News and Insights

California’s Computer Software Exemption Remains in Jeopardy

Tax Development Jul 20, 2013

In the aftermath of a 2011 court defeat involving software taxation, California revenue officials appear poised to seek legislative assistance in undoing the court’s ruling and imposing sales and use taxes—retroactively—on a wide variety of computer software programs. California broadly levies taxes on the sale or use of tangible personal property in the state. However, there is a statutory carve out from these taxes for computer software provided to a user under the so-called Technology Transfer Agreements (TTAs). In recognition of the notion that software is intangible property, these taxes apply in the case of a TTA only to the value of any tangible medium, such as a disk or magnetic tape, on which the licensed program may be transferred to the software user.

The State Board of Equalization (BOE), which administers these taxes, had, by rule, limited the favorable treatment for TTAs to transfers of custom software, not pre-written, or “canned” software programs. In Nortel Networks, Inc. v. Board of Equalization, 191 Cal. App. 4th 1259, 119 Cal. Rptr. 3d 905 (2011), the California Court of Appeals invalidated these rules and awarded the telecommunications equipment maker a multimillion dollar refund.

The California Supreme Court declined to review the decision, leaving taxpayers with a clear victory. But, for two years, the BOE has refused to give up the fight. The agency acknowledged that it is holding back millions of dollars of refund claims filed by other taxpayers. All the while, the BOE appears to be searching for ways to eliminate taxpayer rights to recover or to dramatically reduce the amounts they are entitled to receive:

  • It has mounted a collateral challenge—this time against Lucent Technologies, Inc.—in a Los Angeles courtroom in an attempt to re-litigate the Nortel issues.
  • The BOE is exploring ways to expand the types of items that can be included in the tangible costs that are subject to tax, thus reducing refund claims for taxpayers under Nortel.
  • And, most recently, BOE officials, working with California Governor Jerry Brown, made an eleventh-hour attempt to insert language into a budget trailer bill that would have retroactively overturned the effects of Nortel and curtailed the ability of other taxpayers to claim refunds of taxes on software qualifying for exclusion under the TTA laws.

California lawmakers refused to include the provision in the budget trailer, but the issue is not over. The provision was not rejected on substantive grounds, but, rather, because lawmakers agreed with arguments made by Ryan and others that the issue deserved to go through the usual legislative review process involving a substantive policy committee hearing.

California lawmakers currently are on summer recess and will return to Sacramento in August, when the issue is likely to arise again and could be acted on before they recess for the year in mid-September. If adopted, the BOE’s measure would retroactively repeal the current software exclusion, effectively resulting in a retroactive tax increase for thousands of California businesses and extinguishing any pending refund claims related to the TTA issue.

Rich Carlson, Principal at Ryan’s Los Angeles office, said the Firm has been working to alert its clients that the software exemption is at high risk as the Legislature enters the final six weeks of its 2013 session.

“We believe that a new tax on software would have a significant adverse effect on California’s economy and that a retroactive tax on business decisions made long ago is simply bad policy,” said Mr. Carlson. He said Ryan, the California Taxpayers Association, and the California Manufacturers & Technology Association have led the charge in Sacramento “to oppose this tax increase” and urged companies to join the initiative. “Things can happen very quickly in the final weeks of a legislative session. We are urging our clients who are affected by this issue to get involved, contact your California representatives, and tell them to support the taxpayers of California by opposing this proposal,” he said.

Lastly, the BOE’s most recent proposal may also extend the tax beyond the scope of Nortel, as it amends California Revenue & Taxation Code Section 6010.9(a) to broaden the definition of “storage media” and to add to it the following new language: “Notwithstanding any other provision of this part, a computer program embodied or stored on storage media is tangible personal property.” Mr. Carlson noted that the proposed amendment is disturbingly broad and, when read in the context of the exemption as a whole, could raise questions over whether it also extends the tax to custom software, which California has exempted as a service.