Were video-game royalties taxable when a licensee received masters and the right to reproduce and distribute copyrighted software?

Plain-English summary

A video-game publisher proposed nonexclusive licenses allowing others to convert and modify games for compatible formats, reproduce them, and distribute copies to end users. The licensor would provide object-code masters plus mechanical art or film and receive royalties based on net sales.

The Board said royalties or license fees for the right to reproduce copyrighted software for publication and distribution to third parties were not taxable. A tangible master could accompany the right, and the licensee could modify the program, without changing that result; the transmission medium was incidental to the reproduction right.

Other charges were treated differently. Converting data from one physical recording format to another was taxable. Charges attributable to mechanical art and film transferred with the software media were also taxable, even though the software master associated with the reproduction license could be nontaxable.

The letter also concluded that private rentals of the described video games qualified for the cited videocassette, videotape, and videodisc lease treatment, under which tax was measured by rental receipts.

Transaction-by-transaction treatment

• Copyrighted reproduction and distribution right: royalty or license fee nontaxable under the cited rule.
• Physical master accompanying that right: incidental under the stated licensing facts.
• Conversion from floppy disk to CD-ROM or another physical recordation: taxable.
• Mechanical art and film: taxable portion of the charge.
• Private rental of the described games: tax measured by rental receipts under the cited provisions.

Citations and references

• California Revenue and Taxation Code sections 6006(g)(7) and 6010(e)(7) (as cited)
• California Sales and Use Tax Regulation 1502(d)(1) and (f)(1)(B) (as cited)
• June 23, 1992 request describing proposed nonexclusive licenses, object-code masters, mechanical art or film, licensee-made CD instructions, reproduction and modification rights, and net-sales royalties — request not separately reproduced beyond the letter's quotation
• Assumed ultimate private-use rentals and proposed licensing transactions — agreements, copyright registrations, masters, art, film, instructions, royalty and charge allocations, sales, rentals, invoices, and tax records not reproduced in the official PDF
• Official Annotation 295.0703's floppy-disk video games, proposed licenses and conversion, object-code masters, art or film, net-sales royalties, reproduction-right exemption, taxable art and film, conversion and rental treatment, and Sept. 2, 1992 date — annotation says transfer of “date” where the source says “data” and omits the request provenance, prospective and assumed posture, allocation and private-use conditions, missing evidence, reliance status, and later outcome and supplies no additional transaction record

Source

• Annotated Legal Opinions collection: https://cdtfa.ca.gov/taxes-and-fees/annotations-menu.htm
• Annotation page: https://cdtfa.ca.gov/lawguides/vol2/suta/295-0000-all.html
• Original supporting opinion: https://cdtfa.ca.gov/lawguides/annotations/295-0703.pdf

Original ruling text

295.0703

STATE OF CALIFORNIA

STATE BOARD OF EQUALIZATION

WILLIAM M. BENNETT
First District, Kentfield

1020 N STREET, SACRAMENTO, CALIFORNIA
(P.O. BOX 942879, SACRAMENTO, CALIFORNIA 94279-0001)
(916) 445-6450

BRAD SHERMAN
Second District, Los Angeles
ERNEST J. DRONENBURG, JR.
Third District, San Diego

September 2, 1992

MATTHEW K. FONG
Fourth District, Los Angeles
GRAY DAVIS
Controller, Sacramento

Mr. D--- T----- & --XXX --- Street
--- ---, CA XXXXX

BURTON W. OLIVER
Executive Director

Dear Mr. T---:
This is in reply to your June 23, 1992 letter regarding the application of sales and use tax to a software licensing agreement. You provided the following explanation: "Our clients develop and publish video games. The games are currently manufactured and distributed on floppy disks. Our clients are interested in issuing non-exclusive licensing agreements for their products to persons who would be granted the right to convert and, to the extent necessary, modify the video games to be compatible with computer/interactive entertainment formats such as IBM and IBM compatible CD-ROM's. With respect to the above, our clients ('licensors') would supply to the licensees object code masters for the licensed games, and mechanical art or film for all components necessary to complete the licensed products, with the exception of CD-specific instructions, which would be produced by the licensee. With respect to the sale and distribution of the licensed products, the licensee shall pay the licensor royalties equal to a percentage of net sales." Given this information, you asked the following specific questions:
• Are video games taxable as video cassettes (i.e. tax on rental receipts) or software or as tangible personal property? We assume that you asking whether the ultimate rentals of such video games for private use are subject to Revenue and Taxation Code sections 6006, subdivision (g)(7) and 6010, subdivision (e)(7) which provide generally that tax applies to rentals and leases of videocassettes, videotapes, and videodiscs measured by the rental receipts and preclude the lessor from paying tax measured by cost. Yes, we believe that the video games you describe would qualify for that tax treatment.

Mr. D--- T---

-2-

September 2, 1992
295.0703

• Are the royalties and/or fixed amounts paid for a software license agreement subject to sales/use tax? Yes, generally, the transfer of software for a consideration is subject to tax. However, tax does not apply to royalty payments or license fees paid 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. That is true regardless that a tangible copy of the program is transferred with the granting of such right and that the licensee may modify the program. Any storage media used to transmit the program is merely incidental. (Sales and Use Tax Reg. 1502, Computers, Programs, and Data Processing, subd. (f)(l)(B).)
• Is the transfer of information from one storage media (i.e. floppy disk) to a different storage media (i.e. cd rom) taxable? A charge for converting data from one physical form of recordation to another form is subject to tax. (Reg. 1502, subd. (d)(l).)
• How does tax apply when a master game is sold or licensed for duplication purposes for ultimate resale to the end-user? We believe the response to the second question above answers this.
• What is the tax application for related tangible personal property transferred with the storage media (game) mechanicals, film, etc.? Although the charge for the storage media may be nontaxable as discussed in response to the second question, tax would apply to the portion of the charge attributable to the transfer of the mechanical art and film. We hope this answers your questions; however, if you need further information, feel free to contact me directly. Very truly yours,

Ronald L. Dick
Senior Tax Counsel
RLD:sr