Were an initial software license fee and per-copy royalties taxable when the buyer only reproduced the program inside products sold to others?

Plain-English summary

A hypothetical software developer licensed a spell-checking program to a California company. The buyer planned to incorporate it into its word-processing product sold to the public and would pay a $100,000 initial fee plus a $20 royalty for every copy sold.

Tax counsel said neither charge was taxable if federal copyright attached and the program was transferred solely so the buyer could reproduce and sell it, rather than use it as an end user. The result was the same whether the buyer sold the program unchanged, modified it, or embedded it within another program.

Any storage medium transferred with the reproduction rights was merely incidental. By contrast, software transferred in tangible form for the buyer's own use was a taxable sale under the source's distinction.

Citations and references

• California Sales and Use Tax Regulation 1502(f)(1)(B) (as cited)

Source

• Annotated Legal Opinions collection: https://cdtfa.ca.gov/taxes-and-fees/annotations-menu.htm
• Annotation page: https://cdtfa.ca.gov/lawguides/vol2/suta/120-0000-all.html
• Original supporting opinion: https://cdtfa.ca.gov/lawguides/annotations/120-0116.pdf

Original ruling text

120.0116

STATE OF CALIFORNIA

STATE BOARD OF EQUALIZATION

MEMBER
First District

LEGAL DIVISION (MIC:82)
450 N STREET, SACRAMENTO, CALIFORNIA
(P.O. BOX 942879, SACRAMENTO, CALIFORNIA 94279-0001)
Ph: (916) 324-2637
FAX: (916) 323-3387

BRAD SHERMAN
Second District, Los Angeles
ERNEST J. DRONENBURG, JR.
Third District, San Diego
MATTHEW K. FONG
Fourth District, Los Angeles

November 17, 1994

BURTON W. OLIVER
Executive Director

Mr. S--- S--Associate Editor
K--- Publications
P. O. Box XXX
---, -- XXXXX-XXXX
Re:

GRAY DAVIS
Controller, Sacramento

Unidentified Taxpayer - Taxation
of License and Royalty Fees

Dear Mr. S---:
This is in response to your letter dated September 21, 1994 regarding the application of California sales and use tax to computer program license and royalty fees. You provide the following hypothetical: "Acme Software Development Company is an out-of-state company that already has nexus with California. It develops a spell checking program/technology which it licenses to Bee Company, which is based in California. Bee will not be using the Acme program/technology itself, but rather, will incorporate the spell checker into a word processing program, BeeWord, which Bee has developed and is selling to the general public. "The contract between Acme and Bee required Bee to pay an initial license fee of $100,000 to Acme. Thereafter, Bee is required to pay Acme [a] $20 royalty for each copy of Bee Word which Bee sells." You ask: "1. Is the initial license fee ($100,000) from Bee to Acme subject to California sales tax? "2. Is the $20 per copy royalty subject to California sales tax?

Mr. S--- S---

-2-

November 17, 1994
120.0116

Discussion
Subdivision (f) of Regulation 1502 (a copy of which is enclosed) explains the application of tax to sales of software. Subdivision (f)(1)(B) applies to your hypothetical: "Tax applies to the entire amount charged to the customer. Where the consideration consists of license fees, all license fees, including site licensing and other end users fees, are includible in the measure of tax. Tax does not apply, however, to license fees or royalty payments that are made for the right to reproduce or copy a program to which a federal copyright attaches in order for the program to be published and distributed for a consideration to third parties, even if a tangible copy of the program is transferred concurrently with the granting of such right. Any storage media used to transmit the program is merely incidental." (Emphasis added.) This means that a sale of software in tangible form for use by the transferee is a taxable sale of tangible personal property. On the other hand, if a transaction is actually a transfer of the right to copy and sell software under circumstances that such copying and selling would otherwise be a violation of the transferor's federally protected copyright interests, we do not regard the transaction as a sale of tangible personal property, even if some storage media is incidentally transferred. Under such circumstances, sales tax does not apply to the transferror's charges. If the transferee obtains the software for the purpose of copying and selling, and not for use, the transaction is not taxable whether the transferee sells the program in the identical form as received, modifies it and sells the modified program, or incorporates it into another program and then sells that program. Thus, provided a federal copyright attaches to the spell checking program and it is transferred solely for the purpose of being copied and sold as part of the word processing program, tax does not apply to Acme's initial fee or to the royalty fee. If you have further questions, feel free to write again. Sincerely,

Warren L. Astleford
Staff Counsel
WLA:plh
Enclosure: Reg. 1502
cc:

--- Sacramento District Office - --