiny to how thecompany valued software rights and other intellectual property itlicensed abroad, said the person, who requested anonymity becausethe audit isn't public. The IRS has requested information fromGoogle about its offshore deals after three acquisitions, includingits $1.65 billion purchase of YouTube, the person said. Thetransfer overseas of these kinds of rights rights has enabledGoogle to attribute earnings to foreign units that pay lower taxes,Bloomberg News reported a year ago.

While Google's potential liability isn't clear, similar dealsbetween companies and offshore arms are often the subject ofdisputes over hundreds of millions of dollars in taxes, said DanielFrisch, an economist at Horst Frisch Inc., which advises businesseson transfer pricing — the allocation of income between units indifferent countries. In 2006, the IRS settled a case with drugmakerGlaxoSmithKline Plc for $3.4 billion.

“The very biggest transfer-pricing tax disputes are overtransfers of intangibles to offshore subsidiaries,” said Frisch,whose firm is based in Washington.

Google, owner of the world's most popular search engine, has cutits worldwide tax bill by about $1 billion a year using a pair ofstrategies called the “Double Irish” and “Dutch Sandwich,” whichmove profits through units in Ireland, the Netherlands and Bermuda.Google reported an effective tax rate of 18.8 percent in the secondquarter, less than half the average combined U.S. and statestatutory rate of 39.2 percent.

Tax Holiday

“This is a routine inquiry,” said Jim Prosser, a spokesman forMountain View, California-based Google. He declined to commentfurther.

Dean Patterson, a spokesman for the IRS in Washington, saidfederal law prohibits the agency from discussing specifictaxpayers.

U.S. companies are sitting on at least $1.375 trillion inearnings in their foreign subsidiaries on which they have paid nofederal income taxes, according to a May report by JPMorgan Chase& Co. Companies including Google, Cisco Systems Inc., PfizerInc., Apple Inc. and Microsoft Corp. are lobbying Congress for atax holiday on bringing home those profits, which would otherwisebe subject to U.S. income tax at the 35 percent corporate rate witha credit for foreign taxes already paid.

The Obama administration is opposed to that tax break and hasbeen stepping up criticism of tax preferences for variousindustries and millionaires. Last week, Senate Democrats proposed anew surtax on people earning at least $1 million a year, a movethat would generate an estimated $453 billion over the comingdecade.

France Probe

The French tax authority also began reviewing Google's incomeshifting in December, examining transactions between the company'sFrench and Irish subsidiaries, according to two people withknowledge of the probe. The French inquiry was prompted by theOctober 2010 Bloomberg article on the company's tax-cuttingstrategy, the people said.

A spokesman for the French budget ministry, which oversees thetax authority, declined to comment, saying the agency cannotdiscuss individual cases.

Multinational companies cut their tax bills by shifting earningsinto subsidiaries in offshore tax havens, a strategy that isdrawing increased scrutiny from the IRS.

In May, the IRS appointed its first transfer-pricing director,Samuel Maruca. Last year, it announced the assignment of additionalagents and attorneys to examine a few large companies as part of apilot program. The IRS wouldn't discuss whether Google is one ofthose companies.

Valuable Patents

Moving profit abroad is particularly important for cutting thetax bills of technology and pharmaceutical companies because oftheir valuable and easily transportable collection of patents andcopyrights. Google, Cisco, Facebook Inc., Microsoft and ForestLaboratories Inc., maker of the blockbuster antidepressant Lexapro,have used tax-cutting strategies that move profits into units —often with no employees or offices — in havens such as Bermuda, theCayman Islands and Switzerland, Bloomberg has reported.

In recent years, the IRS has engaged in a number of high profiledisagreements with multinational companies over their transferpricing. In 2006, the agency announced it was settling its disputewith GlaxoSmithKline.

In 2009, the IRS lost a closely watched U.S. Tax Court case withVeritas, now a part of computer-security software maker SymantecCorp. In that dispute, over intellectual property rights moved toan offshore subsidiary, the IRS sought $545 million.

Enforcement Setback

The win for Veritas was a major setback for the IRS's ability toenforce transfer-pricing rules, according to H. David Rosenbloom,an attorney at Caplin & Drysdale in Washington, and director ofthe International Tax program at New York University School ofLaw.

Income shifting by multinational companies cost the U.S. $90billion in federal tax revenue during 2008, according to a Marcharticle in the trade journal Tax Notes by Kimberly Clausing, aneconomics professor at Reed College in Portland, Oregon.

Google cuts its tax bill by about $1 billion a year using atechnique that allocates profits to a unit managed out of a lawfirm in Bermuda, where there is no corporate income tax. In 2009,the most recent year for which records are available, thissubsidiary collected 4.34 billion euros (about $6.1 billion) inroyalties from a Google unit in the Netherlands, according to aDutch corporate filing.

As of June 30, Google held $18.8 billion in cash in its foreignsubsidiaries, almost half its total $39.1 billion in cash andmarketable securities.

'Buy In'

The IRS has already approved a major part of Google's strategy.In 2006, the agency signed off on a 2003 intracompany transactionthat moved foreign rights to its search technology to an Irishsubsidiary managed in Bermuda called Google Ireland Holdings. Thatdeal — known as a “buy in” in tax parlance — meant subsequentprofit overseas based on those copyrights has been attributed toforeign subsidiaries rather than to Google in the U.S. where thetechnology was developed.

The IRS approval came in an accord known as an advance pricingagreement. Those arrangements are part of an agency programintended to forestall disputes with companies, includingdisagreements over the price paid by offshore units for patent andother intellectual property rights.

Google Acquisitions

That deal between the IRS and Google only covered rights thecompany held as of the 2003 licensing deal with its Irish unit. Itdidn't cover copyrights subsequently acquired by the U.S. parentand then moved abroad.

Following that 2003 transaction, Google made severalacquisitions, spending $1.65 billion for online-video site YouTubein 2006; $625 million for e-mail security service Postini in 2007;and $3.2 billion for web-advertising company DoubleClick Inc. in2008. The IRS now is examining the prices paid by the foreignsubsidiaries for the rights to software and other intangibles movedoffshore that formerly belonged to those three companies.

According to U.S. Treasury Department rules, foreign unitslicensing rights from their U.S. parents are supposed to pay an“arm's length” price, or the amount that would be paid by anunrelated company. If the offshore subsidiary pays too little, thathas the effect of shifting income overseas, thus helping the parentavoid U.S. income taxes.

SEC Review

Google's taxes have also drawn government scrutiny from theSecurities and Exchange Commission. Last December, the SEC askedthe company for “greater detail” about the profit it said it hadearned in countries with lower tax rates and the impact on itseffective tax rate, according to correspondence released by theagency in March. The SEC said in a February letter that it hadcompleted its review of Google's filings. It is unclear whataction, if any, the agency took.

In August, Google announced it was spending $12.5 billion toacquire Motorola Mobility Holdings Inc., the Libertyville, Illinoistelecom-equipment and mobile-phone maker. Google said it was doingthe deal primarily for Motorola's collection of valuable patents.Prosser didn't respond to a question about whether Google would bemoving any of those patent rights offshore.

Bloomberg News

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