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September 26, 2012

Last year's Nortel Networks decision spurred a spate of optimism and activity surrounding potential sales tax refund opportunities and planning considerations for certain transfers of prewritten software. To the consternation of industry groups, however, the California State Board of Equalization (SBE), while acknowledging some of the favorable aspects of Nortel, has until now posited interpretations that would severely limit its applicability. Recently, there have been a few signs that some compromise could take shape in revised SBE regulations expected to be proposed early next year. But, given other pending litigation, don't expect much yet.

This controversy was born in 1993 when the California State Legislature enacted technology transfer agreement (TTA) exemption statutes over the objection of the SBE. The statutes broadly exempt the amount charged for intangible personal property transferred with tangible personal property in any TTA, if a reasonable price is separately stated for the tangible personal property. The SBE feared the broad language would exempt software licensing agreements that limit the buyer to conditional use of the program. The real fear was the significant potential tax revenue loss.


In Nortel Networks Inc. v. State Board of Equalization (191 Cal.App.4th 1259, Jan 18, 2011; petition for review denied, Cal. Sup. Ct., No. S190946, April 27, 2011), the California Court of Appeal held that Nortel's license of Switch-Specific Programs (SSPs) and certain related prewritten software programs met the definition of a technology transfer agreement and was therefore exempt from sales tax, even though the SSPs were not "custom" software. To be exempt, the prewritten software being sold also needed to be subject to a copyright or patent interest. The Court of Appeal further held that the SBE had exceeded its authority in excluding by regulation all prewritten computer programs from the definition of what qualifies as a TTA. Two similar cases are expected to be heard soon involving Lucent Technologies.

SBE Current Positions:

A) The Good

The SBE states that if you hold patent or copyright interests in non-custom software and you make retail sales of the software on tangible media, then a portion of the proceeds from your retail sales of the software may be excluded from your gross receipts subject to sales tax. Likewise, if you purchase non-custom software on tangible media in a transaction that is subject to use tax from a retailer who holds patent or copyright interests in the software, then a portion of the price you paid for the software may be excluded from the sales price of the software that is subject to use tax.

B) The Catch ---- SBE Will Not Concede Core Assertions from Industry

1. Assertion of a Broad Nortel Exemption ---- Off the Shelf 

Industry groups have asserted that >Nortel establishes a broad exemption for all sales of non-custom computer programs transferred on tangible storage media because practically all computer programs are subject to copyrights and the Court of Appeal cited Preston in holding that "transferring the right to reproduce [a] copyrighted work is a TTA."

The SBE responds that the TTA statutes create a "holder requirement" where the seller must hold a patent or copyright interest. Following the Nortel decision, the SBE issued a news release claiming that Nortel does not affect sales tax imposed on off-the-shelf software because the typical retailer does not hold copyright or patent interests in the software. Thus, for an agreement to qualify as a TTA, the retailer must be able to provide documentation from the United States Patent and Trademark Office documenting that the retailer obtained the patent, or, in the case of a copyright, the retailer must be able to provide a certificate from the U.S Copyright office or other reasonable and satisfactory documentation to establish original ownership or authorship of the copyrighted work. If the retailer obtained the patent or copyright interests from another party, the retailer must be able to provide written documentation to show that it held the patent or copyright interests at the time of sale. If you are the purchaser of the software seeking a refund, you will still be required to provide written documentation establishing that the retailer held the patent or copyright interests at the time of the sale.

2. Valuation of the Taxable Measure

Industry groups have asserted that valuation of the measure of sales and use tax in TTAs involving the transfer of non-custom computer programs encoded on tangible storage media (i.e., the disk, thumb drive, etc.) should be limited to the cost of the storage media, alone, based on the measure of tax ultimately upheld in Nortel.

The SBE's response is that Nortel didn't address the issue and has limited precedential impact, and that such a policy is neither legally justified nor appropriate. Furthermore, the SBE does not concede that refunds are due in the Lucent and Lucent II lawsuits. The Nortel decision is fact specific, and a broad reading of Nortel would be inconsistent with the language of the TTA statutes, the Legislature's intent in enacting the TTA statutes, the provisions of Regulation 1507, and the California Supreme Court's and Court of Appeal's holdings in Navistar and Touche Ross regarding the taxation of the transfer of tangible media upon which computer programs have been encoded. It is interesting that legislative intent is asserted when the Legislature evidently ignored the warnings of the SBE upon enactment.

Mechanical guidance from the SBE provides that sales tax generally applies to a retailer's gross receipts from the sale of tangible personal property, while use tax applies to the sales price of tangible personal property. When tangible personal property is transferred with patent or copyright interests under a TTA, the taxable gross receipts from the sale of the tangible personal property or the sales price of the tangible personal property is:

  1. The separately stated reasonable price for the tangible personal property stated in the TTA; or
  2. If there is no separately stated reasonable price in the TTA, the separately stated reasonable price at which the tangible property or like tangible personal property was previously sold by this retailer or by a third party; or
  3. If there is no separately stated reasonable price available, 200 percent of the cost of the materials and labor used to produce the tangible personal property.

The SBE further provides that the cost of the materials and labor used to produce tangible personal property includes the software development costs of non-custom software imprinted on tangible media. Establishing the software development costs for each sale of software may be no easy task.

Optional Percentage for Valuation and Industry Study

Because of the difficulty in establishing the taxable portion of a TTA's lump-sum sales price for non-custom software and patent or copyright interests, the SBE approved a cooperative study with industry groups to determine the feasibility of adopting an optional percentage that can be applied to a TTA's lump-sum sales price to estimate the amount paid for the tangible personal property transferred under the TTA if the 200 percent formula had been used. Only one company came forward offering to participate in the study, and there has been no study yet, but the SBE may adopt an optional percentage in the future.

Interested Parties Process and Amending the SBE Regulation

In March 2012, an interested parties process was started to discuss whether Regulation 1507 should be amended to explain when an agreement involving the transfer of software on tangible storage media qualifies as a TTA and how tax applies to the sale of tangible personal property transferred in a software TTA.

Partly because of the uproar from the business community about the SBE's amendment proposals in its June discussion paper, the second interested parties meeting has been postponed from September 2012 to January 2013 to buy time to receive more comments and to try to work out a compromise. The proposed regulations, which industry groups assert may not be valid, had been scheduled to be issued in November but have now been postponed until after the January interested parties meeting. Hopefully, some positive compromises can be reached. 


Alvarez & Marsal Taxand Says:

While industry groups are unhappy with the SBE's current party line, which must in part be motivated by their soon-to-be-heard defenses in the two Lucent cases, the Nortel case has indeed provided opportunities for refunds and planning. Time will tell how broad these opportunities will become, and we may know more after the Lucent cases and after the next round of proposed regulations following the January interested parties meeting. 

In the meantime, consider the following: 

  1. Wherever possible, separately state a reasonable price for the tangible personal property stated in your TTAs. This should avoid the 200 percent mark-up method. 
  2. You may have filed protective refund claims ---- consider adding another year before the statute of limitations runs. 

For current and future transactions, you can conservatively treat sales and purchases of software transferred on tangible storage media as subject to tax, and file protective refund claims. Or, you may consider certain transactions exempt sales of TTAs, where you must allocate the gross receipts or sales price of the software licenses between taxable tangible personal property and nontaxable intangible property. If the latter, consider the documentation and valuation obstacles you may have to overcome.


As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer. 

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.