State & Local Tax Bulletin
(Volume 1, Number 3, February 1995)
California Supreme Court Holds Trade
Recorded on Paper to Be Tangible
Property Subject to Sales Tax
By Jeff Vesely, a tax partner in the San Francisco office and
Craig Becker, now a tax partner in the Palo Alto office of Pillsbury
Winthrop Shaw Pittman LLP.
This information is only of a general nature, intended
as background material, omits many details and special rules and cannot
be regarded as
legal or tax advice.
On November 28, 1994, the California Supreme Court issued its decision in Navistar
International Transportation Corporation, et al. v. State Board of Equalization (No. S032195,
1994), 8 Cal. 4th 868, a case handled by the firm, concerning the scope of nontaxable transfers of
intangible personal property and custom computer software under the California sales and use tax.
The Court's 7-0 decision on intangibles concludes that the transfer of trade secrets recorded on
paper is properly classified as the transfer of taxable tangible personal property, and
distinguishable from the nontaxable transfer of intangible personal property such as copyrights and
patents. The 6-1 decision on the computer software concludes that the transfer of computer
programs, which qualify as nontaxable custom computer programs in the hands of the original
owner (under California Revenue and Taxation Code section 6010.9[fn. 1]), lose that nontaxable status and are subject to the California sales tax
upon a sale by the original owner.
California tax practitioners had hoped that the California Supreme Court would provide guidance
for distinguishing between transfers of tangible and intangible assets for California sales and use
tax purposes. Unfortunately, most practitioners will find the Court's decision disappointing and
difficult to reconcile with prior decisions and rulings of the California courts and taxing
As of 1981, Solar Turbines International ("Solar"), a division of Navistar International
Transportation Corporation ("Navistar"), was the world's leading producer of industrial gas
turbine engine powered systems for gas compression, power generation and mechanical drive
applications. Solar's preeminent market position was based centrally on its trade secrets, patents,
copyrights, know-how and similar other confidential information. In 1981, after years of
unsuccessful attempts to develop its own turbine engine technology, Caterpillar, Inc.
("Caterpillar") purchased Solar from Navistar in order to secure this technology. The parties
allocated $47.5 million of the $505 million purchase price to assets labeled drawings, designs and
engineering specifications which were stipulated by the parties to contain Solar's legally protected
trade secrets, and $21.4 million to Solar's in-house developed computer software, which was
never offered for sale to the general public and only used in the operation of Solar's business.
Navistar did not include these amounts within the measure of tax on its California sales and use tax
returns, claiming that the transfer of Solar's legally protected trade secrets was a nontaxable sale of
the intangibles and that the transfer of the Solar software was a nontaxable sale of custom computer
software under R&TC section 6010.9. On audit, the California State Board of Equalization
("SBE") disagreed and issued a deficiency assessment. The assessment was affirmed at trial (San
Francisco Sup. Ct. No. 885174, 1991) and by the California Court of Appeal (1st Dist.,
No. A053413, 1993) 13 Cal. App. 4th 1472. On May 25, 1993 the California Supreme Court
granted Navistar's Petition for Review.
Trade Secrets - Tangible or Intangible
The California sales and use tax extends only to transfers of tangible personal property, but not
transfers of intangible personal property or the performance of services (R&TC sections 6051,
6203). All parties agreed that the property at issue was Solar's legally protected trade secrets
recorded on paper documents (i.e., the paper drawings, designs and engineering specifications),
and that this property had not been transferred to Caterpillar incidental to the performance of any
service. Accordingly, the sole question before the Court was whether Solar's trade secrets
recorded on paper documents were taxable tangible personal property or nontaxable intangible
Navistar's Trade Secret Argument
Navistar argued that Solar's trade secrets should be classified as nontaxable intangibles, and the
paper documents on which they were recorded ignored, because Caterpillar's "true object" was the
acquisition of the intangible trade secrets, rather than the tangible paper documents. Navistar's
reliance on the "true object" test to distinguish taxable tangible personal property from nontaxable
intangible personal property was derived from decisions of the California courts, numerous
administrative rulings of the SBE, and the following provision of the SBE's Regulation 1501:
- 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 his 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. Tax would also apply to
the sale of artistic expressions in the form of paintings and sculptures even though the work of art
may express an original idea since the purchaser desires the tangible object itself; that is,
since the true object of the contract is the work of art in its physical form.
Navistar argued that Regulation 1501 establishes that the transfer of intangible personal property
(i.e., an original idea) recorded on paper is nontaxable as long as the true object of the transaction
is the acquisition of the intangible property rather than the paper. Navistar relied on the
Regulation's manuscript example and asserted that since the transfer of original ideas in an author's
paper manuscript is nontaxable because the true object of the transaction is the author's original
ideas (rather than the paper manuscript), its transfer of original trade secrets in paper documents
should also be nontaxable because the true object of the transaction was the trade secrets (not the
Navistar contended that the evidence supported the conclusion that the true object was the
nontaxable trade secrets since the tangible means of conveying the intangible property (the paper)
was not "of particular value as an item of tangible personal property" and was not physically useful
in the manufacturing process. Navistar relied on Simplicity Pattern Co. v. State Bd. of
Equalization, 27 Cal. 3d 900, 909 (1980), where the California Supreme Court concluded the
transfer of the right to reproduce original ideas, recorded on film negatives and master tapes, was
subject to sales tax because the physical means used to convey the original information (i.e., the
negatives and tapes) was physically useful in the manufacturing process as "printing plates" to
stamp out copies for sale to the public. The Simplicity Court created this "physically
useful" principle to distinguish Regulation 1501's nontaxable transfer of original ideas in an
author's paper manuscript, noting that the paper manuscript lacks the required physical usefulness
because it only provides "verbal guidance to editors and typesetters."[fn. 2] Id. Navistar argued that the SBE used this physical usefulness
principle in ruling that patents, copyrights, trademarks, customer lists, discount coupons and a
variety of other similar assets, are all nontaxable intangible property, despite the fact they are
typically recorded and conveyed on paper documents.[fn. 3]
Navistar, based on the above, argued that the trade secrets were nontaxable intangibles because the
record established that Caterpillar's true object was the turbine engine trade secrets, not the paper
documents. Moreover, the record established that since the paper documents recording the trade
secrets were used only as a reference material by engineers, and never even seen on the production
floor, the paper documents were not physically useful in the manufacturing process.
The Court's Rejection of Navistar's Trade Secret Arguments
The Court, noting that the R&TC does not include a definition of nontaxable intangible personal
property,[fn. 4] developed its own definition. It
concluded that intangible property is a "right" rather than a physical object, and remains nontaxable
even if the right is "evidenced or represented by a physical object" that is not itself "intrinsically
- Although there appears to be no comprehensive definition of
intangible property [citations], such property is generally defined as property that is a "right" rather
than a physical object. [Citations.] As the court in Roth Drug, Inc. v. Johnson, supra,
13 Cal.App.2d at page 734 observed: "Tangible property is that which is visible and corporeal,
having substance and body as contrasted with incorporeal property rights such as franchises,
choses in action, copyrights, the circulation of a newspaper, annuities and the like." An intangible
right may be evidenced or represented by a physical object such as a promissory note or a certifi-
cate of stock. When an intangible right is so represented, the physical object representing the
particular right, while capable of perception by the senses, is nevertheless considered intangible
property for tax purposes. Thus, for purposes of the law of taxation, intangible property is
defined as including personal property that is not itself intrinsically valuable, but that derives its
value from what it represents or evidences. [Citations.] Slip Op. at 5.
While this intangible property definition appeared to be consistent with Navistar's claims that paper
documents recording its trade secrets should be ignored, the Court's ultimate holding was to the
contrary. The Court concluded Navistar's trade secrets were subject to tax because they did not
include any intangible property right separate from the paper on which they were recorded. Slip.
Op. at 9.
The Court first rejected use of the Regulation 1501 true object test for distinguishing nontaxable
intangible property from taxable tangible personal property, holding that the true object test was
only applicable for distinguishing taxable tangible personal property from nontaxable services.
The Court cited its statement in Simplicity that Regulation 1501 does not support the
"broad theory that a sale becomes nontaxable whenever its principal purpose is to transfer the
intangible content of the physical object being sold." Slip Op. at 7-8.
The Court also rejected Navistar's claim that the subject trade secrets, recorded on paper
documents, were analogous to Regulation 1501's example of a nontaxable transfer of an original
idea on an author's paper manuscript. The Court maintained that the manuscript example is
distinguishable because the transfer of a manuscript includes a separate intangible property interest,
i.e., the copyright to reproduce and publish the author's work. The Court summarily concluded
that the trade secrets at issue included no similar separate intangible right. Slip Op. at 8-9.
The Court also dismissed Navistar's argument that the Simplicity "physical usefulness"
principle is relevant in distinguishing tangible personal property from intangible property. The
Court found this to be mere dicta, and concluded that there were alternative grounds for the Court's
decision in Simplicity as well as the subsequent appellate court decisions in Capitol
Records and A & M Records.[fn. 5] Slip Op. at 9-11.
Comments on the Court's Trade Secret Opinion
The Court's intangible property definition seems to accept that an intangible "evidenced or
represented by a physical object" can remain nontaxable as long as the physical object is not itself
"intrinsically valuable." However, the Court never reconciles this with its rejection of the "true
object" test. While the Court would apparently conclude that the paper documents here were
"intrinsically valuable," it never articulates how this could be when the paper documents were not
the "true object" of the transaction. Nor does it explain why the paper manuscript conveying an
author's original ideas is not likewise "intrinsically valuable." The Court's omissions are all the
more puzzling in view of the record which established that the trade secret information could have
been transferred by modem, facsimile or orally, and that the tangible documents were not essential
or even inspected by Caterpillar prior to their purchase.
Equally confusing is the Court's conclusion that the transfer of the paper documents containing the
trade secrets did not include a separate intangible property right. This is difficult to square with the
record which indicates that the $47.5 million allocated to the property at issue (i.e., the drawings,
designs and engineering specifications containing the trade secrets) was the only portion of
Caterpillar's $505 million purchase price allocated to the trade secrets which were purchased. The
Court's decision also ignores the fact that these trade secrets provided Caterpillar the separate and
exclusive right to manufacture and sell turbine engines for profit and fails to explain why this right
to exploit the trade secrets is different than a nontaxable patent right.[fn. 6] Finally, the Court's conclusion is difficult to reconcile with SBE
rulings that a customer list (which is itself a trade secret) or a discount coupon, recorded on paper,
include separate nontaxable intangible property rights.[fn. 7]
The Court's opinion also indicates that the "physical usefulness" of any tangible personal property
used to record an intangible is no longer relevant in determining a property's taxable status.
However, without this standard, it is difficult to understand what separates the taxable film
negatives and master tapes in Simplicity, Capitol Records and A & M
Records from Regulation 1501's nontaxable paper manuscript, as both involve the transfer of
an underlying intangible right to reproduce goods for sale to the public. While the Court's new
"intrinsically valuable" standard could be used to conclude that the tangible nature of film negatives
and master tapes were sufficient to tax the transactions in Simplicity, Capitol
Records and A & M Records, it is unclear why the paper manuscript would not also
be "intrinsically valuable" since it provides "verbal guidance to editors and typesetters."
Before the Court's decision, the relevant authorities indicated there was a two-prong "true object"
test used in the manufacturing context to distinguish nontaxable transfers of intangible personal
property from taxable transfers of tangible personal property. First, a nontaxable intangible
transfer had to include the transfer of a separate intangible property right. Second, any tangible
medium used to convey that right could not be physically useful in the manufacturing process. The
Navistar decision seems to have created a similar two-prong test, but it is difficult to
determine the scope of either prong. The first continues to be the requirement that there be a
transfer of a separate intangible property right; however, the decision appears to limit the rights
which will qualify. Copyrights, trademarks and patents apparently are such intangible rights;
however, since Caterpillar's trade secret right to manufacture turbine engines fails to qualify, it
remains doubtful whether any other intangible right would qualify. As to the second prong, the
Court seems to have replaced the "physical usefulness" standard with an "intrinsically valuable"
standard. However, no insight has been provided for determining when the tangible means used
to convey an intangible right becomes "intrinsically valuable" thereby triggering application of the
What Guidance Can Be Found for Taxpayers
After Navistar, the rule for transferring intangible property in California is clearly
"Taxpayer Beware." Planning around Navistar will require careful attention to the form
of the transaction in order to minimize the existence of any tangible personal property to
which intangible property values might be "attached" and thereby held subject to the California
sales and use tax. First, all intangible property should be transferred outside of California.
Second, all intangible property transfers should be done by electronic transmission, so
absolutely no tangible personal property is exchanged in or out of California.[fn. 8] Third, if the intangible property transaction
involves copyrights and patents, and cannot be consummated without some exchange of tangible
personal property in California, taxpayers should attempt to avail themselves of the newly enacted
R&TC sections 6011(c)(10) and 6012(c)(10).[fn. 9] These statutes allow taxpayers to make a reasonable allocation to the
tangible personal property, pay sales tax on the allocated amount, and preserve the nontaxable
intangible status of all remaining amounts allocated to copyrights or patents. Fourth, in all cases,
even if other intangible assets are involved, taxpayers should make a specific allocation between
the tangible personal property transferred and the intangibles.
Computer Software - Custom Computer Programs or Canned
R&TC section 6010.9(d) provides that transfers of custom computer programs are not subject to
the California sales and use tax. R&TC section 6010.9(d) defines a custom computer program
- a computer program prepared to the special order of the
customer and includes those services represented by separately stated charges for modifications to
an existing prewritten program which are prepared to the special order of the customer. The term
does not include a "canned" or prewritten computer program which is held or existing for general
or repeated sale or lease, even if the prewritten or "canned" program was initially developed on a
custom basis for in-house use.
The parties stipulated that the Solar computer programs were all developed on a custom basis
solely for use in the Solar business and that the programs had never been held for general or
repeated sale or lease. Thus, the programs had been R&TC section 6010.9 custom computer
programs in Navistar's hands, and the question presented was whether the programs retained this
nontaxable status during their sale from Navistar to Caterpillar.
Navistar's Argument for Custom Computer Programs
Navistar argued that once a computer program qualifies as an R&TC section 6010.9(d) custom
computer program, the statute mandates that it retains that status until it is held for "general or
repeated sale or lease." Since the parties stipulated that the computer programs had not been held
for general or repeated sale or lease (both before and after the subject transaction), the computer
programs retained their nontaxable custom status throughout their sale to Caterpillar.
Navistar continued by pointing out that because the stipulated facts established that the subject
computer programs had never been held for general or repeated sale or lease, they could not be
"canned or prewritten programs" under R&TC section 6010.9 or Regulation 1502(b) and (f).
Navistar noted that these provisions provide for only two types of computer programs, "canned or
prewritten" and "custom", and argued that the programs must be nontaxable custom computer
programs since they were not "canned or prewritten" programs.
Navistar also argued that an earlier appellate court decision, Touche Ross & Co. v. State Bd.
of Equalization, 203 Cal. App. 3d 1057 (1988), was an erroneous statement of the law and
should be overturned. In Touche Ross, a liquidation agent sold all assets of a bankrupt
business, which included in-house developed software. Touche Ross held the
liquidator's sale was not a nontaxable sale of R&TC section 6010.9 custom computer software
because the software had not been prepared to the "special order" of the party which purchased the
software from the liquidator.
Court's Rejection of Navistar's Argument
The Court affirmed Touche Ross and held the Solar computer programs to be taxable.
The Court held that R&TC section 6010.9(d) custom computer software is a legislative recognition
of a service transaction that is not subject to tax. Since the computer software at issue was
prepared for Solar, but not for Caterpillar, Caterpillar's acquisition of the software was not a
service transaction qualifying for R&TC section 6010.9(d) exclusion from sales tax. Slip Op.
The Court also rejected Navistar's claim that the software was required to be nontaxable custom
computer software because it was stipulated to not be taxable prewritten or canned software. The
Court concluded the statute does not prevent an additional class or classes of software.
Accordingly, the fact that the software is not prewritten or canned, does not mandate that it be
classified as custom computer software. Slip Op. at 14-15.
Comments on the Court's Software Decision
The Court's decision leaves two questions unanswered. First, if an R&TC section 6010.9(d)
custom computer program includes only the service transaction of preparing computer programs
for the original user, it could never possibly include any type of a canned or prewritten
program. Why then does the R&TC section 6010.9(d) definition of a custom computer program
include the following qualifier?
- The term does not include a "canned" or prewritten computer
program which is held or existing for general or repeated sale or lease, even if the prewritten or
"canned" program was initially developed on a custom basis or for in-house use. [Emphasis
This provision indicates that computer software, initially developed for in-house use, retains its
status as nontaxable custom computer software until such software is held for general or repeated
sale or lease. The software in Navistar met this definition. It was in-house developed
software, stipulated to have never been held for general or repeated sale or lease.
Second, as noted by the concurring and dissenting opinion, despite the Court's assertion that there
are additional categories of software beyond "custom" and "prewritten or canned", neither the
R&TC nor the SBE's Regulations provide for any additional categories.
In any event, it is clear the R&TC section 6010.9(d) definition of nontaxable custom computer
software is only applicable to the acquisition by the customer who contracts for the preparation of
the software. The Court's decision, along with Touche Ross, confirms this narrow
definition and establishes that any subsequent sales of such software will be subject to the tax.
In Navistar, the California Supreme Court has sent a strong signal to businesses currently
operating or considering whether to operate in California. When transferring intellectual property
in California, be mindful of the sales and use tax implications of such a transfer, and if possible,
take the necessary steps to minimize the risk of taxability.
- Unless otherwise noted, all "R&TC" references are to the California
Revenue and Taxation Code, and all regulatory references are to Title 18 of the California Code of
Regulations. [return to text]
- Navistar also cited California appellate court decisions where the
Simplicity physically useful analysis was used to conclude that the transfer of the right to
reproduce original music recordings on master tapes was also subject to sales tax. Navistar argued
that these decisions were similarly based on the fact that the master tapes were physically useful as
printing plates to stamp out copies for sale to the public. See Capitol Records, Inc. v. State
Bd. of Equalization, 158 Cal. App. 3d 582, 600-01 (1984); A & M Records, Inc. v. State
Bd. of Equalization, 204 Cal. App. 3d 358, 375-76 (1988). California has since adopted a
sales and use tax exemption applicable to the transfer of master tapes and the related right to
reproduce music recordings. R&TC § 6362.5.
See also Atari Inc., v. State Bd. of Equalization, 170 Cal. App. 3d 665 (1985), a partially
depublished decision, where a prototype pinball machine was transferred for its design concept
with no incidence of California sales tax. [return to text]
- See California Sales Tax Counsel Rulings 515.0320, 540.0240,
540.0180. Navistar noted that trade secrets may be even more intangible than patents, copyrights
and trademarks, which are all required to be recorded on some tangible medium in order to qualify
for federal intellectual property protections. 17 U.S.C. § 102; 35 U.S.C.
§§ 111-113; 15 U.S.C. § 1051. Conversely, trade secrets can exist
independent of any tangible medium. Cal. Civ. Code § 3426.1. [return to text]
- The R&TC does, however, define tangible personal property as
"personal property which may be seen, weighed, measured, felt, or touched, or which is in any
other manner perceptible to the senses." R&TC § 6016. [return to text]
- Only one member of the present Court (J. Mosk) was a member of
the Simplicity Court that developed the physical usefulness reasoning. [return to text]
- The Court's distinction between trade secrets and other intangible
properties also appears to be at odds with California's adoption of the Uniform Trade Secrets Act
which provides trade secrets with statutory intellectual property protection, similar to that provided
patents, copyrights and trademarks. See Cal. Civ. Code § 3426, et seq. [return to text]
- The Court's statement that Navistar's trade secrets are similar to mass
produced books appears incorrect, since the Navistar documents were originals that were never
offered for sale to the public. Moreover, the purchaser of a mass produced book acquires only
rights to the particular copy of the book which was purchased and no separate intangible property
rights, whereas the subject trade secrets provided Caterpillar the intangible right to manufacture
turbine engines. [return to text]
- All documentation or representations associated with intangible
property that cannot be faxed or modemed (whether paper, computer disk, blueprints or otherwise)
should be delivered to the buyer outside of California. If the buyer intends to bring any of this
documentation into California, the tangible materials transferred should not include any tangible
medium (i.e., paper documents, computer disks, blueprints, etc.) provided by the seller, but rather
copies of such materials prepared out-of-state. Furthermore, all tangible materials (i.e., the blank
paper, computer disks, blueprints, etc.) used for making the out-of-state copies should be supplied
by the buyer, rather than the seller. The buyer, upon bringing the copies into California, would
then owe use tax, at most, on the nominal value it paid to acquire the blank materials used to make
the copies. [return to text]
- These provisions apply to technology transfer agreements, which are
- 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.
R&TC sections 6011(c)(10) and 6012(c)(10) were discussed in the briefs and at oral argument by
both Navistar and the SBE. However, as their effective date was April 1, 1994, these provisions
arguably had no effect on the Court's decision. [return to text]
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