California software is nontaxable as intangible personal property

AT&T to BOE “Can you hear me NOW?” California’s 25 million sales tax appeal denied

On October 8, a California appeals court rejected the state’s effort to collect an additional $25 million in sales taxes on specialized computer equipment used by telephone and data networks. This was not the first time California officials tried to collect such taxes, nor the first time the appeals court determined these actions were illegal. As a result, the court also ordered the state to reimburse the equipment manufacturer’s attorney fees and litigation costs, which were reportedly more than $2.5 million.

Telephone switches are computers used to route data and provide other telecommunications services such as voicemail. AT&T manufactured switches until 1996, when it spun the business off into Lucent Technologies. AT&T/Lucent continued to develop not only the physical switches but their underlying software. This software includes both copyrighted and patented material. When a telephone company purchased a switch from AT&T/Lucent, it included the right to copy and use this proprietary software. But as anyone who has ever owned a Windows computer knows, that does not mean the purchaser “owned” the software; it merely acquired a “license” to use the program on that particular switch.

AT&T/Lucent only collected sales tax on the physical equipment sold, not the software licenses. The California State Board of Equalization (SBE), which oversees sales and use taxes in that state, claimed this was an incorrect reading of the law. It assessed additional sales tax liability of approximately $24.7 million to cover the software licenses.

AT&T/Lucent paid the sales tax under protest then filed a court challenge. A trial judge ruled for the manufacturers and not only awarded a full refund but an additional $2.6 million in “reasonable litigation costs.” The SBE appealed.

But the California Court of Appeal, Second District, upheld the trial judge’s decision. As the appeals court explained, “transactions not involving tangible personal property, such as the sale of services or the sale of intangible personal property, are not subject to the sales tax.” With respect to software, the “default rule” in California held when a seller “grants an intangible license to copy copyrighted material” through tangible media, the transaction is not taxable provided the physical media itself is “not essential” to the buyer’s ability to use the program, in other words, software is nontaxable.  This was an “all-or-nothing” rule, according to the appeals court. So in 1993, the California legislature amended the default rule such that when a seller licenses a copyrighted or patented product, the seller must then separate the tangible and intangible portions of the sale and pay tax on the former.

Which is exactly what AT&T/Lucent did here. Nevertheless, the SBE argued the switch software should still be treated as “tangible” property because it was physically transmitted on magnetic tapes. (Essentially, the SBE claimed AT&T/Lucent sold magnetic tapes that happened to include software.) The Court of Appeal said this argument was not only “inconsistent with precedent,” but “leads to an absurd result,” because it would mean AT&T/Lucent owed an additional $25 million merely because it transmitted the software on tape and not electronically.

Indeed, the SBE was well aware of “precedent.” In January 2011, the same appeals court rejected the same argument from the SBE when it tried to assess sales tax on switching software sold by Nortel Networks, Inc. The SBE actually asked the court to overrule its Nortel decision. It declined to do so, noting the earlier case relied on a California Supreme Court decision, which the intermediate court was “not at liberty to disregard.” And since the Nortel decision “foreclosed” the SBE’s arguments in this case, the trial judge was within his authority in ordering the state to pay AT&T/Lucrent’s litigation costs.