Metropolitan News-Enterprise

 

Wednesday, December 19, 2012

 

Page 1

 

C.A. Rules for Microsoft on Taxation of Software Licenses

 

By JACKIE FUCHS, Staff Writer

 

Microsoft does not have to pay state corporate franchise taxes on royalties paid by computer manufacturers for the bundling of Microsoft software, the First District Court of Appeal held yesterday.

In a unanimous decision, Div. One held that San Francisco Superior Court Judge John Kennedy Stewart erred when he ruled that such licenses constituted tangible property, and remanded the case for a determination of the amount of tax Microsoft owed for tax years 1995 and 1996 based solely on income derived from sales of its keyboard and mouse.

The case turned on whether the royalties manufacturers paid for the right to install Microsoft’s software on their computers was tangible or intangible property.

The distinction is important because in California income from a sale of tangible personal property is subject to taxation if the property is shipped to a purchaser within the state, whereas the sale of intangible property is treated as a California sale only if a greater proportion of the property‘s income-producing activity is performed in California than in any other state.

In the 1990s, Microsoft entered into licensing agreements allowing original equipment manufacturers and delivery service providers to install Microsoft’s software on computer systems, which the manufacturers then sold to consumer bundled with the pre-installed software.

Microsoft also designed a mouse and keyboard that were sold together or individually with the computers.  The manufacturers would pay Microsoft royalties on either a per system or per copy basis, depending on the particular licensing agreement.

Franchise Tax

California imposes a franchise tax on corporations doing business in the state based on the corporation‘s net income derived from or attributable to sources within California. Such income is expressed as a fraction, with the denominator consisting of amounts from all of a corporation‘s activities or assets everywhere it does business, and the numerator representing the portion of that revenue attributable to California. 

Microsoft reported income from the licensing of its software in California at just under $235 million in tax year 1995, and just under $407 million in 1996. These amounts represented royalties paid to it by manufacturers with billing addresses within the state.

Microsoft reported overall royalties from such licenses for tax years 1995 and 1996 at approximately $1.65 billion and $2.5 billion, respectively.

In 2002 the Franchise Tax Board issued a notice of proposed assessment to Microsoft for franchise taxes for 1995 in the amount of approximately $3.9 million, plus an accuracy related penalty in the amount of $760,260, for a total of approximately $4.7 million.  For 1996 it issued a notice for approximately $21.3 million, plus a penalty in the amount of $477,070, for a total amount of approximately $21.8 million.

Protests Filed

Microsoft timely filed protests of the two notices and the parties entered into an agreement whereby, among other things, the tax board agreed to withdraw the penalties. Microsoft thereafter paid the entire amount of the asserted tax deficiencies, plus interest.

Seeking a refund of such amounts, however, Microsoft filed claims for a refund with both the tax board and the superior court.

Both ruled against Microsoft, the superior court judge finding that the licensing of Microsoft’s software bundling with computers constituted the licensing of tangible personal property.

Stewart ruled that computer software is inherently tangible in that it is arranged and recorded in a physical form that takes up space on a computer hard drive, and is perceptible to the senses.

Additionally, he found, the licensing of Microsoft’s software involved the transfer of actual physical disks to the manufacturers for use in installing the software and for distribution to end users as back-up copies.

Court’s Opinion

But Justice Robert Dondero, writing for the Court of Appeal,  looked for guidance to California’s sales taxes regulations, which define “tangible personal property” as “personal property which may be seen, weighed, measured, felt, or touched, or which is in any other manner perceptible to the senses.”

Such regulations specifically provide, however, that with respect to computer software, sales tax does not apply “to license fees or royalty payments that are made for the right to reproduce or copy a program to which a federal copyright attaches in order for the program to be published and distributed for a consideration to third parties, even if a tangible copy of the program is transferred concurrently with the granting of such right.”

Dondero said that:

“While California sales tax cases and regulations are not controlling as to the outcome of this franchise tax case, we find them to be relevant. We see no rational justification for treating licenses to replace software as intangible in the context of sales taxation, while treating these very same licenses as tangible in the context of franchise taxation.”

As to the matter of the software being provided to the manufacturers on disks he wrote:

“The disks themselves were not essential to the reproduction process.  Rather, they were simply a means used to transmit plaintiff‘s software programs.…They served merely as a convenient storage medium to transfer plaintiff‘s copyrighted content.”

The panel also found relevant an unpublished decision of the State Board of Equalization, Appeal of Adobe Systems, Inc. (1997) 1997 Cal. Tax Lexis

257, in which it was held that royalties from licensing contracts constituted gross receipts from the licensing of intangible personal property.

While Dondero acknowledged that such a decision was not controlling, he found it troubling that the tax board appeared to the panel “to have advocated a position … that is directly contrary to the position it advances against plaintiff in the present case.  Unfortunately, the inconsistency suggests a result-orientated bias based on the domicile of the taxpayer.”

The panel also looked to the Internal Revenue Code, which defines “intangible property” to include franchises, licenses and contracts, as well as copyrights and literary, musical or artistic compositions.

Dondero rejected the tax board’s contention that “federal statutes and regulations have little relevance to the principles of formula apportionment under the unitary business principle, because federal law provides that a corporation is taxed on all of its income, regardless of where it is earned.”

To the contrary, he said, such regulations are “helpful as to the appropriate characterization of the transferred rights at issue here.”

In sum, he wrote, Stewart erred in concluding that Microsoft’s software licenses to manufacturers pertained to the licensing of tangible personal property and, accordingly, the board improperly included the gross receipts Microsoft obtained from these licenses in calculating its liability for state franchise taxes.

Presiding Justice James Marchiano and Justice Kathleen Banke concurred in the opinion.

The case is Microsoft Corporation v. Franchise Tax Board; A131964.

 

Copyright 2012, Metropolitan News Company