United States: California Court Of Appeal Holds Right To Replicate And Install Software Is License Of Intangible Property For Apportionment Purposes

On December 18, the California Court of Appeal reversed a trial court's ruling and determined that a taxpayer's license of proprietary software, which transferred the right to replicate and install the software, but not the right to use the software, constituted the license of "intangible property" for apportionment purposes.¹ As a result, pursuant to California sales factor sourcing rules in effect for the taxpayer's tax years in controversy, a cost of performance analysis was required. Because most of the costs of performance for the royalties from the software licenses were incurred outside California, the entire amount of the royalties received from the licenses was excluded from the numerator of the taxpayer's California sales factor.

Background

The taxpayer, based in the state of Washington, is engaged in the business of developing, licensing, manufacturing, and distributing computer software and providing computer software-related services. During the tax years at issue, the taxpayer entered into licensing agreements with original equipment manufacturers (OEMs) or computer sales companies that assembled or manufactured computer systems that were sold to end users. The licenses gave the OEMs the right to install the taxpayer's software products into their computer systems for sale with the pre-installed software. The taxpayer shipped the software directly to the OEMs on disks. During an OEM's assembly process, the software on the disks was copied onto the hard drives of the assembled units.² Royalties accrued to the taxpayer on a per system or per copy basis, depending on the terms of the licensing agreement. The taxpayer also designed and sold a mouse and keyboard that could be sold as a set or individually.

In 2002, the California Franchise Tax Board (FTB) issued notices of proposed assessment for additional California tax plus penalties for the taxpayer's 1995 and 1996 tax years. The taxpayer eventually paid the entire amount, including interest and penalties,³ and filed a refund claim. After the FTB denied the taxpayer's refund claim, the taxpayer filed a complaint in trial court.

The trial court rejected the taxpayer's claims and held that the licensing of the software for use in the manufacturing of computers constituted the licensing of tangible personal property, which pursuant to the statute in effect during the taxpayer's tax years at audit, was sourced to California if the property is delivered to a purchaser within the state (i.e. the billing addresses of the licensees). The taxpayer appealed, alleging that the licenses should be characterized as sales of "other than tangible personal property" or intangibles that are sourced based on where the greater cumulative amount of the costs of performance relating to the licensed products was incurred.

Applicable Sourcing Rules for Tangible and Intangible Property

The distinction between sales of tangible and intangible property is important for purposes of calculating the California sales factor.⁴ During the tax years at issue, a sale of tangible personal property was sourced to California if the property is shipped to a purchaser within the state.⁵ However, the sale of intangible property was sourced to California if a greater proportion of the property's income-producing activity, as measured by its costs of performance, was performed in California than in any other state.⁶

Right to Replicate and Install Software Is Intangible

In reversing the trial court, the Court of Appeal determined that licensing the right to replicate and install software was an intangible right. As explained by the Court, the issue in this case was not whether the software itself could be classified as tangible or intangible property, but whether the right to replicate and install the software was a tangible or intangible right. While the Court of Appeal was comfortable in characterizing the software as a tangible item, the right to replicate and install the software was the element required to be analyzed. Because most of the costs of performance under these contracts were outside California, the Court concluded that the receipts from licensing the right to replicate and install the software should not be included in the numerator of the California sales factor.

Sales Tax Law Supports Conclusion

The Court of Appeal agreed with the taxpayer that California sales tax law supported its position that the OEM licenses were intangible property for purposes of corporate franchise tax. In reaching its decision, the Court gave weight to California case law and regulations addressing the proper classification of software licenses as tangible versus intangible property for sales and use tax purposes. In Preston v. State Board of Equalization,⁷ the California Supreme Court held that a professional artist's transfer of finished and copyrighted artwork in tangible form, which provided clients with an exclusive right to reproduce the artwork prior to returning the tangible artwork to the artist, was only taxable to the extent that the artist's income was attributable to the temporary transfer of the tangible artwork. The California Supreme Court reasoned that the transaction fell under the statutory provisions governing "technology transfer agreements" (TTAs), and since the TTA statutes exempt the "amount charged for intangible personal property," only the part of the tangible transfer of the artwork was taxable.⁸ Therefore, Preston was indicative of the California legislature's view of TTAs. Although the TTA statutes did not control with respect to the present matter, they supported the taxpayer's position that the OEM licenses involved the transfer of an intangible right.

Likewise, in Nortel Networks, Inc. v. State Board of Equalization,⁹ the California Court of Appeal found that under the TTA statutes, the taxpayer's sale of licensed software to operate telephone switching equipment was exempt from sales tax as protected intellectual property copied by the licensee onto its computers for the purposes of manufacturing its products.

In addition, the Court noted that California's sales and use tax regulations specifically exempt license fees or royalties paid for the right to reproduce a copyrighted program even where "a tangible copy of the program is transferred concurrently with the granting of such right."¹⁰ Thus, for sales and use tax purposes, the OEM licenses would be treated as intangible property. The Court saw no justification for treating OEM licenses differently when it came to corporate franchise taxation.

Cases Prior to TTA Legislation Not Persuasive

The Court next addressed the FTB and trial court's reliance on sales and use tax decisions that pre-dated the enactment of the TTA provisions. Prior to Preston, the California Supreme Court had found that the sale of tangible items that transferred intellectual property resulted in the sale of taxable tangible personal property,¹¹ and that the sale of internally developed prewritten computer programs was the taxable sale of a tangible asset.¹² The Court noted that the FTB's reliance on these pre-Preston sales and use tax authorities contradicted its position that Preston and the California regulations were inapplicable because sales and use tax authorities do not bear any weight with respect to corporate franchise tax issues.

Furthermore, the Court stated that the trial court was erroneously persuaded by American Business Information, Inc. v. Department of Revenue,¹³ a Nebraska Supreme Court decision, which was distinguishable from the present facts. In American Business Information, the customer acquired computerized information that was relevant to the computation of the taxpayer's sales factor. Unlike the OEM licenses, the American Business Information customers did not acquire a right to replicate or install the software into their products. Rather, they were given the right to use the software.

The Court found it troublesome that the FTB appeared to argue that a 1997 unpublished State Board of Equalization (SBE) decision, Appeal of Adobe Systems, Inc., supported its position.¹⁴ Adobe found that licensing of the taxpayer's software involved intangible property because doing so led to the inclusion of royalties in the sales factor numerator, and greater revenue for the state. This ruling was contrary to the FTB's argument that OEM licenses should be considered tangible property and suggested that the state was merely concerned with a favorable result.

Federal Law Indicates OEM Licenses Are Intangible

Finally, the Court turned to federal law for guidance. The California statutes addressing a water's-edge election had adopted the definition of intangible property contained in the Internal Revenue Code,¹⁵ which states that intangible property includes franchises, licenses, contracts, copyrights, and literary, musical or artistic compositions. Moreover, the federal regulations define "copyright rights" as including the right to make copies of computer programs for distribution to the public by sale or other transfer of ownership.¹⁶ Giving weight to these federal definitions as well as current sales and use tax authorities, the Court determined that the trial court erred in its conclusion and that the gross receipts from bundled OEM licenses were excludable from the sales factor numerator based on the fact that the costs of performance for the royalties were incurred outside the state.¹⁷ However, the Court remanded the matter to the trail court for the determination of the proper tax owed based solely on income derived from the taxpayer's sales of its keyboard and mouse products.

Commentary

This case is the first in California to specifically address the licensing of computer software for purposes of computing the sales factor numerator. The Court of Appeal has established that the transfer of the right to replicate or install prewritten software, regardless of the delivery method of the prewritten software, is sourced to California under the rules applicable to the sourcing of intangible property. That is, the receipts are includible in the sales factor numerator only if the greater proportion of the incomeproducing activity is performed in California, based upon costs of performance. This is a favorable decision for out-of-state taxpayers that license the right to replicate and install software and have the greater proportion of their costs of performance outside the state. In contrast, California taxpayers that ship items to other states and have a greater proportion of their costs of performance in California than in other states will be adversely affected. Note that the Court of Appeal did not address the competing operational and transactional approaches in determining the costs of performance.¹⁸ It appears that the Court of Appeal implicitly used the operational approach, which resulted in the exclusion of all sales from the taxpayer's sales factor numerator because when viewed as a whole, the taxpayer's California costs were minimal in relation to costs incurred in other states. Under a transactional approach, it is possible that the taxpayer would have had to include sales from certain transactions in which the taxpayer incurred more costs in California than in other states.

The different approaches to sourcing revenue from the licensing of software may support refund opportunities, or may cause additional exposure in certain instances. Under prior law, the trial court determined the software licenses were tangible property and sourced the revenue according to the licensee's billing address. The Court of Appeal concluded that the software licenses were intangibles and sourced the revenue according to the location of the licensor's costs. As discussed above, for tax years beginning on or after January 1, 2013, California is replacing the cost of performance method with a marketbased sourcing approach for most taxpayers. Under the new law, the trial court's determination that the software licenses are tangible property would result in the revenue being sourced according to the property's location. The Court of Appeal's conclusion that the software licenses are intangible property would cause the revenue to be sourced according to the location where the intangible is used.¹⁹ With four potential sourcing rules in play (depending upon the tax years at issue and the use of the methodology contained in the trial court versus the Court of Appeal), it stands to reason that taxpayers with material revenue streams from the licensing of software should review their historic and current sales factor sourcing methodology in this area.

Even though the cost of performance rules are not supposed to have an impact for the 2013 tax year and beyond, there is one potential situation in which the cost of performance rules may retain their vitality. The state is still in the process of determining whether a taxpayer could elect to apportion income under a standard equally-weighted apportionment formula under the Multistate Tax Compact,²⁰ in lieu of using California's property, payroll and double-weighted sales factor apportionment formula applicable for tax years beginning on or after January 1, 1993.²¹ The California Supreme Court is likely to have the final say in The Gillette Co. v. Franchise Tax Board case where the Court of Appeal has determined that the Compact was binding upon the state and thus, taxpayers could make the election to apportion their income under a standard equally-weighted formula.²² One of the ancillary effects of making the election to apportion under the Compact is the requirement to use cost of performance sourcing for sales of items other than tangible property, which is the governing rule contained in the Compact. Presumably, the Court of Appeal's conclusion that the software licenses were intangible property would result in the application of the cost of performance rule under the Compact as a means to source receipts from such items.

1 Microsoft Corp. v. Franchise Tax Board, California Court of Appeal, First District, No. A131964, Dec. 18, 2012.

2 In addition to licenses with OEMs, the taxpayer also entered into licenses with delivery service providers (DSPs), companies that license copyrighted proprietary software through authorized replicators and resell the product to smaller OEMs. The taxpayer shipped the software to the DSP on a plastic back-up disk. These disks were then bundled with each unit shipped by the OEM.

3 The parties entered into an agreement to withdraw the accuracy-related penalties imposed for the two years.

4 This is particularly true given the increased importance of the sales factor in the determination of California apportionment. For tax years beginning after 1992 and before 2013, California used a three-factor apportionment formula (property, payroll and double-weighted sales) to apportion income to the state. CAL. REV. & TAX. CODE § 25128(a). For the 2011 and 2012 tax years, taxpayers could elect to use a single sales factor apportionment formula. CAL. REV. & TAX. CODE § 25128.5. For tax years beginning after 2012, most taxpayers must use a single sales factor apportionment formula. CAL. REV. & TAX. CODE § 25128.7. Note that there are certain industry exceptions to the standard apportionment formula, including agriculture business, extractive business, savings and loan activities, and banking and financial businesses. These entities continue to use an equally-weighted three-factor formula. CAL. REV. & TAX. CODE § 25128(b), (c).

5 CAL. REV. & TAX. CODE § 25135.

6 CAL. REV. & TAX. CODE § 25136. For the 2011 and 2012 tax years, taxpayers making a single sales factor apportionment election were required to use market-based sourcing. For tax years beginning after 2012, all taxpayers that are required to use single sales factor apportionment must use market-based sourcing.

7 19 P.3d 1148 (Cal. 2001).

8 CAL. REV. & TAX. CODE § 6011(c)(10)(A). Under this statute, TTAs are defined as agreements under which a person who holds a patent or copyright interest assigns or leases 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.

9 Nortel Networks, Inc. v. State Board of Equalization, 191 Cal.App.4th 1259, Jan. 18, 2011.

10 CAL. CODE REGS. tit. 18, § 1502(f)(1)(B).

11 Simplicity Pattern Co. v. State Board of Equalization, 615 P.2d 555 (Cal. 1980).

12 Navistar International Transportation Corp. v. State Board of Equalization, 884 P.2d 108 (Cal. 1994).

13 650 N.W.2d 251 (Neb. 2002).

14 California State Board of Equalization, Aug. 1, 1997 (unpublished).

15 IRC § 936(h)(3)(B).

16 Treas. Reg. § 1.861-18(b)(1)(i), (c)(2)(i).

17 Although the costs of performance for the PowerPoint program component of the software were incurred within California, the Court deemed the percentage of income attributable to the PowerPoint program to be de minimis.

18 Under the operational approach, the overall cost of performance for the entire income-producing activity is considered, while under the transactional approach, the cost of performance for each separate transaction is considered.

19 See the special sourcing rules provided by CAL. CODE REGS. tit. 18, § 25136-2.

20 CAL. REV. & TAX. CODE §§ 38001 to 38021.

21 CAL. REV. & TAX. CODE § 25128(a).

22 California Court of Appeal, First District, No. A130803, Oct. 2, 2012. Note that the California Supreme Court has extended its deadline for deciding whether to hear this case to February 11, 2013.

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