On August 10, 2017, the Wisconsin Tax Appeals Commission (TAC) issued its decision in Microsoft Corp. v. Wisconsin Dep't. of Rev.,¹ in which it determined that the taxpayer's sales factor does not include receipts from royalties received from original equipment manufacturers (OEMs) to the extent no income-producing activity occurred in Wisconsin. In so doing, the TAC rejected the Wisconsin Department of Revenue's (Department) arguments asserting a "look-through" approach in situsing the royalties based on where end-users utilized the software that was the subject of the royalties.

Background

The Department audited Microsoft Corporation (Microsoft) Wisconsin Corporate Franchise Tax returns for the tax years 2006-09.² It assessed tax and interest of almost $3 million, primarily by adjusting the situsing of certain royalties Microsoft received from OEMs. Microsoft appealed to the TAC.

Microsoft had entered into licensing agreements with OEMs. These OEMs would assemble computer systems for sale either to retailers or directly to end-users. The OEMs would combine components from various vendors and combine them with software into a desktop or laptop computer. The OEMs solely determined how the computers were to be configured, including what software to use, and how much to charge for the computers. Most of these OEMs were located outside Wisconsin. Microsoft's OEM business, including R&D activities, was run primarily out of Washington and Nevada. Microsoft did not have any significant physical presence in Wisconsin during this time.

The licensing agreement granted the OEMs three intellectual property rights with regard to the Microsoft software: (1) the right to make a copy of the Microsoft software to be preinstalled on a computer, (2) the right to make a copy of the software to create recovery media for backup purposes, and (3) the right to distribute the software that had been preinstalled on computers to its customers under the terms of an end-user licensing agreement.³ Microsoft received royalty payments from the OEMs that were calculated on a "per-system" or "per copy" basis. These calculations were based on the number of computers that the OEM assembled or copies of the Microsoft software made for its computers, respectively, without regard to whether the software was ever loaded onto the computers and/or whether those computers were ever sold. The royalties due Microsoft were not tied to the price for which the OEM sold the computer. OEMs were responsible for warranting the products they sold, including the software contained on those products.

TAC's analysis and decision

The Department argued that Wis. Stat. Section 71.25(9)(df)⁴ applied to the royalties Microsoft received from the OEMs for the use of its software and therefore, they should be sitused to Wisconsin as receipts from the use of software. Although most of the OEMs did not have a presence in Wisconsin, the Department argued any royalty that a manufacturer pays Microsoft for software used by a Wisconsin customer should be apportioned to the state regardless of where the manufacturer is located, reasoning that the right the OEMs purchased under the licensing agreement in order to "install" the software is worthless without the accompanying right to "use" the software. Accordingly, the Department argued that a "look-through"⁵ approach to the end-user was warranted. In contrast to the presence of the OEMs in Wisconsin, a significant percentage of their end-users were located in Wisconsin.

Microsoft's argument was two-fold: (1) Wis. Stat. Section 71.25(9)(df) did not apply as the receipts were not from the use of software in Wisconsin; and (2) instead, Wis. Stat. Section 71.25(9)(d),⁶ which addresses the situsing of royalties from intangibles, applied to the payments received from the OEMs.

The TAC first stated that this case was a matter of statutory interpretation and that both parties agreed that the receipts at issue were not from the sale of tangible personal property. The TAC then turned to the issue of whether Wis. Stat. Section 71.25(9)(df) applied. Since the OEMs did not "use" the software (the TAC finding that "[t]he OEMs are not creating documents or running spreadsheets") as contemplated by the statute, the TAC concluded that Microsoft sold licenses that allowed the OEMs to replicate Microsoft software onto some, but not necessarily all, of the computers they built for potential sale to end-users or retail customers. The OEMs, and not the end-users or retail customers down the line, were Microsoft's customers. Therefore, the TAC rejected the Department's look-through approach since: (1) the royalties received by Microsoft were not a function of use by actual end-users, and (2) the royalties were due without regard to whether the software was ever used by any end-users.⁷ Instead, the TAC found that Wis. Stat. Section 71.25(9)(d) applied and that the royalties could not be sourced there because none of the income-producing activities performed by Microsoft occurred in Wisconsin.

Implications

It is not known at this time whether the Department will appeal this decision.

For tax years beginning on or after January 1, 2009, the Wisconsin Legislature changed the rules for situsing intangible property sales. See Act 25 (Laws 2005); Act 2 (Laws 2009), which added Wis. Stat. Section 71.25(9)(dj). Under this provision, receipts from royalty income are sitused to Wisconsin if the purchaser or licensee uses the intangible property in the operation of a trade or business at a location in Wisconsin. If the purchaser or licensee uses the intangible property in more than one state, the royalties from the use of the intangible property are divided in proportion to the use of the intangible property in those states. The 2009 law change would not seem to change the result in this case as the situsing rule still is applied in reference to the customer and does not seem to provide any means to apply the "look-through" approach advocated by the Department.

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ENDNOTES

¹ Microsoft Corp. v. Wisconsin Dep't. of Rev., Wisconsin Tax Appeals Comm'n. Dkt. No. 13-I-042 (Wis. Tax Appeals Comm'n Aug. 10, 2017).

² Microsoft was a June 30 year-end taxpayer during each year of the audit period.

³ Although Microsoft drafted the end-user licensing agreement, it was not a party to the agreement. The end-user licensing agreement was between the OEM and the end-user of the software.

⁴ Wis. Stat. Section 71.25(9)(df) provides that receipts from the use of computer software are sitused to Wisconsin if the purchaser or licensee uses the software in Wisconsin.

⁵ The Department also argued for a look-through approach based on an agency theory, that is, the OEMs were sublicensing the software to end-users on Microsoft's behalf. The TAC rejected that argument too because it found that the OEMs alone decided what software to incorporate into their products, what markets to pursue and set the pricing for those products, none of which indicated that they acted as Microsoft's agent. Moreover, the TAC also found persuasive that Microsoft was not a party to the end-user licensing agreement that was actually held by Wisconsin sitused customers.

⁶ Wis. Stat. Section 71.25(9)(d) provides that, except as provided in subsection (df) (i.e., software), sales, other than sales of tangible personal property, are sitused to Wisconsin if the income-producing activity is performed in the State.

⁷ The TAC also rejected the Department's argument that Wis. Stat. Section 71.25(9)(df) was created to carve-out all computer software from the more general provisions of Wis. Stat. Section 71.25(9)(d) since the statutory provisions were not ambiguous and it was not their role to "divine the unwritten intentions of the legislature".