California Court of Appeals Rules Telecommunications Software Licenses Exempt as Technology Transfer Agreements

On January 18, 2011, the Second District Court of Appeals of California (“Court of Appeals”) filed its decision in the case of Nortel Networks Inc. v. Board of Equalization. At issue in this case was the taxability of certain “switch-specific programs” and process function software licensed by Nortel Networks Inc. (“Nortel”) to Pacific Bell Telephone Company (“Pacific Bell”) for use in its telecommunications business.

The Court of Appeals affirmed the trial court’s holding that the licenses to use switch-specific programs were exempt from sales and use tax as technology transfer agreements (TTAs) and reversed the trial court, holding that the process function software licenses were also exempt as TTAs. The process function software at issue enabled Pacific Bell to perform certain telecommunications functions, including the following: connecting customers to operators, connecting customers to directory assistance, and operating telecommunications switch hardware.

Section 6010.9 of the California Revenue and Taxation Code generally provides for the taxation of prewritten computer software. TTAs are exempt, and California broadly defines exempt TTAs by statute 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.” The California Supreme Court (“Supreme Court”) has interpreted this definition as covering any agreement whereby a patent or copyright holder “transfers that patent or copyright to another person so the latter person can make and sell a product embodying that patent or copyright.”

In the Court of Appeals case, the Board of Equalization (BOE) put forth two arguments challenging the applicability of the TTA exemption to Nortel’s prewritten process function software. First, the BOE rejected the idea that the telecommunications functions made possible by the software at issue constituted “products” under the Supreme Court’s interpretation of the TTA exemption. The Court of Appeals disagreed, stating that telephone calls and telephonic features are “products” within the meaning of the TTA exemption. Not stopping here, the Court of Appeals further indicated that a license “to use a process that is subject to [a licensor’s] patent or copyright interest” constitutes a TTA, even if the process is not used to create a “product.”

As an alternative argument, the BOE urged, citing to one of its own regulations, that licenses to use prewritten software never constitute exempt TTAs, regardless of whether the software is subject to patent or copyright interests. In response, the Court of Appeals overturned the provision of this regulation cited by the BOE, stating that the BOE had “exceeded its authority” in adopting that provision, and held that the prewritten software licenses at issue were exempt as TTAs because these licenses were clearly embraced by the statutory definition of TTAs as rights “to use a process that is subject to the [licensor’s] patent or copyright interest.”