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.


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.


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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Similar Articles
Relevancy Powered by MondaqAI
Morrison & Foerster LLP
In association with
Related Topics
Similar Articles
Relevancy Powered by MondaqAI
Morrison & Foerster LLP
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions