In a January 18, 2011 decision, the California Court of Appeal in Nortel Networks, Inc. v. State Board of Equalization, (2011) 191 Cal. App. 4th 1259, held that the license of prewritten software by Nortel Networks, Inc. (“Nortel”) to Pacific Bell Telephone Company (“Pacific Bell”), used to operate switching equipment sold by Nortel to Pacific Bell, was exempt from sales tax because it was a Technology Transfer Agreement (“TTA”).

Under California law, a licensing agreement is exempt from sales tax if it is a TTA. A TTA 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.” (Cal. Rev. & Tax. Code § 6011(c)(10)(D), 6012(c)(10)(D).) Thus, under California law, not every software program qualifies as a TTA for sales tax purposes. Only the transfer of a program that is subject to a patent or copyright is a TTA. But an agreement does not need to expressly reference a patent or copyright in order to be a TTA. (Nortel, 191 Cal. App.4th at 1276.)

The State Board of Equalization (“Board”) also adopted Regulation 1507 defining a TTA and, importantly, describing what a TTA is not. Regulation 1507(a)(1) states, in part, that a TTA “does not mean an agreement for the transfer of prewritten software…” (Cal. Code Regs., tit. 18, § 1507(a)(1).)

In Nortel, the taxpayer manufactured and sold telecommunication hardware to Pacific Bell that processed telephone calls, and handled features such as conference calling, call waiting, and voice mail. As part of the transaction, the parties entered into licensing agreements giving Pacific Bell the right to use Nortel’s copyrighted software programs in the hardware, which implemented processes that were subject to Nortel’s patents. Pacific Bell used these patented processes to create and sell a product – telephone communications for consumers.

The California Court of Appeal in Nortel considered, among other things, whether Nortel’s license of prewritten software to Pacific Bell is subject to sales tax. The court held that Nortel’s license of prewritten software was a TTA and thus exempt from sales tax because it was (1) copyrighted, (2) contained patented processes, and (3) enabled the licensee to copy the software, and to make and sell products. (Nortel, 191 Cal. App.4th at 1265.)

The Board argued that, pursuant to Regulation 1507(a)(1), Nortel’s license of prewritten software was not a TTA. The court disagreed, holding that the Board’s regulation was invalid. The court reasoned that “the TTA statutes do not restrict agreements transferring an interest in prewritten software. Instead, they apply to ‘any agreement’.” (Id. at 1277.) Because the Board in its regulation “exclud[ed] prewritten software that is subject to a copyright or patent” it “thereby creat[ed] an exception that the Legislature did not see fit to make” and thus was outside the scope of its authority. (Id.) The court held the regulation was, therefore, invalid.

As a result of the Nortel case, the Board may no longer be able to tax many prewritten software programs. Instead, the Board will now have to look at the transfer of a prewritten software program on a case-by-case basis to determine if it constitutes a TTA. Companies or individuals licensing, assigning, or selling software that is subject to a copyright or patent should consider the Nortel decision and the application of the TTA statutes when determining their sales tax reporting obligations.

The Board has filed a petition for review with the California Supreme Court.