On October 8, 2015, the California Second District Court of Appeal held that a manufacturer’s sale of software, delivered via tangible personal property (“TPP”), was exempt from sales tax if sold pursuant to a technology transfer agreement (“TTA”). Lucent Technologies, Inc. v. State Bd. of Equalization, No. B257808, 2015 WL 5862533, (Cal. Ct. App. Oct. 8, 2015). In so doing, the court reaffirmed its decision in Nortel Networks, Inc. v. Board of Equalization, 191 Cal. App. 4th 1259, 119 Cal. Rptr. 3d 905 (2011), and offered an informative analysis for bundled transactions in California. Additionally, the court described Lucent as being factually and legally indistinguishable from its 2011 decision in Nortel, and upheld an award to the taxpayer of $2.6 million in reasonable litigation costs after rejecting every legal argument made by the California State Board of Equalization (“SBE”).
California Revenue & Tax Code §§ 6011(c)(10) & 6012(c)(10) provide an exemption from sales tax for software delivered under a TTA, which allows the purchaser to pay sales tax only on the value of TPP, and not on the value of the intangible property (e.g., software) being transferred. The California Tax Code defines a TTA 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.
Similar to the taxpayer in Nortel, Lucent Technologies sold telecommunications equipment containing copyrighted software to companies that would enable those companies to provide both telecommunication and internet services. The contracts provided that Lucent would sell the telecommunications equipment, provide instructions on how to install and run the equipment, develop and produce a copy of the software necessary to operate the equipment, and grant the companies the right to copy the software from storage media onto hard drives and thereafter use the software. Notwithstanding the Nortel decision, the SBE imposed sales tax on the software licensing fees paid to Lucent, resulting in an assessment of nearly $25 million.
The SBE’s main arguments focused on Lucent’s transfer of the software to TPP, thereby allowing sales tax to be assessed on the transactions. By copying the software to a disc or magnetic tape, the SBE claimed that the software was recorded in physical form because the data transferred could be microscopically seen on the discs or tapes and therefore became perceptible to the senses. The court rejected this argument for two reasons. First, such an argument directly contradicted the Nortel decision, and would also be inconsistent with other California cases holding that media used to transfer software is not essential to its later use and is merely a convenient storage medium, which does not cause the transaction to be taxable. Second, the court found that holding for the SBE under this theory would create an “absurd result” since the taxpayer would face a $25 million tax liability for choosing to deliver software through a tangible medium as opposed to transferring it electronically.
The court also rejected the SBE’s argument claiming that that the agreements with the purchasing companies failed to meet the statutory requirement of a TTA. The SBE asserted that in order to qualify as a TTA, the agreement must transfer a “meaningful right,” such as the right to mass produce the item or later sell the copyrighted item. Because Lucent merely granted the right to use the software, the SBE contended that the agreement failed to transfer a “meaningful right,” and did not rise to the level of a TTA. The court dismissed this argument as going beyond the statutory requirements because the requirement that the transferred intellectual property interest be “meaningful” or more than “conventional” does not appear in the text of the statute. The court reemphasized that in order to qualify as a TTA, the taxpayer need only show a single copyright or patent interest transferred (i.e., the right to make a copy or use a patented process would suffice.)
Finally, the court ruled on the proper valuation of the TPP transferred in the transaction. The SBE disagreed with the valuation of the TPP (storage media holding the software) that was subject to tax under the TTA agreement. The TTA statutes provide a tiered valuation structure for determining the proper taxable value, none of which include research and development costs incurred in developing the software embedded in the storage media transferred to customers. The court rejected the SBE’s argument to include the research and development costs in the valuation and stated that the SBE’s position was “little more than a variation on an argument we have already rejected,” essentially reiterating its holding that copying software onto a disc does not transform the software into tangible personal property.
The SBE may appeal the decision to the California Supreme Court within 40 days, with all appeals being discretionary. While not dispositive, it is noteworthy that the SBE appealed the Nortel decision, but was denied review by the California Supreme Court.
GMG Observation: The court in Lucent clarified the threshold for agreements qualifying as a TTA in California. Pursuant to the court’s ruling, as long as a taxpayer can show a single copyright or patent interest was transferred, the agreement may qualify as a TTA in California. Accordingly, taxpayers should consider whether transactions involving the transfer of software would qualify for a potential sales and use tax exemption as TTAs.
Although Lucent is not final (the SBE may petition the California Supreme Court for review), taxpayers who transfer software pursuant to TTA’s should consider filing refund claims with the SBE to protect their rights.
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