United States: California Court Treats Copyright Royalties As Income From Tangible Property In Microsoft Case

The San Francisco Superior Court recently denied Microsoft Corporation's ("Microsoft"), claim for refund of over $30 mil in franchise (income) taxes plus applicable interest and penalties imposed by the California Franchise Tax Board ("FTB"). Microsoft Corp. v. FTB, Case No. CGC 08-471260 (Feb. 17, 2011). The case involved four issues:

Two of these were issues of first impression in California: whether software licensing income gives rise to income from tangible or intangible property and whether intangible property should be included in the property factor for a company like Microsoft where the value of intangible property exceeds that of tangible property.

During tax years ending 1995 and 1996 ("Periods at Issue"), Microsoft's business activities included manufacturing, distributing, and licensing its proprietary computer software to OEMs. Microsoft's licensed software products were carried on "Golden Master" disks, which licensees used to copy Microsoft's software onto hard drives on computers they built and sold and back-up disks included with the assembled computer units. The Microsoft license gave OEMs the right to install Microsoft software into OEM computer systems and sell those computers with the pre-installed software.

Income from Copyright Rights

In this case, Microsoft argued that its royalty income constituted receipts from the licensing of something "other than tangible personal property," i.e., intangible property ("IP"). As such, the income should be sourced under California's "costs-of-performance" method. Cal. Rev. & Tax Code Section 25136. Under this method, Microsoft's IP royalties would be sourced entirely to Washington, where the majority of the IP's income-producing activity took place, thus significantly reducing Microsoft's California franchise tax liability. The court rejected Microsoft's argument, holding that the royalties constituted receipts from the licensing of tangible as opposed to intangible personal property, and thus should be sourced to California if the licensed property is located in the state. Cal. Code Regs. 25136(d)(2)(B). Pointing to the "Golden Master" disk format, the court stated that "the computer software licensed by Microsoft was inextricably intertwined with the disks on which they were embedded" and therefore "the royalties from the licensing of such programs should be classified as deriving from the sale of tangible personal property."

In reaching this conclusion, the court relied primarily on sales tax cases treating the sale of canned software as tangible property along with other authorities classifying the transfer of software to an end user as a transaction involving tangible personal property. The court failed to cite any authorities dealing with the license of copyright rights, such as the right to reproduce involved in Microsoft's case. The federal tax regulations in Treas. Reg. § 1.861-18, distinguishing between a copyrighted article and a copyright right, were summarily dismissed by the court as "unpersuasive." The court failed to grasp the fundamental distinction between tangible objects and intangible rights.

Treasury Receipts

Microsoft also protested the FTB's exclusion of total gross receipts from the sale or disposition of marketable securities from its sales factor denominator. In making its adjustment, the FTB sought to modify the standard three-factor apportionment formula, pursuant to Cal. Rev. & Tax Code Section 25137. Microsoft's marketable securities were handled by its Treasury Department in Washington, and any sales or dispositions occurred entirely out-of-state. Under the standard apportionment formula, such total gross receipts would have increased the size of Microsoft's sales factor denominator without affecting its numerator, thus significantly reducing its California franchise tax liability. The court upheld the FTB's use of a modified three-factor-formula, holding that only net receipts from the marketable securities should be included in Microsoft's sales factor. In so doing, the court largely followed the reasoning of prior decisions in Microsoft Corp. v. Franchise Tax Board, 39 Cal. 4th 750 (Cal. 2006) and Limited Stores, Inc. v. Franchise Tax Board, 152 Cal. App. 4th 1491 (Cal. 2007).

Property Factor Modification

The court also rejected Microsoft's argument that the three-factor apportionment formula should be modified to include the value of Microsoft's IP. Microsoft sought modification under section 25137, arguing that the failure to include IP in its property factor unfairly reflected the extent of Microsoft's California business activity. Clearly, Microsoft's IP represents a major business income producing asset that is core to its business. The court rejected this argument, holding that Microsoft failed to establish by clear and convincing evidence that modification was warranted.

Penalties

Finally, the court also upheld the imposition of amnesty penalties, imposed pursuant to Cal. Rev. & Tax Code Section 19777.5. Microsoft argued that the penalty statute was void because it operated retroactively, was unconstitutionally vague, and did not provide an opportunity for administrative or judicial pre-payment or post-payment review. Instead, the court held that the statute did not operate retroactively, as it did not increase the amount of a taxpayer's underlying tax liability, but rather increased "the consequences of not paying the proper amount for the years at issue within the dictates of the amnesty program." The court also held that the amnesty penalty statute was not vague as applied to Microsoft, and there was adequate opportunity for pre-payment and post-payment review.

Significance of Case

In practice, the FTB has long treated end-user software, even when delivered electronically, as tangible personal property, and a few taxpayers have received informal written statements from the FTB confirming this position. However, we are not aware of previous instances where the FTB publicly staked out the position that the license of copyright rights produced income from tangible property for apportionment purposes. The impact of the court's decision depends on the location of the taxpayer. Classification as income from tangible property is helpful to California-based software companies licensing to out-of-state unrelated parties who reproduce and distribute the software. Conversely this classification results in higher California apportionment for out-of-state software licensors licensing to California based OEMs, like Microsoft. If California switches from elective to mandatory single sales factor, the effects of this decision will be doubly important (and disadvantageous) for out-of-state software licensors. At the time this article was written, Microsoft had not announced whether it will appeal the decision.

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