Washington's royalty tax requires that any entities engaging in the business of software licensing pay a small, .484 percent tax on gross income.
RCW 82.04.2907 - Tax on royalties from granting intangible rights
(1) Upon every person engaging within this state in the business of receiving income from royalties or charges in the nature of royalties for the granting of intangible rights, such as copyrights, licenses, patents, or franchise fees, the amount of tax with respect to such business shall be equal to the gross income from royalties or charges in the nature of royalties from the business multiplied by the rate of 0.484 percent.
In 2009, 3,088 Washington taxpayers paid Washington's royalty tax under threat of enforcement. Any or all of these individuals and businesses have a strong legal case for a refund on the basis of federal equal protection statutes. How can Washington State continue to assess the royalty tax on many but not on Microsoft?
The doctrine of Nexus represents ties or links that a corporation has with a state. Microsoft business activities clearly have 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.
Compared to Microsoft’s 40,224 Puget Sound employees that produce its software, Microsoft’s 200+ 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.
On what basis does Microsoft claim the tax does not apply? It won't say. However, it seems to be using its office in Nevada to justify not paying the tax.
Microsoft Washington Has Legal Control of Microsoft Nevada
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.
According to the Department of Revenue, to avoid the B&O Royalty 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. Based on Microsoft's Washington control of Microsoft Licensing GP, it’s not clear that Microsoft has done this.
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.
Nevada Office is an Artificial Step to Evade Washington Tax
More significantly, the Step Doctrine can be applied when a corporation creates additional artificial steps to appear as if it is not liable to pay tax. It focuses on whether steps of a transaction may stand alone or, rather, whether the transaction should be treated as a whole. It
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.”
Compared to Microsoft's 40,224 Washington employees, Microsoft's 200+ Reno, Nevada employees seem to have no other purpose than to evade Washington's royalty tax. Microsoft's Nevada office is simple an artificial step in the transaction to evade Washington tax law.
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 earlier at left via 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.
Microsoft's CEO Steve Ballmer has said that the transparency of its business practices is one of the company's core values:
"Another focus for us is ensuring the integrity and transparency of our business processes and practices. ... Some of this effort has to do with our internal processes of corporate governance, but a lot of it has to do with being open, honest and respectful with others, which is one of the core values of our company."
He's also called for transparency in government despite relying on Washington to shield Microsoft's own tax filings.
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. Recently, they issued this statement and denied my appeal for a public records request to review their policy findings/letter rulings on the software royalty tax.
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.
In recent years, the Supreme Court has required that state taxes meet a 4-part test articulated in Complete Auto Transit, Inc. v. Brady, 430 U.S. 274, 51 L. Ed. 2d 326, 97 S. Ct. 1076 (1977). [***10] Under this test, HN4state taxation of interstate business must (1) tax only interstate activities having a sufficient connection to the taxing state (nexus requirement); (2) be fairly apportioned to taxpayer's activities in the state (apportionment requirement); (3) not discriminate against interstate commerce (nondiscrimination requirement); and (4) be fairly related to the services provided by the state.
- See Am. Nat'l Can Corp. v. Dep't of Revenue, 114 Wn.2d 236, 241 (Wash. 1990)
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.
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