Introduction
In September 2023, the Internal Revenue Service (IRS) sent Microsoft notices proposing $28.9 billion of additional tax, plus penalties and interest, for the years 2004 to 2013, mainly over how the company priced transactions between its subsidiaries in different countries. Microsoft disagreed and said it would contest the claim through the IRS appeals process and, if necessary, the courts. Its June 2025 tax note nevertheless reported $24.7 billion of gross unrecognized tax benefits, mostly carried in long-term income taxes on the balance sheet, and $8.2 billion of accrued interest on them. Those are not admissions of liability. They are the accounting for tax positions that might not survive scrutiny.
Every large company takes uncertain tax positions, ones that the tax authorities could challenge: how profits are allocated across countries, whether a cost is deductible, when income is recognized. The tax return claims the benefit. The financial statements may not, and the gap is one more reason book tax and cash tax differ, alongside the timing differences covered in book vs tax accounting.
The Two-Step Test
Accounting Standards Codification (ASC) 740 applies two steps to each uncertain position, as Deloitte's chapter on uncertainty in income taxes describes. First, recognition: the company may record the benefit only if it is more likely than not, a likelihood above 50%, that the position will be sustained on its technical merits, assuming the tax authority examines it with full knowledge of the facts. A position that fails gets no benefit at all.
Second, measurement: a position that passes is recorded at the largest amount of benefit that is more than 50% likely to be realized on final settlement. Suppose a deduction would save $21 of tax if fully upheld, and management estimates the possible outcomes of an audit as follows:
| Benefit sustained | Probability | Cumulative probability |
|---|---|---|
| 21 | 40% | 40% |
| 15 | 30% | 70% |
| 10 | 20% | 90% |
| 0 | 10% | 100% |
The cumulative probability first exceeds 50% at $15, so the company records a $15 benefit and a $6 liability for the unrecognized portion. The measurement is not an expected value, which would be $14.90, but the largest amount the company is more likely than not to keep.
- Unrecognized tax benefit
The difference between the tax benefit claimed, or expected to be claimed, on a tax return and the benefit recognized in the financial statements under ASC 740's recognition and measurement test. It is usually recorded as a liability, or as a reduction of a deferred tax asset, and is disclosed in a roll-forward in the income tax note.
The liability is updated as facts change: new information, settlements with the tax authority, court decisions in similar cases, and the lapse of the statute of limitations all change it. Companies choose whether to record interest and penalties on these positions within income tax expense or elsewhere, and disclose the policy. Microsoft includes interest in its tax provision: $1.3 billion in fiscal 2025.
Reading the Exposure
The tax note carries most of what an analyst needs. Microsoft's 2025 annual report shows the elements:
- The roll-forward: gross unrecognized tax benefits rose from $22.8 billion to $24.7 billion during the year, mostly from $2.1 billion of new positions on current-year returns, with only $240 million settled.
- The effective rate impact: $21.2 billion of the total would lower the effective tax rate if recognized, the part that would reach earnings if the positions were upheld.
- The open years and disputes: the IRS is still auditing 2014 to 2017, and the 2004 to 2013 dispute is not expected to be resolved within twelve months.
- The interest accrued: $8.2 billion, net of tax benefits, a figure that grows every year the dispute continues.
Reserves also move earnings when they are released. When a statute of limitations expires or an audit settles for less than was reserved, the unused reserve becomes a tax benefit, lowering the effective rate in that period. Such releases are non-recurring and belong outside a normalized tax rate, as covered in effective, statutory and cash tax rates. Disputes over taxes other than income taxes, such as sales or payroll taxes, follow the general contingency rules instead, covered in contingencies and litigation reserves.
