State & Local Tax Bulletin (November 2001)
Preston v. State Board of Equalization
25 Cal.4th 197 (2001)
Application of the California
Tax to Intangibles
A. Becker, a tax partner in the
Palo Alto office of Pillsbury Winthrop
Shaw Pittman LLP.
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Mr. Becker presented this paper at the Santa Clara
County Tax Executives Institute on
October 9, 2001.
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Summary of Preston's Four Holdings
- Refund claim allegation that asset transferred was
nontaxable reproductive right sufficiently raises
Technology Transfer Agreement ("TTA") copyright
sales tax exclusion.
- Regulation 1501 manuscript exclusion is limited
to textual copyrights and does not extend to
copyrights on drawings and illustrations.
- TTA sales tax exclusion extends to any transfer of
any patent or copyright interest, including artwork,
if there is also the transfer of a "right to make and
sell a product or use a process that is subject to that
patent or copyright interest."
- TTA sales tax exclusion is retroactive, despite 1994
"operative" date, because statute is explicitly stated
to be clarification of existing law.
Factual and Procedural History
- Facts: Preston, a commercial artist, entered into
two types of transactions:
- 1981-1993: Preston transfers original
illustrations to book publishers for reproduction
in children's books, in return for cash advances
and 5% royalty on book sales.
- 1988-1993: Preston transfers original artwork
to toy manufacturer to be reproduced in rubber
stamps, in return for cash advances and 5%
royalty on sales.
- Procedural history.
- SBE audit finds Preston liable for sales tax on all
advances and royalties from the above
transactions. Preston files timely petition for
redetermination and claim for refund. SBE
denies Preston relief.
- San Francisco Superior Court and California
Court of Appeal deny Preston relief. Court of
- Preston's refund claim fails to adequately raise any
- Preston's transfer of original artwork is a fully
taxable transfer of tangible property, rather than
intangible property, under Regulation 1501 "true
object" test. Buyers would have been unable to
exploit Preston's artwork without possession of
- It is irrelevant that Preston only temporarily
transferred the tangible artwork to the book
publisher. Temporary usage of tangible personal
property for a consideration is fully taxable.
Court's First Holding: Preston's Refund Claim
Sufficiently Raises Intangible Claims
- Background: Filing an SBE refund claim is a
prerequisite to bringing a refund suit. The refund
claim must state the specific grounds for relief.
Revenue and Taxation Code ("R&TC") sections
6932, 6094. California courts cannot consider
issues not raised in the refund claim. R&TC § 6933.
- Preston refund claim stated:
- Transfers were nontaxable transfer of
reproduction rights, not the transfer or sale of
tangible original artwork.
- Transfers were nontaxable transfer of author's
manuscript, exempt under Regulation 1501.
- Court concludes Preston's refund claim adequately
raised her copyright claims.
- Allegation that transfers are intangible
reproductive rights sufficiently raises copyright
- Allegation that transfers are exempt manuscripts
under Regulation 1501 sufficiently raises
- Court implicitly concludes that raising a
"copyright" claim automatically raises the
statutory TTA provisions.
Court's Second Holding: Preston Cannot Completely
Avoid Sales Tax Because Tangible Artwork was
Transferred with the Intangible Copyrights
- Historical background.
- California sales tax only applies to transfers of
tangible personal property, not intangibles.
Clearly defining the dividing line between
nontaxable intangible property and taxable
tangible property has proven difficult.
- R&TC § 6016: Tangible personal property means
personal property which may be seen, weighed,
measured, felt, or touched, or which is in any way
perceptible to the senses.
- California case law: [Intangible] property is
generally defined as property that is a right rather
than physical object. Navistar Internat.
Transportation Corp. v. State Bd. Of Equalization
(1994) 8 Cal.4th 868, 874; Roth Drug, Inc. v. Johnson
(1936) 13 Cal.App.2d 720, 734.
- California has had difficulty separating
nontaxable intangible property from taxable
tangible property used to memorialize or convey
an intangible property right. Transactions have
generally been held either (i) entirely taxable,
with the intangible property folded into and
taxed as part of the tangible personal property,
or (ii) entirely nontaxable, with the tangible
property deemed incidental.
- 1945 Regulation 1501: The "true object" test.
"The basic distinction in determining whether a
particular transaction involves a sale of tangible
personal property or the transfer of tangible
personal property incidental to the performance of
a service is one of the true object of the contract;
that is, is the real object sought by the buyer the
service per se or the property produced by the
"Similarly, an idea may be expressed in the form of
tangible personal property and that property may
be transferred for a consideration from one person
to another; however, the person transferring the
property may still be regarded as the consumer of
the property. Thus, the transfer to a publisher of
an original manuscript by the author thereof for
the purpose of publication is not subject to taxation.
The author is the consumer of the paper on which
he has recorded the text of this creation. However,
the tax would apply to the sale of mere copies of an
author's works or the sale of manuscripts written
by other authors where the manuscript itself is of
particular value as an item of tangible personal
property and the purchaser's primary interest is in
the physical property."
- 1980 Simplicity Pattern:
Narrowing of the "true
object" test with the "physically useful in
In Simplicity Pattern Co., Inc. v. State Bd. Of
Equalization (1980) 27 Cal.3d 900, Simplicity sold
its copyrights to educational film strips and
recordings, conveying the copyrighted material to
the buyer on master tapes and film negatives. The
Court concluded that it was irrelevant that the
buyer's true object of the transaction was the
intangible copyrighted material. Since the master
tapes and film negatives used to convey the
copyright rights were physically useful as printing
plates in the manufacturing process, the master
tapes and negatives were distinguishable from the
nontaxable manuscript in Regulation 1501. The
Court concluded the value of the copyrights should
be folded into the master recordings and negatives
and the entire transaction subjected to sales tax.
In Capitol Record, Inc. v. State Bd. of Equalization
(1984) 158 Cal.App.3d 582 and A&M
Records, Inc. v. State Bd. of Equalization (1988) 204
Cal.App.3d 358, the Simplicity analysis was
reaffirmed for master tapes conveyed from
recording artists to record companies. Since the
master tapes were physically useful as printing plates
in the manufacturing process, the entire royalty
stream flowing from a record company to a
recording artist was subject to sales tax.
- 1994 Navistar: Narrowing of the "physically
useful" test by making it inapplicable to trade
secrets, concluding that the trade secret rights
cannot be separated from the tangible personal
property conveying the rights.
Navistar sold its trade secrets of turbine engine
technology to a third party buyer, thereby providing
the buyer the necessary intangible rights to
reproduce turbine engines for sale to the public. The
drawings conveying the trade secrets were used only
as a means of conveying the intangible, never used
in manufacturing operations, and not physically
useful. Nevertheless, the Court concluded that the
intangible trade secrets could not be separated from
the tangible means of conveyance which caused the
entire transaction to be subject to tax.
- Court concludes that Preston's conveyance of
tangible artwork along with her copyright
prevented the transaction from being entirely
- Regulation 1501 and the true object test is
inapplicable as this is not a service contract.
- Regulation 1501 manuscript example is
inapplicable as these are illustrations rather than
- Preston's tangible original artwork was physically
useful in the manufacturing process. The Court
agrees with the lower courts that it would have
been impossible for the book publishers and toy
manufacturers to reproduce Preston's
copyrighted ideas without the physical drawings.
- Even if Preston's tangible original artwork had
not been physically useful, since tangible personal
property was transferred along with an intangible
property right, Navistar prevents Preston from
avoiding sales tax.
- Justice Kennard's dissent: Preston's entire
transaction should be respected as tax free transfer
of a copyright on an inconsequential Regulation
- Regulation 1501 indiscriminately applies to an
entire manuscript, text and illustrations. The
majority would illogically make the Regulation
1501 manuscript exception dependent on
whether the author's manuscript included any
- Preston's illustrations were no more physically
useful in manufacturing a book than text in a
manuscript. Without the text in a manuscript,
it would be impossible to publish the book.
Whether text or illustrations, the paper used to
convey the intangible serves no useful function
other than a vehicle of conveyance and it
therefore should be ignored.
- Difficult to reconcile Kennard's Preston dissent
- In Navistar a paper vehicle of conveyance for a trade
secret was enough to cause the trade secrets to be
folded into the paper documents and fully taxed as
tangible personal property.
- Kennard resurrects Simplicity's "physically useful"
test for Regulation 1501, after it was affirmatively
rejected in Navistar.
- It is difficult to fit the Preston tangible artwork
transferred for creation of rubber stamps into the
manuscript example. If so, the manuscript example
should be extended to the transfer of other
intangibles for production of derivative toy and
technology products, e.g., trade secrets for Navistar
- Reconciling Navistar with Preston implies that a
trade secret is different than a patent and copyright,
and that a trade secret cannot be separated from its
tangible means of conveyance.
Court's Third Holding: Preston's Agreements are
Technology Transfer Agreements
- Background on Technology Transfer Agreements
- Replaces "all or nothing" regime for copyright
and patent transfers with a purchase price
allocation between taxable tangible properties
and nontaxable intangible properties.
Segregation principle evolved from 1992 SBE
Appeal of Intel decision. January 18, 1994,
1993-1995 Cal.CCH New Matters ¶ 402-675.
- Intel licensed various copyrights, patents and other
intellectual property rights to Burroughs and AMD
to use Intel processes to produce integrated circuits,
and also conveyed written information,
instructions, schematics, database and test tapes.
- SBE held the Intel transaction should be segregated
into a taxable tangible taxable transaction, and
nontaxable intangible transaction. Even though the
transaction had no allocations, the SBE held the
taxable tangible property should be allocated 200%
of its direct manufacturing cost ($33,000), with the
remaining transaction proceeds allocated to
- Legislation passed as AB 103 on October 8, 1993
and incorporated as sales price exclusion for use
taxes (R&TC § 6011(c)(10)) and a gross receipts
exclusion for sales tax (R&TC §6012(c)(10)).
- Statute provides that for TTAs only the portion of
the transaction proceeds allocated to "tangible
personal property" is taxed.
- TTA is defined as any agreement under which:
- A person who holds a patent or copyright interest
- Assigns or licenses to another person
- The right to make and sell a product or use a
- That is subject to the patent or copyright interest.
- The portion of the transaction proceeds allocated
to the taxable tangible personal property is
statutorily set as:
- Any reasonable allocation agreed to by the
- The market price for the tangible personal
property, absent the intangible property rights.
- 200% of the cost of materials and labor to
produce the tangible personal property.
- Court's analysis that Preston's transactions are
- Preston owned copyrights in her original artwork
and her agreements transferred a portion of her
copyright right in that artwork.
- The agreement is a TTA since the products sold
by the book publisher and toy manufacturer were
"subject to" Preston's copyrights. It is irrelevant
that the book publisher and the toy manufacture
could have made and sold a version of their
products without Preston's copyrighted
- TTA provisions apply indiscriminately despite
the fact that Preston's copyrights are illustrations
for children's books and toys rather than "high"
- The statute has no limit on type of copyrights or
- The legislation purposely encompasses transfers of
copyright or patent rights (rather than copyrights
and patent rights), with the legislative history
verifying it was understood that this would extend
the provision to artwork and illustrations.
- The case is remanded for Preston and the SBE to
determine the proper allocation of taxable value
to the tangible artwork based on the TTA
specified 200% of the cost of materials and labor
to produce the original artwork because:
- Preston's agreements have no specific allocation to
the tangible personal property and
- There is no set market price for Preston's original
- Court's revisions to existing authorities based on
its TTA analysis.
- Regulation 1540(d)(4) invalidated. It had
Charges for the transfer
by a tangible medium of a photograph or of
finished art for purposes of reproduction are
taxable even though there is no transfer of title
to the person reproducing the photograph or
work of art. Charges for the right to use the
photograph or finished art which has been
transferred by tangible medium in the
production of tangible personal property are
taxable. Charges for a license or copyright (such
as a right to reproduce or prepare derivative
works) to exploit the photograph or finished art
are taxable if they are sold along with the
photograph or finished or transferred by tangible
media or they are sold by a subsequent contract
entered into within one year of the original
transfer of the photograph or finished art.
- Three SBE Annotations invalidated.
- 295.0460 (7/8/55). Royalty payments received in
connection with the retail sale of a patented
machine found taxable.
- 330.3540 (12/30/69). Royalty payments paid by
theatrical groups for renting scripts and vocal scores
- 420.0280 (7/28/75). Royalty payments paid to artist
for designs used in publication of greeting cards
Court's Fourth Holding: 1994 TTA Provisions
Retroactively Applied to Preston's 1981-1993
- AB 103 added TTA to R&TC in October 1993, with
an April 1, 1994 operative date (Section 5). Court
concludes that retroactive application is merited.
- Section 3 of AB 103 specified statute was
clarification of existing law:
It is the intent of the Legislature in enacting this
act to clarify the application of the Sales and Use
Tax Law to technology transfer agreements, as
defined. It is also the intent of the Legislature
that the amendments made by this act not create
any inference regarding the application of the
Sales and Use Tax Law to other transactions
involving the transfer of both intangible rights
and property and tangible personal property.
- Legislative history shows that the above language
was the result of substantial debate, evidencing
the legislature understood the legislation would
be retroactively applied.
- Legislative history verifies that the statute was
intended to implement the SBE's 1992 decision
in Appeal of Intel.
- No Constitutional barrier to retroactive
application. No due process issues. No gift of
public funds. Public benefit of providing clarity
and certainty and improved California business
climate overrides any SBE argument for vested
claim to tax revenues.
- Kennard dissent on retroactive application of TTAs.
- Presumption is that statutory exemptions are
only applied prospectively, which is bolstered by
legislation's stated April 1, 1994 "operative date."
- TTA provisions are not clarification as they are
substantively broader than Intel, which applied
to only patented and copyrighted technology.
Planning Intangible Asset Transfers After Preston
- Court's retroactive application of TTA provisions
prompts attempt to reconcile existing authorities
into TTA regime.
If the Appeal of Intel segregation principle has
always been part of California law, why would it
only apply to TTA designated patents and
copyrights? Can taxpayers presume that they are
now free to also segregate other intangibles (e.g.,
trade secrets) by any agreed contractual allocations,
or only free to segregate out TTA designated patent
and copyrighted intangibles?
- Regulation 1501's paper manuscript fits into the
TTA example as a "zero value" property because
it is not physically useful in the manufacturing.
- Simplicity is viewed as being consistent with
Preston as the value of the master recordings and
film negatives subject to sales tax was only the
historical cost of the tangible property; Simplicity
is overuled to the extent it taxed more.
Nevertheless, Preston does overrule Capitol
Records and A&M Records and indicates that the
subsequent legislative solution secured by the
recording and film industry was unnecessary.
- Navistar was ineligible for TTA relief as it
involved trade secrets rather than patents or
copyrights. Yet the TTA provisions were built
on Appeal of Intel, where the intellecutal property
transferred included patents, trade secrets and
"other intellectual propery" which presumably
includes trade secrets.
- Court's reliance on statutory TTA exclusion
counsels continued use of structured exclusions
rather than broad intangible analysis.
- Regulation 1501 limited to textual copyright
- Statutory exclusions for transfers of master tapes
and motion picture negatives. R&TC §§ 6060(g),
6010(e), 6362.5, Regulation 1529 and 1527.
- Regulation 1502(f)(1) exclusion for transfers of
- TTAs for copyright and patent transfers.
- 5. Minimizing California transfers of tangible
- Electronic transfers.
- Stock and LLC interests.
- Out-of-state transfers of tangible mediums.
- Carefully structuring purchase price allocations.
- Planning TTAs.
- Structuring a TTA Transaction. R&TC
§§ 6011(c)(10), 6012(c)(10).
- "Technology transfer agreement" means:
- Any agreement under which a person who holds
a patent or copyright interest
- Assigns or licenses to another person the right to
make and sell a product or to use a process
- That is subject to the patent or copyright interest.
- Structuring agreements to include reasonable
allocations to the tangible personal property.
- SBE developing Regulation 1507 on TTAs.
As technology advances, and the scope of
material that can be transferred digitally expands,
this entire area of law may well become
- Requiring a written contract for technology transfer
- Limiting "process" technology transfer agreements
to only patent transfers, rather than patents or
- Proper computation of 200% of direct labor and
material cost, and whether author's own labor
should be included in computation.
- Zero or minimal allocations to tangible personal
property when original artwork is only transferred
temporarily, and only used for computer scanning.
SBE interested parties meeting on Regulation
1507 scheduled for October 10, 2001 in
- Industry proposed revisions to Regulation 1540.
Advertising Agencies, Commercial Artists and
- Charges for photography, illustration and design
copyrights added to enumerated nontaxable
items in Regulation 1540(b)(3).
- Proposed revision to Regulation 1540(c)
implements Preston's broad directive that any
assignment or license of a copyright interest in
artwork qualifies as a TTA.
When commercial artists, photographers, or
designers enter into agreements with a client in
which the artist, photographer or designer
holding a copyright interest in artwork assigns
or licenses to the client the right to make and sell
a product that is subject to the copyright interest
in the transferred artwork, such agreements are
designated "technology transfer agreements."
The "right to make and sell a product" includes,
but is not limited to, the right to use the artwork
in the manufacturing process such as in the
production of rubber stamps, books, packaging,
games, posters, greeting cards, or similar
products, or to exploit the artwork by
reproducing it as illustrations in advertisements
"Subject to the copyright interest" means that the
client would not be able to legally exploit the
artwork in the contracted manner in the absence
of the transfer of license or assignment of the
copyright interest from the interest holder.
The application of tax to transfers of finished art
transferred as part of a technology transfer
agreement is governed by subdivision (d)(6).
- Proposed revision to Regulation 1540(d)(4) and
(d)(6) specify that any tangible artwork
transferred as part of a TTA pursuant to 1540(c)
is separated out and taxed separately based on
the allocated purchase price under standard TTA
provisions. As noted above, the pre-Preston
version of Regulation 1540 provides that the
entire revenue stream received from licensing of
illustrations and photographs is taxed pursuant
to Regulation 1540(d)(4).
- Industry proposed revisions to Regulation 1541.
Printing and Related Arts. Proposed revision to
- Charges for licenses for the right to reproduce
illustrations (e.g., drawings, diagrams, halftones, or
color images), photographs, drawings, paintings,
handlettering and computer generated artwork in
printed matter are "technology transfer
agreements" as defined in Regulation 1540 and
subject to sales tax as applied in that Regulation.
- Industry proposed revisions to Regulation 1543.
SBE interested parties meeting on Regulation 1540,
1541 and 1543 scheduled for November 28, 2001
- "Illustrators" and "Photographers" added to the
list of "authors" covered by Regulation
- Proposed Regulation 1543(a)(7) defines
"finished art" as follows:
Finished art means the final original art or
photographic image licensed to the client for
reproduction by photo-mechanical or other
processes. Finished art does not mean any copy
of the final original art or photographic image
produced for a mechanical or paste-up by
scanning, photography, photostat, or other
means for use in the actual process of
reproduction by photo-mechanical or other
- Proposed Regulation 1543(a)(10) specifies that
licenses of copyrights in finished art are TTAs,
reiterating the language stated above for
- Proposed Regulation 1543(c)(7)-(9) includes
examples specifying that for artwork "TTAs"
there is no allocation to the temporary transfer
of tangible personal property that is scanned into
the purchaser's computer system.
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