On December 18, 2012, the California Court of Appeal ruled that receipts from the right to replicate software are sourced as sales “other than tangible personal property.” In reversing the trial court, the Court of Appeal upheld the taxpayer’s use of costs of performance sourcing. Microsoft Corporation v. Franchise Tax Board, Case No. A131964, Cal Ct. App. (1st App. Dist.). Sutherland State and Local Tax (SALT) attorneys represented Microsoft in the appeal.

Background -

The issue in Microsoft was whether royalties received for the right to replicate and install software on original equipment manufacturers’ (OEM) computers constitute receipts from the sale of tangible or intangible property for purposes of California’s franchise tax. This characterization is important because California includes receipts from the sale of tangible personal property in the sales factor numerator if the property is delivered or shipped to California customers. However, receipts from intangibles are included in the sales factor numerator only if the greater proportion of the taxpayer’s income-producing activity is performed in California, based upon costs of performance. California has not defined “tangible property” or “intangible property” for purposes of its franchise tax.

Characterization of Receipts from Replicating Software -

The trial court ruled for the State and determined that the OEM royalties constituted receipts from the sale of tangible personal property because they constituted receipts from computer software products, which the trial court found to be tangible. The Court of Appeal determined that the right to replicate software is different than the right to use software: “While we appreciate that computer software purchased by an end-user consumer may be characterized as tangible property, our inquiry does not end there. As plaintiff clarifies in its reply brief, ‘the issue in this case is 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.’” Op. at p. 9. The Court of Appeal thereafter held that the OEM royalties constituted the license of an intangible right.

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