In InterSystems Corporation v. Wisconsin Department of Revenue,¹ a Wisconsin Circuit Court (court) recently ruled that an out-of-state corporation's receipts from software licensed to an intermediary application partner located in Wisconsin and sublicensed to customers nationwide are sourced entirely to Wisconsin. This decision affirms the ruling of the Wisconsin Tax Appeals Commission (WTAC), which upheld the Department of Revenue's (DOR) assessment of income and franchise taxes.

Background

InterSystems Corporation (InterSystems), a Massachusetts software company, develops Caché, a database management system software used by software developers and end users. InterSystems licenses Caché to third-party "Application Partners" (APs), which develop software applications using Caché and deliver those applications to their customers (end-user customers). Caché serves as a foundational tool for APs to develop software and as a database management system for end users to operate those applications. Epic Systems Corporation (Epic), a Wisconsin corporation, is one of InterSystems' APs. Epic develops healthcare software applications that depend on Caché to manage large repositories of patient-related data. While Caché operates in conjunction with Epic's software, it is "separate and distinct from Epic's software, though it may appear otherwise to end users."

InterSystems and Epic's relationship is governed by agreements granting Epic the right to use Caché in Epic's own application development and to sublicense Caché to end-user customers. InterSystems fulfills application-specific license orders by issuing unique license keys to individual end-user customers. The license key specifies usage parameters (e.g., the number of concurrent users) and must be present on the end-user system for Caché to operate. Epic orders the license keys from InterSystems and delivers them to end-user customers, who do not pay InterSystems directly. Instead, Epic determines pricing, collects payments from its end users and remits the portion owed to InterSystems. End users must agree to InterSystems' Caché Addendum to receive a license key.

Court analysis

InterSystems argued that its end-user customers are "licensees" under Wis. Stat. 71.25(9)(df), which would have sourced the income from those customers to where end users operate Caché. That sourcing would have reduced InterSystems' Wisconsin tax liability, as most end-user customers are located outside Wisconsin. The court rejected this argument, relying heavily on the Wisconsin Court of Appeals' decision in Wisconsin Dep't of Revenue v. Microsoft Corp., 2019 WI App 62, 389 Wis. 2d 350, in which the court determined that Wisconsin end users of Microsoft software embedded in computers sold by original equipment manufacturers (OEMs) were not "licensees" as that term is used in Wis. Stat. 71.25(9)(df). (See Tax Alert 2019-1986.) The Microsoft court drew a clear distinction between a licensee (who receives rights directly from the licensor through a license) and a sublicensee (who receives rights through a sublicense granted by the licensee). Applying that framework, the court concluded that (1) Epic is the licensee of InterSystems (a direct contractual relationship exists through the AP agreements); (2) end-user customers are sublicensees receiving their rights to use Caché through Epic, not directly from InterSystems; and (3) although InterSystems issues license keys directly to end users and end users must agree to InterSystems' Caché Addendum, there is no direct license agreement between InterSystems and the end users sufficient to establish a licensor-licensee relationship under Wis. Stat. 71.25(9)(df).

The court concluded the correct statutory provision to apply was Wis. Stat. 71.25(9)(dj), which sources receipts from the "use of" intangible property. The DOR characterized the income as arising from Epic's purchase of the intangible right to sublicense Caché to end-user customers. Wis. Stat. 71.25(9)(dj) applies a cascading set of rules to determine sourcing, looking at the location of the purchaser's:

• Use of the intangible property in the regular course of business
• Billing address
• Commercial domicile

The court concluded that the first sourcing test could not be applied because Epic's "use" of its intangible right to sublicense Caché lacked a discernable geographic location. Epic granted sublicenses to end users located throughout the country, and the act of sublicensing is not connected to a single physical location. Accordingly, the court proceeded to the second test, which sources income based on the licensee's billing address. Because Epic is billed for Caché licenses at its Wisconsin address, the court held that 100% of the income should be sourced to Wisconsin.

InterSystems challenged the statute under the Commerce Clause on both facial and as-applied grounds. The court declined to consider the facial challenge because it was raised for the first time in InterSystems's reply brief and was inadequately developed. The court also rejected the as-applied challenge, finding that the statute's sequential sourcing framework assigns all of the income to Wisconsin and none to any other state). By sourcing the income exclusively to Wisconsin using the billing address test, the statute did not create the risk of multiple taxation.

Implications

It is unknown whether the taxpayer will appeal the decision. The court's decision extends the principles of the 2019 Microsoft case to a new fact pattern and highlights the significance of Wisconsin's cascading sourcing rules. When the "use" of an intangible right (such as a sublicensing right) has no ascertainable physical location, the billing address becomes the determinative factor. Software vendors that distribute products through intermediary partners may expect the DOR to argue that the intermediary, not the end user, is the "purchaser" or "licensee" for apportionment purposes. This can dramatically shift where income is sourced and potentially concentrate all taxable income in a single state where the intermediary is located.