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Microsoft Wins Another Round in Royalties Fight With Wisconsin DOR

Posted on Nov. 1, 2019

Royalties paid to Microsoft Corp. by out-of-state manufacturers shouldn’t be used in calculating Microsoft’s tax liability in Wisconsin, according to a recent court decision.

The Wisconsin Fourth District Court of Appeals agreed with Wisconsin’s Tax Appeals Commission, which “determined that royalties Microsoft Corporation received from licensing its software to original equipment manufacturers (OEMs) that are not located in Wisconsin, but whose products are used in Wisconsin, should not be considered in calculating Microsoft’s franchise tax liability to the State of Wisconsin for the tax years 2006 to 2009,” according to the appellate court's ruling. “We reject the DOR's arguments.”

In its October 31 ruling, the court rejected the Wisconsin Department of Revenue's argument that the royalties paid to Microsoft by out-of-state manufacturers such as Dell and Hewlett-Packard to license Microsoft software and include it in computer products sold for use in Wisconsin should be included in Microsoft’s Wisconsin sales factor. As noted by the court, the state Tax Appeals Commission shot down the DOR’s claims in 2017, and the Dane County Circuit Court later ruled against the department in the case. The tax liability that would result from the DOR’s proposed inclusion of the royalties for the years in question is equal to roughly $2.9 million.

According to the ruling, under Wisconsin law, “gross receipts from the use of computer software are in this state if the . . . licensee uses the computer software at a location in this state.” However, the court disagreed with the DOR that end-users — the people buying computers containing Microsoft software — are licensees under state law, and thus found that the royalties paid by out-of-state manufacturers don’t count toward Microsoft’s Wisconsin tax liability.

The DOR argued in particular that because computer purchasers agree to an “end-user licensing agreement” dictated by Microsoft when they use the company's software installed on computers sold in Wisconsin, they’re effectively accepting a license with Microsoft to use the software, and that a “sublicensee is still a licensee of the licensor.” But the appeals court argued that the source of that argument was weak — a footnote in a federal case repeating a passage from a treatise, the reasoning of which the federal court declined to adopt.

Also, the treatise in question “states that a sublicense is, at most, ‘in effect’ an agreement between the sublicensee and the licensor . . . exclusively for the limited purpose of continuation of the sublicense when the license has been terminated,” the court said.

The DOR also argued that the “economic reality” of the sale of computers containing Microsoft software to end-users confers the de facto status of licensee on Wisconsin end-users. But the court determined that the facts didn't support that conclusion.

“There was no license between Microsoft and the [Wisconsin] end-users because the end-users did not purchase anything, including a license, from Microsoft,” according to the ruling, which held that the end-user agreements were between the out-of-state manufacturers and end-users. The court also rejected the DOR’s claim that end-users had a license with Microsoft because, through the purchase price of the computer products they bought, they were paying Microsoft indirectly for the right to use its software.

“Substantial evidence in the record demonstrates that the amounts paid to Microsoft by the [manufacturers] for the software licenses were not paid as a result of end-user payments to OEMs for the sublicenses as the DOR asserts,” according to the court. “The Commission found, and the DOR does not dispute, that the obligations of the OEMs to pay royalties to Microsoft for licenses did not depend on the OEMs’ sales of the computers because OEMs were required to pay royalties to Microsoft even when the OEMs did not sell the computers on which the Microsoft software was installed.”

The ruling cited several other arguments raised by the DOR, all of which it rejected, including a claim that manufacturers were effectively Microsoft’s agents in the state.

Fred Nicely, senior tax counsel with the Council On State Taxation, told Tax Notes in an October 31 email that he’s “pleased the Wisconsin Court of Appeals affirmed the lower court’s decision” and the decision by the Tax Appeals Commission. He said the Wisconsin DOR arguments dismissed by the court are similar to those being made by some other state tax authorities.

“For sales factor apportionment purposes, some state revenue agencies are attempting to utilize a look-through approach and not use the actual purchaser’s location for sourcing a sale; instead, the revenue agency focuses on using the purchaser’s customers’ locations,” Nicely said. “The look-through approach raises significant statutory interpretation arguments along with raising constitutional due process concerns.”

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