The following article was originally published in Spidell‘s July, 2011 issue of “California Taxletter”
The California Supreme Court has denied the State Board of Equalization’s (BOE) Petition for Review of the 1-18-11 Appeals Court Decision. In that decision, the California Court of Appeal ruled that software licensed by a taxpayer to operate switching equipment was exempt under Revenue and Taxation Code Section 6011 & 6012, as it qualified as a Technology Transfer Agreement. The case involved software sold by Nortel to PacBell. In the end, Nortel was awarded a refund of over $29 million, plus costs and interest.
The software in question was copyrighted, contained a patented process, and enabled the licensee to copy the software and make and sell products (telephone calls) that embodied the patents and copyright. The BOE’s attempt to limit the scope of exempt Technology Transfer Agreement (TTA) by adopting Regulation 1507, which excluded all prewritten software including software that assigned or licensed a copyright or patent interest for the purpose of reproducing and selling other property subject to the copyright or patent interest, was overturned by the court.
Before the TTA Legislation was passed in 1993, the Appeals Court noted that the Board objected. The Board warned the legislature that the language exempting TTA from sales tax was too broad. In fact, they specifically pointed out that software could be included in this exemption. Despite the Board’s concerns, the legislature enacted the TTA provisions without excluding software. Nonetheless, the Board created Regulation 1507 which excluded software even though this was not in the TTA Statute. Although the BOE has the authority to create regulations, they do not have the authority to change the scope of the controlling statute.
For that reason, the Court of Appeals rejected this portion of the Regulation, and stated the Board exceeded its authority by adopting it. It found that TTA statutes do not restrict agreements transferring an interest in pre-written (or canned) software. Instead, the exemption applies to any agreement.
Because the TTA statutes under 6011 (c) (10) (d) & 6012 (c) (10) (d) cover “any agreement” that involves the sale or license of copyrighted material or patented processes, The Board cannot exclude prewritten software that is subject to a copyright or patent thereby creating an exception the legislature did not see fit to make. The companion Regulation 1502 stating prewritten software transferred in tangible form is taxable will also need to be revised to reflect this decision.
However, not all prewritten or canned software is exempt. Only the transfer of a program that is subject to a patent or copyright is a TTA. Per Revenue & Taxation Code Section 6012 (c) (10) (d), a TTA means 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.
Since most computer software is subject to copyright and/or involves patented processes, taxpayers who sell prewritten computer software and have been collecting California sales or use tax on such sales should consider filing claims for refunds. Additionally, customers who have paid California sales tax on purchases or licenses of prewritten software should work with vendors to file claims for refund. Also, consumers who have paid use tax directly to the SBE should also file claims for refund as well.
In a sales tax refund claim, the SBE will most likely take the position that the claimant (seller) will have the burden of proving they were the party that held the patent or copyright interest and assigned or licensed that interest to the party they sold it to. Per Regulation 1700, they will also only be given a refund if they refund the tax to the person from whom it was collected.
If the claimant is the Buyer (use tax transaction), they will also have the burden of showing the purchase was from a person who held the patent or copyright interest, and such interest was transferred.
This is a major case that will have far reaching applications to many businesses. The opportunity for potential refunds should not be overlooked. Each case will have unique facts and circumstances. You may contact me for a complimentary consultation to ascertain if a potential refund exists for you or your clients. Please email me your questions, comments and/or specific facts and circumstances to firstname.lastname@example.org