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Bloomberg BNA regularly spotlights the insights of state and local tax professionals at Grant Thornton. In this installment of Grant Thornton Insights, Patrick Shine discusses state tax sourcing of software licensing royalties received from original equipment manufacturers.
By Patrick Shine
Patrick is an associate in Grant Thornton's state and local tax practice in Seattle, Washington. Patrick earned his J.D. and M.B.A. from Seattle University. To contact Patrick, please email him at firstname.lastname@example.org.
On August 10, 2017, the Wisconsin Tax Appeals Commission held that the Wisconsin Department of Revenue could not assess additional corporate franchise taxes based on royalty income received by Microsoft Corporation (“Microsoft”) from the licensing of its software to out-of-state “original equipment manufacturers” (“OEMs”) that ultimately sold computers containing the software to Wisconsin purchasers. Microsoft Corp. v. Wis. Dep't of Revenue, No. 13-I-042 (WTAC 2017). In its decision, the Commission rejected the Department's argument that it must “look-through” the OEM purchasers to the end-users of the software to properly source the royalty receipts. The Commission's limitation on the Department's ability to apply a look-through analysis is significant for its potential application to receipts from other forms of intangible property.
OEMs are companies that acquire computer equipment or components from various vendors and combine them with software (e.g., Microsoft Office) into a single product, such as a desktop or laptop computer, which is then sold to retailers or individual customers. During the tax years in question, Microsoft entered into licensing agreements with out-of-state OEMs, including Dell Inc. and Hewlett Packard, under which the OEMs were given the right to copy and install Microsoft software on computers they assembled in exchange for royalty payments. The royalty amounts were determined based on a per system or per copy calculation that did not consider the number of computers ultimately sold. Microsoft's OEM business was run primarily out of two locations: Redmond, Washington, and Reno, Nevada. No Microsoft employees located in Wisconsin were involved.
The central issue in the case focused on whether a portion of the royalty payments received by Microsoft from OEMs located outside Wisconsin should be treated as Wisconsin sales when calculating Microsoft's Wisconsin sales factor. “Gross receipts from the use of computer software” in Wisconsin are included in the numerator of the sales factor. Wis. Stat. §71.25(9)(df) (as in effect 2007-2008). The Department argued that the royalties received by Microsoft from the OEMs were for the rights of the end-user to use the software and, as such, qualified as “gross receipts from the use of computer software.” The Department's argument hinged on looking through the OEMs to end-users of the software in Wisconsin, resulting in any royalty received by Microsoft for software used by a customer in Wisconsin being treated as a Wisconsin sale. Microsoft, in contrast, argued that the royalty payments were not for the use of software in Wisconsin, but rather for the licensing of its software to out-of-state OEMs, an activity which took place out-of-state, and, therefore, should not be included in the numerator of the sales factor.
Ultimately, the Commission rejected the Department's proposal to look-through the OEMs to the end-users of the software to source the sales. Specifically, the Commission explained that although state law requires “gross receipts from the use of computer software” in Wisconsin to be included in the numerator of the sales factor, the receipts in dispute are from Microsoft's customers, the OEMs, and the OEMs “do not use the software in Wisconsin or anywhere.” Microsoft Corp., No. 13-I-042, at 13. The Department contended that, to source receipts to Wisconsin, the receipts must be from the “use of computer software” in Wisconsin, but the OEMs themselves are not required to use the software. Instead, the users can be the end-users of the software, some of whom, unlike the OEMs, are located in Wisconsin. In rejecting the Department's end-user argument, the Commission found issue with the fact that Microsoft's royalty payments were due regardless of whether any computers containing the software were ever sold. As a result, Microsoft's gross receipts “were not a function of use by actual end-users.” Id. at 14.
After determining that the royalty payments did not constitute receipts from the use of computer software in the state, the Commission proceeded to examine the sourcing of the royalty payments under the rules related to sales of intangible property. Under the intangible property sourcing rules in effect during the years at issue, Microsoft's royalty receipts for the sale of software to out-of-state OEMs could be sourced to Wisconsin only if the income-producing activity occurred in the state. Wis. Stat. §71.25(9)(d) (as in effect in 2007-2008).
To assess the proper sourcing of Microsoft's royalty payments, the Commission relied on a 2015 Tax Appeals decision involving a similar factual scenario, Skechers USA, Inc. II v. Wis. Dep't of Revenue, No. 10-I-173 (WTAC 2015). In Skechers, the taxpayer (“SKII”) owned and engaged in the sale of licensed intellectual property in the form of Skechers' branding. SKII sold the licensing rights to the Skechers' shoe manufacturer, which then incorporated the branding into the footwear products. SKII, which had no offices, employees, or representatives in Wisconsin and owned no real or tangible personal property in the state, received royalty payments from Skechers based on the number of footwear products sold. The issue was whether SKII engaged in income-producing activity in Wisconsin. The Department argued that the Commission should look-through to the sale of Skechers' shoes as the relevant income-producing activity because SKII's royalty income was generated by the sale of Skechers' shoes in Wisconsin and elsewhere. As a result, the Department claimed that the royalties from the sale of Skechers' shoes in Wisconsin should be included in the numerator of the Wisconsin sales factor.
The Commission rejected the Department's contention and found that SKII's income-producing activity was the licensing of intellectual property. In reaching its decision, the Commission noted that SKII did not directly engage in the sale of shoes. Any of SKII's activities that assisted with the sale of shoes occurred outside Wisconsin. Therefore, the Commission held SKII engaged in no income-producing activity in Wisconsin and its Wisconsin sales factor numerator was zero.
After analyzing the Skechers decision, the Commission found that the income-producing activity engaged in by Microsoft was the “licensing to OEMs of the rights to copy, install, and sublicense the software.” Microsoft Corp., No. 13-I-042, at 16. Similar to SKII in Skechers, it was the OEMs that sold the computers in question to end-users in Wisconsin, not Microsoft, and the end-users were customers of the OEMs, not Microsoft. Based on the foregoing reasoning, the Commission determined that the sale of computers was “not an activity directly engaged in by Microsoft … [and] … [t]o the extent Microsoft software may have aided in the OEMs' sales, those activities took place outside this state.” Id. at 15-16. Therefore, no portion of the royalty payments was includable in the numerator of Microsoft's Wisconsin sales factor, regardless of the location of the end-user of the software.
The Wisconsin decision in favor of Microsoft marks the second time in five years that Microsoft has won on the issue of royalties received from OEMs. In 2012, the California Court of Appeal for the First Appellate District held that royalties received by Microsoft from OEMs located in California could not be included in the numerator of Microsoft's California sales factor. Microsoft Corp. v. Franchise Tax Board,212 Cal. App. 4th 78 (Cal. Ct. App. Dec. 18, 2012). In that case, the California Franchise Tax Board argued that the royalties should be treated as arising from sales of tangible personable property and attributed to California because the licensed software was shipped to OEM purchasers located in California.
Microsoft argued that the royalties from software licensing to California OEMs should be treated as arising from the sale of intangible property and thus sourced to the state where the greater proportion of the income-producing activity occurred. The Court of Appeal agreed with Microsoft and found that the sale was actually for the intangible intellectual property rights to copy the software onto the OEM's computers. Since the greater proportion of income-producing activity occurred outside California, in Washington State, the royalties received from California OEMs were sourced to Washington and excluded from California's sales factor numerator.
The Wisconsin and California decisions on Microsoft's software royalties highlight the fact that states continue to struggle over the proper methods of taxing the software industry and receipts from the sale and/or licensing of intangible property. As the software industry has expanded, states have sought new ways to tax software companies, especially as the traditional methods of sourcing sales of tangible personal property often fail to capture receipts from the sale and licensing of intangible property by out-of-state entities. As evidenced by the Wisconsin decision, one method by which states have attempted to tax receipts from intangible property is by looking through to the end-users of the intangible property for sales factor apportionment sourcing.
The Wisconsin decision, however, ultimately serves as a reminder that there is a limit on how far a state can look-through the supply chain to determine the end-users of intangible property. The decision is also valuable for the guidance it provides taxpayers concerned with the proper sales factor treatment of receipts from licensing the right to replicate and install software.
Arguably, the limitation imposed by the Commission on the Wisconsin Department of Revenue's ability to look-through to end-users could also have significant implications for other industries and forms of receipts from intangible property. For example, a mutual fund management company may be headquartered in a state other than Wisconsin and have a management contract with various mutual funds owned by investors residing in Wisconsin and elsewhere. The management contract provides for investment services, accounting services and management services. Under the cost of performance sourcing rules applicable to the years in question in the Microsoft decision, the management fees earned by such mutual funds would have been sourced to the state where the management company is headquartered. However, under the theory the Department was attempting to use in the Microsoft case, the Department may attempt to look through the agreement with the management company and source the management fee to the state in which the fund's investors reside, including the investors residing in Wisconsin.
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