United States: California Court Holds Software Agreements Exempt From Sales

On September 27, 2013, the California Superior Court ruled in a summary judgment that software agreements to operate telephone switching equipment were qualified technology transfer agreements (TTAs) and exempt from sales tax under California statutes.¹ Thus, the taxpayer was entitled to a refund of more than $24 million in sales and use tax. In its determination, the Superior Court noted that the facts in this case were indistinguishable from those at issue in the California Court of Appeal's decision in Nortel Networks.² In that decision, software licensed by Nortel and included in its telephone switching equipment was determined to be exempt from sales tax under the TTA statutes.

Background

Lucent, a global supplier of products and services supporting landline and wireless telephone services, the Internet, and other public and private data, voice, and multimedia communications networks using terrestrial and wireless technologies, manufactured and sold switching equipment to its telephone customers. The equipment allowed the customers to provide telephone calling and other services to the end customers. In order to operate the switches, software provided on storage media was transferred to the telephone customers pursuant to written agreements.

The issues considered by the court were whether the software agreements at issue were TTAs as a matter of law, and if so, whether there was a triable issue of fact as to the amount of the refund due to Lucent based on the value of the tangible personal property transferred.

Licensing Agreement Is Defined Technology Transfer Agreement

In California, a transfer of intangible personal property is not subject to sales tax. Intangible personal property is defined as property that is a "right" rather than a physical object.³ Intellectual property is an intangible right that exists separately from the physical medium that embodies it. Intangible property includes a license to use information under a copyright or patent.⁴ Additionally, 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."⁵ If a reasonable price for the tangible personal property element is not separately stated, two alternative methods for valuation must be considered.⁶

The statutory definition of a TTA is met if: (1) the holder of a patent or copyright assigns or licenses to another person "the right to make and sell a product" that is subject to the patent or copyright interest; or (2) the holder of a patent assigns or licenses a "process" that is subject to the patent.⁷ A product is subject to a copyright interest when it copies the protected expression or incorporates copy of the protected expression.⁸ In other words, a copyright only confers the "sole right of multiplying copies,"⁹ whereas a license of a patent interest gives the licensee the right to actually make a product or use a process.¹⁰

Lucent manufactured and sold switches to its customers, including telephone company customers. The switches were responsible for processing telephone calls and operating hundreds of features. Each switch was operated by a "switch-specific software program" (SSP) that was uniquely created for that switch to enable the switch to perform the particular functionalities desired by the telephone company customer. The SSP was included along with basic code and other necessary integrated information on the switch hard drive and enabled the switch to perform its desired function. The software agreements between Lucent and its customers allowed customers to utilize the software in the switches.

Similarly, in the Nortel decision, Nortel designed, manufactured, and sold switches to customers which would process telephone calls and handle desired features. The switches required software to perform their desired functions, so Nortel entered into "licensing agreements" giving its customers the right to use Nortel's software programs in the switches. The California Court of Appeal, in reaching its decision that the software licensed by Nortel to operate the switching equipment was exempt from sales tax as TTA, noted that the software: (i) is copyrighted; (ii) contains patented processes; and (iii) enables the licensee to copy the software, and to make and sell products – telephone calls – embodying the patents and copyright. ¹¹

Lucent and the State Board of Equalization (SBE) agreed that the storage media and documentation transferred with the software pursuant to the agreements was subject to sales tax, as well as the value of such property. However, the SBE argued that the computer code, since it was stored on a physical medium (the switches), also was tangible personal property, the sale of which was subject to sales tax. Testimony from an intellectual property expert was offered to support this position, which the Superior Court found to be both irrelevant and contrary to the conclusion reached in Nortel. Furthermore, the Superior Court found that no triable issue of material fact existed as to whether the agreements between Lucent and its customers were TTAs.

The Superior Court concluded that the Nortel decision was directly on point and controlling. The software licensed by Lucent and included in its switches transferred an interest in intangible property that was subject to patents and copyrights and, as a result, was exempt from sales tax under the TTA statute.

In granting Lucent's motion for summary judgment and approving the refund of overpaid sales tax, the Superior Court did not address whether Lucent was due any associated prejudgment interest and, if so, the amount, as the prepared briefs did not speak to this issue. A hearing is scheduled for November 18, 2013 to determine the issue of prejudgment interest.

Commentary

A central issue in the Nortel case was a California regulation which provided that a TTA "does not mean an agreement for the transfer of prewritten software" as defined in other SBE regulations.¹² The Court of Appeal concluded that the SBE had exceeded its authority by excluding all prewritten computer programs from the definition of what could be included in a TTA and the offending language has since been repealed.

The Court's broad interpretation of the TTA statutes, particularly to the application of prewritten software, created potential refund opportunities for some taxpayers, especially in light of the fact that the SBE did not appeal the Nortel decision.

Following the decision in Nortel, the SBE published a press release claiming that Nortel does not affect sales tax imposed on off-the-shelf software.¹³ Specifically, the SBE announced that with respect to the typical off-the-shelf retail sale of canned massmarketed software, such items would still be taxable because the typical retailer does not hold copyright or patent interests in the software.

The SBE is currently engaged in what has proven to be a lengthy process addressing how to revise the statutes and regulation to set criteria to qualify software as a TTA. An interested parties meeting was most recently held in January 2013 to discuss whether the TTA regulations should be amended for clarification. Industry representatives and SBE staff have not yet reached a consensus regarding the application of the TTA statutes. Current points of contention include: (i) whether prewritten software recorded on tangible storage media is tangible personal property subject to sales tax; (ii) the proper treatment of embedded patented processes; (iii) the treatment of transactions involving related entities; and (iv) the valuation of tangible storage media containing prewritten software for sales tax purposes. Further interested parties meetings are expected to be held to continue these discussions. In the meantime, companies with fact patterns similar to those presented by Nortel and Lucent should consider treating software agreements transferred in conjunction with tangible storage media as TTAs exempt from California sales tax. The SBE has provided information regarding taxability of software agreements, including how to determine if a sale or purchase of software qualifies as a TTA on its Web site.¹⁴

Footnotes

1. Lucent Technologies v. State Board of Equalization, Cal. Superior Court, Los Angeles County, Dkt. No. BC402036, Sep. 27, 2013.

2. Nortel Networks Inc. v. Board of Equalization, 119 Cal. Rptr. 3d 905 (2011).

3. See Preston v. State Board of Equalization, 615 P.2d 555 (Cal. 1980). Intangible property is distinguishable from tangible personal property, which is defined as "personal property which may be seen, weighed, measured, felt, or touched, or which is in any other manner perceptible to the senses." CAL. REV. & TAX. CODE § 6016.

4. Id.

5. CAL. REV. & TAX. CODE §§ 6011(c)(10)(A); 6012(c)(10)(A).

6. CAL. REV. & TAX. CODE §§ 6011(c)(10)(B), (C); 6012(c)(10)(B), (C). To determine the price of the tangible personal property element for sales tax purposes, the property is first valued at the amount for which it was previously sold, leased, or offered for sale or lease to third parties at a separate price. If the actual personal property or like property was not previously sold, leased, or offered for sale or lease to third parties at a separate price, the retail fair market value is equal to 200 percent of the cost of the materials and labor used to produce the tangible personal property subject to tax.

7. CAL. REV. & TAX. CODE §§ 6011(c)(10)(D); 6012(c)(10)(D).

8. See Preston, 615 P.2d 555.

9. Id.

10. Id.

11. Nortel Networks Inc. v. Board of Equalization, 119 Cal. Rptr. 3d 905 (2011).

12. CAL. CODE REGS. tit. 18, § 1507(a)(1) (language later repealed).

13. "Nortel Case Does Not Affect Sales Tax On Off-The-Shelf Software," California State Board of Equalization, NR 66-11-H, May 27, 2011.

14. For additional information on TTAs, see the SBE's Web site at http://www.boe.ca.gov/sutax/stta.htm#2.

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