Trial Court: Superior Court of the City and County of San Francisco Trial Judge: Hon. John Kennedy Stewart Super. Ct. No. CGC 08-471260
The opinion of the court was delivered by: Dondero, J.
CERTIFIED FOR PUBLICATION
(San Francisco City & County)
In this action, plaintiff Microsoft Corporation seeks a refund of California state corporate franchise taxes paid for the tax years of 1995 and 1996. The taxes were based on income received in connection with the licensing of plaintiff's software and sales of its keyboard and mouse. Plaintiff claims the royalties it received from computer manufacturers for the licensing of the right to replicate and install its software arise from an intangible property right, and therefore should not have been considered in calculating its tax liability. After a court trial, judgment was entered in favor of defendant, the Franchise Tax Board. The court concluded all the royalties at issue were taxable because they constituted receipts from the licensing of computer software products, which the court found to be tangible personal property. We reverse and remand the matter to the trial court for determination of the amount of tax owed by plaintiff based solely on income derived from the sales of its keyboard and mouse during the taxable years at issue.
FACTUAL BACKGROUND AND PROCEDURAL HISTORY
The parties have stipulated to the following facts. Plaintiff is a corporation organized and existing under the laws of the State of Washington. At all times relevant to this lawsuit, plaintiff was engaged in the business of developing, licensing, manufacturing, and distributing computer software and providing computer software-related services.*fn1
Plaintiff filed timely corporate franchise tax returns for the taxable years ending June 30, 1995, (tax year 1995) and June 30, 1996, (tax year 1996). During the years at issue, plaintiff and all its domestic and foreign subsidiaries operated as a single worldwide "unitary business"*fn2 for purposes of the California Revenue and Taxation Code.
During the relevant tax years, plaintiff entered into licensing agreements with companies referred to as original equipment manufacturers (OEM's) and delivery service providers (DSP's). OEM's are computer sales companies that assemble, and in some cases manufacture, computer systems for sales to end users.*fn3 These systems include both software and hardware. The OEM's acquire computer equipment from a single vendor, or components from various vendors, and combine them with software into a single product. DSP's are companies that license copyrighted proprietary software through authorized replicators and resell the product to smaller OEM's.
The license agreements (OEM licenses) gave the OEM's the right to install plaintiff's software products into their computer systems and then sell those computer systems with the pre-installed software. There were two methods by which plaintiff's software was made available to the OEM's. First, "Golden Master" disks were generally shipped from plaintiff directly to an OEM upon signing of the licensing agreement. These disks were used by the OEM's in the assembly process to copy the proprietary software onto the hard drives of the units they were assembling. Second, the OEM's obtained plaintiff's software purchased in the form of plastic back-up disks separately by the OEM's from third party authorized replicators. These back-up disks were bundled with each unit shipped by the OEM's. Royalties would accrue to plaintiff on either a per system or per copy basis, as provided in the particular licensing agreements. Plaintiff also designed a mouse and keyboard that were sold either both as sets or individually. These sales also generated revenue during both tax years at issue.
Under the Corporation Tax Law (Rev. & Tax. Code, § 23001 et seq.),*fn4 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. Here, the standard apportionment formula (SAF) was used to calculate plaintiff's franchise tax liability for state taxes. The SAF is based on three factors: property, payroll, and sales. Each of the three factors 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 represented the portion of the factor attributable to California. (§§ 25129, 25132, 25134.) For example, the denominator of the property factor consists of the value of all of a corporation's property worldwide. The numerator of the property factor consists of the property based in California.
In calculating the denominator of the sales factor for royalties received from the OEM licenses, plaintiff reported approximately $1.65 billion for tax year 1995, and approximately $2.5 billion for tax year 1996. For the numerator, plaintiff reported royalties received from the licensing of its software in California at just under $235 million in tax year 1995, and just under $407 million for tax year 1996. The numerator represented royalties paid to it by OEM's with billing addresses in California.
In June 2002, defendant issued a notice of proposed assessment (NPA) to plaintiff for franchise taxes for tax year 1995 in the amount of approximately $3.9 million, plus an accuracy related penalty (ARP) in the amount of $760,260, for a total of approximately $4.7 million. Defendant also issued an NPA for franchise taxes for tax year 1996 in the amount of approximately $21.3 million, plus an ARP in the amount of $477,070, for a total amount of approximately $21.8 million. In August 2002, plaintiff filed a timely protest of the two NPA's.
In September 2007, the parties entered into an agreement whereby, among other things, defendant agreed to withdraw the ARP's imposed for the two fiscal years at issue.
On or about January 15, 2008, plaintiff paid the entire amount of the tax deficiencies asserted in the two NPA's, plus interest. On January 22, 2008, plaintiff filed a complaint in superior court for refund of the franchise taxes and interest imposed by defendant for tax years 1995 and 1996.
On February 27, 2008, plaintiff filed administrative claims with defendant for a refund of taxes paid for tax years 1995 and 1996. On June 4, 2008, defendant denied plaintiff's tax refund claims.
On July 7, 2008, plaintiff filed an amended complaint. The complaint asserts four separate causes of action. The first three causes of action relate to the proper computation of plaintiff's California tax liability for the years in question. The fourth cause of action relates to the question of whether defendant was authorized to impose penalties against plaintiff.*fn5 On August 6, 2008, defendant filed its answer to the amended complaint.
A non-jury trial commenced on August 23, 2010. The trial court issued its statement of decision on February 17, 2011, rejecting plaintiff's refund claim in full. Specifically, the court concluded the licensing of plaintiff'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 OEM's were properly classified as gross receipts for purposes of calculating the sales factor numerators. In a footnote, the court also found merit to defendant's contention that plaintiff would not be entitled to relief even if the fees were derived from intangible property because it failed to meet its burden of segregating the correct amount of tax owed in connection with certain receipts that were clearly subject to taxation.
On March 15, 2011, the trial court entered judgment in favor of defendant. Plaintiff timely ...