Last week, the California Supreme Court denied the State Board of Equalization’s (BOE’s) petition for review in Lucent Technologies, Inc. v. State Bd. of Equalization, No. S230657 (petition for review denied Jan. 20, 2016). This comes just months after the California Court of Appeals held against the BOE and ordered it to pay Lucent’s $25 million sales tax refund. As explained in more detail below, the denial finalizes the favorable precedent of the Court of Appeals in Nortel Networks Inc. v. State Bd. of Equalization, 191 Cal. App. 4th 1259, 119 Cal. Rptr. 3d 905 (2011)—representing a monumental victory for a broad range of taxpayers in California and opening the door for significant refund opportunities. Moreover, the California Supreme Court’s denial affirms the Court of Appeals decision that the BOE’s position was not substantially justified and the taxpayer was entitled to reasonable litigation costs of over $2.6 million.

Background

Lucent and AT&T (collectively Lucent) are and were global suppliers of products and services supporting, among other things, landline and wireless telephone services, the internet, and other public and private data, voice and multimedia communications networks using terrestrial and wireless technologies. Lucent manufactured and sold switching equipment (switches) to their telephone customers, which allowed the customers to provide telephone calling and other services to the end customers. The switches required software, provided on storage media, to operate. Lucent designed the software (both switch-specific and generic) that runs the switches they sell, which was copyrighted because it is an original work of authorship that has been fixed onto tapes. The software also embodies, implements and enables at least one of 18 different patents held by Lucent.

Between January 1, 1995, and September 30, 2000, Lucent entered into contracts with nine different 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). Lucent gave the telephone companies the software by sending them magnetic tapes or CDs containing the software. Lucent’s placement of the software onto the tapes or discs, like the addition of any data to such physical media, physically altered those media. The telephone companies paid Lucent over $300 million for a copy of the software and for the licenses to copy and use that software on their switches.

The BOE assessed sales tax on the full amount of the licensing fees paid under the contracts between Lucent and its telephone company customers. Lucent paid the assessment and sued the BOE for a sales tax refund attributable to the software and licenses to copy and use that software at the trial court. The parties filed cross-motions for summary judgment on Lucent’s refund claims, and the Los Angeles County Superior Court issued a 15-page ruling granting Lucent’s motions in 2013. The court concluded that the contracts between Lucent and the telephone companies were technology transfer agreement’s (TTA’s) within the meaning of the California exemption statute. See Cal. Rev. & Tax. Code §§ 6011(c)(10); 6012(c)(10) (exempting the amount charged for intangible personal property transferred with tangible personal property in any TTA from the definition of “sales price” and “gross receipts”). According to the California statute, a TTA is “any agreement under which a person holding 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.” As a result, Lucent was obligated to pay sales taxes on the tangible portion of the sale (the switches, the instructions, and the tapes and CDs used to transmit the software), but not required to pay tax on the intangible portion (the software and licenses). Because of this, the court ordered the BOE to refund the sales taxes paid on the software and licensing fees—totaling more than $24.5 million. The court also awarded court costs and “reasonable litigation costs” of more than $2.6 million after finding the BOE’s position in the litigation was not “substantially justified.”  The BOE appealed to the California Court of Appeals.

Court of Appeals Decision

On October 8, 2015, the California Court of Appeals for the Second Appellate District affirmed the Superior Court ruling granting Lucent’s motion for summary judgment and ordering the BOE to pay Lucent’s refund and costs (including attorneys’ fees). Once again, the BOE argued that copying the software to a CD or tape, rather than transferring it over the internet, transformed the software or the rights to use it into tangible personal property (i.e., subject to sales tax). The appellate court rejected this argument, citing to the 2011 Nortel case involving nearly the exact same facts. Consistent with Nortel, the court determined that that the BOE’s sales tax assessment was erroneous. In so concluding, the court held that: (1) the manufacturer’s decision to give the telephone companies copies of the software on tapes and CDs (rather than over the internet) does not turn the software itself or the rights to use it into tangible personal property subject to the sales tax; (2) a TTA, 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 TTA 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. Procedurally, the court held that the BOE’s trenchant opposition to the manufacturer’s refund action in this case was all but foreclosed by Nortel and other binding decisional and statutory law, making the BOE’s position not “substantially justified” and the trial court did not abuse its discretion in awarding the manufacturer its “reasonable litigation costs.”

Impact of the Decisions

The Lucent denial by the California Supreme Court could have a significant impact. Although both Lucent and Nortel were factually based on telecommunications equipment in interpreting the TTA, there is nothing in either decision to suggest that their scope is limited to telecommunication equipment. The decisions involve the sales and use tax statutes and broadly apply to any mixed or bundled transaction where the driving cost behind the transaction is an intangible, including software. Any business selling or buying software should consider whether refund opportunities exist for open years. In the sales tax context for California, the period of limitations to file a refund is generally “three years from the last day of the month following the close of the quarterly period for which the overpayment was made.” See Cal. Rev. & Tax. Code § 6902(a)(1).

As the refund madness plays out over the coming months (any beyond), it will be interesting to see if the BOE once again attempts to retroactively mitigate the effects of the courts’ precedent. Specifically, in June 2013, BOE officials, working with 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 ultimately rejected the inclusion of the provision in the budget trailer on procedural grounds, but left the door open for future legislation on the substance. The language would have broadened the definition of “storage media” such that prepackaged software sold on storage media is always tangible property subject to sales tax. Whether the BOE pursues legislation or not, the fight over the scope of the TTA exemption will likely continue despite the recent precedential victory and slap on the wrist by the appellate courts.