Lucent Technologies, Inc. v. State Board of Equalization: A Satisfying Sequel to Nortel Networks, Inc. v. Board of Equalization
By Jason C. DeMille.
Under the California Sales and Use Tax Law the value of a patent or copyright interest that is transferred pursuant to a technology transfer agreement is not subject to tax. In Nortel Networks, Inc. v. State Board of Equalization (2011) 191 Cal.App.4th 1259, the California Court of Appeal held that software (custom and pre-written) licensed pursuant to technology transfer agreements is not subject to tax. In response, taxpayers filed claims for refund with the California Board of Equalization (“SBE”) seeking refunds of taxes paid with respect to transfers of their software licenses. The SBE placed those refund cases on hold pending the outcome of its follow-up litigation in Lucent Technologies, Inc. v. State Board of Equalization.
On October 8, 2015, the Court of Appeal filed its opinion in the Lucent Technologies case, which came to the same conclusion as the Nortel case. The following briefly discusses the applicable statutory and regulatory law, the Nortel case, and the recently decided (though not yet final) Lucent case. In light of Nortel and now Lucent, Taxpayers who transfer software pursuant to technology transfer agreements should file protective claims for refund with the SBE.
A. Statutory and Regulatory Law.
The Sales and Use Tax Law provides that the “amount charged for intangible personal property transferred with tangible personal property in any technology transfer agreement” (hereinafter “TTA”) is not subject to tax. (TTAs are excluded from sales tax by Revenue and Taxation Code §6012(c)(10)(A), and from use tax by identical language in §6011(c)(10)(A).) A TTA is defined broadly as follows:
“For purposes of this paragraph, ‘technology transfer agreement’ means 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.” (§6012(c)(10)(D); §6011(c)(10)(D).
The SBE adopted Regulation 1507 (18 California Code of Regulations §1507) which defines a TTA as follows:
“‘Technology transfer agreement’ means an agreement evidenced by a writing (e.g., invoice, purchase order, contract, etc.) that assigns or licenses a copyright interest in tangible personal property for the purpose of reproducing and selling other property subject to the copyright interest. A technology transfer agreement also means a written agreement that assigns or licenses a patent interest for the right to manufacture and sell property subject to the patent interest, or a written agreement that assigns or licenses the right to use a process subject to a patent interest.” (Regulation 1507(a)(1).)
A “copyright interest” is defined as “the exclusive right held by the author of an original work of authorship fixed in any tangible medium to do and to authorize any of the following: to reproduce a work. . .; to prepare derivative works . . .; to distribute copies . . . of a work . . . by sale or other transfer of ownership . . . .” (Id. at (a)(2).)
A “patent interest” is defined as “the exclusive right held by the owner of a patent issued by the United States and Trademark Office to make, use, offer to sell, or sell a patented process, machine, manufacture, composition or matter, or material. ‘Process’ means one or more acts or steps that produce a concrete, tangible and useful result that is patented . . . such as the means of manufacturing tangible personal property.” (Id. at (a)(3).)
“‘Assign or license’ means to transfer in writing a patent or copyright interest to a person who is not the original holder of the patent or copyright interest where, absent the assignment or license, the assignee or licensee would be prohibited from making any use of the copyright or patent provided in the technology transfer agreement.” (Id. at (a)(4).)
B. The Nortel Case.
Nortel manufactured and sold telephone switching equipment to Pacific Bell Telephone Company. The switches were hardware, comprised of computer processors, frames, shelves, drawers, circuit packs, cables, and trunks. A “line card” for each PacBell customer was also contained within the switch. Nortel also entered into licensing agreements that gave PacBell the right to use the software programs in the switches. The software included (1) prewritten software (the data center program, the operator workstation program, and the switch-connection program) and (2) switch-specific programs (“SSP”), each of which was unique. Nortel provided the software on storage media. Pursuant to licensing agreements, PacBell was allowed to copy the software from the storage media and load it into the operating memory of a switch’s computer hardware without violating or infringing on any of Nortel’s copyrights or patents.
The SBE conducted an audit and determined that Nortel owed sales tax on its transactions with PacBell (most of which related to the SSPs). After paying the determined tax, Nortel sued the SBE for a refund. The trial court allowed a refund for the SSPs, but determined that the prewritten software was subject to tax. Evidence at trial showed that the SSPs implemented processes that were subject to Nortel’s patents, and that the SSPs were copyrighted. Evidence also showed that Nortel held between 200 – 500 patents on inventions related to its switches. The SBE also admitted that Nortel had copyright interests in both its SSPs and prewritten software.
On appeal, with respect to the SSPs, the SBE challenged the idea that creating telephone calls and providing telephonic features is a “product.” The court of appeal disagreed, concluding that the telecommunications equipment at issue manufactured a product that is sold at retail, i.e. the equipment made it possible for a voice to be manufactured into electronic impulses which could be transmitted and received and rendered understandable. However, even assuming PacBell did not make and sell a product, Nortel had licensed it the right to use patented processes within the meaning of the technology transfer statute. The statute broadly covers agreements licensing “the right to make and sell a product or to use a process that is subject to the patent or copyright interest.” A TTA includes a written agreement that licenses the right to use a process subject to a patent, even if a tangible product is not being sold.
With respect to the prewritten software, the SBE prevailed at trial with its argument that Regulation 1507 specifically excluded from the definition of a TTA pre-written or “canned” software. The court of appeal reversed, noting that the statute applies to “any agreement” that involves the sale or license of copyrighted materials or patented processes, including agreements transferring an interest in prewritten software. To the extent it excluded prewritten software, Regulation 1507 was found invalid. Nortel’s licenses gave PacBell the right to reproduce the copyrighted material on its computers. As a result, the prewritten programs were TTA’s and not taxable.
C. The Lucent Technologies Case.
The Lucent case also involved telephone switching equipment (which was run both by switch-specific software and generic software) similar to that involved in the Nortel case. The Court observed that ‘“One could almost substitute the names of the plaintiff and the monetary amounts, and the facts would be essentially the same.”’ (Slip Opinion, p. 17.) Lucent and its predecessor (AT&T) manufactured the switches as well as the software that ran them. The software was copyrighted and embodied, implemented and enabled at least one of 18 different patents held by AT&T/Lucent.
AT&T/Lucent entered into contracts with nine telephone companies “to (1) sell them one or more switches, (2) provide the instructions on how to install and run those switches, (3) develop and produce a copy of the software necessary to operate those switches, and (4) grant the companies the right to copy the software onto their switch’s hard drive and thereafter to use the software (which necessarily results in the software being copied into the switch’s operating memory).” (Id. at p. 4.) The software was sent to the telephone companies on magnetic tapes or compact discs. The SBE assessed sales tax on the full amount of the license fee paid by the telephone companies for a sales tax liability of $24,773,185.73. AT&T/Lucent paid the tax and filed an action for a refund.
AT&T/Lucent did not seek a refund of the sales tax assessed on the switches, nor on the written instructions. The issues on summary judgment were whether the SBE correctly assessed sales taxes on “(1) the computer software sent to the telephone companies using tapes and compact discs, and (2) the licenses to copy and use that software on the switches.” (Id. at p. 10.)
The SBE argued that the grant of summary judgment in favor of Lucent was erroneous for three reasons: First, the software transferred to the telephone companies on magnetic tapes and compact discs was taxable “tangible” personal property because the alterations to the media could be microscopically seen and, therefore, “perceptible to the senses” (i.e. it was taxable tangible personal property under §6016). Second, the contracts between AT&T/Lucent and the telephone companies did not qualify as TTAs because they (a) did not transfer “a sufficiently meaningful cluster” of intellectual property rights, and (b) AT&T/Lucent did prove that infringement would occur absent the license to the telephone companies. Third, assuming the agreements were TTA’s, AT&T failed to establish the cost of developing the cost of the software.
These arguments were rejected as follows:
First, the tape or disc is merely a storage medium and is neither essential nor physically useful to the later use of the intangible personal property. The SBE’s construction of §6016 leads to absurd results: AT&T/Lucent is subject to tax because it physically transmitted magnetic tapes and compact discs containing software (microscopically perceptible to the senses) to the telephone companies, but it would not have incurred any tax liability if it had transmitted the software electronically (via the Internet). “Ascribing such tremendous consequences to the manner in which a software program is transmitted – when that manner is wholly collateral to the subsequent use of the licenses regarding that software and when that manner is so easily manipulated by the buyer and seller – is an absurd result nowhere sanctioned by the language of, or policy underlying, California’s sales tax law.” (Id. at p. 12-13.)
Second, the Court noted that, pursuant to the statute, a TTA exists when the agreement satisfies the following three elements: “(1) a person holds a patent or copyright; (2) that person assigns or licenses to another the right to make and sell a product or to use a process; and (3) the resulting product or process is subject to the assignor’s or licensor’s patent or copyright interest.” (Id. at p. 15.) All three elements were present in AT&T/Lucent’s agreements. Evidence was provided that AT&T/Lucent held a copyrighted and patented interest in its software; a portion of that interest was transferred to the telephone companies who were given the right to reproduce the copyrighted work; and the resulting products which were sold by the telephone companies were subject to the copyrighted interest. (Id. at p. 16.) Moreover, AT&T/Lucent also transferred a portion of its patent rights by granting the telephone companies the right to use the processes embodied in its software.
The Court rejected the SBE’s argument that a contract may qualify as a TTA only if there was a transfer of “meaningful” copyright and patent rights. The Court found no support for this argument in the TTA statutes at issue, and found the argument inconsistent with federal copyright law as well as the California Supreme Court’s decision in Preston v. State Board of Equalization (2001) 25 Cal.4th 197, which held that a TTA may be based upon the transfer of a single copyright right. The Court also declined to “engraft” a requirement onto the TTA statutes that a TTA only exists if, without the license granted, the licensee would have infringed the copyright or patent. The Court observed that the SBE’s “defeat-every-possible-copyright-and-patent-defense requirement” appears nowhere in the TTA statute, is inconsistent with the holding in the Preston case, and for all intents and purposes forecloses use of the TTA statutes. The “defenses a taxpayer would have to refute are limited only by the Board’s ingenuity and imagination. This is a profoundly unsound result. It would turn every taxpayer refund action involving the technology transfer agreement statutes into a full-blown copyright and/or patent trial.” (Id. at p. 21.)
Third, the Court was unpersuaded by the SBE’s argument that AT&T/Lucent had failed to establish the cost of developing the cost of the software, finding it little more than a variation on an argument it had already rejected. “[T]he fact that placing a computer program on storage media physically alters that media does not thereby transmogrify the software itself into tangible personal property; the media is tangible, the software is not. Thus, the price of blank media is the price of the tangible personal property, and is what is to be taxed under the technology transfer agreement statutes.” (Id. at p. 22.)
The Court’s holding in the case is stated as follows: “(1) the manufacturer’s decision to give the telephone companies copies of the software on magnetic tapes and compact discs (rather than over the Internet) does not turn the software itself or the rights to use it into ‘tangible personal property’ subject to sales tax, (2) a ‘technology transfer agreement’ within the meaning of sections 6011, subdivision (c)(10)(D) and 6012(c)(10)(D), which exempts from the sales tax the intangible portions of a transaction involving both tangible and intangible property, can exist when the only intangible right transferred is the right to copy software onto tangible equipment, and (3) a technology transfer agreement can exist as long as the grantee of copyright or patent rights under the agreement thereafter copies or incorporates a copy of the copyrighted work into its product or uses the patented process, and any of these acts is enough to render the resulting product or process ‘subject to’ the copyright or patent interest.” (Id. at p. 3.)
Finally, the Court determined that the SBE’s position was not “substantially justified” and affirmed the trial court’s award of costs and reasonable litigation costs of over $2.6 million (noting that the SBE had propounded thousands of discovery requests and generated a 20,000 page record on appeal.) The Court observed that, while the SBE may decide its odds with “binding, on point authority,” under §7156 it is not free to require taxpayers to bear the cost of its litigation strategy aimed at taking multiple bites at the apple. (Id. at p. 25.)
The SBE has never liked the TTA exclusion. When the legislation was pending the SBE warned the Legislature of how broadly the statutes could be construed, but the Legislature enacted the TTA statutes anyway. (Id. at p. 18.) The message the Court sent with the Lucent case is that it meant what it said in Nortel and that it is unwilling to stray from what it regards to be clear statutory language in the Revenue and Taxation Code excluding from tax copyrighted or patented intangible property interests that are transferred pursuant to TTA’s.
The Lucent case is not final and the SBE is likely reviewing its options, including California Supreme Court review. However, in the meantime, taxpayers who transfer software pursuant TTA’s should consider filing refund claims with the SBE to protect their right to refunds once the SBE finally decides to stop nibbling at this apple.