State Sales & Use Tax Alert
Nortel Provides an Opportunity to Minimize Sales & Use Tax on Purchases of Prewritten Software
Nortel Networks, Inc. v. State Board of Equalization (1/18/11) - A California Court of Appeal recently ruled that Nortel Networks, Inc. was entitled to a refund of California sales tax paid on software that it licensed to operate switching equipment in the State. In its analysis, the Court determined that "the software licensed by Nortel was exempt from sales tax under the Technology Transfer Agreement (TTA) statutes.
The TTA statutes apply when the transfer of patents and copyrights is at issue. Under the TTA statutes, a licensing agreement is exempt from sales tax if it is a TTA. An agreement is a TTA if (i) the holder of a patent or copyright assigns or licenses to another person the right to make and sell a product that is the subject of the patent or copyright interest, or (ii) the holder of the patent or copyright interest assigns or licenses "a process" that is subject to the patent or copyright. Contrary to the Board's assertions, the Court determined that the TTA statutes cover agreements licensing the right to make and sell a product or to use a process that is subject to the patent or copyright interest, even if a tangible product is not being sold.
Significantly, the Court also found that the Board exceeded its authority by excluding in its regulations all prewritten computer programs - even those that are the subject to a patent or copyright interest - from the definition of a TTA. Rather, the Court found that the TTA statutes apply to any agreement that involves the sale or license of copyrighted materials or patented processes, including agreements transferring the rights to prewritten computer software. Accordingly, Nortel was entitled to recover sales tax on its licenses of prewritten computer programs that were subject to patent and copyright interests.
Potential Refund Opportunity - Based on Nortel, taxpayers who license prewritten computer software subject to a patent or copyright interest in California may have an opportunity to seek refunds of sales tax paid if the software licenses qualify as TTAs. Since most commercially available software is subject to patents/copyrights, the Nortel decision could have a significant impact on the sales and use tax treatment of prewritten software licenses in the state.
Other Considerations - The Nortel decision and developments in the methods of transferring technology and licensing software should serve as an impetus for corporate tax departments to reevaluate the taxability of their software purchases/licenses for sales and use tax purposes in all jurisdictions. In addition to determining if such licenses may qualify as a TTA, consideration should be give to the following factors:
Is the software canned or custom? Most states have provisions providing that prewritten (or "canned") software is taxable while custom software is not. For this purpose, pre-written software is generally defined as a computer program or other prewritten application offered for general or repeated sale or lease, while custom software is software developed and designed to the specifications of a specific purchaser. Since the definitions of such terms may differ amongst the various jurisdictions, and different rules may apply when prewritten software is modified, taxpayers should continue to properly classify their software purchases as canned or custom.
How is the software delivered? Some states determine whether software is taxable tangible personal property or nontaxable intangible property based upon how the software is transferred (i.e., software transferred using a CD-ROM is taxable while software downloaded electronically is not). Accordingly, taxpayers downloading electronic copies of software or accessing software applications through the Internet may have opportunities to reduce or recover sales and use tax in such states.
Where does the sale of the software take place? While some states, like New Jersey, tax software at the location in which the master copy of the software is received, more and more states, like New York, are applying a multijurisdictional approach and taxing software in each location where the use of the software will occur. The contrasting approaches to sourcing software sales may create opportunities for taxpayers to structure software purchases in a tax efficient manner.
Do any other exemptions apply? Even if software is taxable under the foregoing rules, it may still be exempt from tax under other provisions. For example, several states provide exemptions for software that is used in manufacturing production or research and development.
If you have any questions regarding this alert please contact Chris Vignone at (914) 798-9903 or cvignone@gmgconsulting.com.
For more information about Grant McCarthy Group and its services, please visit our website at www.gmgconsulting.com.