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Microsoft sues IRS over 936 refunds
The San Juan Star / August 9, 1996

By Larry Luxner

WASHINGTON -- Is churning out software titles by the millions manufacturing, or merely copying?

That's the heart of a dispute between Microsoft Corp. and the Internal Revenue Service, which is denying the world's largest software maker a $19 million refund from its 1990 and 1991 tax returns.

On Thursday, Microsoft -- which employs 200 people at a factory in Humacao -- filed a petition in U.S. Tax Court, challenging the agency's interpretation of Section 936 tax incentives written long before the software industry existed.

"We are leading the way in asking that the software industry receive a fair interpre-tation of existing law," said Mike Boyle, Microsoft's chief tax counsel. "The software industry is following the rules that Congress established to promote U.S. exports, to encourage economic development, and to provide American jobs.

"While the amounts involved are not material to our financial statements, we are still looking forward to clarifying these issues with the IRS," he said.

The debate is part of a larger battle involving the Foreign Sales Corporation (FSC) exemption, an incentive for exporters of film and music recordings and "similar reproduc-tions." According to the Wall Street Journal, the 1984 law that allowed companies to set up FSCs -- thereby exempting 15% to 30% of their export income from U.S. taxation -- doesn't specifically mention software, and the IRS isn't willing to extend the tax exemption to the software industry.

Microsoft, which argues that the exemption by definition must include master soft-ware recordings exported overseas, is the first software company to challenge the IRS interpretation of the FSC exemption in court. It's also the only software firm drawn to Puerto Rico by Section 936 that is still operating on the island. Although 936 is unrelated to the larger FSC debate, Microsoft's lawsuit addresses both concerns.

"The basic issue is whether what we are doing in Puerto Rico is considered to be manufacturing," said Boyle in a phone interview Thursday from the company's Seattle headquarters. "The folks in the software industry all believe that when we make our product, that is manufacturing. The IRS has not accepted that. They're used to more traditional notions of manufacturing."

In 1989, Microsoft decided to set up a 45,000-square-foot facility in Humacao. It applied for and received a 15-year industrial tax exemption from the Puerto Rican government, based on Fomento's determination that MS-Puerto Rico's manufacture of software-loaded diskettes qualified as the "production of a manufactured product" within the meaning of the law. The company also decided to calculate its taxable federal income using the profit-split method under Section 936(h)(5)(C)(ii).

In 1991 -- the subsidiary's first full year of operation -- MS-Puerto Rico produced 2.6 million licensed disk packs, consisting of 41 million software-loaded diskettes for 178 versions of leading software programs including Microsoft Word, Windows, MS-DOS and Excel. It later added the enormously popular Windows 95 program to its product lineup.

The company says things were fine until earlier this year, when IRS Commissioner Margaret Milner Richardson "erroneously determined that MS-Puerto Rico did not satisfy the direct labor costs test and the manufacture or production test" under the 936 provision. As a result, according to Microsoft's petition, the IRS "determined that MS-Puerto Rico was not entitled to use the profit-split method and erroneously" increased the company's taxable income by $1.37 million for 1990 and $43.78 million for 1991.

Despite Microsoft's overwhelming domination of the world computer software market, Lotus Development Corp. of Cambridge, Mass., was the first software firm to locate in Puerto Rico. Lotus set up its Caguas plant in November 1985, duplicating half a million units annually of the popular Lotus 1-2-3 spreadsheet program from original master disks.

Three years later, one of the company's chief rivals -- California-based Ashton Tate Corp., makers of dBASE-IV -- opened a 43,000-square-foot factory in nearby Gurabo, assembling 600,000 software packages a year and generating $15 million in annual sales for the parent company. And in 1990, MicroCom Inc. opened its own plant in Caguas, where it produced Virex-PC, a software program that destroyed computer viruses.

Like other U.S. companies here that make everything from athletic shoes to Zantac, the software giants chose Puerto Rico because of Section 936, which exempted them from paying federal income tax on profits earned by their local subsidiaries. In addition, under the island's own Industrial Incentives Act of 1987, qualified companies got 90% exemptions from Commonwealth taxes ranging from 10 to 25 years.

Yet except for the Microsoft factory, all the other plants have since closed, putting an end to Puerto Rico's little "Silicon Valley" in the mountains south of San Juan.

Microsoft, which also has plants in Washington state and Ireland, refused to say how much of its worldwide software production comes from Humacao. It also refused to quantify the value of its Puerto Rico production either in volume or dollar terms, saying that information was confidential. Rodolfo Acevedo, general manager of the Humacao plant, didn't return phone calls. The IRS itself doesn't comment on pending lawsuits.

Company spokesman Greg Shaw, however, said Puerto Rico "has been a fast-growing area for us" and that "it's an important facility."

Microsoft's fight against the IRS is being backed by a formidable army of business groups including the Software Publishers Association, the Business Software Alliance and the Information Technology Alliance.

"I know of no other case involving software publishers and Section 936," said Mark Nebergall, a lawyer for the Software Publishers Association. "This is a test case that companies will be able to rely on should Microsoft win."

Nebergall said he's confident Microsoft will emerge victorious from this fight.

"The IRS is somehow bent on denying foreign tax benefits to software companies. This is probably part of the IRS software company audit package," he told The STAR. "The value of the technology lies in your ability to reproduce it. To the extent you need somebody to do what in essence is repetitive work, how is that any different from somebody plugging a circuit board or making pharmaceuticals?"

Asked whether Microsoft might pull out of Puerto Rico if it loses this battle with the IRS, Boyle declined to answer the question directly. "We feel we have a very strong basis for our position," he said. "We're not focusing on losing."

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