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We have Windows XP and were advised to download a Service Pak because of security holes. But, I wasn't aware of this spying capability. You mean if I buy software which is not Microsoft, they have the right to threaten me?

No, this is the stuff of Urban Legends.

Everyone knows of a neighbor's cousin's ex-roommate's son-in-law's friend's ex-classmate that says that he received a threatening letter from MS. The rules of illegal search without a warrant still apply.

Furthermore, in my line of work, we have THOUSANDS of machines, in which we load THE SAME program (OS, Game, Apps, Utilities) over and over. We do NOT register as the legit entity we are, because we want to emulate the user's experience. We do this to find bugs. I personally reload hard drives 3-4x a week with every program you can imagine. We do this on different revisions of Mobo's, chipsets, and such.

How would MS be able to seperate us, from you? We don't register as the company; as that may somehow cause the program to behave differently.

The PC is your property. You have more to fear from the DCMA than from MS.