More Bad News at Tax Time?

The Internal Revenue Service has proposed new rules that would pull within its orbit any software patent that affects taxes, likely choking innovation

by John Kheit

While I have previously defended software patents on this very site, I come now to bury them. It's not because I've changed my mind. It's that the latest nemesis is so imposing, many would give up the fight before it starts.

The most feared meddler of all, the Internal Revenue Service, recently proposed new rules to regulate software patents. These proposed regulations attempt to deal with an alleged growing social ill—dreaded "tax patents" for financial tools and strategies based on IRS rules. But in the subtle way that only the IRS can manage, the agency is taking the elephant gun to the ant hill. The proposed rules purport to pull within the IRS's jurisdiction any licensed patent that "affects" taxes, except for programs like TurboTax. (Apparently, Intuit (INTU) has very good lobbyists. Kudos!)

These days, just about every piece of business software handles some sort of data that has an impact on a company's taxes. So, in effect, the proposed IRS rules would govern not only patented software that focuses on a company's tax strategies, but potentially just about any licensed, patent-protected software that handles any function of its business. But even worse, any thus-declared "tax patent" would become a "reportable transaction" to the IRS. Commercially speaking, a "a reportable transaction" equals death. What this means is that each and every licensing deal between a software maker and a customer would need to be reported to the IRS.

Forcing Sunshine on Software Deals

For starters, the rules would saddle software makers with an onerous new regulatory burden and draconian penalties whenever they mistakenly fail to report a transaction. An IRS disclosure also might serve as a deal-killer for clients not keen on publicizing these potentially strategic, or even embarrassing, business decisions. To put it very hypothetically and simplistically, if Google (GOOG) suddenly decided to license Microsoft's (MSFT) Web search and ad delivery technology, it might want to keep such a revelation private.

The IRS has previously, and effectively, used reportable transactions as a device to force sunshine into the murky world of abusive tax shelters. While the agency is understandably concerned with certain patent filers gaming both the patent system and tax compliance, the solution is to shoot the innocent. Their plan, supported by tax attorneys, is to bring the entire reportable transaction apparatus down on "middleware" software patents, stigmatizing those companies that develop and patent legitimate software innovations. Not surprisingly, a public hearing held Feb. 21 to discuss the proposal essentially boiled down to an episode of Bar vs. Bar—that is, tax lawyers vs. patent lawyers.

This regulatory land grab by the nation's tax collector would threaten an explosion of innovation and technology in the financial-services industry that has produced astonishing productivity gains, directly and substantially feeding U.S. economic growth over the last decade. Software and systems that connect the front and back offices—middleware—have prominently figured into these breathtaking efficiencies and have been patented by the likes of IBM (IBM), Microsoft, Novell (NOVL), Oracle (ORCL), ADP (ADP), and many, many others.

Middleware: Lifeblood of Info Tech

Now, before you doze off at the prospect of discussing middleware, it's important to note that this type of software is the glue that makes many computer systems work. It may sound boring, but it is the lifeblood of the information technology industry. Yet by merely occupying the middleware space, these software patents would be effectively deemed to affect taxes.