In Wisconsin Dep't. of Rev. v. Microsoft Corporation,¹ the Wisconsin Court of Appeals (court) affirmed decisions of the Wisconsin Circuit Court and Wisconsin Tax Appeals Commission, rejecting the use of the "look-through" approach by the Wisconsin Department of Revenue (Department) in attempting to impose franchise tax liability on software license royalties Microsoft Corporation received from original equipment manufacturers (OEMs) outside of Wisconsin.

Background

Microsoft Corporation (Microsoft) entered into licensing agreements with OEMs that assembled computer systems for sale either to retailers or directly to end-users. The OEMs combine components from various vendors and combine them with software, such as Microsoft Office, 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 of Wisconsin.

The licensing agreement between the parties granted the OEMs three intellectual property rights with regard to the Microsoft software: (i) the right to copy the Microsoft software to be preinstalled on a computer; (ii) the right to copy the software to create recovery media for backup purposes; and (iii) the right to distribute the software that had been preinstalled on computers to customers under the terms of an end-user sublicensing agreement. The end-user sublicensing agreement was between the OEM and the end-user; Microsoft was not a party to that agreement.

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 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. There was no tie between the royalties due to Microsoft and the price for which the OEM sold the computer. The OEMs were responsible for warranting the products they sold, including the installed software.

The Department audited Microsoft for Wisconsin Corporate Franchise Tax purposes for the period from 2006 to 2009. The Department assessed tax and interest of almost $3 million, primarily by adjusting the situsing of certain royalties Microsoft received from the OEMs so that the royalties reflected the location of the end customers in Wisconsin. Microsoft appealed the assessment, which both the WTAC and the Wisconsin Circuit Court overturned, finding in favor of Microsoft. The Department then appealed to the court.

Court of Appeals analysis and decision

The court first discussed the statutory framework in place during the audit period. At issue was the application of the sales factor sourcing rule relating to sales of intangible property. Wis. Stat. Section 71.25(9)(d) sourced receipts from intangible property to Wisconsin if the income-producing activity was performed in Wisconsin. Based on the foregoing rule, the WTAC determined that the royalties paid by the OEMs to Microsoft should not be included in the Wisconsin sales factor numerator because those royalties did not result from any income-producing activities occurring in Wisconsin.

The Department argued that the WTAC erred in failing to apply an exception to the foregoing rule found in Wis. Stat. Section 71.25(9)(df), which sources receipts from the use of computer software to Wisconsin if "the licensee uses the computer software at a location in [Wisconsin]." The court rejected the Department's argument that the end-users were licensees of the software as a matter of law. The Department had relied on a footnote in a federal circuit court decision to argue that an authorized sublicense is effectively an agreement with the original licensor. The court noted that the footnote was not a holding of law, but a quote from a treatise on patent licensing. The court further noted that the Department misapplied the quoted portion of the treatise in trying to use it to support its position.

The court then turned to the Department's argument that, "when viewing the transactions as a whole," the end-users of the software installed on the computers sold by the OEMs were "licensees" as that term is used in Wis. Stat. Section 71.25(9)(df). The Department had argued that the WTAC disregarded the economic reality of the transactions and that, although the OEMs were licensees of Microsoft, the end-users were also de facto licensees of Microsoft. The court rejected the Department's argument based on the statutory framework,² the WTAC's findings of fact³ regarding the transactions, and the terms of the end-user agreements. The court's analysis reflected a refusal to allow the Department to "reject statutory language in favor of the Department's desired result."

The court also rejected secondary and tertiary arguments made by the Department, including that the OEMs were agents⁴ of Microsoft and that use of the software alone⁵ satisfied the statutory "licensee" requirement set forth in Wis. Stat. Section 71.25(9)(df).

Implications

The Department can appeal the court's decision to the Wisconsin Supreme Court. It is unknown at this time whether the Department will appeal. EY will continue to monitor developments in this area.

For tax years beginning on or after January 1, 2009, Wisconsin changed the rules for situsing sales of intangible property. Under the 2009 statutory change, receipts from royalty income are sitused based on a market-based approach.⁶ Thus, such receipts are sitused to Wisconsin if the purchaser or licensee uses the intangible property in the operation of a trade or business 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 property's use in those states. Accordingly, the 2009 law change would not seem to change the result in this case, as the situsing rule still only applies in reference to the licensee or purchaser. Moreover, the statutory language in Wis. Stat. Section 71.25(9)(df), which applies only to licensees, remains unchanged.

The decision also may be relevant to other situations in which the Department attempts to apply a "look-through" approach in sourcing receipts, especially receipts from services. Wis. Stat. Section 71.25(9)(dh) sources receipts from services to Wisconsin " … if the purchaser of the service received the benefit of the service in [Wisconsin]." There is no reference to the purchaser's customer. Given the court's literal application of the statute in Microsoft, it appears that similar arguments might be made against other "look-through" sourcing, depending on facts and circumstances.

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ENDNOTES

¹ Wisconsin Dep't. of Rev. v. Microsoft Corporation, Appeal No. 2018AP2024 (Wis. Ct. App. October 31, 2019).

² The court held that the language in Wis. Stat. Section 71.25(9)(df) is limited to a "licensee" who uses the software in Wisconsin. The statute does not refer to usage of the software by a sublicensee. The court held that the terms "license," "licensee," "sublicense," and "sublicensee" have commonly understood meanings in the law and presumed the legislature chose the term "licensee" to express the statute's intended meaning.

³ The court cited to numerous findings of fact by the WTAC leading to the conclusion that the end-users were not licensees. Among those facts were: (i) there was no direct relationship between Microsoft and the end-users (e.g., the end-users did not purchase a license from Microsoft); (ii) the end-user sublicensing agreements were between the OEMs and the end-users, and Microsoft was not a party to those agreements; (iii) the end-users did not "indirectly" pay Microsoft for the right to use the software; and (iv) Microsoft's gross receipts were not a function of use by actual end-users (e.g., the obligations of the OEMs to pay the royalties did not depend on the sale of the computers; the payments were required even when the OEMs did not sell the computers).

⁴ The court rejected this argument, in part, because the WTAC made a specific finding that the OEMs were not agents of Microsoft.

⁵ The court rejected this argument because the Department's position ignored the statutory requirement for a "licensee" to use the software in Wisconsin. The court said that it was "beyond the purview of this court to redraft [the statute] as the DOR requests."

⁶ See Act 25 (A.B. 100), Laws 2005; Act 2 (S.B. 62), Laws 2009, which added Wis. Stat. Section 71.25(9)(dj).