Was a $250,000 settlement over alleged unauthorized use of licensed software subject to California sales tax?

Plain-English summary

A software vendor licensed programs to a customer for use on an individual central processing unit. The vendor alleged unauthorized use; the customer denied it but agreed to pay $250,000 to settle the dispute. The vendor also invoiced $20,625 as sales tax.

Tax counsel explained that Regulation 1502 applied tax to prewritten software transferred on tangible media and to associated license fees. Prior staff annotations likewise treated added fees for expanded software use or transfer to other equipment as taxable.

Because this settlement resolved disputed amounts attributed to acquiring the software and its license rights, the $250,000 was taxable gross receipts from the software sale. The letter did not say that settlements are categorically taxable; it tied this result to what the payment represented.

Citations and references

• California Sales and Use Tax Regulation 1502(f)(1)(B) (as cited)
• Board of Equalization Annotations 120.0552 and 120.0540 (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/120-0525.pdf

Original ruling text

120.0525

STATE OF CALIFORNIA

STATE BOARD OF EQUALIZATION
LEGAL DIVISION (MIC:82)
450 N STREET, SACRAMENTO, CALIFORNIA
(PO BOX 942879, SACRAMENTO, CALIFORNIA 94279-0082)
TELEPHONE (916) 327-2291
FAX (916) 323-3387

JOHAN KLEHS
First District, Hayward
DEAN F. ANDAL
Second District, Stockton
ERNEST J. DRONENBURG, JR.
Third District, San Diego
KATHLEEN CONNELL
Controller, Sacramento
___
JOHN CHIANG
Acting Member
Fourth District, Los Angeles
___

March 17, 1997

E. L. SORENSEN, JR.
Executive Director

Ms. C--- M. M--C--- A--- I---, Inc.
--- --- --- Plaza
---, NY XXXXX-XXXX
Re: SC ---B XX-XXXXXX
Dear Ms. M---:
This is in response to your letter of February 4, 1997 in which you inquired about the application of sales tax on amounts received in settlement of a dispute over use of computer software. Your company, C--- A--- (CA), is in the business of designing, developing, marketing, and supporting computer software products which are compatible with most computer systems. According to your letter, CA sold software to the [T] of the C--- S--- U--- ([T]) and entered into a contract with them restricting the use of the software to their individual central processing unit (CPU). There was a dispute as to whether the [T] had used the software programs in an unauthorized manner. While the [T] contended that the software was not used in an unauthorized manner, a settlement was reached whereby the [T] agreed to pay $250,000.00 in settlement of the dispute. CA added $20,625.00 in sales tax on its invoice for the settlement. The [T] contend that sales tax should not apply because the “settlement fee” is a non-taxable transaction. You have written to seek clarification as to whether sales tax applies to the amount received in settlement from the [T]. Sales and Use Tax Regulation 1502(f)(1) explains that tax applies to the sale or lease of tangible personal property such as software onto which prewritten computer programs have been recorded, coded, or punched. Subparagraph (B) of this section further explains that tax applies to the entire amount charged to the customer, including license fees associated with the transfer of the software.

Ms. C--- M. M---

-2-

March 17, 1997
120.0525

Questions regarding the application of sales and use tax on software license transfer fees have been previously addressed in Business Taxes law Guide (BTLG) Sales and Use Tax Annotations. In Annotations 120.0552 (1/6/92) and 120.0540 (7/18/95) the Board of Equalization's legal staff has taken the position that additional license fees charged by a software provider to expand the use of the software or to transfer the license to additional equipment is subject to tax. While the [T] maintain that they did not use the software in any manner other than that authorized under the license, nonetheless the dispute arises over the charges for the purchase of software and the license fees. The settlement fee was paid in order to settle the dispute over amounts owed attributable to the acquisition of the software and the accompanying license fees. Accordingly, the proceeds from the settlement constitute gross receipts attributable to the sale of the software to the [T] and, as such, are taxable. If you have any further questions please feel free to contact this office again. Sincerely,

Patricia Hart Jorgensen
Senior Tax Counsel

PHJ:cl
cc:

Out-of-State District Administrator