Software and California Sales and Use Tax

Editor: Mark G. Cook, CPA, MBA

& Local Taxes

The taxability of software
for sales and use tax purposes has been a point of
persistent debate among states for several years. Many
states, including California, have applied sales tax
to software based on the form in which it is sold and
delivered to consumers. In general, the taxability of
software depends on its classification as either
“canned” (i.e., prewritten programs) or custom
software, as well as how the program is delivered
(e.g., on a CD or other tangible medium).

the downturn in the economy, states have been
attempting to revise their tax laws to broaden the
overall tax base subject to sales and use tax, thereby
increasing revenues to the state. Recently, California
courts decided two cases, Microsoft Corp. v.
Franchise Tax Board
, No. CGC-08-471260 (Cal.
Super. Ct. 2/17/11), and Nortel Networks, Inc. v.
State Board of Equalization
, 119 Cal. Rptr.
3d 905 (Cal. Ct. App. 2011), that have had and will
continue to have an important impact on software
transactions. This item addresses the sales and use
tax implications of canned software under both cases
in light of California’s current statutory scheme. It
also comments on the state’s trend in broadening the
tax base with respect to such transactions.

California Sales and Use Taxability of

California’s sales and use tax applies
to transactions in tangible personal property, which
is defined as any “personal property that can be seen,
weighed, measured, felt, or touched, or is in any
other way perceptible to the senses” (Black’s Law
1337–1338 (9th ed. 2009),
quoted in Microsoft). Sales
of canned software, defined under CA Rev. & Tax.
Code Section 6010.9(d) as computer software “held or
existing for general or repeated sale or lease” and
not developed for an individual customer, are
generally taxable under CA Code Regs. Title 18,
Section 1502(f)(1). Most canned software products are
typically delivered to the consumer via some form of
tangible medium, which makes it easier to identify a
particular transaction as involving the transfer of
tangible personal property. However, note that the
relevant California statutes and regulations do not
specifically define canned software as tangible
personal property.

Microsoft Case

In Microsoft, the San
Francisco Superior Court ruled in favor of the
California Franchise Tax Board (FTB) on all issues
raised. Microsoft Corp. had attempted to reduce its
amount of income apportioned to California by applying
the costs-of-performance sourcing rules to royalties
it received from licensing its computer software.
Generally, under the costs-of-performance method,
gross receipts from the sale of services or other
intangibles are assigned to a taxing jurisdiction for
state income tax purposes based on where the greater
portion of the costs of performance was incurred.

Microsoft argued that the royalties at issue were
not attributable to licensing tangible personal
property, but rather to licensing intangible property.
As such, the source of the royalties should have been
determined in accordance with the costs-of-performance
rules, the company said. This method would have
excluded 100% of the company’s royalty income from
California. The court, however, disagreed, holding
that the royalties were from tangible personal

In its holding, the court relied upon
similar rulings from other jurisdictions, quoting the
Utah Supreme Court case South Central Utah
Telephone Ass’n v. Utah State Tax Comm’n
, 951
P.2d 218 (Utah 1997): “Software is information
recorded in a physical form which has a physical
existence, takes up space on the tape, disc, or hard
drive, makes physical things happen, and can be
perceived by the senses.” The California court added,
citing the Louisiana Supreme Court in South Central Bell
Telephone Co. v. Barthelemy
, 643 So. 2d 1240
(La. 1994):

software itself, i.e., the physical copy, is not
merely a right or an idea to be comprehended by the
understanding. The purchaser of computer software
neither desires nor receives mere knowledge, but
rather receives a certain arrangement of
that will make his or her computer
perform a desired function. This arrangement of
matter, physically recorded on some tangible medium,
constitutes a corporeal body. [Emphasis added]

In short, the court found that the classification
of software as tangible personal property does not
depend on the separability of the program from the
tangible medium on which it is recorded, but rather on
the view that the written program is a “tangible
manifestation of intellectual property.”

Although Microsoft is a
corporate income tax case, the court’s ruling on
software as tangible personal property should be
authoritative (under the principle of stare decisis)
for purposes of the sales and use tax, to maintain
consistency between both tax types. At the time of
this writing, Microsoft has not indicated whether it
will appeal the Superior Court’s ruling.

Electronically Delivered Software

Historically, California has exempted
electronically delivered software from sales and use
tax. CA Code Regs. Title 18, Section 1502(f)(1)(D),
provides that

[t]he sale or lease of a
prewritten program is not a taxable transaction if the
program is transferred by remote telecommunications
from the seller’s place of business, to or through the
purchaser’s computer, and the purchaser does not
obtain possession of any tangible personal property,
such as storage media, in the transaction.

holding in Microsoft, however,
is inconsistent with the regulation, as software was
defined as tangible personal property regardless of
the form in which it is recorded. The Microsoft case may
thus represent a move toward broadening the tax

The notion of sales taxability of
electronically delivered software is not without
foundation. The Streamlined Sales and Use Tax
Agreement (SSUTA), a compendium of sales and use tax
laws developed and adopted by 24 member states, aims
to simplify and uniformly administer sales and use tax
laws. The SSUTA defines canned software, whether
delivered on a tangible format or electronically, as
tangible personal property. Member states are allowed,
but are not required, to exempt electronically
delivered software from sales or use tax. California
is not a member of the SSUTA. However, many of the
state’s sales tax laws are modeled closely on the
SSUTA, and the state has continuously tended to align
its tax laws with the agreement. As of the date of
this item, only 15 states, including California,
exempt electronically delivered software from sales
and use taxation, and it is unclear whether California
will change its position.

Nortel Case

The implications of the
case and the growing influence of the SSUTA may not be
welcome news to most software developers. However, the
looming “tax cloud” may not be as dark as it appears.
The California Supreme Court recently denied the
California State Board of Equalization’s (BOE) appeal
in Nortel of
the state appellate court’s holding that licensing of
prewritten software under a technology transfer
agreement was statutorily exempt from sales and use

The decision in Nortel has had
broad implications for the taxation of prewritten
software in California. The BOE has long maintained
that all sales of canned software not exempt under any
other provision of the state code are subject to the
sales tax. Based on the Nortel decision,
however, the BOE has had to review every software
license on a case-by-case basis, including
mass-produced canned software, to determine whether
the software is subject to a patent or copyright and
thus covered under the technology transfer agreement
exemption. As such, sales of mass-produced software
programs, such as those produced by Microsoft, will be
subject to claims of exclusion from tax.

manufactured and sold switches to Pacific Bell
Telephone Co. (PacBell). Each switch processed
telephone calls and handled features such as
conference calling, call waiting, and voice mail. A
switch is hardware composed of computer processors,
frames, shelves, drawers, circuit packs, cables, and
trunks. In addition, Nortel and PacBell entered
licensing agreements that gave PacBell the right to
use Nortel’s software programs in the switches. Nortel
licensed two types of software to PacBell:

  • Prewritten operator workstation programs
    (connecting customers to operators), data center
    programs (connecting customers to directory
    assistance), and switch-connection programs
    (allowing switches to communicate with each other);
  • Switch-specific programs (SSPs)
    that operated the switch and enabled it to process
    telephone calls.

Each SSP was unique,
created for a particular switch, and PacBell could not
use it to operate any other switch. Nortel did not
claim, however, that it created a tax-exempt custom
computer program for PacBell.

Both types of
software licensed by Nortel were copyrighted and
subject to Nortel’s patents. The company shipped the
software to PacBell on a tangible storage medium, such
as disks, magnetic tapes, or cartridges. The licensing
agreements allowed PacBell to copy the software from
the storage medium and load it into the operating
memory of a switch’s computer hardware. This
authorization to copy the software onto its computers
allowed PacBell to use the programs without violating
Nortel’s copyright.

Before the Nortel ruling, most
companies had been collecting California sales or use
tax on all sales or licenses of prewritten computer
software. However, under CA Rev. & Tax. Code
Sections 6011(c)(10)(D) and 6012(c)(10)(D), sales tax
does not apply to amounts charged for intangible
personal property transferred in a technology transfer
agreement. Under CA Rev. & Tax. Code Section
6011(c)(10)(D), a technology transfer agreement is
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 interest.”

Directly at
issue in Nortel was CA Code
Regs. Title 18, Section 1507(a)(1), which the BOE had
issued to try to limit the scope of the technology
transfer agreement provisions. The regulation
provided, in relevant part, that “a technology
transfer agreement also does not mean an agreement for
the transfer of prewritten software.” However, the
court, noting the “any agreement” language of the
statute, disagreed with the BOE and ruled that the
technology transfer agreement statutes did not
restrict agreements transferring an interest in
prewritten software. As a result, the court said,
Section 1507(a)(1) cannot exclude prewritten software
that is subject to a copyright or patent. The court
ruled that the regulation exceeded the scope of the
BOE’s authority and was invalid.


As the law stands,
canned software in whatever form may be exempt from
taxation under either Nortel or the
exemption for electronically delivered software.
However, given the decision in Nortel, the state
may be reevaluating its position as it continually
struggles to increase revenue. Therefore, taxpayers
and preparers alike should be wary of the constantly
changing climate.


Mark Cook is a partner at SingerLewak LLP in
Irvine, CA.

The editor would like to offer a
special thanks to Christian J. Burgos, J.D., LL.M.,
for his assistance with this column.

For additional information about these items,
contact Mr. Cook at (949) 261-8600, ext. 2143, or



Unless otherwise noted,
contributors are members of or associated with
SingerLewak LLP.

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