California Trial Court Rules on Sales of Software for Franchise Tax Purposes

Red buy now button on computer where enter button is located.


As a state that has a substantial number of software development companies located within its borders, California does not have any administrative or legal guidance with respect to assigning gross receipts from the licensing of software for franchise/income tax purposes.  This is mostly because California has generally adopted its method of apportioning business income using the provisions under the Uniform Division of Income Tax Purposes Act ("UDITPA"). UDITPA does not have guidance on whether sales of software are tangible or intangible property.

Under UDITPA California apportions business income for franchise/income tax purposes using a three factored apportionment formula (the three factor formula).  This formula consists of a payroll factor, a property factor, and a sales factor.  Each of these factors is a fraction, the numerator expresses the sum of the taxpayer’s payroll, property and sales within the state and the denominator is the sum of the taxpayer’s payroll, property and sales everywhere. California provides that the sales factor be double weighted.

Under California law, receipts from the sale of tangible personal property shipped or delivered to a purchaser in the state are included in the numerator of the sales factor.  Likewise, the gross receipts from the licensing of tangible personal property are sourced to California if the licensed property is in California.  Receipts from the sales of property other than tangible property are sourced to the state to the extent the income-producing activities are carried in the state, determined based on cost of performance.   

For companies with taxable years beginning on or after January 1, 2011, California now provides two options for taxpayers to apportion their taxable income: (1) a new single sales factor formula or (2) the existing three factor formula.  To use the new single sales factor formula the taxpayer must make an irrevocable annual election on a timely filed return. If the taxpayer elects to use the single sales factor formula, sales of tangible personal property are sourced to the ultimate destination state, while sales of intangible property are generally sourced where the customer is located.   

The Microsoft Case

Microsoft Corporation (Microsoft), based in the State of Washington, received royalties from the licensing of proprietary computer software to Original Equipment Manufacturers (OEM's).  The license agreement gave OEMs the right to install Microsoft software into OEM's computer systems and then sell those systems to the public.  The license agreement did not transfer ownership of the software to the OEMs.  The software was made available to the OEMs on a "Golden Master" disk, from which the OEMs copied the software onto the hard drives of the computer systems for later sale to customers.

In 2002, the Franchise Tax Board issued notice of proposed assessments to Microsoft for additional taxes for the tax years 1995 and 1996.  The Franchise Tax Board asserted the royalties received by Microsoft are from the sale of tangible personal property and should be properly assigned to California based on the billing address of the licensee.

Microsoft contended the royalties it received from the licensing of its computer software in California should not have been included in the numerator of the California sales factor. Rather the royalties were receipts from licensing of intangible property that should be sourced to Washington because the greater cumulative cost of performance was incurred in that state.  Microsoft paid the deficiency and filed for a claim for refund.

The San Francisco Superior Court (the Court) heard the case and on February 17, 2011 issued its Statement of Decision. 

The Court agreed with the Franchise Tax Board and determined that the licensing of computer software was the licensing of tangible personal property for purposes of assigning the sales factor numerator and is properly assigned to the billing address of the OEM licensee.

In support of its ruling, the Court looked at other state courts which held that computer software is tangible personal property, in that it “ is knowledge recorded in physical form which has physical existence, takes up space on the tape, disc, or hard drive, makes physical things happen, and can be perceived the senses.”  The court further cited a Nebraska Supreme Court case in which a taxpayer licensed marketing information to clients delivering the product to its customers through tangible computer disks or over the internet.  The Nebraska court held that there is a distinction between the acquisition of intellectual property rights and the acquisition of a license to use the physical embodiment of intellectual property, the latter which is a sale of tangible personal property.  The Nebraska court ruled that the transmission of data over the internet did not change its decision as the data could be received and stored in the purchaser’s computer. 

While the Microsoft decision adopted the simpler method of sourcing the licensing of software to the state where the purchaser is located, the decision does mirror the market based single sales factor option.  Another interesting fact with respect to the case is the Court's acceptance that the medium of delivery of the software did not have an adverse impact on its decision. Thus, it could be implied that delivery of software over the internet would not change the outcome vs. using a disk or CD-ROM.

Please contact your RINA representative if you have further questions.

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