District Court Grants Evidentiary Hearing In Dispute Over IRS Use Of Private Firm In Microsoft Audit

On June 17, 2015, the United States District Court for the Western District of Washington granted Microsoft Corporation an evidentiary hearing on whether the IRS' use of lawyers from Quinn Emanuel Urquhart & Sullivan LLP in the summons process was lawful.38 The IRS has been auditing Microsoft's transfer pricing arrangements from the company's 2004 to 2006 tax returns, and seeking to enforce the related summonses in United States v. Microsoft Corp. et al.39

What began as a routine IRS audit of Microsoft's cost-sharing arrangements with affiliates soon became a case full of rare happenings: the first time the IRS has hired a private law firm to aid in the audit process, and one of the rare instances where a District Court has granted an evidentiary hearing in a summons enforcement proceeding. The IRS contracted for Quinn Emanuel Urquhart & Sullivan LLP to help in its Microsoft audit, relying on the temporary regulations it issued in June 2014. Microsoft challenged both that contract and the validity of the regulation that permitted it. US District Judge Ricardo S. Martinez found that Microsoft had carried its burden for an evidentiary hearing, distinguishing this case from prior ones where hearings had been denied. On July 17, 2015, Judge Martinez also denied the Government's motion to exclude witnesses, allowing Microsoft's attorneys to testify at the hearing and agreeing with the company that an evidentiary hearing is not a trial.

Timeline of Events

The saga started in 2007, when the IRS began investigating Microsoft's activities from 2004 to 2006. The IRS audit focused on two of the company's cost-sharing arrangements, one with Microsoft affiliates in Puerto Rico and another with affiliates in Asia, a process that continued over the next seven years. The fact gathering had been done by just the agency thus far, but on June 9, 2014, the Treasury and the IRS issued a "temporary regulation" without notice and comment that would allow third-party contractors like private law firms to "receive books, papers, records or other data summoned by the IRS and take testimony of a person who the IRS has summoned as a witness to provide testimony under oath."40

Based on this temporary regulation, the IRS entered into a $2,185,500 contract with Quinn Emanuel for help on the audit of the Puerto Rico arrangement, which included services such as analysis of issues, identification of any further documents needed and participation in interviews. Quinn...