Microsoft Corp. v. C.I.R., 01-71584.

• Decision Date: 03 December 2002
• Docket Number: No. 01-71584.,01-71584.
• Citation: 311 F.3d 1178
• Parties: MICROSOFT CORPORATION, Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.
• Court: U.S. Court of Appeals — Ninth Circuit

311 F.3d 1178

MICROSOFT CORPORATION, Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Appellee.

No. 01-71584.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted September 11, 2002.

Filed December 3, 2002.

James M. O'Brien, Chicago, IL, for the petitioner.

Andrea R. Tebbets, Washington, DC, for the respondent.

On Appeal from a Decision of the United States Tax Court, No. 16878-96.

Before: THOMPSON and RAWLINSON, Circuit Judges, and SCHWARZER,^* Senior District Judge.

DAVID R. THOMPSON, Circuit Judge:

Microsoft Corporation appeals the tax court's deficiency judgment in favor of the Commissioner of Internal Revenue (the "Commissioner"). In 1990 and 1991, Microsoft claimed "export property" deductions for certain commissions it paid to Microsoft Foreign Sales Corporation. These commissions were for royalty income subsidiaries earned from the international distribution of master copies of Microsoft computer software. The Commissioner disallowed the deductions because it concluded that master copies of computer software were not deductible "export property" under now repealed I.R.C. § 927(a)(2)(B). During the applicable period, that section provided, in relevant part:

The term `export property' shall not include... patents, inventions, models, designs, formulas, or processes whether or not patented, copyrights (other than films, tapes, records, or similar reproductions, for commercial or home use), good will, trademarks, trade brands, franchises, or other like property....

§ 927(a)(2)(B).¹ Because we interpret this section's phrase "copyrights (other than films, tapes, records, or similar reproductions, for commercial or home use)" to include computer software masters, we reverse the tax court's judgment.

I Statutory Background

In 1970, in response to a troubled economy, Congress twice tried but failed to enact legislation that would have exempted export property from tax liability in certain circumstances. Both bills stated that intangible intellectual property would not be deductible export property, but exempted certain copyrightable materials. One bill provided that "copyrights (other than motion picture films or films or tapes used for radio or television broadcasting)" were not export property. H.R. 18392, 91st Cong. sec. 2, § 991 (1970). The other provided that "copyrights (other than films, tapes, or records for the commercial showing of motion pictures or used for radio or television broadcasting or to provide background music)," were not export property. H.R. 18970, 91st Cong. sec. 402, § 991 (1970). Neither bill was enacted.

The next year, Congress successfully passed the Revenue Act of 1971, Pub.L. No. 92-178, 85 Stat. 497, with stated goals which included putting the lagging economy on a high growth path, increasing the number of jobs, reducing the high unemployment rate, increasing exports, and improving the balance of payments (hereinafter "the DISC legislation"). S.Rep. No. 92-437, at 1 (1971), reprinted in 1971 U.S.C.C.A.N.1918. The Senate Report explained that:

To provide tax incentives for U.S. firms to increase their exports, [Congress] has provided tax deferral for one-half of export-related profits, so long as they are retained in a new type of U.S. corporation known as a Domestic International Sales Corporation or a "DISC." The requirements for qualification as a DISC in general are that substantially all of the corporation's gross receipts and assets must be export related.

Id. at 12, reprinted in 1971 U.S.C.C.A.N. at 1928. By this legislation, Congress sought "to provide substantial stimulus to exports and at the same time to avoid granting undue tax advantages to the DISC's [sic]." Id. at 13, reprinted in 1971 U.S.C.C.A.N. at 1928.

In 1984, responding to pressure from signatories to the General Agreement on Tariffs and Trade, Congress supplemented the DISC regime with Foreign Sales Corporations ("FSCs") in the Tax Reform Act of 1984, Pub.L. No. 98-369, § 801(a), 98 Stat. 494, 991 (1984) (hereinafter "the FSC legislation"). Polychrome Int'l Corp. v. Krigger, 5 F.3d 1522, 1526 (3d Cir.1993) (citing Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, 98th Cong.2d Sess., at 1041-42 (CCH 1985)). Under the new legislation, FSCs promoted the same goals as DISCS, but a FSC could permanently exclude, rather than defer, a portion of its profits from qualifying export sales. See H.R. Conf. Rep. No. 98-861, at 968-77 (1984), reprinted in 1984 U.S.C.C.A.N. 1445, 1656-65. The language that determined qualifying export property remained the same in both the 1971 and 1984 versions of the law. In each, export property must have been:

(A) manufactured, produced, grown, or extracted in the United States by a person other than a DISC [FSC],

(B) held primarily for the sale, lease, or rental, in the ordinary course of trade or business, by, or to, a DISC [FSC], for direct use, consumption, or disposition outside the United States, and

(C) not more than 50 percent of the fair market value of which is attributable to articles imported into the United States.

§§ 993(c)(1), 927(a)(1). Both statutes excluded from export property "patents, inventions, models, designs, formulas, or processes[,] whether or not patented, copyrights (other than films, tapes, records, or similar reproductions, for commercial or home use), good will, trademarks, trade brands, franchises, or other like property." §§ 993(c)(2)(B), 927(a)(2)(B) (The only difference between the clauses is that a comma after the word "processes" was omitted from the § 927 version.).

Although some uncertainty was expressed regarding whether and to what extent this exception applied to copyrighted computer software programs, (see, e.g., Tech. Adv. Mem. 85-49-003, 1985 WL 297327 (Aug. 16, 1985)), the parenthetical exception remained unchanged until 1997 when Congress amended § 927(a)(2)(B) to specify that computer software was within the parenthetical exception: "[t]he term `export property' shall not include ... copyrights (other than films, records, or similar reproductions, and other than computer software (whether or not patented), for commercial or home use)..." See Tax-payer Relief Act of 1997, Pub.L. No. 105-34, § 1171, 111 Stat. 788, 987. In making this change, Congress recognized that then-current Treasury Regulations excluded from treatment as "export property" computer software accompanied by the right to reproduce, but directed that "[n]o inference [was] intended regarding the qualification as export property of computer software licensed for reproduction abroad under present law." H.R. Conf. Rep. No. 105-220, at 636 (1997), reprinted in 1997 U.S.C.C.A.N. 1129, 1448.

II Factual Background

Organized as a partnership in 1975, Appellant incorporated as Microsoft Corporation ("Microsoft") in 1980. Microsoft's 1990 and 1991 Forms 10-K described its business as the "development, production, marketing, and support of a wide range of software for business and professional use, including operating systems, languages and application programs, as well as books, hardware and CD-ROM products for the microcomputer marketplace."

Microsoft distributed its products internationally through two principal lines: foreign computer makers (known as original equipment manufacturers or "OEMs") and Microsoft's foreign subsidiaries (known as controlled foreign corporations or "CFCs"). OEMs and CFCs purchased from Microsoft computer software master copies ("software masters"), which contained the object code for computer programs and related data files for Microsoft products including operating systems (such as MS-DOS and Windows) and applications (such as Word and Excel). Such purchases included a license which gave the OEMs and CFCs the right make copies for distribution to others. The software licensees could store the digital information from the masters on network computers at their facilities and modify, reproduce, and distribute the licensed software, paying a royalty for each copy of the copyrighted work distributed in the market or for each computer system the OEMs sold.

Microsoft's Product Release Services group ("PRS") produced the master copies of the software and related documentation for distribution to the OEMs and CFCs. During the years at issue, PRS provided masters on .25 inch magnetic tape and on 5.25 inch and 3.5 inch magnetic diskettes ("diskettes"). During this period, Microsoft also exported individually packaged retail software, but deductions for these items are not at issue in this appeal because the Commissioner determined that these individually packaged standardized software products came within the definition of "export property." See Microsoft, Corp. v. Comm'r of Internal Revenue, 115 T.C. 228, 248-50, 2000 WL 1310664 (2000); Temp. Treas. Reg. § 1.927(a)-1T(f)(3).

Microsoft organized Microsoft FSC Corporation ("MS-FSC") as a Virgin Islands corporation in 1984, and qualified it as a FSC to take advantage of the favorable tax provisions available under the FSC legislation. Microsoft and MS-FSC treated the royalties that Microsoft earned from the software master licenses to the OEMs and CFCs as foreign trading gross receipts ("FTGRs") for the purpose of determining foreign trade income under § 924. Microsoft then paid MS-FSC a commission based upon these gross receipts, using the applicable administrative pricing rules of § 925.

The Commissioner disallowed Microsoft's deductions for commission amounts attributable to software masters because the Commissioner determined that the software masters, which included the right to reproduce, did not qualify as "export property," but instead constituted disqualified copyright property under § 927(a)(2)(B). In response, Microsoft filed suit in the tax court. It contended that the Commissioner incorrectly disallowed its FSC commission deductions attributable to the export of software copies. The amounts of...