Software License Held to Be Intangible Property Right

By James A. Beavers, J.D., LL.M., CPA, CGMA

State & Local Taxes

The California Court of Appeals held that royalties that the taxpayer earned for the licensing of the right to replicate and install its software to computer manufacturers were from licenses of intangible property for purposes of the corporate franchise tax.


Washington-based software titan Microsoft Corporation filed timely California corporate franchise tax returns for its tax years ending June 30, 1995, and June 30, 1996. During the years at issue, Microsoft and all its domestic and foreign subsidiaries operated as a single, worldwide “unitary business” for California tax purposes.

During the relevant tax years, Microsoft entered into licensing agreements with computer manufacturers (commonly called original equipment manufacturers or OEMs) inside and outside California. These OEMs produced computer systems that included both software and hardware. The license agreements gave the OEMs the right to install Microsoft’s software products into the computer systems they produced and then sell those computer systems with the preinstalled software.

There were two methods by which Microsoft transferred the software to the OEMs. The first was by providing “Golden Master” disks directly to the OEMs, which they used in their assembly process to copy the software onto the hard drives of the computers they were assembling. The second way the OEMs obtained the software was by separately purchasing it from third-party authorized replicators in the form of plastic backup disks, which were bundled with each computer shipped by the OEMs. Royalties would accrue to Microsoft on either a per system or per copy basis, as provided in the particular licensing agreements.

California Franchise Tax and Apportionment of Income

California imposes a franchise tax on a corporation doing business in the state based on the corporation’s net income derived from or attributable to sources within California. In Microsoft’s case, the standard apportionment formula (SAF) was used to calculate its franchise tax liability. The SAF is based on three factors: property, payroll, and sales. Each factor is expressed as a fraction with the denominator including all of a corporation’s activities or assets from everywhere it does business, and the numerator represents the portion of the factor attributable to California.

In determining its California income under the SAF, Microsoft treated the royalties from its software licensing to California OEMs as arising from a sale of intangible property. The sale of intangible property is treated as a California sale only if a greater proportion of the property’s “income-producing activity,” as measured by its “costs of performance,” is performed in California than in any other state. Almost all of the costs of performance related to the licensed software occurred outside California. Therefore, Microsoft did not treat the royalties as California income and did not include the income in its California sales factor when apportioning its income under the SAF.

The California Franchise Tax Board (FTB) disagreed with Microsoft’s treatment of the royalties, arguing that they should be treated as arising from sales of tangible personal property. A sale of tangible personal property is treated as a sale in California for purposes of computing a corporation’s tax liability if the property is shipped to a purchaser within the state. If the software was treated as tangible personal property, the royalties would be California income because the software was transferred to the OEMs on disks shipped to them in California.

The FTB issued multimillion-dollar notices of proposed assessment for 1995 and 1996 for franchise tax on the software license royalties and related penalties. Microsoft paid the tax deficiencies with interest and filed a suit for refund and an administrative claim for refund shortly after filing the suit. California denied the administrative claim, and two years later the case went to trial.

The trial court issued its statement of decision in February 2011, rejecting Microsoft’s refund claim in full. Specifically, the court concluded the licensing of Microsoft’s software programs for use in the manufacturing of computers constituted the licensing of tangible personal property, and that the licensing fees paid by California OEMs were properly classified as California sales for purposes of the SAF. Microsoft appealed the decision to the California Court of Appeals.

Court of Appeals Decision

The California Court of Appeals reversed the trial court and held that royalties from licensing the software should be treated as sales of intangible property and thus were not California sales for purposes of apportioning Microsoft’s income under the SAF. As Microsoft argued, the court found that the actual issue in the case was not whether software itself is tangible or intangible property, but whether the right to replicate and install software is a tangible or intangible property right. Because there was little guidance in the California regulations or case law on the issue in the context of the franchise tax, the court based its analysis primarily on sales and use tax case law and regulations.

The court found two cases particularly relevant to Microsoft’s situation. In Preston, 25 Cal. 4th 197 (Cal. 2001), the California Supreme Court considered the case of an artist who entered into contracts to produce artwork, provided the artwork in physical form to customers so that they could copy or reproduce the artwork, and then received the artwork back from the customers. The court found that these agreements were both transfers of tangible personal property and technology transfer agreements (TTAs). Under California law, TTAs are defined as any agreement under which a person who holds a patent or copyright interest assigns or licenses to another person the right to make and sell a product or to use a process that is subject to the patent or copyright interest, and it exempts from taxation the amount charged for intangible personal property—specifically, a patent or copyright interest—transferred pursuant to a TTA. The California Supreme Court held that sales and use tax only applied to the part of the income from the artist’s agreement that was attributable to the transfer of the physical copy of the artwork, not to the part attributable to the artist’s grant of a right to reproduce the artwork. The Court of Appeals found that the Preston opinion supported Microsoft’s “position that the OEM licenses—granting the right to replicate and install—are best understood as involving an intangible property right” (Microsoft Corp., slip op. at 11).

The appeals court also cited its own decision in Nortel Networks, Inc. v. State Board of Equalization, 191 Cal. App. 4th 1259 (Cal. Ct. App. 2011). In that case, Nortel, a producer of telephone switching equipment, licensed software that was specific to switches it sold as well as noncustomized, prewritten (canned) software. The trial court found that customized software was not taxable, but the canned software was. The appeals court found that the licenses for both types of software were TTAs that were nontaxable, stating that the TTA statutes covered any transfer of an interest subject to patent or copyright.

With regard to the regulations, the appeals court explained that California sales and use tax regulations specifically provide that sales tax does not apply “to license fees or royalty payments that are made for the right to reproduce or copy a program to which a federal copyright attaches in order for the program to be published and distributed for a consideration to third parties, even if a tangible copy of the program is transferred concurrently with the granting of such right” (Microsoft Corp., slip op. at 12, quoting Cal. Code Regs., tit. 18, §1502(f)(1)(B)). Thus, it appeared to the appeals court that California sales and use tax law would treat the Microsoft licenses as intangible property. While the court admitted that the sales and use tax regulations did not apply to the sourcing of licensing fees for corporate franchise taxes, it saw “no rational justification” for treating licenses to reproduce software as intangible in the context of sales taxation, while treating these very same licenses as tangible in the context of franchise taxation.

The court found further justification for treating the software licenses as intangible in a California State Board of Equalization (SBE) unpublished decision that involved the California-based software manufacturer Adobe Systems (Appeal of Adobe Systems, Inc., No. 96R-0722 (Cal. State Bd. of Equalization 8/1/97)). In that decision, the SBE espoused the position that a software license was intangible property, thereby increasing the amount of Adobe Systems’s income apportioned to California. Although it was an unpublished opinion and did not have precedential value, the court nonetheless found it informative in making its decision.

Finally, the court discussed the federal law treatment of intangibles. The court noted that under Sec. 936(h)(3)(B)—which is adopted in Cal. Rev. & Tax. Code Section 25114—intangible property includes franchises, licenses, and contracts, as well as copyrights and literary, musical, or artistic compositions. Additionally, Regs. Secs. 1.861-18(b)(1)(i) and (c)(2)(i) define “copyright rights” for purposes of federal tax law as including the right to make copies of a computer program for purposes of distribution to the public by sale or other transfer of ownership or by rental, lease, or lending. The FTB argued federal statutes and regulations have little relevance to the principles of formula apportionment under the unitary business principle because federal law provides that a corporation is taxed on all of its income, regardless of where it is earned. However, the court of appeals disagreed, stating that it found federal law helpful as to the appropriate characterization of the transferred rights at issue in the case.


As was noted above, the SBE took the exact opposite position in its Adobe decision as the FTB took in this case. Although the Adobe Systems decision was unpublished and did not have to be followed by the FTB, the court stated, “We find it troubling, however, that defendant appears to have advocated a position in Adobe that is directly contrary to the position it advances against plaintiff in the present case. Unfortunately, the inconsistency suggests a result-orientated bias based on the domicile of the taxpayer” (Microsoft Corp., slip op. at 17).

Microsoft Corp. v. Franchise Tax Bd., No. A131964 (Cal. Ct. App. 12/18/12)



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