Earlier this year, the California Court of Appeal (2nd District) issued its decision in Nortel Networks, Inc. v. State Board of Equalization, holding that sales of prewritten software fall within California’s sales and use tax exemption for transfers of intangible property pursuant to a technology transfer agreement (TTA).  The Court held that as long as the software was subject to a patent or copyright and the purchaser was permitted to load the software on to its computer, the software was exempt from tax.

The Nortel case has broad implications for the taxation of prewritten software in California. In the SBE’s own words (written to the California Supreme Court), under the Court of Appeal’s ruling, which is now final, sales of almost all software programs, even “sales of software programs, such as Windows 7 operating system, Microsoft Word, Quicken or TurboTax, will be subject to claims of exclusion from tax.”

By way of an internal audit memorandum issued on November 7, 2011, the SBE changed its story. That memo adds certain “qualifications” to the Nortel Court’s decision. Qualifications that the Court clearly did not intend. For example, the SBE’s memo states that in order to qualify for the TTA exemption, the owner of the patent or copyright must also be the retail seller of the software. So when Wal-Mart or Best Buy sells a copy of Microsoft Word you must pay tax on the retail price, but if Microsoft sells it directly to you, the sale qualifies for the TTA exemption. The memo also adds qualifications regarding what portion of the sales price of the software is actually exempt. Neither of these requirements appear in the Court’s decision.

These requirements may frustrate and deter taxpayers from seeking the refunds they deserve. We urge taxpayers to consider that these requirements do not flow from the Court’s decision and to continue pursuing these refunds. For a more detailed description of the Nortel decision’s impact, please see an alert authored by my colleagues Marty Dakessian, Mike Shaikh, and Brian Toman.