Nov. 4, 2019 – Microsoft received royalties through software licensing agreements with out-of-state hardware manufacturers whose products were used in Wisconsin. Recently, an appeals court rejected a claim that such royalties were taxable to Wisconsin.

The Wisconsin Department of Revenue (DOR) argued that Microsoft’s royalties were subject to state franchise tax, under Wis. Stat. section 71.25(9)(d) (2005-2006), which reached sales of intangibles where the income-producing activity occurs in Wisconsin.

The software licensing agreements allowed the computer hardware manufacturers to install Microsoft’s software on their computers, with sublicenses sold to “end-users” in retail stores such as Best Buy. In this case, the end-users were located in Wisconsin.

An end-user agreement created a contract between the end-user and the computer manufacturer. Microsoft’s stance was that any royalties from end-user sales were not taxable. For tax years 2006 to 2009, DOR sought about $2.9 million in tax and interest.

After a four-day trial, the Wisconsin Tax Appeals Commission reversed the assessed franchise tax, and the Dane County Circuit Court affirmed. In Wisconsin Department of Revenue v. Microsoft Corp., 2018AP2024 (Oct. 31, 2019), the appeals court affirmed.

A three-judge panel for the District IV Court of Appeals noted that Wisconsin’s franchise tax is based on a corporation’s income attributable or derived from sources within Wisconsin, and an “apportionment” determines the tax for multiple-state transactions.

A “sales factor” apportions the total sales of the taxpayer in Wisconsin, with the resulting quotient representing the percentage of the sales subject to franchise tax.

The DOR calculated tax based on a provision concerning “sales of intangibles” that produced income from in-state activity. The Tax Appeals Commission had determined that the royalties were not income-producing activities that occurred in Wisconsin.

DOR’s appeal centered on section 71.25(9)(df) (2005-2006), which focuses directly on computer software. It says, for purposes of the franchise tax, that “computer software is used at a location in this state if the purchaser or licensee uses the computer software in the regular course of business operations in this state, for personal use in this state, or if the purchaser or licensee is an individual whose domicile is in this state.”

Further, if the licensee uses the computer software in more than one state, “the gross receipts shall be divided among those states having jurisdiction to impose an income tax on the taxpayer in proportion to the use of the computer software in those states.”

The question on appeal was “whether the Wisconsin end-users of the Microsoft software in computers sold by the [computer manufacturers] were ‘licensees’ as that term is used in Wis. Stat. § 71.25(9)(df),” wrote Judge Michael Fitzpatrick.

Microsoft Prevails

Microsoft, through its tax lawyers at Eversheds Sutherland based in New York City, successfully defended against the DOR’s assertion that end-users were “licensees” of Microsoft “as a matter of law.” The appeals court rejected the DOR’s argument.

Specifically, the appeals court rejected the argument that, despite the sublicense that hardware manufacturers sold to end-users, “a sublicensee is still a licensee of the licensor.” In other words, end-users were still licensees of Microsoft, the licensor.

For that proposition, DOR relied on a footnote in an opinion from the U.S. Court of Appeals for the Federal Circuit, which said “an authorized sublicense is in effect an agreement with the [original] licensor.” That was not enough for the court of appeals.

“[T]his footnote passage is not a holding,” wrote Judge Fitzpatrick. “Rather, the passage merely repeats a statement contained in a treatise on patent licensing that was cited to the Rhone-Poulene Agro court, and that court declined to adopt the reasoning of the treatise.”

“The quoted language from the treatise does not stand for the proposition that, as a matter of law, the end-user agreements were licenses between the end-users and Microsoft.”

The appeals court, in line with the Tax Appeals Commission, noted that the franchise tax law reaches a licensee” who uses Microsoft’s software in Wisconsin, but the statutory language does not determine that Microsoft was the “licensor.”

“The text of the statutory provision makes no reference to use of the computer software in Wisconsin by a sublicensee,” wrote Judge Fitzpatrick, noting that technical words have peculiar meanings and should be interpreted as such.

The licensor of the Microsoft software was the computer manufacturers who sold the hardware (with software included) to the sublicensees (end-users) in Wisconsin.

“[T]he Commission found there was no ‘direct relationship’ between Microsoft and the end-users,” Judge Fitzpatrick wrote. “Those findings inevitably lead to the conclusion that there was no license between Microsoft and the end-users because the end-users did not purchase anything, including a license, from Microsoft.”

The three-judge panel noted that the end-user agreement confirmed the Commission’s conclusion that the license agreement was between the manufacturer and the end-user.

“[T]he end-user agreements explicitly stated that the contracts were between the end-users and the [computer manufacturers], and the DOR does not content that Microsoft was a party to the end-user agreements,” Judge Fitzpatrick wrote for the panel.

The panel rejected the argument that end-users paid for the Microsoft software as part of purchase computers, thus triggering Microsoft’s contractual privity with end-users.

Microsoft received royalties whether the computers sold or not, the panel noted, supporting the argument that the income-producing activity was not tied to end-users.

Finally, the appeals court panel rejected DOR’s claim that Microsoft was subject to franchise tax because they were “agents” of the computer manufacturers who sold software licenses to end-users on Microsoft’s behalf, and that franchise tax liability is determined based solely on where the product, here Microsoft software, is used.

“[T]he DOR’s exclusive focus on the use of the software ignores the statutory requirement that there must be a ‘licensee’ that uses the software in this state for Wis. Stat. § 71.25(9)(df) to apply,” Judge Fitzpatrick wrote.