Infotech Eludes the Tax Man

P> High-tech companies avoid paying millions of dollars in annual property taxes because city and county governments can't estimate the value of infotech hardware and software.

The tax loophole represents the lag between the nation's tax laws and the rapid advance of infotech, which is pushing more and more of the nation's economy out of manufacturing and into cyberspace. The problem is that tax laws are designed to extract revenue from the second-wave economy -- traditional manufacturing, business and real estate -- while more and more of the nation's revenue is generated by third-wave companies -- the merchants of intellectual property. As a result, tax officials are unsure how to calculate depreciation rates in an infotech industry with constantly shrinking product lifecycles.

"A lot of tax codes need to be rewritten to recognize software," said Jim McMillan, a tax official in Texas.

And to make matters worse, the infotech industry's lobbyists have become extremely effective in convincing governments to pass loopholes.

"Industry is pretty powerful; it is not going to be an easy struggle," said McMillan.

Take the case of Microsoft Corp. In 1991, Microsoft's home state of Washington exempted most software -- including the master copy of MS/DOS software -- from local property taxes. As a result, property taxes in the state are paid only on shrink-wrapped software less than three years old, said Joe Simmonds, a revenue manager in Washington's state capital, Olympia.

"The [taxable] money is all in the custom software. We felt we gave up an awful lot to business," he complained. "I see [the trend] headed toward exemption of software."

In another instance, Virginia voted in 1984 to exempt all software from the property taxes levied by Virginia's cities and counties. And in 1994, its assembly directed counties and cities to adjust their depreciation tables to account for the rapid obsolescence of hardware.

Infotech's tax exemptions hit local cities and counties hardest, because their revenue is based almost entirely on property taxes -- taxes on automobiles, houses and corporate assets. In contrast, state and federal revenues are raised mostly through sales and income taxes.

The issue came into sharper focus when a judge in Fairfax County, Va., recently granted Mitre Corp., a $500,000 property-tax refund; he found that the county had underestimated the depreciation rate for computers. The judge's decision clears the way for many similar cases that could net $50 million for local companies, said James Kurz, an attorney with Hazel &amp Thomas, Falls Church, Va.

In the Fairfax County court case, Judge Thomas Middleton rejected the county's tax tables, which rates a computer's value at one-fifth its original cost after five years. This depreciation table meant that a 10-year-old IBM mainframe computer would be valued at 20 percent of its 1986 purchase price -- generating a tax bill greater than for a newer and more powerful network server.

Mitre Corp. and its lawyers successfully argued that a computer's taxable value should drop to 4 percent of its purchase price after five years, and only 1 percent of its purchase price after six years.

The new depreciation table should give another infotech services provider, McLean, Va.-based PRC Inc., a tax rebate worth several hundred thousand dollars, said Ronald Shingler, associate general counsel for the company. PRC soon may pursue similar tax-refunds for its operations in California. Also, the Fairfax lawsuit prompted company officials to expunge the cost of software programs -- such as MS-DOS -- from their computer-related property tax bills, saving roughly $25,000 a year in Fairfax County, he added.

Kurz also is suing the adjacent city of Arlington, Va., on behalf of other companies seeking hardware-related tax refunds. At worst, the city could lose $6 million of the $30 million it earns from corporate property taxes every year, said Geraldine Whiting, Arlington's revenue commissioner. However, the city has prepared its budget to deal with any revenue loss, she said. The city's total tax revenues of $94 million fund the schools, police and other services.

One reason why custom software is not taxed is that no one can work out what it is worth, said tax officials and accountants. "I don't know what it is worth.... I don't know that anybody does," said Patrick Chambers, a Los Angeles partner in the accounting firm, Arthur Andersen LLP, based in Chicago. Even states such as California that tax basic forms of software -- such as operating systems -- can't work out the fair market value of custom software, he said.

Even when local tax officials try to price custom software, they often have been rebuffed by the courts. For example, Loral Defense Systems' unit in Litchfield Park, Ariz., saved more than $100,000 a year because a local court directed officials to stop taxing Loral's custom software three years ago, said D.W. Craytor, assistant vice president for finance. Similarly, Washington state moved to eliminate taxes on custom software following a court decision in 1991.

Still, cities and counties earn significant property taxes from high-tech companies, whose nationwide revenues totaled $394 million in 1994. Taxes from companies' real estate, manufacturing gear and office equipment, as well as from property taxes paid by employees, contribute to local revenues.

And the tax code is riddled with similar loopholes and exemptions, said Gordon Richards, chief economist at the Washington-based National Association of Manufacturers. For example, the federal government taxes workers' wages, but not their benefits, such as health insurance.