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State & Local Tax Bulletin (October 2008)

Bundled or Embedded Applicational
Software Is Not Subject to
Personal Property Taxation




By Richard E. Nielsen, counsel in the San Francisco office of Pillsbury Winthrop Shaw Pittman LLP.

If you have or can obtain the Acrobat Reader, or have an Acrobat-enabled web browser, you may wish to download or view our October 2008 State & Local Tax Bulletin (a 178K pdf file), containing a printed version of this article and also available via ftp at:

    ftp.pmstax.com/state/bull0810.pdf.

This bulletin concerning state and local tax matters is part of the Tax Page, a World Wide Web demonstration project, no portion of which is intended and cannot be construed as legal or tax advice. Comments are welcome on the design or content of this material.

California's Fourth District Court of Appeal, reversing the trial court and Orange County Assessment Appeals Board ("Appeals Board"), recently held that applicational software is not subject to property taxation even if it comes "bundled" with the computer hardware. At issue were the Pyxis MedStation 2000 systems, leased to hospitals by Cardinal Health 301, Inc. for a single price ("bundled"). The system is a series of stand-up medicine storage cabinets, each called a "MedStation," with a built-in computer that serves as a medicine tracking system and is programmed with patient and medication information. Pillsbury obtained a total reversal of an earlier unfavorable tax ruling, handling the matter from the administrative appeal hearing, through court trial and before the court of appeal.

Cardinal Health contended that a portion of the bundled lease price was allocable to applicational software, which was not subject to property tax. The company presented information to the Orange County Assessor and the Appeals Board that would have allowed the Assessor to segregate the value of the firm's nontaxable proprietary application software from the otherwise taxable MedStation units. The Appeals Board noted that Cardinal Health's software "is not sold or leased separately from the MedStation equipment, and is not priced separately for sale or lease, and does not have any use outside of the MedStation itself. The software is therefore 'embedded' or 'bundled' in the various MedStation units." The Appeals Board then noted that the Assessor had "used the cost of the MedStation units as a basis for valuing each unit, with no deduction or offset for the software embedded in the equipment." The Appeals Board made its decision assuming that such information was irrelevant. It was strictly on the basis of the "bundling" or "embedding" of the software that the Appeals Board upheld the Assessor's approach.

Cardinal Health filed a suit for refund of property taxes in the Superior Court. The case was tried on stipulated facts—basically, the administrative record before the Appeals Board. Like the Board, the trial court considered the fact of bundling (or "embedding") dispositive.

In reversing the trial court, the court of appeal conducted a thorough and lengthy analysis of the relevant statutory and regulatory provisions. The court noted that sections 995 and 995.2 of the Revenue and Taxation Code provide that "application" software, as distinct from "basic operational" software, is not to be valued for purposes of property taxation. Further, the State Board of Equalization has clearly provided, in section 152 of title 18 of the California Code of Regulations—often referred to as "Rule 152"—that taxpayers may demonstrate that a portion of the value of a computer represents nontaxable application software despite the fact that application software came "bundled" inside the computer when the customer bought or leased it.

The court of appeal rejected the Assessor's contention adopted by the Appeals Board and trial court that bundling rendered the application software subject to property taxation. The court of appeal also reviewed in detail the lone appellate decision, Hahn v. State Board of Equalization, 73 Cal. App. 4th 985 (1999), which the Assessor, Appeals Board and trial court, misconstrued. The court of appeal reversed the trial court judgment and remanded for further proceedings on the issues of the valuation of the non-BIOS software in the Medstations that is not to be included in each station's taxable value.

The case is Cardinal Health 301, Inc. v. County of Orange, ___ Cal. App. 4th ___, 2008 WL 4405337 (September 30, 2008).


This material is not intended to constitute a complete analysis of all tax considerations. Internal Revenue Service regulations generally provide that, for the purpose of avoiding United States federal tax penalties, a taxpayer may rely only on formal written opinions meeting specific regulatory requirements. This material does not meet those requirements. Accordingly, this material was not intended or written to be used, and a taxpayer cannot use it, for the purpose of avoiding United States federal or other tax penalties or of promoting, marketing or recommending to another party any tax-related matters.


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