The California State Board of Equalization (BOE) held an interested parties meeting on July 17, 2012, to discuss whether to amend its Regulation 1507 (Technology Transfer Agreements (TTA)) to clarify how the TTA statutes (Cal. Rev. and Tax Code §§ 6011(c)(10) and 6012(c)(10)) should apply to transfers of computer programs on tangible storage media. Under California law, the value of intangible property transferred under a TTA is excluded from the sales or purchase price under the Sales and Use Tax Law.
At the outset of the meeting, the BOE discussed the background of the TTA statutes and identified key issues for discussion. The background and key issues, as well as the comments from interested parties, are summarized below. Written comments will be accepted until August 1, and the BOE Business Taxes Committee will receive an update on the interested parties process at its meeting on August 21-23. A second interested parties meeting currently is scheduled for September 6.
- The Legal Department does not read Nortel v. State Bd. of Equalization as exempting all prewritten software. It believes Nortel is limited to its facts. Nortel held that the right to “use a process” subject to a patent, when combined with the transfer of tangible personal property, qualifies as a TTA even when the “process” is prewritten computer software.
- The TTA statutes only provide TTA treatment to agreements where the holder of the copyright or patent transfers a patent or copyright interest to third parties. Thus, the holder of the patent or copyright interest must be the transferor. Nonetheless, the BOE indicated that it would be open to considering whether the “holder” requirement has been met through a licensing entity in a group of entities.
- The Legal Department believes prewritten and canned computer programs transferred on TPP are TPP. Thus, software development costs should be included within the value of the taxable tangible personal property transferred under a TTA.
- The Nortel court did not invalidate the provision of Regulation 1507 that requires patented processes to be external to the tangible personal property, necessarily excluding embedded software from TTA treatment.
- If a TTA is created based on the transfer of a copyright interest, the copyright interest must provide the right to make and sell a product subject to the copyright interest for TTA treatment.
- The Nortel case did not address the measure of tax related to the TTA because the parties stipulated to the value of the tangible personal property. Thus, there was no guidance on which costs to include in determining the value of the tangible personal property based on the statutory test of 200% of the cost of labor and materials used to produce the tangible personal property.
- The BOE does not intend to change its position that software development costs are included in the value of the tangible personal property transferred under a TTA because that would be compromising its position in Lucent, which is at the superior court.
Several interested parties provided comments in response to the background, discussion paper, and identified issues.
- One interested party took issue with the BOE’s statement that lack of an expert witness for the BOE in that case resulted in an undeveloped factual record, pointing out that the expert’s testimony would have been limited to the issue of whether the software in that case was prewritten. Because the issue of whether software was prewritten did not impact the court’s decision, the fact that the expert did not testify was inconsequential. Additionally, that interested party stated that the BOE’s expert sat at the BOE counsel’s table during the first two days at trial and offered advice to the BOE’s counsel.
- The BOE was reminded that, in Nortel, it had taken the position that prewritten software transferred on storage media was itself tangible personal property, and the court did not agree. The BOE was also criticized for its citation of the superior court’s decision in Microsoft v. FTB for the proposition that prewritten software is tangible personal property. The court in that case rejected the notion that sales and use tax law informs income tax law.
- It was suggested that the BOE was trying to create a regulation that would preserve its ideal version of the law and not to interpret the statute as it has been authoritatively construed. Another interested party added that the BOE’s interpretation of the TTA statutes is inconsistent with the legislative intent of the TTA statutes to codify the Intel decision and objected to the inclusion of software development costs in valuing the cost of labor and materials used to produce tangible personal property for purposes of determining the amount of the TTA exclusion.
- An objection was made to the BOE’s study on the basis that it requested information related to software development costs. Electronically delivered software is not tangible personal property, so why should software development costs be included in the value of tangible personal property for purposes of determining the TTA exclusion?
- Concerns were raised regarding the ability to distinguish between taxable tangible personal property and nontaxable intellectual property on audit based on the BOE’s regulation, which limits the TTA exclusion to external (rather than embedded) patented processes.
- Most of the interested parties said that the BOE’s analysis departs from the TTA statutes and the holding in Nortel.