Software license held to be intangible property right.

• Author: Beavers, James A.
• Position: California

The California court of appeals held that royalties that the taxpayer earned for the licensing of the right to replicate and install its software to computer manufacturers were from licenses of intangible property for purposes of the corporate franchise tax.

Background

Washington-based software titan Microsoft Corporation filed timely California corporate franchise tax returns for its tax years ending June 30, 1995, and June 30, 1996. During the years at issue, Microsoft and all its domestic and foreign subsidiaries operated as a single, world-wide "unitary business" for California tax purposes.

During the relevant tax years, Microsoft entered into licensing agreements with computer manufacturers (commonly called original equipment manufacturers or OEMs) inside and outside California. These OEMs produced computer systems that included both software and hardware. The license agreements gave the OEMs the right to install Microsoft's software products into the computer systems they produced and then sell those computer systems with the preinstalled software.

There were two methods by which Microsoft transferred the software to the OEMs. The first was by providing "Golden Master" disks directly to the OEMs, which they used in their assembly process to copy the software onto the hard drives of the computers they were assembling. The second way the OEMs obtained the software was by separately purchasing it from third-party authorized replicators in the form of plastic backup disks, which were bundled with each computer shipped by the OEMs. Royalties would accrue to Microsoft on either a per system or per copy basis, as provided in the particular licensing agreements.

California Franchise Tax and Apportionment of Income

California imposes a franchise tax on a corporation doing business in the state based on the corporation's net income derived from or attributable to sources within California. In Microsoft's case, the standard apportionment formula (SAF) was used to calculate its franchise tax liability. The SAF is based on three factors: property, payroll, and sales. Each factor is expressed as a fraction with the denominator including all of a corporation's activities or assets from everywhere it does business, and the numerator represents the portion of the factor attributable to California.

In determining its California income under the SAF, Microsoft treated the royalties from its software licensing to California OEMs as arising from a sale...