1 BEFORE THE CALIFORNIA STATE BOARD OF EQUALIZATION 2 450 N STREET 3 SACRAMENTO, CALIFORNIA 4 5 6 7 REPORTER'S TRANSCRIPT 8 MARCH 30, 2016 9 10 11 12 ITEM M 13 OTHER CHIEF COUNSEL MATTERS 14 ITEM M1 15 LUCENT TECHNOLOGIES, INC. V. STATE BOARD OF 16 EQUALIZATION AND SALES AND USE TAX REGULATIONS 1502, 17 COMPUTERS, PROGRAMS, AND DATA PROCESSING, AND 1507, 18 TECHNOLOGY TRANSFER AGREEMENTS 19 20 21 22 23 24 25 26 27 REPORTED BY: Kathleen Skidgel 28 CSR NO. 9039 1 1 P R E S E N T 2 3 For the Board of Equalization: Fiona Ma, CPA 4 Chairwoman 5 Diane L. Harkey Vice Chair 6 Jerome E. Horton 7 Member 8 Sen. George Runner (Ret.) Member 9 Yvette Stowers 10 Appearing for Betty T. Yee, State Controller 11 (per Government Code Section 7.9) 12 Joann Richmond 13 Chief Board Proceedings 14 Division 15 16 For Board of Equalization Staff: Randy Ferris 17 Chief Legal Counsel 18 Robert Tucker Assistant Chief Legal 19 Counsel 20 Speaker: Therese Twomey Fiscal Policy Director 21 California Taxpayers Association 22 23 ---oOo--- 24 25 26 27 28 2 1 450 N STREET 2 SACRAMENTO, CALIFORNIA 3 MARCH 30, 2016 4 ---oOo--- 5 MS. MA: Next item, Ms. Richmond? 6 MS. RICHMOND: Our next item is Item M 7 Other Chief Counsel matters; Item M1, Lucent 8 Technologies, Inc. versus State Board of 9 Equalization, and Sales and Use Tax Regulations 10 1502, Computers, Programs and Data Processing, and 11 1507, Technology Transfer Agreements. 12 MS. MA: Welcome, Mr. Ferris and 13 Mr. Tucker. Please introduce yourself for the 14 record and then commence with your presentation. 15 MR. TUCKER: Yes. I'm Robert Tucker with 16 the Board's Legal Department, and with me is 17 Mr. Randy Ferris, our Chief Counsel, here to discuss 18 Lucent. 19 As the Board is aware, on January 20th, 20 2016, the Board's petition for review of the Court 21 of Appeal's opinion deciding Lucent Technologies, 22 Inc. versus the State Board of Equalization was 23 denied by the California Supreme Court. 24 Accordingly, we're here to present options 25 for the Board to consider in order to implement the 26 Lucent decision. 27 In Lucent, the Court of Appeal applied the 28 provisions of Revenue and Taxation Code sections 3 1 6011 subdivision (c)(10) and six -- or 6012 2 subdivision (c)(10), which are collectively the 3 Technology Transfer Agreement, or otherwise referred 4 to as TTA statutes. 5 These were applied to transactions in which 6 AT&T Corporation and Lucent Technologies sold 7 telephone companies: (1) switches used to connect 8 telephone and data networks; (2) written 9 instructions on how to use the switches; and (3) 10 copies of copyrighted switch-specific software and 11 generic software recorded on tapes and discs, which 12 were each subject to at least one patent held by 13 Lucent, together with the right to copy the software 14 onto the switches' hard drives and the right to use 15 the software to route calls and data and to offer 16 call waiting and other features to their 17 customers. 18 The Court of Appeal held the transactions 19 constituted software TTAs because: (1) the software 20 was copyrighted and patented; (2) Lucent established 21 that it was the holder of the copyrights and 22 patents; and (3) Lucent established that it 23 transferred a portion of its copyright and patent 24 interest in the software to the telephone companies 25 so they could produce telephone products that were 26 subject to Lucent's copyrights and patents. 27 The Court of Appeal also held that under 28 the TTA statutes the charges for the right to copy 4 1 and use the software under the TTAs were not subject 2 to sales and use tax, but the price of the blank 3 media transferred -- pardon me, were not only -- 4 were not subject to sales and use tax, but that the 5 price of blank media transferred was subject to tax. 6 As more fully explained in the Chief 7 Counsel memorandum to the Board, the Legal 8 Department makes three recommendations to this 9 Board: 10 First, we recommend making amendments to 11 Sales and Use Tax Regulation 1507, Technology 12 Transfer Agreements, to clarify the requirements 13 that establish an agreement for the transfer of 14 software on tangible storage media is a software TTA 15 in accordance with the primary holding in Lucent, 16 and to clarify the measure of tax when software's 17 transferred under a software TTA, and also to make 18 conforming amendments to Regulation 1502, Computers, 19 Programs and Data Processing. 20 In accordance with the holdings in Lucent, 21 the Legal Department recommends the Board makes 22 amendments to Regulations 1502 and 1507 to clarify, 23 one, the requirements to establish an agreement for 24 the transfer of non-custom software on tangible 25 storage media is a software TTA, the measure of tax 26 when software is transferred under a software TTA, 27 and the measure of tax when storage media on which 28 software is placed is sold at retail in a non-TTA 5 1 transaction. Such rulemaking would need to consider 2 the correct application of the tax to transactions 3 involving exclusive holder-retailers, non-exclusive 4 holder-retailers, and non-holder retailers. 5 Procedurally, we recommend rulemaking could 6 be initiated through either a Chief Counsel Matters 7 agenda item or an interested parties process 8 overseen by the Business Taxes Committee. 9 Second, the Legal Department recommends the 10 Board issue a notice to clarify: 11 One, that typical off-the-shelf retail sale 12 of canned mass-marketed software still does not 13 constitute a software TTA because the typical 14 retailer can only sell the tangible storage media 15 and does not hold any intangible copyright or patent 16 interests in the software to transfer with the 17 storage media; 18 And, two, Lucent is only dispositive with 19 respect to software transmitted on tangible storage 20 media that is wholly collateral to the subsequent 21 use of the licenses regarding the software and is 22 not dispositive with respect to embedded non-custom 23 software or preloaded non-custom software. These 24 items were not at issue in Lucent. 25 Although the Board is not obligated to do 26 so under Lucent, the Board also has the option of 27 considering rulemaking for sales and use tax 28 purposes with respect to these transactions 6 1 involving software embedded at the time of 2 manufacture. Again, any such rulemaking would need 3 to consider the correct application of the tax to 4 the transactions involving exclusive 5 holder-retailers, non-exclusive holder-retailers and 6 non-holder retailers. 7 And finally, the Legal Department 8 recommends and it -- or acknowledges that certain 9 refund claims may be potentially ready for immediate 10 processing. Based on the Lucent opinion itself, 11 unless the Board directs staff otherwise, staff is 12 prepared to begin processing immediately, meaning 13 prior to the completion of any rulemaking, 14 any timely valid refund claims for which staff can 15 verify the existence of software TTA between an 16 exclusive holder-retailer and purchaser licensee 17 pursuant to which software was transmitted on 18 tangible storage media which is wholly collateral to 19 the subsequent use of the licenses regarding that 20 software. 21 Under Lucent, it's clear that the taxable 22 measure for such software TTA transactions would be 23 the retail fair market value of the storage media, 24 which is deemed to be blank without reference to any 25 potential like transactions involving third-party 26 vendors. 27 Thank you very much. 28 MS. MA: Thank you. 7 1 We have one member of the public here today 2 to testify, Ms. Therese Twomey of the California 3 Taxpayers Association. 4 ---oOo--- 5 THERESE TWOMEY 6 ---oOo--- 7 MS. TWOMEY: Good afternoon, Members. And 8 thank you so much for the opportunity to present 9 testimony. 10 In the Lucent decision, Lucent made very 11 clear what was taxable and what was not taxable, 12 particularly to the items at fact in the Lucent 13 case. However, as indicated in the Chief Counsel's 14 memo, there are still other areas that need guidance 15 from the Board of Equalization. 16 And as the Board deliberates these issues, 17 we ask that the Board consider three overarching 18 principles in providing such guidance in addressing 19 issues specific to whether or not Lucent is 20 applicable to embedded software and how holders and 21 retailers and non-holder retailers would be subject 22 to the measure of tax. 23 The first principle that we'd like to 24 address is a reasonable test. And when we talk 25 about reasonable tests, what we're saying is we're 26 asking the Board to provide an interpretation and an 27 implementation program that is neither too broad, 28 such that all taxpayers with de minimis, you know, 8 1 sales tax who have ever purchased any software would 2 be subject to a refund. We think that is too broad 3 and that would be something that the court would 4 likely consider, quote unquote, "absurd" under their 5 interpretation. 6 And there's precedent for having a not too 7 broad interpretation under Loeffler versus the 8 Target case in which a taxpayer brought suit for 9 imposition of sales tax on hot beverage. 10 We also ask that, under the reasonable 11 test, that the provisions not be interpreted too 12 narrowly, that we look at the spirit and the intent 13 of the legislation and not to exclude things such as 14 embedded software. We're concerned that such an 15 interpretation may lead to further litigation and 16 another lawsuit. 17 The second principle that we ask the Board 18 to consider is ease of administration. As outlined 19 in the Chief Counsel's memo, there are a lot of 20 implementation concerns, not only for the Board of 21 Equalization, but also for taxpayers. 22 We ask that to that end the Board consider 23 centralized processing of refunds at the Board. 24 This is something that would streamline the process 25 as well as provide for more consistent application 26 of the refunds. There is also precedence for doing 27 this when the Board of Equalization processed 28 refunds in the Dell case. 9 1 But beyond just processing refunds, we ask 2 that the Board consider future administration. 3 Going forward, how do retailers and vendors and 4 manufacturers provide a framework so that not only 5 are they able to track what is taxable/what is not 6 taxable, but how do we as businesses provide an 7 audit trail that is easily accomplished through our 8 reprogramming costs and taking into consideration 9 how much it would cost businesses to reprogram, as 10 well as to take into consideration what the Board of 11 Equalization staff costs would be. 12 Lastly, a concept that we ask you to 13 consider is the market neutrality. And when we talk 14 about market neutrality, we're talking about the 15 equal measure of tax between holder-retailers, 16 holders, and non-holder retailers. 17 The memo outlines an approach. I think the 18 intent is to get there. But we'd like to have more 19 discussion with the approach. The approach that's 20 outlined, we're concerned about because it may be 21 overly cumbersome and perhaps too costly for 22 businesses that we represent and others, 23 particularly smaller businesses who may be impacted 24 for them to be able to comply with. 25 With these goals in mind, we ask that if 26 the Board were to adopt any kind of notice or issue 27 a notice today, that the notice not be too 28 prescriptive. Because, as we've outlined, these are 10 1 some of the goals that we'd like to achieve, we'd 2 like to work with the Board to achieve these 3 overarching principles, but is a complex issue that 4 requires careful thought and approach to how it's 5 administered. 6 And, with that, we look forward to working 7 with the Board and to your legal staff on 8 implementation. 9 MS. MA: Thank you, Ms. Twomey. 10 Okay, Members, discussion? 11 Mr. Runner. 12 MR. RUNNER: Just a couple of -- just to 13 kind of start off with just some clarifications on a 14 couple of issues. 15 Let me start off with -- with -- from 16 CalTax. The issue of centralized refunds, can 17 you -- help me understand -- can you lay out for me 18 what the other alternative would be? 19 MS. TWOMEY: The other alternative, which 20 we would not be supportive of -- 21 MR. RUNNER: Right. 22 MS. TWOMEY: -- is to direct -- is to 23 direct the vendors and the retailers and certain 24 other manufacturers to issue a form process refund 25 that would not go directly to the Board of 26 Equalization. There'd be a two-layer or three-layer 27 process in which the retailers would be the ones 28 accepting refund claims from the taxpayer, as 11 1 opposed to going directly to the Board. 2 MR. RUNNER: Okay. 3 The -- the issue of the market neutrality, 4 is that -- is that -- is that the issue there in 5 regards to the manufacturer who also may retail and 6 then also may use another retailer? 7 MS. TWOMEY: Yes. 8 MR. RUNNER: Okay. 9 MS. TWOMEY: Yes. And, you know, I think 10 the staff memo's intent is to try to -- is trying to 11 achieve market neutrality. However, it's going to 12 be very difficult for us to definitively say that, 13 yes, this measure of tax and this pricing is going 14 to be the same as what sold at retail by a 15 non-holder retailer versus one that's being sold by 16 a holder-retailer. And that's because with IT 17 products, there's pricing promotions, there's 18 agreements for a short period of time. It would be 19 administratively cumbersome, if not impossible, for 20 businesses to provide that kind of tracking in order 21 to provide any audit trail to prove that we are 22 consistent with that kind of requirement. I think 23 that's the intent, and we like the intent. But I 24 think there's ways, different ways to approach it. 25 MR. RUNNER: And then the other issue is, 26 in regards to their reasonable test -- 27 reasonableness test, I'm trying to -- well, let me 28 start off with saying this, I believe our best path 12 1 to go down through this is using the BTC. I think 2 the -- I think using the -- using an interested 3 parties process in order to fully vet and engage 4 everybody is a good path at that point. 5 So let me ask you this, in regards to then 6 the reasonableness test, I'm not sure exactly in 7 your opinion what would be the language to which 8 this Board would be instructing the BTC at that 9 point? Or is just this discussion help providing 10 that kind of direction? And I'll give that to both 11 you and also then to -- to counsel. 12 MS. TWOMEY: I think it's going to be a 13 work in progress as we take a look at the fiscal 14 implications of what it is that the Board of 15 Equalization has in-house right now and potentially 16 what are the outstanding refunds still. 17 We don't want to be in a situation where we 18 bankrupt the State by having every single taxpayer 19 who's ever purchased a de minimis software, you 20 know, be eligible for a refund. I don't think 21 that's the Board's intent. I mean that would be the 22 very extreme. But we do not believe that Lucent 23 would eliminate any possibility for exemption on 24 embedded software either. 25 MR. RUNNER: Do you believe that -- what 26 about the thought -- I mean, again, I agree. But I 27 think the fine line that we end up walking is to 28 make sure that as we interpret then what is taking 13 1 place, when we apply that to other places, that we 2 don't -- in our effort to not be too broad, we 3 interpret too narrowly, which then leads to 4 potential other litigation. 5 MS. TWOMEY: Yes. It's likely that if 6 embedded software were not included -- I mean, from 7 what we're hearing, there's likely going to be 8 potential litigation, follow-up litigation. 9 MR. RUNNER: Okay. 10 Let me ask, in regards to the refunds that 11 are out there, do we -- do we have any kind of a 12 thought in regards to -- again, and again, I'm 13 talking about the category of refunds that we 14 believe fit clearly into the court case right now. 15 And so there, I guess it would be the facts 16 themselves clearly identified this -- this group of 17 folks who would then be eligible for refund. Do we 18 have any idea in terms of the number? Not the -- I 19 guess both the -- I guess the dollar number; do we 20 have any idea? 21 MR. FERRIS: I don't think we do. I don't 22 think staff has -- I think there are roughly 900 23 pending administrative refund claims. 24 MR. RUNNER: Uh-huh. 25 MR. FERRIS: About a third of which specify 26 a specific refund amount, and two-thirds of which do 27 not. But even with -- 28 MR. RUNNER: We don't even know, of the 14 1 900, how many actually then fit the facts of the 2 case versus what we may need to do through the 3 regulatory process. 4 MR. FERRIS: Correct. We -- staff has not 5 analyzed it to see which claims involve storage 6 media that was transferred that's wholly collateral 7 to the copyright and patents that were assigned. 8 MR. RUNNER: Okay, thanks. 9 MS. MA: Ms. Harkey. 10 MS. HARKEY: For Legal, I think one of the 11 biggest issues we will have, the largest issue we're 12 going to have to address is the -- Lucent is not 13 dispositive as a transaction involving embedded are 14 preloaded software. 15 Can you expand on that as to what you see 16 the potential being, because you're saying it's not 17 dispositive. Lucent was decided on a specific set 18 of facts, and that's really what we're trying to 19 address here, is that specific set of facts. 20 What can you see, or do you see coming 21 forward on the specific set of facts that we're not 22 addressing, I guess? 23 MR. FERRIS: Right. And just to be 24 clear -- you know, "dispositive" is kind of a 25 lawyerly term. But we're using it just to -- 26 because we think it's important for it to be clear 27 to the public and to our retailers that the Lucent 28 opinion is, as you said, is dealing with a very 15 1 specific kind of fact pattern that was an exclusive 2 holder-retailer that was transferring the storage 3 media that was wholly collateral to the exercising 4 of the rights that were also transferred. So that's 5 what that case was about. 6 MS. HARKEY: There was an agreement and 7 everybody was a party to it. 8 MR. FERRIS: Right. Right. And that's why 9 we can begin to process similar claims immediately. 10 We don't need rulemaking. We don't need any 11 interpretive guidance from the Board with respect to 12 that kind of fact pattern. 13 But for other things, like software that's 14 embedded at the time of manufacture that could 15 potentially be part of a TTA transaction, what we're 16 saying by saying that it's not dispositive with 17 respect to those types of facts pattern is the Board 18 needs to engage in its policy and interpretive 19 function to -- to the extent the Board wants to 20 apply the guidance that the Lucent opinion might 21 give towards analyzing those types of other fact 22 patterns, that would be what this interested parties 23 process potentially could be about, depending upon 24 how broad the scope the Board refers to the Business 25 Taxes Committee, if that's the path that you take. 26 But we wanted to make it really clear that 27 anyone who thinks they might have a potential refund 28 claim with respect to embedded software issues, 16 1 needs to be coming to the Board of Equalization to 2 go through the administrative refund process. That 3 Lucent is not dispositive in such a way that you 4 could avoid coming to the Board of Equalization to 5 pursue the administrative refund claim. So -- 6 MS. HARKEY: Thank you. 7 So, Therese, I guess this is probably a -- 8 maybe you can't quantify it. But to what level are 9 you -- I mean, what we're trying to do right now is 10 get out the refunds that qualify under Lucent. 11 What -- what level of engagement would you expect 12 there to be on the other -- the other end? 13 MS. TWOMEY: It would be up to the Board 14 whether the Board wishes to pursue this through an 15 interested parties process, or whether the Board 16 wishes to pursue this as a Chief Counsel matter. We 17 will be engaged as we have engaged with, you know, 18 all of you through either process. 19 We agree that the claims that currently 20 meet the fact patterns of Lucent ought to be 21 refunded, you know, precipitously and expeditiously. 22 Going forward it would be up to the Board on your 23 time frame, but we will be there in either 24 process. 25 MS. HARKEY: Okay. Because I think -- I 26 think we need to establish some -- some parameters, 27 otherwise we'll be legislating. So, you know, 28 that's -- that's kind of the options here. 17 1 Okay, thank you. 2 MS. MA: Anyone else? 3 Okay. 4 MR. HORTON: I agree with Mr. Runner. 5 Should be the Business Tax Committee that provides 6 for far more engagement with the general public on 7 the matter, the process, the timing also. That's 8 not to say that the coming forth as a Chief Counsel 9 matter does not also provide that same level of 10 engagement. It is the perception of the public that 11 that may be a little more exclusive, if you will. 12 So I would concur with Member Runner in 13 that regard. 14 MS. MA: So do we have a staff 15 recommendation today? 16 MR. FERRIS: Right. So staff would 17 recommend that you refer the implementation of 18 Lucent to the Business Taxes Committee, and that the 19 Board also authorize staff to issue a special notice 20 that would specify what Lucent is dispositive with 21 respect to and would also notify interested parties 22 about the Business Taxes Committee interested 23 parties process with respect to the other issues 24 that the Board may be prepared to engage in with 25 respect to implementing Lucent. 26 MS. MA: Ms. Twomey. 27 MS. TWOMEY: With respect to the notice, 28 may we ask that the Board prescribe in that notice 18 1 only what the decision was dispositive of and not 2 what it was not dispositive of? 3 Going back to Vice Chair Harkey's comment 4 about embedded software, we're concerned about any 5 notice that is too prescriptive and indicates that 6 it's not dispositive of embedded software. Those in 7 the legal world understand what that means, but 8 those outside may be looking at interpreting it in a 9 different way. 10 So, once again, our request would be to 11 have the notice identify what it is dispositive of 12 and be silent on what it is not dispositive of. 13 MR. FERRIS: I envision a special notice 14 that would specifically state what the Board is 15 going to consider through the interested parties 16 process. Which, if the Board says you want embedded 17 to be discussed there, then the special notice would 18 say that. So I think it would be clear. 19 MS. HARKEY: I'm ready to support staff 20 recommendation. 21 MR. HORTON: Second. 22 MS. MA: Okay. Ms. Harkey moves, Mr. 23 Horton seconds. 24 Motion carries. 25 Thank you. We look forward to this ongoing 26 process. 27 ---oOo--- 28 19 1 REPORTER'S CERTIFICATE 2 3 State of California ) 4 ) ss 5 County of Sacramento ) 6 7 I, Kathleen Skidgel, Hearing Reporter for 8 the California State Board of Equalization certify 9 that on March 30, 2016 I recorded verbatim, in 10 shorthand, to the best of my ability, the 11 proceedings in the above-entitled hearing; that I 12 transcribed the shorthand writing into typewriting; 13 and that the preceding pages 1 through 19 constitute 14 a complete and accurate transcription of the 15 shorthand writing. 16 17 Dated: April 21, 2016 18 19 20 ____________________________ 21 KATHLEEN SKIDGEL, CSR #9039 22 Hearing Reporter 23 24 25 26 27 28 20