Contract Smarts: Using Technology Transfer Agreements to Cut Your Sales Tax

By: Robert T. Leonard, J.D., C.P.A.
Copyright 1999, All Rights Reserved.

Sales and use tax revenues have become a multi-million dollar piece of the California tax pie. No surprise, then, that in recent years, the California State Board of Equalization ("SBE") has become increasingly aggressive about pursuing income from sales tax audits and enforcement programs.

Recently, however, the SBE has gone too far -- attempting to collect tax from transactions that are clearly exempt under current law. Their target: transfers of intangible property.

We're all used to sales tax on transfers of tangible personal property -- and that's clearly proper. Intangibles are another matter. Transfers of intangibles -- such as the right to make and sell another party's patented goods, or the performance of services -- have long been exempted from sales tax.

The SBE generally does a good job of understanding, and therefore making the right assessment, when only one item is transferred. However, in the real world, many transfers involve two or more items (tangible and intangible) in the same transaction. In these situations, the SBE has recently tried to claim that the entire transaction is taxable, refusing to separate out the value of any non-taxable intangible property.

By now, you'd think the law was abundantly clear. The SBE asserted its unreasonable position -- and lost -- in the 1993 case the Petition of Intel Corp. To make sure that the SBE couldn't assert such frivolous positions again, the California State Legislature followed up in 1993 by amending Revenue and Taxation Code Section 6011(c)(10)(D) to specify that taxable "gross receipts" do not include proceeds from a transfer of intangible personal property, even if accompanied by a transfer of tangible personal property.

This amendment was important because it confirmed that in general the value of tangible and intangible personal property must be separately calculated, with only the tangible portion being subject to sales tax. Even more important for planning purposes, however, was a little-noticed definition tucked into the fine print: a brand-new concept known as a "technology transfer agreement," for which apportionment is mandatory.

Just what kind of contract will qualify as a technology transfer agreement, or "TTA"? The legislature defined the term loosely 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 to use a process that is subject to the patent or copyright interest." Clearly, the legislature was intent on casting a rather broad net. But until now, the scope of this definition has remained untested. And the SBE has largely ignored it.

Wild Side West, Inc. ("WSW") appears to be the first reported case which challenged the SBE based on this 1993 statutory change. WSW is a manufacturer of heat transfers, which are used to print designs on garments. WSW sometimes purchases artwork outright, and consequently becomes the sole owner of the artwork. However, in certain situations, WSW would enter into a license agreement with outside graphic artists giving WSW exclusive rights to produce and market heat transfers using the designs provided by the artist in exchange for royalties paid to the artist based on sales of heat transfers containing their artwork. These License Agreements provided, among other things, that copyrights on the original designs would remain with the artist, and that WSW was restricted to using the artwork for heat transfers for printed apparel.

The SBE audited WSW and claimed that royalty payments made to artists / licensor pursuant to such License Agreements were actually "lease" payments for tangible artwork, and as such, were subject to sales tax. After exhausting its administrative remedies, WSW paid the assessed tax and filed a Claim for Refund in Los Angeles Superior Court.

At trial, WSW pointed to the plain language of the 1993 amendment. The License Agreements constituted a technology transfer agreement; therefore, WSW argued, an apportionment of tangible and intangible assets was required. The SBE disagreed. Without any support, it claimed that the Legislature never contemplated that technology transfer agreements would apply to artwork. The SBE further argued that licenses of artwork couldn't qualify as TTAs because the artists / licensor did not transfer anything "technological" in nature. Plaintiff's expert witness, Mark Venit, provided persuasive testimony as to why the transfer of art constituted a transfer of technology. Furthermore, Mr. Venit discussed the several advantages from having an exclusive license from a leading artist. These advantages related to significant value to be attributed to the intangible asset (license) transferred.

In a strong victory for common sense, the judge soundly rejected the SBE's arguments. The definition of a TTA was not ambiguous, uncertain, or unclear, he said, and the plain meaning of the statute must be followed. Furthermore, the judge noted, SBE's own Legislative Analysis Unit had concluded before the amendment was passed that the broad statutory definition of a TTA would apply to artwork. The argument that something "technological" in nature must be transferred for the agreement to qualify as a TTA was also roundly rejected, based on the plain wording of the statute.

The Trial Court held that the License Agreement entered into between WSW and its artists was indeed a TTA. Accordingly, the royalty payments made by WSW to its artists for the intangible right to copy and reproduce artwork were non-taxable.

FUNDAMENTAL RULE OF COPYRIGHT LAW

The WSW decision involved a fundamental principle in copyright law: that a buyer or lessor of artwork does not necessarily acquire the right to reproduce that copyrighted art. Suppose, for example, you purchased a Mickey Mouse T-shirt at your neighborhood Disney store. Would you then have the right to use that artwork to make your own line of T-shirts? Clearly not. Possessing an item of copyrighted art is clearly different from owning the right to use or duplicate that art.

The judge in the WSW case made the right call. What the SBE failed to recognize was that intangible property rights -- like the right to duplicate an image -- continue to belong to the artist / licensor, until such time as that separate legal right is transferred. And when those intangible rights are transferred -- as they were under WSW's License Agreement -- the payments aren't subject to sales tax.

OPPORTUNITIES TO AVOID SALES TAX BY USING TTA's

The WSW decision is good news for anyone who buys or licenses art or other copyrightable works. As long as your purchase or license agreement meets all of the qualifications of a Technology Transfer Agreement, then the value of the intangible personal property -- often the largest component of the deal -- will be non-taxable. And while careful planning is always advisable, it is quite likely that your purchase or license agreement already contains the basic elements needed to qualify as a Technology Transfer Agreement.

Let's start with the basics: the artist who is transferring his artwork must have a copyrighted interest in his artwork. Despite the name, nothing technological in nature must be transferred. And the copyright does not have to be one granted by the U.S. Copyright office; a "common" copyright, which consists of typing "copyright" or using the copyright symbol will suffice. This is a very small step for an artist to make in order to avoid a substantial amount of royalty payments subject to tax, and a prudent precaution for the artist as well.

Beyond that, the documentation must simply be clear about what is being transferred: a right to re-use of the copyrighted material. And that right need not even be exclusive. In a typical license agreement, for example, the licensee might be acquiring only the right to reproduce the art work in North America. No matter. The license agreement may still qualify as a TTA.

And what if you're used to purchasing rather than licensing works of art? Many freelance artists sell their artwork without bothering to enter into formal agreements. However, the better practice is to draw up a standard purchase agreement. This can be a short one page, and should simply provide that ownership rights in the artwork (including the right to reproduce it) are being transferred at the same time as the physical artwork itself. This will enable the artist to exclude a portion of his compensation from tax. For example, an artist may expect to sell a piece of artwork for $500. By having a written Purchase Agreement, the artist can claim that the intangible personal property transferred to the buyer (consisting of the right to reproduce the artwork) is worth $400 and the tangible personal property (the art itself) is worth $100). Without much exercise, the artist has just reduced his tax liability by 80%.

Your agreement can (and should) specify an allocation between tangible and intangible components. And so long as that allocation is reasonable, the Revenue & Taxation Code says your written allocation will be upheld. Even if your paperwork doesn't allocate the purchase price, however, the Code steps in with a taxpayer-friendly presumption: the tangible (taxable) portion, it says, will be equal to 200% of the cost of labor and materials. For art work, that usually translates into a rather small sum that will be subject to tax. The remaining purchase price is deemed consideration for the intangible personal property and non-taxable.

Keep in mind that a wide range of transactions involving the sale/lease of copyrightable works can be structured as technology transfer agreements. A TTA could be used for purchases or leases of sketches or designs by graphic designers for magazines, posters, and prints, for example. Or a TTA could be used by galleries purchasing artwork by artists / licensor, or by advertising or design firms which purchase or license artwork.

The SBE, as you might imagine, is less than excited about the benefits of using TTAs. Proposed changes in their regulations to acknowledge the broad application of technology transfer agreements were rejected when the SBE's Finance Committee projected annual loss of revenues of approximately $50.0 million. Consequently, the SBE may well continue to attempt to collect and assess tax on intangible personal property.

The moral of this story: Payors beware -- and become familiar with TTAs. Don't rely on the SBE to warn you that you're overpaying sales taxes.