Earlier this week, the California Court of Appeal, First District, held that the right to replicate and install software is an intangible property right for sales-factor sourcing purposes. Thus, for the years at issue, the cost-of-performance rule applied to source software royalties. Since the greater portion of Microsoft’s costs of performance with respect to developing, copyrighting, and licensing the software were incurred in Washington state, the court determined that Microsoft properly sourced the software royalties to Washington, even though the software disks were shipped to a California location. Microsoft entered into licensing agreements with original equipment manufacturers and delivery service providers, who assemble or manufacture computer systems and replicate and resell Microsoft’s computer programs. Microsoft received royalties for these licenses on a per-system or per-copy basis. Microsoft filed its California returns treating royalties from these licenses as sales other than sales of tangible personal property. Accordingly, Microsoft sourced such sales to Washington, where its costs of performance were incurred.

The Franchise Tax Board issued notices of proposed assessment after finding that the licenses were sales of tangible personal property. The taxpayer then paid the assessed amounts and filed a refund action in San Francisco County Superior Court. After a trial de novo, Judge John Kennedy Stewart ruled in favor of the Franchise Tax Board, concluding that licensing software programs for use in manufacturing computers consisted of licensing tangible personal property. Microsoft appealed this decision.

The Court of Appeal clarified that the issue in this case involved whether the right to replicate and install software is a tangible or intangible property right, not whether software is itself tangible personal property.

The court cited and discussed several California sales tax cases, including the recent appellate court decision in Nortel Networks v. State Bd. of Equalization, an important pro-taxpayer decision involving the sales tax treatment of computer software, as well as Preston v. State Bd. of Equalization,1 where the California Supreme Court held that an exclusive right to reproduce a taxpayer’s copyrighted artwork involved a “separate and distinct transfer of a copyright—an intangible right distinct from any materials object in which the work is embodied,” and thus were the transfer of an intangible right.2 The court also cited to a regulation that provides that the 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… even if a tangible copy of the program is transferred concurrently with the granting of such right.”3 Although the court agreed that sales tax cases and regulations are not controlling in the franchise tax realm, it found such cases to be relevant. In fact, the court saw “no rational justification for treating licenses to replace (sic) software as intangible in the context of sales taxation, while treating these very same licenses as tangible in the context of franchise taxation.” (Emphasis in original.)

After an analysis focused mostly on sales tax cases and, to a lesser extent, certain federal authorities, the court held that Microsoft’s license of the right to replicate and install software was a sale of intangible property, and therefore the court sourced the receipts from the licenses to the location where the greater portion of Microsoft’s income-producing activity with respect to the software occurred, based on costs of performance.