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California Court of Appeal Switcheroo: Software Constitutes Technology Transfer Agreement

The California Court of Appeal held that receipts from Nortel’s license of computer programs used to operate a telephone company’s switch hardware were not subject to sales tax.

The California Court of Appeal held that receipts from Nortel’s license of computer programs used to operate a telephone company’s switch hardware were not subject to sales tax. Nortel Networks, Inc. v. State Board of Equalization, Case No. B213415 (2d App. Dist. Jan. 18, 2011). The court also partially invalidated Regulation 1507 on the grounds that the State Board of Equalization (SBE) had exceeded its authority when it enacted the regulation.

The Court of Appeal’s decision provides guidance regarding the scope of exempt Technology Transfer Agreements (TTA), which are defined 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.” Cal. Rev. & Tax. Code § 6011(c)(10)(D); 6012(c)(10)(D).

Under California law, amounts charged for intangible property transferred with tangible personal property under a TTA are exempt from sales tax if the TTA separately states a reasonable price for the tangible personal property. When enacting the TTA statutes, the SBE warned the Legislature that the language covering licenses to “use a process” could include the right to use a computer program. Despite the SBE’s concerns and objections, the Legislature enacted the TTA statute. To remedy the perceived flaw, the SBE enacted a regulation specifically excluding “agreements for the transfer of prewritten software” from the definition of a TTA. See Cal. Reg. 1502(a)(1).

Nortel shipped switch-specific programs (SSPs) and prewritten software programs to its telephone company customer on disks, magnetic tapes, or cartridges. The license agreement authorized the telephone company to copy the programs and use them to operate telephone switches. The SBE took the position that Nortel’s license agreement was not a TTA because a TTA must grant the licensee the right to sell a product, and telephone service did not constitute a product. The Court of Appeal disagreed, finding that telephone service was a product, and held that even if it was not, the agreements permitted the telephone company to use a process, which was also encompassed by the TTA statute. The court rejected the SBE’s attempt to exclude agreements involving prewritten software from the definition of a TTA, holding that the regulation contained no such limitation and was therefore invalid.

Nortel provides some needed clarity regarding the taxability of certain intangible property rights in California and highlights the limitations of any state agency’s discretionary authority.

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