Microsoft (MSFT)

Income Taxes

Fiscal year 2009 compared with fiscal year 2008

Our effective tax rates in fiscal years 2009 and 2008 were 27% and 26%, respectively. While the fiscal year 2009 rate reflects a higher mix of foreign earnings taxed at lower rates, the rate increased from the prior year because the fiscal year 2008 rate reflects the resolution of tax positions relating to our agreement with the Internal Revenue Service (“IRS”) settling the 2000-2003 examination, partially offset by the European Commission fine which was not tax deductible. As a result of the settlement and the impact on subsequent years, we paid the IRS approximately $4.1 billion during fiscal year 2009.

Fiscal year 2008 compared with fiscal year 2007

Our effective tax rates in fiscal year 2008 and 2007 were 26% and 30%, respectively. The fiscal year 2008 rate was lower due to the items noted above.

FINANCIAL CONDITION

Cash, cash equivalents, and short-term investments totaled $31.4 billion as of June 30, 2009, compared with $23.7 billion as of June 30, 2008. Equity and other investments were $4.9 billion as of June 30, 2009, compared with $6.6 billion as of June 30, 2008. Our investments consist primarily of fixed-income securities, diversified among industries and individual issuers. Our investments are generally liquid and investment grade. The portfolio is invested predominantly in U.S. dollar-denominated securities, but also includes foreign-denominated securities in order to diversify risk. We invest primarily in short-term securities to facilitate liquidity and for capital preservation. As a result of the special dividend paid in the second quarter of fiscal year 2005 and shares repurchased, our retained deficit, including accumulated other comprehensive income, was $22.8 billion at June 30, 2009. Our retained deficit is not expected to affect our future ability to operate, pay dividends, or repay our debt given our continuing profitability and strong cash and financial position.

Income Taxes

SFAS No. 109, Accounting for Income Taxes, establishes financial accounting and reporting standards for the effect of income taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current year and deferred tax liabilities and assets for the future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Accruals for uncertain tax positions are provided for in accordance with the requirements of FIN No. 48, Accounting for Uncertainty in Income Taxes – An interpretation of FASB Statement No. 109. Under FIN No. 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. FIN No. 48 also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our financial position, results of operations, or cash flows.

Income Taxes

Income tax expense includes U.S. and international income taxes, plus the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested. Certain income and expenses are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes.

Income Taxes

Our effective tax rate was 27% for the three and twelve months ended June 30, 2009. Our effective tax rate was 28% for the three months and 26% for the twelve months ended June 30, 2008. The fiscal year 2008 rate was lower primarily due to the resolution of tax positions relating to our agreement with the Internal Revenue Service (“IRS”) settling the 2000-2003 examination. As a result of this settlement and the related impact on subsequent years, we paid the IRS approximately $4.1 billion during fiscal year 2009.

Note 11 – Income Taxes

Our effective tax rate was 27% for the three and nine months ended March 31, 2009. Our effective tax rates were 9% for the three months and 25% for the nine months ended March 31, 2008. The fiscal year 2008 rates were lower primarily due to the resolution of tax positions relating to our agreement with the Internal Revenue Service (“IRS”) settling the 2000-2003 examination. As a result of this settlement, we paid the IRS approximately $3.1 billion during the first quarter of fiscal year 2009.

Tax contingencies and other tax liabilities were $5.8 billion as of March 31, 2009 and $3.8 billion as of June 30, 2008, and were included in other long-term liabilities.

Income Taxes

Our effective tax rate was 27% for the three and nine months ended March 31, 2009. Our effective tax rates were 9% for the three months and 25% for the nine months ended March 31, 2008. The fiscal year 2008 rates were lower primarily due to the resolution of tax positions relating to our agreement with the Internal Revenue Service (“IRS”) settling the 2000-2003 examination. As a result of this settlement, we paid the IRS approximately $3.1 billion during the first quarter of fiscal year 2009.

Note 10 – Income Taxes

Our effective tax rates were 26% for the three months and 27% for the six months ended December 31, 2008, and 31% for the three and six months ended December 31, 2007. The fiscal year 2009 rates reflect a decline in the recurring effective tax rates primarily as a result of foreign earnings taxed at lower rates.

During the first quarter of fiscal year 2009, we paid the Internal Revenue Service (“IRS”) approximately $3.1 billion as a result of our settlement with the IRS on its 2000-2003 examination.

Tax contingencies and other tax liabilities were $5.1 billion as of December 31, 2008 and $3.8 billion as of June 30, 2008, and were included in other long-term liabilities.

Income Taxes

Our effective tax rates were 26% for the three months and 27% for the six months ended December 31, 2008, and 31% for the three and six months ended December 31, 2007. The fiscal year 2009 rates reflected a decline in the recurring effective tax rates primarily as a result of foreign earnings taxed at lower rates.

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During the first quarter of fiscal year 2009, we paid the Internal Revenue Service (“IRS”) approximately $3.1 billion as a result of our settlement with the IRS on its 2000-2003 examination.

INCOME TAXES

Income tax expense includes U.S. and international income taxes, plus the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested. Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes.

Income Taxes

Our effective tax rates were 27% and 31% for the three months ended September 30, 2008 and 2007, respectively. The fiscal year 2009 rate reflected a decline in the recurring effective tax rate primarily as a result of foreign earnings taxed at lower rates.

During the first quarter of fiscal year 2009, we paid the Internal Revenue Service (“IRS”) approximately $3.1 billion as a result of our settlement with the IRS on its 2000-2003 examination.

INCOME TAXES

Income tax expense includes U.S. and international income taxes, plus the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested. Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes.

INCOME TAXES

ALIGN="justify">Income tax expense includes U.S. and international income taxes, plus the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested. Certain
items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes.

ALIGN="center">FINANCIAL INSTRUMENTS

We consider all highly liquid interest-earning investments with a maturity of
three months or less at the date of purchase to be cash equivalents. The fair value of these investments approximates their carrying value. In general, investments with original maturities of greater than three months and remaining maturities of
less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that
is available for current operations. All cash equivalents and short-term investments are classified as available for sale and are recorded at market value using the specific identification method. Changes in market value are reflected in OCI
(excluding other-than-temporary impairments).

Equity and other investments classified as long-term include both debt and equity
instruments. Debt securities and publicly traded equity securities are classified as available for sale and are recorded at market using the specific identification method. Changes in market value are reflected in OCI (excluding other-than-temporary
impairments). All other investments, excluding those accounted for using the equity method, are recorded at cost.

We lend certain
fixed-income and equity securities to enhance investment income. The loaned securities continue to be carried as investments on our balance sheet. Collateral and/or security interest received is determined based upon the underlying security lent and
the creditworthiness of the borrower. Cash collateral is recorded as an asset with a corresponding liability.

Investments are
considered to be impaired when a decline in fair value is judged to be other-than-temporary. We employ a systematic methodology on a quarterly basis that considers available quantitative and qualitative evidence in evaluating potential impairment of
our investments. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, the duration and extent to which the fair value is less than cost, and our intent and ability to hold the investment.
We also consider specific adverse conditions related to the financial health of and business outlook for the investee, including industry and sector performance, changes in technology, operational and financing cash flow factors, and rating agency
actions. Once a decline in fair value is determined to be other-than-temporary, an impairment charge is recorded and a new cost basis in the investment is established.

ALIGN="justify">We use derivative instruments to manage exposures to foreign currency, equity price, interest rate and credit risks, to enhance returns, and to facilitate portfolio diversification. Our objectives for
holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Derivative instruments are recognized as either assets or liabilities and are measured at fair value. The
accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation. For a derivative instrument designated as a fair-value hedge, the gain or loss is recognized in earnings in the
period of change together with the offsetting loss or gain on the hedged item attributed to the risk being hedged. For a derivative instrument designated as a cash-flow hedge, the effective portion of the derivative’s gain or loss is initially
reported as a component of OCI and is subsequently recognized in earnings when the hedged exposure affects earnings. The ineffective portion of the gain or loss is recognized in earnings. For options designated either as fair-value or cash-flow
hedges, changes in the time value are excluded from the assessment of hedge effectiveness and are recognized in earnings. Gains and losses from changes in fair values of derivatives that are not designated as hedges for accounting purposes are
recognized in earnings.

Income Taxes

The effective tax rate was 28% and 29% for the three months ended June 30, 2008 and 2007, respectively. The decreased rate reflects a higher mix of earnings in low rate tax jurisdictions. The effective tax rate was 26% and 30% for the twelve months ended June 30, 2008 and 2007, respectively. The decreased rate resulted from resolution of tax positions related to our agreement with the Internal Revenue Service (“IRS”) for the 2000-2003 examination. This decline was partially offset by the tax effect of the European Commission fine of $1.4 billion (€899 million), which was not tax deductible. As a result of our agreement related to the 2000-2003 examination, we expect to pay the IRS approximately $3.1 billion during fiscal year 2009 in addition to amounts we otherwise would pay.

Income Taxes

The effective tax rate was 9% and 25%, respectively, for the three and nine months ended March 31, 2008. The fiscal year 2008 rates reflect a decline in the recurring effective tax rate from 31% to 30%, primarily as a result of resolution of tax positions relating to our agreement with the Internal Revenue Service (“IRS”) of the 2000-2003 examination. The effective tax rate also declined as a result of the reduction in previously accrued taxes and interest related to the 2000-2003 IRS examination. This decline was partially offset by the tax effect of the European Commission fine of €899 million, which is not tax deductible.

The effective tax rate was 29% and 30%, respectively, for the three and nine months ended March 31, 2007. These rates reflect an increase in the recurring effective tax rate from 31% to 31.5% due to a higher mix of earnings in high rate tax jurisdictions and were offset by a $195 million reduction resulting from various changes in tax positions taken in prior periods, related primarily to favorable developments in an IRS position and multiple foreign audit assessments.

On July 1, 2007, we adopted the provisions of the Financial Accounting Standards Board (“FASB”) Interpretation No. 48 (“FIN 48”) Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109, which provides a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Under FIN 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. FIN 48 also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures.

Adopting FIN 48 had the following impact on our financial statements: increased current assets by $228 million, long-term assets by $1.1 billion, long-term liabilities by $2.1 billion, and our retained deficit by $395 million; and decreased our income taxes payable by $394 million. As of July 1, 2007, we had $7.1 billion of unrecognized tax benefits of which $5.3 billion, if recognized, would affect our effective tax rate. Our policy is to include interest and penalties related to unrecognized tax benefits in income tax expense. As of July 1, 2007, we had accrued interest related to uncertain tax positions of $863 million, net of federal income tax benefit, on our balance sheet.

Income Taxes

Our effective tax rate was 31% for the three and six months ended December 31, 2007 and 2006.

On July 1, 2007, we adopted the provisions of the Financial Accounting Standards Board (“FASB”) Interpretation No. 48 (“FIN 48”) Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109, which provides a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Under FIN 48, we may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. FIN 48 also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures.

Adopting FIN 48 had the following impact on our financial statements: increased current assets by $228 million, long-term assets by $1.1 billion, long-term liabilities by $2.1 billion, and our retained deficit by $395 million; and decreased our income taxes payable by $394 million. As of July 1, 2007, we had $7.1 billion of unrecognized tax benefits of which $5.3 billion, if recognized, would affect our effective tax rate. Our policy is to include interest and penalties related to unrecognized tax benefits in income tax expense. As of July 1, 2007, we had accrued interest related to uncertain tax positions of $863 million, net of federal income tax benefit, on our balance sheet.

Income Taxes

Our effective tax rate was 31% for the three months ended September 30, 2007 and 2006.

On July 1, 2007, we adopted the provisions of FIN 48, Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109, which provides a financial statement recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return. Under FIN 48, the Company may recognize the tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position. The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. FIN 48 also provides guidance on derecognition of income tax assets and liabilities, classification of current and deferred income tax assets and liabilities, accounting for interest and penalties associated with tax positions, and income tax disclosures.

Adopting FIN 48 had the following impact on our financial statements: increased current assets by $228 million, long-term assets by $1.1 billion, long-term liabilities by $2.1 billion, and our retained deficit by $395 million; and decreased our income taxes payable by $394 million. As of July 1, 2007, we had $7.1 billion of unrecognized tax benefits of which $5.3 billion, if recognized, would affect our effective tax rate. Our policy is to include interest and penalties related to unrecognized tax benefits in income tax expense. As of July 1, 2007, we had accrued interest related to uncertain tax positions of $863 million, net of federal income tax benefit, on our balance sheet.

INCOME TAXES

Income tax expense includes U.S. and international income taxes, plus the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested. Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes.

Income Taxes

Our effective tax rate for the fourth quarter of fiscal year 2007 was 29% and for full fiscal year 2007 was 30%. The decreased rate for the fourth quarter was due to a higher mix of earnings in low rate tax jurisdictions. The fiscal year 2007 recurring effective tax rate was 31% and was offset by a $195 million reduction resulting from various changes in tax positions taken in prior periods related primarily to favorable developments in an IRS position and multiple foreign audit assessments. Our effective tax rate for the fourth quarter of fiscal year 2006 was 34% and for full fiscal year 2006 was 31%. The increased rate for the fourth quarter of fiscal year 2006 resulted primarily from the European Commission fine of €281 million ($351 million) which was not tax deductible. During the second quarter of fiscal 2006, we recorded a tax benefit of $108 million from the resolution of state audits.

Income Taxes

The effective tax rate was 29% and 30% for the three and nine months ended March 31, 2007, respectively. The effective tax rate was 31% and 30% for the three and nine months ended March 31, 2006, respectively. The fiscal year 2007 rate reflects an increase in the recurring effective tax rate to 31.5% due to a higher mix of earnings in high-rate tax jurisdictions and was offset by a $195 million reduction resulting from various changes in tax positions taken in prior periods, related primarily to favorable developments in an IRS position and multiple foreign audit assessments.

Income Taxes

Our effective tax rate was 31% for the three and six months ended December 31, 2006. Our effective tax rate for the three months and six months ended December 31, 2005 was 29% and 30%, respectively.

Income Taxes

Our effective tax rate was 31% for the three months ended September 30, 2006, and 2005.

INCOME TAXES

Income tax expense includes U.S. and international income taxes, plus the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested. Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes.

Income Taxes

Our effective tax rate for the fourth quarter of fiscal year 2006 was 34% and for full fiscal year 2006 was 31%. The increased rate for the fourth quarter resulted primarily from the European Commission fine of €281 million ($351 million) which is not tax deductible. During the second quarter of fiscal 2006, we recorded a tax benefit of $108 million from the resolution of state audits. Our effective tax rate for the fourth quarter of fiscal year 2005 was 4% and for full fiscal year 2005 was 26%. The decreased rate for the fourth quarter and full year resulted primarily from the reversal of $776 million of previously accrued taxes upon settling an Internal Revenue Service examination for fiscal year 1997 – 1999 and a tax benefit of $179 million generated by the decision to repatriate foreign subsidiary earnings under a temporary incentive provided by the American Jobs Creation Act of 2004.

Income Taxes

Our effective tax rate for the three and nine months ended March 31, 2006 was 31% and 30%, respectively. We expect to have an effective tax rate of 31% for the fourth quarter of fiscal year 2006. Our effective tax rate for the three and nine months ended March 31, 2005 was 33%. The decline in the tax rate reflected an increase in earnings taxed at lower rates in foreign jurisdictions and by $108 million of benefits from state audit settlements.

Income Taxes

Our effective tax rate for the second quarter and first half of fiscal year 2006 was 29% and 30%, respectively. We expect to have an effective tax rate of 31% for the third quarter and the remainder of fiscal year 2006. Our effective tax rate for second quarter and first half of fiscal year 2005 was 33%. The decline in the tax rate was driven by an increase in earnings taxed at lower rates in foreign jurisdictions and by $108 million of benefits from state audit settlements.

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Income Taxes

Our effective tax rate for the first quarter of fiscal year 2006 and the first quarter of fiscal year 2005 was 31% and 33%, respectively. The decline in the tax rate was driven primarily by an increase in earnings taxed at lower rates in foreign jurisdictions.

INCOME TAXES

Income tax expense includes U.S. and international income taxes, plus the provision for U.S. taxes on undistributed earnings of international subsidiaries not deemed to be permanently invested. Certain items of income and expense are not reported in tax returns and financial statements in the same year. The tax effect of such temporary differences is reported as deferred income taxes.

Income Taxes

Our effective tax rate for the fourth quarter of fiscal year 2005 was 4% and for full fiscal year 2005 was 26%. The decreased rate for the fourth quarter and full year resulted primarily from the reversal of $776 million of previously accrued taxes upon settling an Internal Revenue Service examination for fiscal years 1997–1999 and a tax benefit of $179 million generated by the decision to repatriate foreign subsidiary earnings under a temporary incentive provided by the American Jobs Creation Act of 2004. The effective tax rate for the fourth quarter of fiscal year 2004 was 27% and for full fiscal year 2004 was 33%. The decreased rate for the fourth quarter resulted from the reversal of previously accrued taxes associated with resolving the remaining tax matters related to fiscal years before 1997.

Income Taxes

Our effective tax rate for the third quarter and first nine months of fiscal 2005 was 33%. The effective tax rate for the third quarter and first nine months of fiscal 2004 was 42% and 35% respectively. The increased rate in 2004 resulted from the nondeductible European Commission fine. Excluding the effect of the European Commission fine, the tax rate for fiscal 2004 would have been 33%.

The American Jobs Creation Act of 2004 (the “Act”) was enacted in October 2004. The Act creates a temporary incentive for U.S. corporations to repatriate foreign subsidiary earnings by providing an elective 85% dividends received deduction for certain dividends from controlled foreign corporations. The Company may make this election with respect to dividends paid during either its fiscal year 2005 or 2006. The deduction is subject to a number of limitations and requirements, including a specific domestic reinvestment plan for the repatriated funds. On January 13, 2005 the U.S. Treasury published Notice 2005-10 providing guidance on the implementation of the repatriation deduction. Based on our current understanding of the Act, we believe that we may repatriate from $0 to approximately $780 million in dividends subject to the elective 85% dividends received deduction generating a corresponding tax provision benefit of $0 to approximately $179 million from the reversal of previously provided U.S. deferred tax liabilities on these unremitted foreign subsidiary earnings. We expect to confirm our understanding of this provision and if we decide to repatriate earnings, will seek the required chief executive officer and Board of Directors approval of the required domestic reinvestment plan within the timeframe the incentive is available.

Income Taxes

Our effective tax rate for the three and six month periods ended December 31, 2003 and 2004 was 33%.

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On October 22, 2004, the President signed the American Jobs Creation Act of 2004 (the “Act”). The Act creates a temporary incentive for U.S. corporations to repatriate foreign subsidiary earnings by providing an elective 85% dividends received deduction for certain dividends from controlled foreign corporations. The Company may make this election with respect to dividends paid during either its fiscal year 2005 or 2006. The deduction is subject to a number of limitations and requirements, including adoption of a specific domestic reinvestment plan for the repatriated funds. On January 13, 2005 the U.S. Treasury published Notice 2005-10 providing guidance on the implementation of the repatriation deduction. Based on our current understanding of the Act, we believe that we may repatriate from $0 to approximately $780 million in dividends subject to the elective 85% dividends received deduction generating a corresponding tax provision benefit from $0 to approximately $179 million from the reversal of previously provided U.S. deferred tax liabilities on these unremitted foreign subsidiary earnings. We expect to confirm our understanding of this provision and seek the required chief executive officer and Board of Directors approval of the required domestic reinvestment plan within the timeframe the incentive is available.