California Court Of Appeal Holds Right To Replicate And Install Software Is License Of Intangible Property For Apportionment Purposes

On December 18, the California Court of Appeal reversed a trial court's ruling and determined that a taxpayer's license of proprietary software, which transferred the right to replicate and install the software, but not the right to use the software, constituted the license of "intangible property" for apportionment purposes.1 As a result, pursuant to California sales factor sourcing rules in effect for the taxpayer's tax years in controversy, a cost of performance analysis was required. Because most of the costs of performance for the royalties from the software licenses were incurred outside California, the entire amount of the royalties received from the licenses was excluded from the numerator of the taxpayer's California sales factor.

Background

The taxpayer, based in the state of Washington, is engaged in the business of developing, licensing, manufacturing, and distributing computer software and providing computer software-related services. During the tax years at issue, the taxpayer entered into licensing agreements with original equipment manufacturers (OEMs) or computer sales companies that assembled or manufactured computer systems that were sold to end users. The licenses gave the OEMs the right to install the taxpayer's software products into their computer systems for sale with the pre-installed software. The taxpayer shipped the software directly to the OEMs on disks. During an OEM's assembly process, the software on the disks was copied onto the hard drives of the assembled units.2 Royalties accrued to the taxpayer on a per system or per copy basis, depending on the terms of the licensing agreement. The taxpayer also designed and sold a mouse and keyboard that could be sold as a set or individually.

In 2002, the California Franchise Tax Board (FTB) issued notices of proposed assessment for additional California tax plus penalties for the taxpayer's 1995 and 1996 tax years. The taxpayer eventually paid the entire amount, including interest and penalties,3 and filed a refund claim. After the FTB denied the taxpayer's refund claim, the taxpayer filed a complaint in trial court.

The trial court rejected the taxpayer's claims and held that the licensing of the software for use in the manufacturing of computers constituted the licensing of tangible personal property, which pursuant to the statute in effect during the taxpayer's tax years at audit, was sourced to California if the property is delivered to a purchaser within the state (i.e. the billing addresses of the licensees). The taxpayer appealed, alleging that the licenses should be characterized as sales of "other than tangible personal property" or intangibles that are sourced based on where the greater cumulative amount of the costs of performance relating to the licensed products was incurred.

Applicable Sourcing Rules for Tangible and Intangible Property

The distinction between sales of tangible and intangible property is important for purposes of calculating the California sales factor.4 During the tax years at issue, a sale of tangible personal property was sourced to California if the property is shipped to a purchaser within the state.5 However, the sale of intangible property was sourced to California if a greater proportion of the property's income-producing activity, as measured by its costs of performance, was performed in California than in any other state.6

Right to Replicate and Install Software Is Intangible

In reversing the trial court, the Court of Appeal determined that licensing the right to replicate and install software was an intangible right. As explained by the Court, the issue in this case was not whether the software itself could be classified as tangible or intangible property, but whether the right to replicate and install the software was a tangible or intangible right. While the Court of Appeal was comfortable in characterizing the software as a tangible item, the right to replicate...