Sales Tax Slice: Taxpayers Score a Big Refund Victory—Court Exempts Software Transmitted Using Tangible Storage Media

Compact Disk

Everybody loves a tax refund, especially taxpayers in California who landed a huge victory over the Board of Equalization recently. On October 8, 2015, the Court of Appeals for the Second Appellate District upheld earlier rulings that the sale of software on tangible media is exempt under California’s technology transfer agreement (TTA) statute. The court ordered the State Board of Equalization to pay Lucent Technologies a $24 million sales tax refund and $2.6 million in attorneys’ fees. (Lucent Technologies, Inc. v. State Board of Equalization No. B257808, 2015 BL 332464, (Cal. App. 2d Dist. Oct. 8, 2015)).

This case stems from the BOE’s interpretation of Cal. Rev. & Tax. Code §§ 6011(c)(10) and 6012(c)(10), which exempt intangible personal property and TTAs from sales price and gross receipts. Here, the court clarified (maybe once and for all?) the taxability of the sale of TPP and the transfer of the “right to use software” necessary to use the TPP.

Under the TTA statute, a TTA means “any agreement under which a person holding 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.”

In other words, tax is due on charges for the TPP, but not for the TTA.  The law provides that when a TTA (software) is transferred using physical media (TPP) (e.g. compact disk) as a part of the transaction to copy and use the software, the transaction itself does not turn the software into TPP.  

The California TTA statute also provides “three mechanisms—in declining order of preference—for calculating the value of TPP used in a TTA. Those three mechanisms are: (1) the price stated in the agreement itself; (2) the price at which “the tangible personal property or like tangible personal property has been previously sold or leased, or offered for sale or lease, to third parties at a separate price;” or (3) 200 percent “of the cost of materials and labor used to produce the tangible personal property.”

The BOE argued that copying the software to a compact disk or magnetic tape, rather than transferring it over the internet, transformed the software or the rights to use it into TPP, thus making it subject to tax.  However, the court already decided this issue and established precedent in Nortel, where it determined “that software does not yield a taxable transaction because the tape or disc is “merely … a convenient storage medium [used] to transfer [the] copyrighted content” and hence not in itself essential or physically useful to the later use of the intangible personal property.” The Court in Nortel held that canned software qualified as a TTA under Cal. Rev. & Tax. Code §§ 6011(c)(10) and 6012(c)(10), and is exempt from sales and use tax.

What will the BOE do now about pending refund claims that were waiting on the outcome of this case? In an attempt to mitigate the effects of the Nortel ruling, the BOE made an unsuccessful play to insert language into a budget trailer bill back in June 2013 that would have retroactively overturned the effects of Nortel and extinguished any pending refund claims related to the TTA laws. The Bloomberg BNA Daily Tax Report noted the language would have broadened the definition of “storage media” and the software proposal would have declared that prepackaged software sold on storage media is always tangible property that is subject to sales tax.

Perhaps the BOE will revisit legislation instead of pursue litigation, it certainly would be less costly for taxpayers.

Continue the discussion on LinkedIn: What should the BOE do to limit the impact of other potential taxpayer claims based on the decision in Nortel and Lucent?

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