How did California treat proprietary software and other assets transferred to create a payment-processing business alliance?

Plain-English summary

Two redacted businesses proposed a contractual alliance to provide merchant credit-card and debit-card authorization, processing, and payment services. One party would transfer 100 percent of some assets and 60-percent undivided interests in others, including merchant contracts, collateral, leased point-of-sale hardware, records, other tangible property, and proprietary software. The purchase price would consist of cash and assumed liabilities, with an income-tax allocation to be made later.

The letter concluded that proprietary software, manuals, and documentation transferred electronically by telecommunications were not taxable. Specified merchant contracts, collateral interests, records, and temporary software copies loaned only for evaluation also were not taxable.

If California tax later applied to IBM Model 4381 computers planned for transfer in September 1994, their measure would exclude value attributable to proprietary programming already transferred electronically in late 1993. But the alliance was treated as a partnership only for tax characterization; the agreement still described a retail asset sale because it did not contemplate partnership-owned assets. The letter left possible tax on leased point-of-sale hardware and other listed tangible assets unresolved.

Proposed alliance and source limits

Assistant Chief Counsel Gary J. Jugum answered an October 27, 1993 facsimile letter two days later. The published PDF leaves the salutation blank and redacts both businesses. One already provided merchant credit- and debit-card authorization, processing, and payment; the other offered merchants broader payment-processing services. The source explains that the service covered transaction approval and collection, customer billing, merchant reimbursement, and the provider's responsibility for processing.

The proposed alliance would be treated as a partnership for federal and state income tax. The parties might later convert it into a formal partnership, but there was no current commitment. Their Agreement of Alliance was still being revised. The letter listed eight planned asset categories: 60-percent interests in merchant contracts; reserve accounts and other collateral; point-of-sale hardware leases; merchant-business records; scheduled tangible property excluding software media, documentation, and specified hardware; personal-computer software and related materials; other scheduled assets; and 100 percent of described mainframe, communications, and customized point-of-sale software plus manuals and documentation.

The proposed agreement would exclude tangible media containing proprietary software or intellectual property and require software, manuals, and documentation to move electronically over telecommunications lines. Staff understood that the transmission might occur weeks after closing because the parties needed preparation and a reliable line. The principal proprietary software would move from a California location to Maryland. The source's asset list visibly prints Contacts once where later text uses Contracts, and says proprietary software systems of used by; the original tail preserves both forms.

One party would loan mainframe software only for evaluation before the agreement. Every loaned copy would be returned or deleted and none retained. In September 1994, it planned to transfer title to IBM Model 4381 computers whose storage media might contain software sent in 1993, and might ship them back to Maryland. It might also transfer a 60-percent interest in personal computers containing only off-the-shelf, not proprietary, software.

The letter found no tax on remotely transmitted proprietary software and materials under Regulation 1502(f)(1)(D), or on categories 1, 2, and 4 and evaluation-only copies. It conditioned the IBM-computer measure on whether California tax applied and on the extent the embedded programming had already moved electronically. Although it would regard the alliance relationship as a partnership, the agreement contemplated a retail asset sale rather than partnership assets. The requester did not ask about categories 3, 5, and 7, so counsel expressly did not decide them.

The PDF does not include the October 27 request, Agreement of Alliance, section 1.02, any referenced schedule, merchant contracts, collateral records, point-of-sale leases, asset inventories or values, software ownership or version records, transmission plan or logs, evaluation loan record, deletion or return proof, IBM or personal-computer title and shipping records, cash amount, assumed-liability schedule, income-tax allocation, partnership filing, closing, invoices, sales- or use-tax returns, audit, assessment, protest, hearing, payment, appeal, or later outcome. It never establishes that the alliance closed or any planned transfer occurred.

The live annotation preserves the alliance, 60-percent tangible-property and proprietary-software interests, electronic transmission, later mainframe transfer, retail-sale and non-partnership-asset characterization, Regulation 1502(f)(1)(D) result, embedded-software measure, and October 29, 1993 date. It omits the still-revised proposal, eight-category list, 100-percent software items, contract and collateral no-tax results, point-of-sale leases, records, temporary evaluation loan, weeks-long transmission preparation, California-to-Maryland path, future September 1994 IBM transfer, possible shipment, personal computers and off-the-shelf software, cash and assumed liabilities, income-tax allocation, expressly unresolved categories, source wording defects, missing records, and absent closing and tax outcome.

What this means for you

Businesses transferring software with operating assets

Separate the software transmission from physical media and hardware. The remote-transfer treatment did not exempt the broader asset sale.

Accountants and tax professionals

Allocate cash and assumed liabilities among electronic software, intangible rights, records, hardware, and other tangible property, and identify categories the opinion does not resolve. This source includes no allocation or schedules.

Common questions

Q: Was the proprietary software transfer taxable?
A: No, because the proprietary programs and related materials were to be transferred remotely by telecommunications without tangible media.

Q: Were temporary evaluation copies taxable?
A: No. They were loaned only for review, had to be returned or deleted, and no copies would be retained.

Q: Did partnership treatment make the transfer a contribution?
A: No. The letter characterized the agreement as a retail sale because the assets were not contemplated as partnership assets.

Q: Did the letter decide tax on all tangible property?
A: No. It expressly did not decide the listed point-of-sale leases and several other tangible-property categories.

Q: Had the alliance agreement been finalized?

A: No. The letter says it was still being revised and the parties had no current commitment to form a formal partnership.

Q: Did the software actually move electronically as planned?

A: The source shows no transmission logs, closing records, hardware transfers, tax returns, or later outcome.

Citations and references

• California Sales and Use Tax Regulation 1502(f)(1)(D)
• October 27, 1993 request, Agreement of Alliance section 1.02, and all referenced asset and transmission schedules — described but not included
• Merchant, collateral, hardware, record, software, evaluation, transmission, shipping, price, liability, allocation, partnership, closing, tax, administrative, and outcome records — implicated but not included

Verbatim support

From the official October 29, 1993 Assistant Chief Counsel letter:

We understand that the "Agreement of Alliance" (the asset transfer agreement) is still being revised.

No sales or use tax will be imposed on the sale of the proprietary software and related manuals and documents under the Agreement of Alliance (i.e., the proprietary software described in #6 and #8 above).

While we would regard the relationship established by the Agreement of Alliance between --- and --- as a partnership for sales and use tax purposes, the transfer of assets contemplated by the agreement is properly characterized as a retail sale of assets from --- to ---.

Sales or use tax may apply to the transfers of tangible personal property described in #3, #5 and #7. You did not request our opinion as to these items.

Source

• Annotated Legal Opinions collection: CDTFA Annotated Legal Opinions
• Annotation page: Annotation 395.0079
• Original supporting opinion: 395.0079 PDF

Original ruling text

395.0079

STATE OF CALIFORNIA

STATE BOARD OF EQUALIZATION

October 29, 1993

Dear
This is in response to your letter of October 27, 1993, which was sent to this office by facsimile transmission. We understand that --- and --- a --- desire to establish a contractual business alliance in which they will jointly provide to business merchants credit card and debit card authorization, processing and payment services and certain other services relating thereto. Currently --- is engaged in the business of providing credit card and debit card authorization, processing and payment services to merchants and --- is engaged in the business of providing merchants a broad range of payment processing services. Credit card and debit card authorization, processing and payment services is the approval and collection process of a business merchant's credit transaction. Business merchants accepting a credit card or debit card from a customer as a means of payment receive authorization and payment from --- when utilizing this service. --- then accepts responsibility for processing the transaction so the customer eventually gets billed and --gets reimbursed for the credit extended to the business merchant's customer. To establish the business alliance, --- will transfer to --- 100% of some assets and a 60% undivided interest in certain other assets of its business. In addition, --- and ---.will enter into other arrangements relating to the operation of the business alliance following the transfer of assets. The alliance will be treated as a partnership for federal and state income tax purposes. The parties may also convert the alliance into a formal partnership after the transfer of the assets, although there is no current commitment to do so. We understand that the "Agreement of Alliance" (the asset transfer agreement) is still being revised. The Agreement will require --- to transfer the following assets, however:

1. A 60% undivided interest in various --- Contacts (where --- and a
   merchant agree that, --- will provide various debit or credit card-services);
2. A 60% undivided interest in all merchant reserve accounts, letters of
   credit, bonds, insurance policies, guaranties, cash collateral deposits and other collateral which secures the payments of amounts owed to --- that relate to the --- Contracts;

3. A 60% undivided interest in all leases to merchants of Point of Sale hardware (the card reader machines);

4. A 60% undivided interest in all papers, documents, instruments, customer
   lists, books, records, files, agreements, books of account and other records relating to the merchant business;
5. A 60% undivided interest in all tangible personal property (excluding all
   software storage media and related documentation and various items of computer hardware) related to the merchant business and listed in a separate schedule;
6. A 60% undivided interest in all proprietary personal computer based
   software which is used exclusively or primarily in the merchant business and related manuals and documentation;
7. A 60% undivided interest in various other assets (excluding software
   storage media and related documentation) to be listed in a separate schedule;
8. All computer software programs used primarily or exclusively in the
   merchant business, including (i) the proprietary software systems of used by ---, to provide debit card processing services (subject to ---, paying royalties under a related agreement), (ii) the proprietary software systems used by --- in providing communication services to its customers and (iii) the customized or proprietary point of sale applications as set forth in a separate schedule, plus all related manuals and documentation. The Agreement will also contain a provision similar or identical to the following: Notwithstanding anything to the contrary set forth in Section 1.02 [the asset transfer provisions], the assets --- shall sell, convey, transfer, assign or deliver to --- shall not include any tangible personal property containing proprietary software source or object code or other intellectual property, or any manuals or documentation related to such software or intellectual property. All software source or object code or other intellectual property contained on tangible personal property, and all manuals and documentation related thereto, shall be transferred electronically via
   .
   telecommunications lines as detailed in Schedule
   We understand that the electronic transmission of the software from --- to --- may not occur until several weeks after the closing of the transaction. To transfer the software error free, it will apparently take the parties several weeks to prepare for the electronic transmission and to secure a reliable telecommunications line.

We understand that --- will loan to --- for its review only, a copy of its mainframe system software used in its merchant business operation (the proprietary software described in #8 above). --- will limit its use solely to its evaluation and determination of which software, if any, will be purchased. Upon completion, all software loaned will be returned to --- No copies will be retained and all of the loaned software will be deleted from all --- computer systems. We understand that in September 1994, --- will transfer title to its IBM Model 4381 computers used in the merchant business. The storage media associated with these computers may contain some of the programming transferred in 1993 under the Alliance Agreement. --- may also ship the computers back to --- in Maryland in September 1994. We understand that ---, may transfer a 60% undivided interest in the personal computers used in the merchant business. The storage media for these computers will contain only off-the-shelf programming, and will not contain any software proprietary to
--- in its merchant business.
The purchase price for the assets consists of cash and the assumption of liabilities. The parties will make an allocation of the purchase price for income tax purposes. We understand that one of the principle assets being acquired by --- is the proprietary software for --- merchant business. --- and --- intend to transfer this software (and related manuals and documentation) by remote telecommunications from --location in --- California to a --- location in Maryland. Based on the foregoing, it is our opinion that: a. No sales or use tax will be imposed on the sale of the proprietary software and related manuals and documents under the Agreement of Alliance (i.e., the proprietary software described in #6 and #8 above). Regulation 1502 (f) (1) (D) provides that the sale of a prewritten program is not taxable if transferred by remote telecommunications. b. No sales or use tax applies to the items described in #1, #2 and #4. c. No sale or use tax applies to the copies of the proprietary software given by --- to --- so that --- could review the technology prior to entering into the Agreement of Alliance. d. If California sales or use tax applies to the transfer of the IBM 4381 computers in September 1994, the measure of the tax will not include any value attributable to any proprietary programming contained on the related storage media to the extent that the programming was transferred electronically in late 1993.

e. While we would regard the relationship established by the Agreement of Alliance between --- and --- as a partnership for sales and use tax purposes, the transfer of assets contemplated by the agreement is properly characterized as a retail sale of assets from --- to ---. The Agreement does not contemplate that the assets will be regarded as partnership assets. Sales or use tax may apply to the transfers of tangible personal property described in #3, #5 and #7. You did not request our opinion as to these items.

Sincerely,

Gary J. Jugum
Assistant Chief Counsel

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