United States

California: Appeals Court Affirms Decision Holding that Software Licenses Transferred Pursuant to a Technology Transfer Agreement Are Exempt from Tax

Oct 19, 2015
From KPMG TaxWatch

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The California Court of Appeal, 2nd District, in a decision certified for publication, recently ruled that software licenses transferred with telecommunications switching equipment were exempt from sales and use tax. The taxpayer at issue manufactured switching equipment and licensed software that enabled customers to operate the switching equipment. Specifically, customers that purchased equipment and software from the taxpayer also received the right to copy the software onto hard drives to operate the switching equipment. Under California law, sales and use tax does not apply to intangible personal property transferred with tangible personal property as part of a Technology Transfer Agreement or TTA. However, sales tax does apply to the tangible portions of the transaction. A TTA is defined broadly 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.”

In an earlier case, Nortel, the California appeals court (4th District) held that a taxpayer’s software licensing agreements constituted TTAs, and therefore sales and use tax was not imposed on software (and the right to copy the software) transferred as part of the TTA. As in Nortel, the issue before at the trial court level in Lucent was whether the software licenses were taxable, or whether the transaction was exempt from sales and use tax because it was sold under a TTA. Although the State Board of Equalization (Board) tried to distinguish Nortel and raised additional arguments that the taxpayer’s agreements were not TTAs, the taxpayer argued, and the trial court agreed, that the Nortel decision controlled as the agreements at issue were indistinguishable from those in Nortel.  The trial court also awarded the taxpayer “reasonable litigation costs” of over $2.5 million after determining that the Board’s position in the litigation was not substantially justified. After the trial court granted summary judgment in favor of the taxpayer, the Board appealed.

On appeal, the Board argued that the trial court’s ruling was erroneous for three reasons. First, the Board argued that (apparently despite the TTA statute) the software was taxable tangible personal property because the software was placed onto tapes and discs for transfer to telecommunications company customers. The court, after reviewing the facts, determined that the taxpayer’s decision to give the telecommunications companies copies of the software on magnetic tapes and compact discs (rather than over the Internet) did not turn the software itself or the right to use it into “tangible personal property” subject to sales tax. If it were to accept the Board’s position, the court noted that the taxpayer would be liable for nearly $25 million in sales tax simply because it decided to transmit software to customers using tapes and discs. The taxpayer would have had no sales tax liability if had instead transmitted the software electronically. The court concluded that this would lead to an absurd result.  

Second, the Board argued that even if the software was not tangible personal property, the contracts at issue were not TAAs. Although the court noted that the Nortel case was directly on point, it nevertheless addressed the Board’s two arguments that it should reach a different result in this case. The Board first attempted to argue that a contract can qualify as a TTA only if the manufacturer transfers “meaningful” copyright and patent rights, which the Board defined as “the right to mass-produce or sell downstream some patented or copyrighted item.” The court rejected this argument, noting that nothing in the TTA statute required the rights transferred to be “meaningful” and that this position was inconsistent with federal copyright law, which allows copyrighted works to be transferred piecemeal. Secondly, the Board asserted that the TTA statutes are inapplicable unless and until the taxpayer makes “a prima facie showing that absent the right-to-use licenses in the agreements, customers using the software would have been engaging in copyright or patent infringement. The court again declined to add this requirement into the TTA statute. Finally, the court rejected the Board’s position that even if the contracts qualified as TTAs, the taxpayer did not sufficiently establish the cost of developing the tangible personal property component of the agreement so the entire transaction was taxable.

Next, the court held that the trial court properly awarded the taxpayer “reasonable litigation costs” despite the Board’s view that it was entitled to another “bite at the apple”—meaning that it should not be too quickly forced to adopt legal results that are inconsistent with the Board’s own understanding of the law. In reaching this conclusion, the court observed that the position the Board took in this case had been rejected by the Legislature, rejected by several courts interpreting the relevant statutes, and specifically rejected by Nortel. Despite this, the Board continued to fight the taxpayer’s refund action, countersued for more than $18 million, propounded thousands of discovery requests, and generated a 20,000 page record on appeal. Please contact Chris Craft at 858-750-7301 with questions on the Lucent decision.

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The following information is not intended to be "written advice concerning one or more federal tax matters" subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.

The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.