Update 2: Please be sure to also read my guest post at TechFlash: Pay your tax, Bill!.
Update:Thanks for linking Slashdot, Stranger's Slog, Huffington Post. Just to clarify, while it's legal for Microsoft to sue in Washington on its Nevada-based contracts, doing so further erodes their tax argument that they aren't in the software licensing business in Washington. Read the post for a full explanation.
Microsoft Freeloading on Washington Courts
After King County Superior Court Judge Gregory Canova awarded Microsoft an $8.7 million judgment in a 2008 lawsuit involving unpaid software licenses, he might have been surprised to learn that Microsoft isn’t actually in the software licensing business in Washington – or at least that’s what it reports to the state Department of Revenue.
For tax purposes, Microsoft reports that it’s earned its estimated $143 billion in software licensing revenue in Nevada, where there is no licensing tax. However, for legal purposes, Microsoft executes its licensing contracts so they are governed by and rely on the protections of Washington law and its courts (some regional contracts are governed by the laws in Ireland or China).
When necessary, as in the case Microsoft Licensing GP v. TSR Silicon Resources, which lasted two years, Microsoft uses the resources of Washington courts to enforce its licensing contracts. It does this while simultaneously dodging the taxes it would normally pay for engaging in the software licensing business in Washington - the same taxes that fund the courts.
Since moving to Washington in 1979, Microsoft has been involved in at least 105 lawsuits here, including five known to involve its Nevada licensing efforts. This has contributed to the budget challenges already faced by our court. A 2003 task force on court funding said we face “… the worst fiscal crisis to confront the state judiciary in 50 years.” Next year’s proposed county budget will cut $500,000 from the Superior Court’s already strained $18.5 million budget.
How big is Microsoft's tax dodge?
When you buy Microsoft software in a box for personal use, you pay sales tax at the point of delivery. But, when large corporations purchase Microsoft software, they are actually buying an electronic download with the right to install that software on a pre-determined number of computers. The same goes for PC manufacturers such as Dell that preinstall Microsoft Windows 7 on its computers.
Washington has a specific manufacturing tax for this called the B&O Software Royalty Tax that applies to “…every person engaging within this state in the business of receiving income from royalties…for the granting of intangible rights, such as…licenses.” Furthermore, “Royalty income from software licenses is taxed at the ‘domicile,’ or location, of the owner of the property.” Because it is a wholesale tax, it applies to sales regardless of the location of the customer – whether in the U.S. or in another country. Since the tax is small, less than half a percent of gross revenue, it does not violate the Commerce Clause of the Constitution, which regulates interstate trade.
Microsoft began dodging the tax in 1997 by setting up a small office in Reno, Nevada to record the revenue it generates from software licensing. Since then, I estimate it’s earned $143 billion in licensing therefore avoiding the payment of $728.8 million in Washington State taxes (see table below). Using the historical interest rates for tax delinquency from the Department of Revenue, I estimate Microsoft’s unpaid tax bill at $995 million. This amount does not include penalties, often assessed at 25 percent.
Aren’t there laws against this?
According to the Department of Revenue, to avoid this tax, a company, like Microsoft, would need to “effectively transfer the property to a related company (e.g., parent and subsidiary corporations) located outside Washington” and recognize income from the value of the transfer on its Washington taxes. It’s not clear that Microsoft has done this – and there are legal doctrines to charge a corporation if it illegally evades its taxes:
1) The doctrine of Nexus represents ties or links that a corporation has with a state. Microsoft clearly has nexus in Washington given its 40,224 employees, 9.8 million square feet and 79 physical sites. Its software also has nexus here as most is built, tested, marketed, sold and distributed from these facilities. Microsoft’s historical use of the laws of Washington to govern its licensing contracts, its Washington-based lawyers and its use of Washington’s courts to defend it also contribute to the nexus of its licensing business.
2) The Step Doctrine focuses on whether steps of a transaction may stand alone or, rather, whether the transaction should be treated as a whole. It can be applied when a corporation creates additional artificial steps to appear as if it is not liable to pay tax.
Microsoft’s transfer of electronic license codes from Washington to Nevada appear to fail common applications of the step doctrine as described here by the State of California:
“Under the end result test, if it appears that a series of transfers were really component parts of a single transaction intended from the beginning to be taken for purposes of reaching the end result, the step transaction doctrine may apply and the intermediate steps may be disregarded.
Under the interdependence test, if the steps or transfers taken were so interdependent that the legal relations created by one transaction or transfer would have been fruitless (apart from the parties' intention to qualify for an exclusion) without completing the entire series of steps, then the step transaction doctrine may apply and the intermediate steps may be disregarded.”
3) Alter Ego Theory is often used to “pierce the corporate veil” of liability when a “corporation [is] being used as a ‘façade’ for [the] dominant shareholder(s) personal dealings” (Wikipedia).
Microsoft uses a partnership called Microsoft Licensing GP to conduct its licensing business in Nevada. But, who is Microsoft Licensing GP? In its case against TSR Silicon, it described Microsoft Licensing GP as “a Nevada General Partnership comprised of Microsoft Corporation and Microsoft Management LLC”.
A quick look on the Nevada Secretary of State’s Website reveals that Microsoft Corporation is a Washington-based corporation and Microsoft Management LLC is a Nevada-based corporation. However, all eight registered officers of Microsoft Management LLC are Microsoft employees and half are employed by and based at its Washington State corporation.
Two-thirds of the registered officers for the Nevada entity Microsoft uses to avoid Washington state taxes are based in Washington or have primary affiliation with Microsoft’s Washington State corporation.
In other words, Microsoft Licensing GP is clearly an Alter Ego of Microsoft Corporation.
Microsoft likely chose the partnership form for Microsoft Licensing because courts tend not to use Alter Ego to pierce the corporate veil (since individual partners aren’t shielded from liability caused by a partnership’s actions). However, this protection may not apply here as Microsoft Licensing GP appears to have been formed by two corporations (already shielded by definition), explicitly for the purpose of tax minimization or worse, tax evasion.
While Washington’s Department of Revenue has ruled that intangible property has its situs at the domicile of its owner, to avoid tax Microsoft would have to prove its Nevada partnership is not an Alter Ego.
Compared to Microsoft’s 40,224 Puget Sound employees that produce the software, Microsoft’s 500 Nevada employees are simply instruments used for the corporation to avoid Washington’s royalty tax. Note the "It's Amazing What You Can Do Here" banner on its website.
Do Microsoft’s Practices Constitute Illegal Tax Evasion?
Over the past few weeks, I’ve been asking Washington’s Department of Revenue to publish a finding on the legality of this kind of tax practice. The department is required to protect the privacy of taxpayers and therefore cannot answer specific questions about Microsoft only questions about specific practices in the abstract.
Microsoft could answer these questions itself by honoring its commitment to transparency (seen here in Google’s search cache, transparency does not appear very prominently in it’s newly launched Corporate Citizenship website) by disclosing its state tax returns and providing documentation for the legal structure of its licensing business.
Prior to the discovery of Microsoft’s contracting practices and its use of Washington courts to defend its Nevada-based licensing entity, the department issued this statement. I am currently awaiting more complete findings.
Historically, tax law precedents relate to real property e.g. physical goods you can hold or land you can walk on. Patents, software licenses, and other digital goods such as eBooks and mp3s are often called intangible property and handled differently under the law.
According to the Department of Revenue, it does not apply the Step Doctrine to B&O taxes because of a Washington Supreme Court case, Estep v. King County, 66 Wn.2d 76, (1965). However, this case related specifically to real estate property. The court probably did not anticipate the capability of a Washington-based corporation to electronically transfer license codes in seconds over the Internet to evade a billion dollars in taxes.
Given Microsoft’s nexus in Washington, it’s Alter Ego, Microsoft Licensing GP, its historical record of defending its licensing contracts in Washington courts, and the ongoing pass thru of related income into the paychecks of its Washington State employees and costs for its site operations, it is difficult to argue that Microsoft Corporation is not a “ person engaging within this state in the business of receiving income from royalties” subject to the royalty tax.
If you have concerns about this:
Microsoft's Estimated Licensing Revenue and Royalty Taxes
* All values are in the millions of dollars.
* Microsoft stopped reporting its share of revenue from licensing in 2003, so I’ve continued to track it using a historical average from previous years of 31 percent.
* The table does not include interest or penalties that might be assessed
* In 1997, the royalty tax was 1.5%. Under pressure from software industry lobbyists, it was cut by more than 66% to .484 percent by the Legislature in 1998.