115 T.C. 228 (T.C. 2000)
115 T.C. No. 17
MICROSOFT CORPORATION, Petitioner
COMMISSIONER OF INTERNAL REVENUE, Respondent
United States Tax Court
September 15, 2000
Decision will be entered under Rule 155.
During 1990 and 1991, petitioner engaged its wholly owned subsidiary, a foreign sales corporation, to act as its agent for the international sales of standardized mass-marketed computer software products and computer software masters. The standardized software products were copyrighted articles sold without a right to reproduce abroad. The software masters were licensed to related foreign subsidiaries and unrelated foreign equipment manufacturers with a right to reproduce abroad. In the notices of deficiency, respondent allowed the deductions for the foreign sales corporation commissions attributable to the standardized software products but denied them with respect to the export of the software masters. The issue is whether the software masters constitute " export property" within the meaning of sec. 927(a), I.R.C., and sec. 1.927(a)-1T(f)(3), Temporary Income Tax Regs., 52 Fed. Reg. 6463 (Mar. 3, 1987) (the temporary regulation).
HELD: The temporary regulation is a reasonable and valid interpretation of sec. 927(a)(2)(B), I.R.C.
HELD, FURTHER, computer software masters do not constitute sec. 927(a), I.R.C., " export property" .
James M. O'Brien, Michael P. Boyle, John M. Peterson, Jr.,
Thomas V.M. Linguanti, Andrew J. Gottlieb, Neal J. Block, Scott H.
Frewing, Robert B. Mitchell, Michael J. Bernard, and William H.
Burkhart, for petitioner.
David P. Fuller, John M. Altman, Ronald M. Rosen, Kimberley J.
Peterson, Michelle D. Korbas, and Kevin G. Croke, for respondent.
Jacobs, Julian I., Judge:
Pursuant to two notices of deficiency addressed to petitioner, respondent determined Federal income tax deficiencies and an overpayment, as follows:
Ended June 30 ||Deficiency
_________________ || __________
$ 6,279,330 ||
$ 1,944,520 |
The deficiencies determined for 1987-89 are attributable to respondent's adjustments to general business credit carrybacks from 1990 and 1991 to 1987-89 and to foreign tax credit carrybacks from 1990 to 1987 and 1988. These adjustments are computational, arising from income adjustments for 1990 and 1991. INTRODUCTION Petitioner develops, produces, and markets computer software. During 1990 and 1991, petitioner engaged its wholly owned subsidiary, Microsoft FSC Corp. (MS-FSC), to act as its agent for the international sales of standardized mass-marketed Page 230
computer products and computer software masters. 
These products were sold/licensed to petitioner's controlled foreign corporations (CFC's) and unrelated foreign original equipment manufacturers (foreign OEM's). Pursuant to the licensing agreements with the CFC's, petitioner earned a royalty based upon a percentage of the CFC's revenues from the sale of the licensed software products. Pursuant to the licensing agreements with the foreign OEM's, petitioner earned a royalty equal to the greater of the OEM's computer systems sales or copies of the computer software products distributed. MS-FSC reported the royalties as foreign trading gross receipts (FTGR's). Petitioner paid MS-FSC a commission (based upon the amount MS-FSC reported as FTGR's) and deducted the foreign sales corporation (FSC) commission, using the applicable administrative pricing rules. It is the aforementioned royalties and FSC commissions that are at issue, namely:
|Royalties -- foreign OEM's
||$ 150,349,955 |
|FSC commissions per return
|Royalties -- CFC's
|FSC commissions per return || 4,948,544
|Additional Irish royalties
|Additional FSC commissions per petition
Respondent determined that the disputed royalties were nonqualifying FTGR's. As a result, respondent disallowed FSC commission deductions of $ 16,426,046 for 1990 (i.e., $ 11,477,502 + $ 4,948,544) and $ 15,340,797 for 1991 (i.e., Page 231
$ 5,019,782 + $ 10,321,015), which petitioner claimed in connection with its computer software masters exported for reproduction and distribution abroad. Petitioner also claimed FSC commission deductions of $ 4,049,134 for 1990 and $ 13,625,222 for 1991 with respect to its export sales of standardized software products. Respondent has allowed these deductions. The dispositive issue to be resolved is whether the royalties attributable to the licensees' reproduction and distribution of petitioner's computer software masters outside the United States constitute FTGR's within the purview of section 924. Resolution of this issue hinges upon whether the licensed computer software masters constitute " export property" within the meaning of section 927(a)(1) and the temporary regulations thereunder. Unless otherwise indicated, all section references are to the Internal Revenue Code in effect for the years in issue. All Rule references are to the Tax Court Rules of Practice and Procedure. FINDINGS OF FACT Some of the facts have been stipulated and are found accordingly. The stipulations of facts and the attached exhibits are incorporated herein by this reference. A. BACKGROUND
Petitioner, a Washington corporation, maintained its principal place of business in Redmond, Washington, at the time the petition was filed. It was the common parent of an affiliated group of corporations, which filed consolidated Forms 1120, U.S. Corporation Income Tax Return, for 1987, 1988, 1989, 1990, and 1991. During the years in issue, petitioner conducted its business through several operating groups: Systems software, applications software, systems peripherals and accessories group, OEM sales, U.S. sales and marketing, international operations, and press. Approximately three-quarters of petitioner's worldwide employees were based in Redmond, where petitioner developed its products. Page 232 B. MS-FSC
MS-FSC was organized as a Virgin Islands corporation on December 24, 1984. On January 1, 1985, petitioner and MS-FSC entered into a Commission and Expense Agreement, which remained in effect during the years in issue. At all relevant times, MS-FSC elected to be taxed as a foreign sales corporation and was so qualified. MS-FSC determined its commission income using section 925(a) administrative pricing rules. C. PETITIONER'S PRODUCTS
Petitioner's first products were programming languages and tools that permitted software developers to create computer software. Thereafter, petitioner's product line was expanded to include operating systems. In 1981, petitioner released its first operating system, " Microsoft Disk Operating System" or " MS-DOS", for International Business Machine's (IBM's) first microcomputer. MS-DOS was the operating system used on a majority of IBM's personal computers and IBM-compatible personal computers. Petitioner (MS-DOS), IBM (PC-DOS or IBM-DOS), Digital Research (DR-DOS), and other companies marketed a disk operating system (DOS) under various names. DOS was a text or character-based system; it required computer users to input words or characters to give the computer commands. Since 1981, operating systems software has continually evolved to permit computer users to accomplish increasingly diverse and complex tasks on computers. In addition to MS-DOS, petitioner marketed other proprietary operating systems during the years at issue, such as " Microsoft Windows", " Microsoft LAN Manager", and " XENIX" . At that time, MS-DOS accounted for the largest number of Microsoft operating system units distributed; Microsoft Windows was second. In the early 1980's, petitioner also began to develop and market application software products in order to increase the appeal of the microcomputer. Petitioner's applications included word processing (e.g., " Microsoft Word" ), spreadsheet computations (e.g., " Microsoft Excel" ), graphics (e.g., " Microsoft PowerPoint" ), and video games (e.g., " Microsoft Flight Simulator" ). In 1990 and 1991, petitioner offered a wide line of application software products. Page 233
Petitioner created its software products at its Redmond facilities. It took 25 to several hundred persons to develop a computer software product (i.e., Microsoft Windows or Microsoft Excel). Petitioner's product development, which could take up to 3 years, involved three phases: (1) Product planning, during which a functional specification and final schedule were prepared (3-12 months); (2) product development, during which the source code was completed (and was further revised in the next phase) (6-12 months); and (3) product stabilization, during which a gold master was produced and the software product was released for duplication (3-8 months). D. PRODUCTION OF MASTERS FOR EXPORT
From an American-made gold master, petitioner's product release services group (PRS) in Redmond produced master copies...