Takeaways
- Since their introduction in California in 1993, the sales and use taxation of technology transfer agreements has been the subject of significant litigation and a seemingly endless regulation project.
- In the past few months, there appears to be meaningful movement in the regulation project.
- It remains to be seen whether taxpayers will finally receive useful, administrable guidance in this area.
In 1993, the California Legislature amended Revenue and Taxation Code (RTC) sections 6011 and 6012 to exclude from California sales and use tax amounts charged for intangible personal property transferred with a technology transfer agreement (TTA)[1] if the TTA separately stated a reasonable price[2] for the tangible personal property (TPP). Nine years later, the State Board of Equalization (SBE) adopted Regulation 1507, Technology Transfer Agreements, to implement and interpret the TTA statutes and to incorporate the California Supreme Court’s holding in Preston v. State Board of Equalization, 25 Cal.4th 197 (2001). Subsequent litigation over the next 13 years in Nortel Networks, Inc. v. State Board of Equalization, 191 Cal.App.4th 1259 (2011) and Lucent Technologies, Inc. v. State Board of Equalization, 241 Cal.App.4th 19 (2015), invalidated portions of Regulation 1507, as well as Regulation 1502 (Computers, Programs and Data Processing). In the nine years since the Lucent decision, the SBE and its successor, the California Department of Tax and Fee Administration (CDTFA), have been engaged in a seemingly endless regulation project. There finally appears to be some meaningful movement. But first, a little background.
In Nortel, the Court of Appeal held that “the transfer of a program that is subject to a patent or copyright is a TTA.” The Court invalidated the part of Regulation 1507 that provided that a TTA does not mean an agreement for the transfer of prewritten software, and that language was subsequently deleted from the regulation. The Court held that the copyrighted prewritten software Nortel transferred to Pacific Bell on tangible storage media (disks, magnetic tapes or cartridges) was exempt from sales tax under the TTA statutes because the software was “not embedded in the hardware at the time of manufacture,” and “the licenses gave Pacific Bell the right to reproduce the copyrighted material on its computers.” The Court also granted Nortel’s claim for a refund of the sales tax paid on the charges for the licenses to copy and use the prewritten software.
In Lucent, the Court of Appeal held that software is not TPP and that placing software on tangible storage media does not thereby transmogrify the software itself into TPP. The Court held that “the transmission of software using a tape or disc in conjunction with the grant of a license to copy or use that software does not yield a taxable transaction because the tape or disc is ‘merely ... a convenient storage medium [used] to transfer [the] copyrighted content’ and hence not in itself essential or physically useful to the later use of the intangible personal property.” The Court held that the contrary provisions of subdivision (f)(1) of Regulation 1502 were not sanctioned by California’s sales tax law. The Court held that the transmission of Lucent’s copyrighted prewritten software on tangible storage media (tapes and compact discs) as part of a transaction granting a license to copy and use that software did not transform that software into TPP subject to sales tax, and that the price of the blank tangible storage media used to transmit the software was what was subject to tax under the TTA statutes.
Following Lucent, there were Interested Parties Meetings held on June 30, 2016, and then on November 5, 2019, to discuss proposed amendments to Regulation 1507. Finally, more than four years later, on January 31, 2024, CDTFA held a TTA workshop to provide participants the opportunity to discuss and 5provide input on key issues to inform CDTFA’s efforts to draft a discussion paper for consideration at a future interested parties meeting. During the workshop, there was a broad discussion of TTAs, including TTAs where software is transferred, determining the measure of tax when a TTA exists, and the use of intermediaries in the supply chain. At the conclusion of the workshop, there was a general consensus that the discussion was productive, and several attendees expressed interest in, and recommended, a second workshop to further the effort. At the conclusion of the workshop, attendees were invited to submit written comments to provide additional input on the discussion topics and TTAs in general.
CDTFA held its second 2024 public workshop on June 27, 2024, to discuss TTAs. Topics presented for discussion were prior recommendations of interested parties and several concepts which included proposed presumptions concerning valuation and an auditable safe harbor.
CDTFA requested input at the workshop regarding the following:
- Rebuttable Presumption that for Consumer Transactions the Price Charged for the Transaction is Equal to the Value of the Transferred TPP
The intent of this presumption is that retailers of goods to consumers or businesses purchasing general consumable items (e.g., coffee machines) do not have to determine the value of such interest. This reflects the focus of the TTA provisions was for business-to-business transactions. The Department seeks input on how to best define a consumer transaction.
- Rebuttable Presumption Regarding Intellectual Property Rights Transferred with Embedded Software
The intent of this presumption is to address situations in which software is hardwired or embedded in machinery or equipment when it is manufactured. A rebuttable presumption could provide that with regards to a TTA involving the sale of TPP containing hard-wired or embedded software, the value of the TPP generally equals the total amount charged for the transaction.
- Auditable Safe Harbor
An auditable safe harbor (a shelter harbor) could allow a taxpayer to treat a certain percentage (e.g., 20 percent) of the total amount charged under a TTA as the value of the intangible property transferred under that TTA.
On August 9, 2024, the California Taxpayers Association (CalTax) and the Silicon Valley Leadership Group (SVLG), sent a joint letter providing comments. They emphasized that any amendments should place great importance on the ease of administration to both taxpayers and CDTFA but should not stray from the decisions of Nortel and Lucent. Also, they suggested that any amendments to Regulation 1507 include several examples of transactions that qualify as a TTA and examples of transactions that would not qualify. In addition, they were in favor of incorporating a safe harbor in the regulation.
On August 9, 2024, CTIA[3], which is a trade association for the wireless communications industry, also submitted comments. It stated that the CDTFA’s proposed presumption regarding embedded software contained in manufactured machinery or equipment is invalid because it adds requirements to the TTA statutes that do not exist in the statutes themselves. Further, it contended that a presumption that a transferor would assign or license its valuable patented and/or copyrighted software without charging any amount for the right to use such software (no consideration) whether embedded or not, is arbitrary, capricious and/or without rational basis. CTIA acknowledged that the inclusion of an auditable safe harbor would be a good idea, but the audit should be limited to determining whether the transaction is a TTA transaction and not the value of the TPP being transferred.
After 31 years, taxpayers remain hopeful that there will finally be useful, administrable guidance in this area which comports with the intent of the Legislature and the Nortel and Lucent decisions. Stay tuned.
[1] The TTA statutes define a TTA 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.” (RTC 6011, subd. (c)(10)(D) and 6012, subd. (c)(10)(D).)
[2] If there is no reasonable separately stated price, the TTA statutes prescribe a method for determining the gross receipts from, or the sales price for, TPP transferred under a TTA by using the price at which the TPP or like TPP was previously sold, leased, or offered for sale or lease, to third parties for a separate price. (RTC 6011, subd. (c)(10)(B) and 6012, subd. (c)(10)(B).) The TTA statutes also provide that in the absence of previous sales, leases, or offers to sell or lease, TPP or like TPP, to third parties for a separate price, the taxable measure is equal to 200 percent of the cost of materials and labor used to produce the TPP. (RTC 6011, subd. (c)(10)(C) and 6012, subd. (c)(10)(C).)
[3] It was initially known as the Cellular Telecommunications Industry Association until 2004, and later the Cellular Telecommunications and Internet Association. The organization has since operated under its initialism only, subtitled as CTIA – The Wireless Association until 2015.
[View source.]
