May 2011

In mid-May 2011, the California Supreme Court denied the State Board of Equalization’s petition for review of the Court of Appeal decision in Nortel Networks, Inc. v. State Board of Equalization (Case no. B21341, filed January 11, 2011). The Nortel case has broad implications for California’s taxation of software.

The amount charged for intangible personal property transferred with tangible personal property in any technology transfer agreement (“TTA”) is exempt from tax. Nevertheless, the longstanding position of the State Board of Equalization (“BOE”) has been that all sales of prewritten software are subject to California’s sales tax. The BOE issued regulations that exclude prewritten software from the definition of a TTA.

The underlying Court of Appeal decision determined that the BOE exceeded its authority when it issued its regulation. Specifically:

“We conclude that the software licensed by Nortel is exempt from sales tax under the TTA statutes because it (1) is copyrighted, (2) contains patented processes, and (3) enables the licensee to copy the software, and to make and sell products—telephone calls—embodying the patents and copyright. (§§ 6011, subd. (c)(10)(D), 6012, subd. (c)(10)(D).) The Board’s attempt to limit the scope of the TTA statutes by excluding prewritten computer programs is an invalid exercise of its regulatory power … A tax is imposed on all retailers who sell or lease ‘tangible personal property’ in this state. Tangible personal property ‘may be seen, weighed, measured, felt, or touched’; i.e., is “perceptible to the senses.’ A sale is ‘

[a]ny transfer of title or possession, exchange or barter, conditional or otherwise, in any manner or by any means whatsoever, of tangible personal property for a consideration.’ … By contrast, a transfer of ‘intangible personal property is not subject to sales tax.’ Intangible property ‘is generally defined as property that is a “right” rather than a physical object.’ Intellectual property is an intangible right “existing separately from the physical medium that embodies it.”

Intangible property includes a license to use information under a copyright or patent. [Citations omitted]

In 1993, the Legislature enacted the TTA statutory provisions relating to the transfer of intellectual property. A TTA is broadly defined as ‘any agreement under which a person who holds a patent or copyright interest assigns or licenses to another person the right to make and sell a product or to use a process that is subject to the patent or copyright interest.’ The TTA provisions exempt from taxation “the amount charged for intangible personal property transferred with tangible personal property in any technology transfer agreement, if the technology transfer agreement separately states a reasonable price for the tangible personal property.”

The Court’s broad interpretation of the TTA statutes and invalidation of the BOE’s regulation excluding prewritten software from TTAs may create refund opportunities. Customers who have paid California sales or use tax on purchases or licenses of prewritten software (meaning, practically everyone in California) should work with vendors to file claims for refund. In the BOE’s own words, under the now-final Court of Appeal’s ruling, “sales of software programs, such as Windows 7 operating system, Microsoft Word, Quicken or TurboTax, will be subject to claims of exclusion from tax.”

Currently, hardware and software are often bundled in a single price. The hardware component remains taxable. In order to avoid taxation of the now tax-exempt software portion (whether for a refund or for future sales), an appraisal may be needed of the separate hardware and software components.

Fulcrum Inquiry performs appraisals of intangible and intellectual property, including software.