In Lucent Technologies, Inc. v. State Board of Equalization, 193 Cal. Rptr. 3d 323 (Cal. Ct. App. October 8, 2015), cert. denied January 20, 2016, the California Court of Appeal held that software transferred in conjunction with the concurrent license to copy and use the software was not subject to California sales tax, despite the fact that the software was delivered via magnetic tapes and compact discs, i.e., a tangible medium. As discussed below, the Court of Appeal’s decision addresses the arguments presented by the California Board of Equalization (“Board”) and appears to provide alternative grounds for exemption: one related to bundled transactions of tangible and intangible property and the other related to intangible property transferred pursuant to a Technology Transfer Agreement (“TTA”). Both grounds favored Lucent Technologies, Inc. (“Lucent”).
Lucent manufactured and sold telecommunications switching equipment (“switches”) to its telephone company customers. The switches routed telephone calls or data streams to the appropriate destinations on the network and performed other ancillary telecommunication services, such as call waiting, caller ID, three-way calling, voicemail, etc. Lucent also designed the software necessary to operate the switches and licensed it to its customers. The software was copyrighted, and it enabled its customers to use at least one of the patents held by Lucent.
Between January 1,1995 and September 30, 2000, Lucent entered into contracts with its customers to (a) sell the switches; (b) provide instructions on how to install and run the switches; (c) develop and produce a copy of the software necessary to operate the switches; and (d) grant the companies the right to copy the software onto the switch’s hard drive and use the software uploaded onto the switches. Lucent provided the software to its customers via magnetic tapes or compact discs, and the companies paid for the licenses to copy and use Lucent’s software on their switches.
The ultimate issue was whether the software and the licenses to copy and use the software were subject to California sales tax. The Board contended (1) that the software and licenses were taxable as tangible personal property; (2) that the contracts between Lucent and its customers did not constitute TTAs pursuant to which the software and intangible property would be exempt from sales tax; and (3) that, even if the contracts were TTAs, Lucent did not establish the cost of developing the software, rendering the entire transaction taxable. The California Court of Appeal relied on California precedent to dismiss the Board’s arguments and held (1) that the transmission of software on tangible magnetic tapes or compact discs as part of a transaction granting a license to copy and use the software did not transform the software into tangible personal property subject to the sales tax; (2) that the contracts between Lucent and its customers qualified as TTAs; and (3) the value of the blank media is the relevant value of the tangible personal property subject to tax pursuant to the TTAs.
California Default Rule for Bundled Transactions Involving Tangible and Intangible Property
To reach its conclusion that software transferred on tangible media was not tangible personal property, the Lucent court set forth and applied the relevant sales tax framework applicable to transactions involving both taxable and non-taxable components: “(1) whether the taxable and not-taxable components are ‘inextricably intertwined’ rather than ‘readily separable’; and if they are inextricably intertwined, (2) whether the not-taxable component is a service or is intangible personal property.” If the taxable and non-taxable components are “readily separable,” the sales tax is only imposed on the sale of the taxable components.
If the taxable and non-taxable components are “inextricably intertwined,” the applicable test depends on whether the non-taxable component is a service or an intangible. If the non-taxable component is a service, “a court is to determine whether the ‘true object’ test of the transaction is the sale of tangible personal property or instead the performance of a service.” On the other hand, if the non-taxable component is intangible property, such as a software license, inextricably intertwined with a taxable component, such as a magnetic tape or disc on which the software is embedded, “the default rule is to determine whether the tangible portion of the transaction is ‘essential’ or ‘physically useful’ to the purchaser’s subsequent use of the intangible property.” If so, then the entire transaction is taxable, and the Court cited film negatives, master audio recordings and artwork to be used to make rubber stamps as examples of tangible property essential to the purchaser’s subsequent use of the intangible property. But, if the tangible property is not essential or otherwise physically useful to the buyer’s use of the intangible property, then the entire transaction is not subject to tax.
Applying this test, the California Court of Appeal found that the tangible media upon which the software was transmitted was not essential to the buyer’s use of the software license. Thus, the Court concluded that the transfer of the software onto magnetic tapes or discs for subsequent installation and use on switches did not convert the software into tangible personal property subject to California sales tax. The Court further noted that the Board’s position would lead to an absurd result – holding Lucent liable for $24.7 million in tax simply because it transferred software on magnetic tapes and discs rather than by electronic upload or email.
Intangible Property Transferred Pursuant to a TTA
In addition to finding that the software licenses were not taxable as tangible personal property, the Court also found that the Lucent software licenses would not have been taxable pursuant to the exemption provided for intangible property transferred pursuant to a TTA. A TTA is an 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.” Cal. Rev. & Tax Cd. §§ 6011(c)(10)(D); 6012 (c)(10)(D).
Consistent with the test articulated above for a mixed transaction with “readily separable” taxable and non-taxable components, California’s rules relating to TTAs also provide that only the taxable component of the transaction is taxed, and the intangible, non-taxable component is not taxed. Specifically, “a taxpayer who enters into a contract that qualifies as a technology transfer agreement is required to sort the tangible personal property from the intangible, and to pay sales tax on the tangible personal property that is transferred but not on ‘the amount charged for [the] intangible personal property transferred.’” See Lucent. See also Cal. Rev. & Tax Cd. §§ 6011(c)(10)(A), 6012(c)(10)(A). The value of the tangible property is determined by using one of the following methods, listed “in declining order of preference. . . : (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’. . . .” See Lucent. See also Cal. Rev. & Tax Cd. §§ 6011(c)(10)(A)-(C), 6012(c)(10)(A)-(C).
The Court found that Lucent’s contracts with its customers qualified as TTAs because they met all of the requirements of the statutory definition. Lucent held and licensed copyrighted and patented software property, meeting the requirement that a person hold a patent or copyright. Lucent provided the telephone companies a license to reproduce its copyrighted software onto the switches, meeting the remaining TTA requirements that such a holder of a patent or copyright interest assign or license “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.” Cal. Rev. & Tax Cd. §§ 6011(c)(10)(D); 6012 (c)(10)(D). As a result, the Court found that the Lucent contracts were TTAs, noting that its prior decision in Nortel Networks, Inc. v. State Board of Equalization, 119 Cal. Rptr. 3d 905 (Cal. Ct. App. 2011), a case dealing with an almost identical transaction that was found to qualify as a TTA, was “exactly on point and came to the same conclusion.”
In determining that the Lucent contracts were TTAs, the Court made two key findings that should be of interest for taxpayers attempting to qualify for TTA treatment. First, the Court noted that “[t]he transfer of a single copyright interest is sufficient” to qualify as a TTA, meaning that a single copy of the software from a disc onto a switch was adequate for TTA purposes. Second, the Court rejected the Board’s suggested requirement that the TTA statutes are inapplicable unless the taxpayer made a prima facie showing that “absent the right-to-use licenses in the agreement, [its] customers would have infringed on [the taxpayer’s] patent or copyright interests when using the acquired software.” The Court dismissed the Board’s proposed requirement, not only because it does not appear in the TTA statutes, but also because it would effectively nullify the TTA statutes by turning “every taxpayer refund action involving the technology transfer statutes into a full-blown copyright and/or patent trial. . . . to refute every possible copyright and patent defense. . . .”
After finding that the Lucent contracts were TTAs, the Court dismissed the Board’s claim that the tangible property component transferred pursuant to the TTAs was not properly established in the TTAs. The Court found that “the price of blank media is the price of the tangible personal property, and is what is to be taxed under the technology transfer agreement statutes.”
Lucent-based Refunds and Prospective Effects
The Board appealed the Court of Appeal’s decision, and the California Supreme Court denied the Board’s petition for review on January 20, 2016. The Board is in the process of considering the effects of Lucent, and the Board’s Legal Department issued a memorandum on March 18, 2016, outlining its recommendations and indicating that the Board’s staff is prepared to begin processing refund claims for which they can “verify the existence of a software TTA between an exclusive holder-retailer and a purchaser-licensee pursuant to the subsequent use of the licenses regarding that software.”
The Board’s Legal Department recommended that the regulations relating to TTAs and Computers, Programs, and Data Processing (Cal. Code Regs. tit. 18, §§ 1502, 1507) be amended “to clarify the requirements to establish that an agreement for the transfer of software on tangible storage media is a software TTA, in accordance with the primary holding in Lucent, and clarify the measure of tax when software is transferred under a software TTA.” The Board’s Legal Department also recommended that the Board issue a notice to clarify that:
“(1) the typical off-the-shelf retail sale of canned, mass marketed software still does not constitute a software TTA because the typical retailer can only sell tangible storage media and does not hold any intangible copyright or patent interest in the software to transfer with the storage media; and (2) Lucent is only dispositive with respect to software transmitted on tangible storage media that is wholly collateral to the subsequent use of the licenses regarding that software and is not dispositive with respect to embedded non-custom software or pre-loaded non-custom software, which were not at issue in Lucent.”
While the Board has not yet issued any firm guidance on Lucent, its Legal Department’s recommendations may provide taxpayers with a preview of some aspects of the Board’s prospective position, which could be in tension with Lucent’s bundled transaction rule applicable to a transaction containing tangible and intangible property. If the Board were to adopt a “wholly collateral” standard relating to tangible property in lieu of the “not essential” or “physically useful” standard articulated by the Court, audit disagreements could be reasonably anticipated to ensue.
Software sellers should consider whether they are eligible for refund claims filed pursuant to Lucent. Even though they may not be eligible for refunds based on their historical business model, such companies should evaluate whether they can adjust their business model on a prospective basis to qualify for sales tax exemption pursuant to Lucent, keeping in mind that such a position could be subject to challenge depending on the Board’s eventual response.
Contact the author: Drew Hemmings
This article originally was originally published in the April 2016 edition of Tax News and Developments (Volume XIV, Issue 2) and is available under insights at www.bakermckenize.com.
