California says no sales tax on certain licensed software…
With California’s current budgetary and fiscal issues, the State has attempted to come up with new ways to increase revenue (see my previous blog post on the Amazon sales tax). But doing so through a sales tax on certain software transactions is still a no-no in this State. This rule applies to any transfer of non-tangible intellectual property subject to a patent or copyright.
Recent events
This past April, a California appellate court ordered the State Board of Equalization (“BOE” – a public agency responsible for tax administration and fee collection in California) to refund Nortel Networks $30 million, plus another $13 million in interest, in paid taxes stemming from software Nortel licensed in switching equipment they sold to telephone giant Pacific Bell (now known as AT&T). A “switch” here refers to hardware, comprised of computer processors, frames, shelves, drawers, circuit packs, cables, and trunks. Each switch processes telephone calls, and handles features such as conference calling, call waiting, and voice mail. About a month later the California Supreme Court confirmed this ruling, denying the BOE’s petition to review the appellate court decision.
Legal Analysis
While income from switch hardware sales (tangible property) is taxable by the State, this case boiled down to whether sales tax could be imposed on the software (non-tangible intellectual property) that Nortel licenses to operate the switching equipment.
As noted above, the appellate court determined the tax could not be collected because Nortel’s software was exempt from sales tax under California’s technology transfer agreement (“TTA”) regulation (link opens a PDF). The State Legislature implemented TTA statutory provisions in the 1990’s to help govern the transfer of intellectual property.
A TTA is “any agreement in which a person who holds a patent or copyright interest assigns or licenses to another the right to make and sell a product or to use a process that is subject to the patent or copyright interest.” Not every software program qualifies as a TTA. Only a program that is subject to a patent or copyright is a TTA. An other words, a sale of a program not subject to patent or copyright is taxable. However, most programs are subject to copyright at least, and therefore most programs are exempt from this tax.
These provisions prohibit taxes on “[t]he amount charged for intangible personal property transferred with tangible personal property in any TTA…including any written agreement that licenses the right to use a process subject to a patent, even if a tangible product is not being sold.” (see Nortel v. State Board of Equalization).
Thus, the California Supreme Court held that because Nortel’s licensed programs “are copyrighted, contain patented processes, and enable the licensee to copy the software, and to make and sell products—telephone calls—embodying the patents and copyright,” they are exempt from sales tax per the TTA statutes.
The Bottom Line
Software deals are a big business in California and anyone involved in software sales (especially those that incorporate both software/non-tangible property and hardware/tangible property) should pay particular attention to their tax documentation and make sure they are not being taxed on transactions that might qualify as a TTA. Businesses operating primarily in other states should review their local regulations as well.
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