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election because it failed to maintain a significant business
presence in Puerto Rico with respect to the diskettes under section
936(h)(5)(B)(i). Consequently, respondent recalculated the prices
at which MS-Puerto Rico sold its diskettes to Microsoft and
redetermined MS-Puerto Rico's taxable income under the transfer
pricing rules of section 482, as provided under section 936(h)(3).
The NOPA did not refer to any recalculation of the combined taxable
income.
A report entitled "Report for Disallowance of Election Out
Provisions of Section 936(h)", prepared by Thomas McDonell (the
McDonell report), an Internal Revenue Service team coordinator, was
attached to the NOPA. The McDonell report explained the proposed
adjustment:
The Internal Revenue Service is proposing to increase
taxable income by $1,366,918 for the year ending June 30,
1990 and $43,771,224 for the year ending June 30, 1991 in
determining Microsoft Corporation tax liability. The
increase to taxable income is based on a determination
that diskette duplication activities by Microsoft
Corporation's wholly owned subsidiary Microsoft Puerto
Rico, Inc. do not qualify for the profit split provisions
of Internal Revenue Code section 936(h). This
determination is based primarily on the conclusion that
diskette duplication is not manufacturing as defined by
sections 936 and 954 of the Code.
Throughout the audit, both petitioner and MS-Puerto Rico
executed Forms 872, Consents to Extend the Time to Assess Tax, with
respect to the 1990 and 1991 tax years. The first three of these
extension consents were unrestricted and permitted respondent to
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