                       T.C. Memo. 1998-54



                     UNITED STATES TAX COURT



              MICROSOFT CORPORATION, Petitioner v.
          COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 16878-96.               Filed February 10, 1998.



     Michael P. Boyle, James M. O'Brien, and John M. Peterson,

for petitioner.

     Beth L. Williams, William A. McCarthy, David P. Fuller, and

John M. Altman, for respondent.
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                           MEMORANDUM OPINION


     JACOBS, Judge:       This matter is before the Court on the

parties' cross-motions for partial summary judgment.           Both motions

were filed pursuant to Rule 121.1

     The issue presented by these motions is whether respondent is

barred by the expiration of the statutory period of limitations

from recalculating the amount of petitioner's affiliated group's

combined taxable income under the section 936(h) profit-split

method for the taxable years ended June 30, 1990 and 1991.           In this

regard, we must interpret a restricted consent extending the

limitation periods for 1990 and 1991 to a date subsequent to the

issuance of the notice of deficiency to determine whether the

language     contained   therein   is   sufficiently   broad    to   permit

respondent to recalculate petitioner's affiliated group's combined

taxable income under the section 936(h) profit-split method for the

aforementioned years. Both parties have submitted memoranda of law

in support of their respective motions.

Background

     Microsoft Corporation (Microsoft or petitioner), a Washington

corporation, had its principal place of business in Redmond,


     1
          Unless otherwise indicated, all section references are
to the Internal Revenue Code as in effect for the matter under
consideration, and all Rule references are to the Tax Court Rules
of Practice and Procedure.
                                     - 3 -


Washington, at the time the petition was filed.          Microsoft, as the

common parent of an affiliated group of corporations, filed a

consolidated U.S. Corporation Income Tax Return (Form 1120) for

taxable year ended June 30, 1990 (the 1990 year), on March 15,

1991, and for taxable year ended June 30, 1991 (the 1991 year), on

March 14, 1992.      Microsoft Puerto Rico, Inc. (MS-Puerto Rico), a

Delaware corporation, is a wholly owned subsidiary of Microsoft.

Section 936 Possessions Tax Credit

     During   1990    and    1991,   MS-Puerto    Rico   manufactured2   (by

duplicating   from    a     master   diskette    furnished   by   Microsoft)

software-encoded diskettes at its 45,000-square-foot facility in

Humacao, Puerto Rico.       These diskettes were sold to Microsoft for

packaging with other components and distribution to customers as

standardized, mass-marketed software products. On its 1990 Federal

corporate income tax return, MS-Puerto Rico elected to be taxed as

a possessions corporation under section 936 and to report its

taxable income pursuant to the profit-split method under section

936(h)(5)(C)(ii). These elections continued during the 1991 year.

     Section 936 entitles certain qualifying domestic corporations

(the possessions corporation) to elect to claim as a possessions

tax credit (the section 936 credit) against its U.S. tax liability


     2
          The use herein of the term "manufactured" or "produced"
is not meant to be dispositive of whether Microsoft Puerto Rico,
Inc. (MS-Puerto Rico), satisfied the significant business
presence test of sec. 936(h)(5)(B)(i) and (ii).
                                            - 4 -


an   amount       equal   to   that    portion       of     its   U.S.   tax   that   is

attributable to certain of its possession-source taxable income.

Sec. 936(a)(1).3          To qualify for the section 936 credit, the

possessions corporation (here, MS-Puerto Rico) must show that: (1)

80 percent or more of its gross income for the 3-year period

immediately preceding the taxable year for which the credit is

elected was derived from sources within a possession of the United

States (here, Puerto Rico); and (2) 75 percent or more of its gross

income for that period was derived from the active conduct of a

trade or business within the U.S. possession.                      Sec. 936(a)(2).

       If the possessions corporation qualifies for the section 936

credit, it may further elect to compute its taxable income under

the profit-split method (described in section 936(h)(5)(C)(ii))

provided it satisfies the "significant business presence" test with

respect to its product (here, the diskettes). Sec. 936(h)(5)(B)(i).

This       test   requires     that,    among       other    things,     the   electing

possessions corporation manufacture or produce the product in the

U.S.       possession     within      the    meaning        of    section   954.   Sec.

936(h)(5)(B)(ii).




       3
          For a discussion of the historical development of sec.
936, see Coca-Cola Co. & Subs. v. Commissioner, 106 T.C. 1
(1996). The sec. 936 credit was terminated, effective for all
tax years after Dec. 31, 1995, with a limited phaseout until Dec.
31, 2005. Small Business Job Protection Act of 1996, Pub. L.
104-188, sec. 1601(a), 110 Stat. 1827.
                                  - 5 -


     Under the profit-split method, taxable income is that amount

equal to 50 percent of the "combined taxable income" of the

affiliated group (organizations other than foreign affiliates owned

directly or indirectly by the same interests as provided in section

482) derived from sales (known as covered sales) of units of the

product produced by the qualifying possessions corporation to

persons other than members of the affiliated group (i.e., unrelated

parties) or to foreign affiliates. Sec. 936(h)(5)(C)(ii)(I), (IV).

The method    for   computing   the   combined   taxable   income   of   the

affiliated group is provided in section 936(h)(5)(C)(ii)(II).            See

Coca-Cola Co. & Subs. v. Commissioner, 106 T.C. 1 (1996), relating

to the computation of combined taxable income under the profit-

split method. (Respondent concedes that MS-Puerto Rico qualified as

an affiliate of petitioner for purposes of the profit-split method

election.4)   Where the profit-split method election is in effect,

the combined taxable income of the affiliated group is allocated 50

percent to the electing possession corporation (here, MS-Puerto

Rico).   The remaining 50 percent is allocated to the appropriate

domestic member(s) (other than the electing corporation) of the

affiliated group (here, petitioner) and treated as income from

sources within the United States.       Sec. 936(h)(5)(C)(ii)(III).



     4
          Under sec. 1504(b)(4), MS-Puerto Rico was not eligible
to be a member of petitioner's affiliated group for filing 1990
and 1991 consolidated Federal corporate income tax returns.
                                     - 6 -


     MS-Puerto Rico reported a 1991 combined taxable income of

$102,551,316     attributable   to    the     covered     sales   of   diskettes

manufactured in Puerto Rico to unrelated third parties and foreign

affiliates. After applying the profit-split method, MS-Puerto Rico

reported   its    1991   taxable     income    to    be    $51,275,658.    As   a

consequence of MS-Puerto Rico's profit-split method election and

computation of the combined taxable income, petitioner reported

$102,551,316 as combined taxable income and claimed a $51,275,658

combined taxable income deduction on its 1991 consolidated Federal

corporate income tax return.

Examination of Petitioner

     Respondent conducted an examination of petitioner's 1990 and

1991 Federal corporate income tax returns which lasted more than 3

years. During this audit, respondent issued information document

requests   (IDR's).       Approximately       30    of    these   IDR's   sought

information pertaining to MS-Puerto Rico's software duplication

operations and the prices charged to petitioner by uncontrolled

software duplicators.       Another six IDR's requested information

pertaining to how MS-Puerto Rico calculated the combined taxable

income for purposes of applying the profit-split method.

     On August 29, 1995, respondent issued Form 5701, Notice of

Proposed Adjustment (NOPA), which proposed to disallow MS-Puerto

Rico's election of the profit-split method.                The NOPA indicated

that MS-Puerto Rico did not qualify for the profit-split method
                                  - 7 -


election because it failed to maintain a significant business

presence in Puerto Rico with respect to the diskettes under section

936(h)(5)(B)(i).   Consequently, respondent recalculated the prices

at   which MS-Puerto    Rico   sold   its   diskettes   to   Microsoft   and

redetermined MS-Puerto Rico's taxable income under the transfer

pricing rules of section 482, as provided under section 936(h)(3).

The NOPA did not refer to any recalculation of the combined taxable

income.

      A report entitled "Report for Disallowance of Election Out

Provisions of Section 936(h)", prepared by Thomas McDonell (the

McDonell report), an Internal Revenue Service team coordinator, was

attached to the NOPA.    The McDonell report explained the proposed

adjustment:

      The Internal Revenue Service is proposing to increase
      taxable income by $1,366,918 for the year ending June 30,
      1990 and $43,771,224 for the year ending June 30, 1991 in
      determining Microsoft Corporation tax liability.      The
      increase to taxable income is based on a determination
      that diskette duplication activities by Microsoft
      Corporation's wholly owned subsidiary Microsoft Puerto
      Rico, Inc. do not qualify for the profit split provisions
      of   Internal   Revenue   Code   section   936(h).   This
      determination is based primarily on the conclusion that
      diskette duplication is not manufacturing as defined by
      sections 936 and 954 of the Code.

      Throughout the audit, both petitioner and MS-Puerto Rico

executed Forms 872, Consents to Extend the Time to Assess Tax, with

respect to the 1990 and 1991 tax years.        The first three of these

extension consents were unrestricted and permitted respondent to
                              - 8 -


assess tax against petitioner with respect to any issue. The first

unrestricted consent, executed on October 7, 1994, extended the

limitations period until June 30, 1995; the second unrestricted

consent, executed on May 8, 1995, extended the limitations period

until December 31, 1995; and the third unrestricted consent,

executed on November 9, 1995, extended the limitations period until

March 15, 1996.

     On January 11, 1996, both petitioner and MS-Puerto Rico

executed restricted consents to extend the limitations period for

the 1990 and 1991 tax years to December 31, 1996.   The restricted

consent executed by petitioner read, in pertinent part, as follows:

                       RESTRICTIVE LANGUAGE

          The amount of any deficiency assessment is to be
     limited to that resulting from the following two
     potential adjustments, including any consequential
     changes to other items based on such adjustments:

          (1) The Service's proposed adjustment relating to
     the disallowance of Microsoft's use of the profit split
     method of computing taxable income for purposes of
     section 936(h) of the Internal Revenue Code of 1986 with
     respect to its transactions with Microsoft Puerto Rico
     and any transfer pricing adjustments resulting from such
     disallowance; and

          (2) The Service's proposed adjustments relating to
     the taxpayer's treatment of subsidiary and OEM royalties,
     respectively, as income from qualifying export property
     for FSC purposes pursuant to section 927(a) of the
     Internal Revenue Code of 1986.

     The restricted consent executed by MS-Puerto Rico contained

nearly identical restrictive language to that of petitioner's, but
                                     - 9 -


pertained only to the section 936 issue.           The cross-motions before

us concern only the section 936 issue, and not the FSC issue.

        On the same date that the restricted consents were executed,

respondent issued a "30-day letter" and a revenue agent report

(RAR) that followed the adjustments in the NOPA.              The RAR made no

reference to the recalculation of the combined taxable income. The

RAR stated that "The Service is challenging this profit split

deduction because the activities in the Puerto Rico facility do not

meet the definition of manufacturing as required in IRC 954."

Notices of Deficiency

        On May 9, 1996, respondent issued two notices of deficiency,

one for petitioner's 1987, 1988, and 1989 tax years and the other

for petitioner's 1991 tax year.              A notice was not issued with

respect     to   petitioner's   1990    tax    year   because     respondent's

adjustments left petitioner in an overpayment position for that

year.     However, the 1987, 1988, and 1989 tax year deficiencies

relate to excess business and foreign tax credits that arose in

1990.    See sec. 6501(h).

       In the notice of deficiency for the 1991 tax year (the notice

before us), respondent determined an $8,810,992 deficiency.               The

1991     deficiency    arose,   in     part,     because     of   respondent's

disallowance     of   petitioner's     claimed    combined    taxable   income

deduction as computed under MS-Puerto Rico's election of the

profit-split method.      The notice of deficiency stated:
                                  - 10 -


     You have not established that you qualify to elect the
     profit split method under Internal Revenue Code Section
     936(h) and the Income Tax Regulations thereunder.

     Accordingly, your taxable income has been increased in
     the amounts of $1,366,918.00 and $43,771,224.00 for the
     taxable periods ending June 30, 1990, and June 30, 1991,
     respectively.

     After disallowing the profit-split method election, respondent

recomputed petitioner's combined taxable income deduction to be

$7,504,434 (rather than $51,275,658) by redetermining MS-Puerto

Rico's taxable income for 1991 pursuant to section 936(h)(1)-(4)

(the methods used for determining taxable income when the profit-

split method is not properly elected) and section 482 (the transfer

pricing rules).

Filing of the Petition and Answers

     On August 5, 1996, petitioner filed a petition contesting

respondent's determinations that MS-Puerto Rico was not qualified

to elect the profit-split method.          Respondent filed an answer to

the petition on October 8, 1996, denying any error with respect to

the determination that MS-Puerto Rico was not qualified to elect

the profit-split method.       In the answer, respondent admitted that

the basis for the disallowance of the combined taxable income

deduction was MS-Puerto Rico's failure to satisfy the significant

business presence test.

     On January 22, 1997, respondent filed a Motion for Leave to

Amend Answer.     In   the   motion,   respondent   sought   to   raise   the
                                     - 11 -


alternative issue that if MS-Puerto Rico qualified to elect the

profit-split      method,   then    MS-Puerto    Rico   failed     properly   to

calculate   the    combined    taxable   income    under    that    method.   On

February 25, 1997, petitioner filed a Notice of Objections to

Respondent's Motion For Leave to Amend Answer.             On March 17, 1997,

respondent filed a response to petitioner's objections.               By Order

dated March 17, 1997, we granted respondent's motion and permitted

the filing of the Amended Answer. The Order stated that respondent

was to bear the burden of proof with respect to the adjustment

raised by the alternative issue (the alternative adjustment).                 In

its April 25, 1997, Reply to Amendment to Answer, petitioner raised

as an affirmative defense the claim that respondent was time barred

from making the alternative adjustment under section 6501 because

the limitations period for assessment had expired.

     On February 10, 1997, petitioner moved for partial summary

judgment on the issue of whether MS-Puerto Rico satisfied the

significant business presence test and thus qualified to elect the

profit-split method.        After extensive pleadings and a hearing, we

denied petitioner's motion for partial summary judgment on June 18,

1997.

     On November 4, 1997, respondent moved for partial summary

judgment on the issue of whether the restrictive consent agreement

encompassed    respondent's        alternative   adjustment;       namely,    the

recalculation of the combined taxable income. On December 5, 1997,
                                  - 12 -


petitioner   filed    a   cross-motion   for   partial    summary   judgment

asserting    that    respondent   is   time    barred    from   raising   the

alternative adjustment.

Discussion

     Summary judgment is appropriate where the pleadings show that

no genuine issue of material fact exists and that a decision may be

rendered as a matter of law.           Rule 121(b); Sundstrand Corp. &

Consol. Subs. v. Commissioner, 98 T.C. 518, 520 (1992), affd. 17

F.3d 965 (7th Cir. 1994); Jacklin v. Commissioner, 79 T.C. 340, 344

(1982).   A partial summary adjudication may be made which does not

dispose of all the issues in the case.            Rule 121(b); Naftel v.

Commissioner, 85 T.C. 527, 529 (1985).

     With respect to the matter before us, there are no material

facts in dispute, and the pleadings, briefs, and affidavits before

us are sufficient to render a decision as a matter of law.             Thus,

summary adjudication is appropriate under Rule 121.

     Generally, income taxes must be assessed within 3 years from

the date the tax return is filed.          Sec. 6501(a).        However, the

period of limitations may be extended by the parties through the

execution of Form 872 or 872-A:

     Where, before the expiration of the time prescribed in
     this section for the assessment of any tax imposed by
     this title, except the estate tax provided in chapter 11,
     both the Secretary and the taxpayer have consented in
     writing to its assessment after such time, the tax may be
     assessed at any time prior to the expiration of the
     period agreed upon. The period so agreed upon may be
                                   - 13 -


     extended by subsequent agreements in writing made before
     the expiration of the period previously agreed upon.

Sec. 6501(c)(4).

     In analyzing a consent to extend the limitations period, it is

well settled that such a consent is not a contract but rather a

unilateral    waiver   of   a   defense   by   the   taxpayer.   Stange   v.

Commissioner, 282 U.S. 270, 276 (1931); Kronish v. Commissioner, 90

T.C. 684, 693 (1988).           Nevertheless, contract principles are

significant because section 6501(c)(4) requires the agreement to be

in writing.    Piarulle v. Commissioner, 80 T.C. 1035, 1042 (1983).

Consequently, we examine the objective manifestations of mutual

assent to determine the terms of the agreement.                  Kronish v.

Commissioner, supra at 693; Piarulle v. Commissioner, supra at

1042.

     The restricted consent in this case limited the extension of

the limitations period to:

     The Service's proposed adjustment relating to the
     disallowance of Microsoft's use of the profit split
     method of computing taxable income for purposes of
     section 936(h) of the Internal Revenue Code of 1986 with
     respect to its transactions with Microsoft Puerto Rico
     and any transfer pricing adjustments resulting from such
     disallowance; * * *

        Because the 1991 notice of deficiency was issued on May 9,

1996, which was after the expiration of the final general consent

extending the limitations period to March 15, 1996, respondent's

alternative adjustment may be made only if it comes within the
                                 - 14 -


language of the restricted consent which did not expire until

December 31, 1996.

     Respondent contends that the restricted consent encompasses

the recalculation of the combined taxable income of petitioner's

affiliated group.     Respondent reaches this conclusion by noting

that the restricted consent makes reference generally to section

936(h), which includes the election of the profit-split method and

the calculation of the combined taxable income.     Further, after a

dictionary analysis, respondent argues that the word "use" in

"Microsoft's use of the profit split method" (emphasis added)

refers both to MS-Puerto Rico's "act" of electing the profit-split

method and the "manner" in which the method is employed (i.e., the

calculation of the combined taxable income).

     Petitioner argues that respondent fails to acknowledge the

critical   language   in   the   restricted   consent,   namely,   the

"disallowance of Microsoft's use of the profit split method * * *

and any transfer pricing adjustments from such disallowance".

(Emphasis added.)5 Petitioner asserts that the word "disallowance"


     5
          Petitioner also argues that the language "the
disallowance of Microsoft's use of the profit split method * * *
and any transfer pricing adjustments resulting from such
disallowance" must be read in the conjunctive. In this regard,
petitioner contends that respondent's proposed adjustment to the
combined taxable income does not relate to a transfer pricing
adjustment. Respondent objects to petitioner's interpretation of
the restricted consent. We do not base our ruling on
petitioner's reading of the restricted consent in this respect
                                                   (continued...)
                              - 15 -


limits the restricted consent to the failure to qualify for the

profit-split method election and that respondent's alternative

adjustment (seeking the recalculation of the combined taxable

income) presumes the allowance of the profit-split method in the

first place.   We agree with petitioner.

     The plain language of the restricted consent herein limits the

extension of the limitations period to the proposed disallowance of

the profit-split method election.      See Ferguson v. Commissioner,

T.C. Memo. 1992-451. Respondent seeks a different interpretation

because the restricted consent refers to the "use" of the profit-

split method rather than the "election" of the profit-split method.

While in some circumstances the word "use" might lead to the

meaning ascribed to it by respondent, we believe that in the

instant case the parties intended the word to mean "election". Our

reasons for this conclusion follow.

     First, we consider the circumstances in which the restricted

consent was executed.   Although respondent had issued six IDR's

seeking information on how petitioner and MS-Puerto Rico calculated

the combined taxable income, neither the NOPA (and the accompanying

McDonell report) nor the 30-day letter (and the accompanying RAR)

make any reference to the recalculation of the affiliated group's



     5
      (...continued)
because we find other grounds for denying respondent's attempt to
recalculate the combined taxable income.
                                - 16 -


combined taxable income.     Instead, the NOPA, McDonell report, 30-

day letter, and RAR refer only to MS-Puerto Rico's failure to

qualify for the profit-split method election because of the lack of

a significant business presence in Puerto Rico. The NOPA and

accompanying McDonell report were issued approximately 4-1/2 months

before the execution of the restricted consent, and the 30-day

letter and accompanying RAR were issued on the same date as the

execution of the restricted consent.

      Second, respondent's interpretation of the restricted consent

is inconsistent with the operation of section 936(h). Cf. Southern

v. Commissioner, 87 T.C. 49 (1986).         If petitioner failed to

qualify to elect the profit-split method because of MS-Puerto

Rico's lack of a significant business presence in Puerto Rico, then

MS-Puerto Rico's taxable income would be computed under the rules

provided in section 936(h)(1)-(4).    The combined taxable income of

the    affiliated    group      is    calculated    under    section

936(h)(5)(C)(ii)(II) only if petitioner qualified to elect (and

elected) the profit-split method.        There is no language in the

restricted consent that suggests that the profit-split method is to

be allowed, thus permitting adjustments to the affiliated group's

combined taxable income.

      Finally, if the parties intended the consent to have the

meaning respondent attributes to it, there would have been no need

to preface the consent with the language "The Service's proposed
                                   - 17 -


adjustment   relating   to   the    disallowance".      See   Loeser   v.

Commissioner, 27 B.T.A. 601, 606 (1933).         The restricted consent

could have merely read: "The amount of any deficiency assessment is

to be limited to that resulting from Microsoft's use of the profit-

split method."   In our opinion, "the disallowance of Microsoft's

use of the profit split method" refers to Microsoft's qualification

to elect the profit-split method.       Moreover, we believe reference

to "The Service's proposed adjustment" (emphasis added) is a strong

point in petitioner's favor restricting the consent to issues

previously raised in the NOPA and the 30-day letter.

     To conclude, the restricted consent was not broad enough to

encompass the alternative adjustment raised by respondent's amended

answer.   Consequently, respondent's motion for partial summary

judgment will be denied, and petitioner's cross-motion for partial

summary judgment will be granted.



                                            An appropriate order will be

                                   issued.
