NAVISTAR INTERNATIONAL TRANSPORTATION CORPORATION v. STATE BOARD OF EQUALIZATION (1993)

Appellants Navistar International Transportation Corporation (Navistar), Caterpillar Inc. (Cat) and Solar Turbines, Inc. appeal from a judgment denying their claim for a refund of sales taxes assessed by the State Board of Equalization (the Board) on certain personal property which Cat acquired from Navistar's predecessor in 1981.   The primary question on this appeal is whether drawings, designs, engineering specifications and computer software which contained trade secrets and were used in manufacturing turbine engines were tangible personal property subject to sales tax or intangible personal property, which is exempt from taxation.   We agree with the conclusion of the Board and the trial court that the property transferred was subject to sales tax and therefore affirm the judgment.

BACKGROUND

The facts of the case are all stipulated or the subject of undisputed testimony.   The controversy turns solely on the interpretation and application of sales and use tax statutes, a question of law on which we exercise our own judgment independent of the trial court's determination.  (Touche Ross & Co. v. State Bd. of Equalization (1988) 203 Cal.App.3d 1057, 1060, 250 Cal.Rptr. 408, fn 2.)

In 1981 plaintiff Navistar, then known as International Harvester Company (IH), entered into an agreement by which it sold all of the assets of its Solar Division (Solar) to Cat.   The turbine business is highly competitive and involves many trade secrets, patents, know-how, designs and similar confidential information.   At the time, Solar had developed highly sophisticated technology which it used to manufacture turbines;  Cat's turbine manufacturing business had not been successful and Cat acquired Solar to become “a viable player in that industry.”

The written agreement describes the purchased assets as all property of whatever kind or character, including customer lists, credit and sales records, contract rights, general intangibles and accounts, intellectual property, the name Solar Turbines International, and any goodwill associated with the business of Solar.  “Intellectual Property” was defined to include “licenses, invention disclosures, trade secrets, data, drawings, concepts, know-how, copyrights, patents, patent applications, registered trademarks and trademark applications.”   Although Solar's existing employees were not bound to stay and work for Cat, they were highly encouraged to do so.

Cat and IH also entered into an allocation agreement under which the parties allocated the gross purchase price among various purchased assets.   Included in that allocation were the following assets, which are the subject of this litigation:

“Drawings and designs” represented Solar's in-house turbine technology developed over the years in order to develop and manufacture turbine engines.   They contained confidential information and trade secrets and were kept in vaults under rigorous security.   The drawings depicted the process of manufacturing and assembling the parts that make up the turbine engines.   From the drawings a manufacturing engineer would produce a set of shop drawings and an operational instruction sheet which tells the workers how to produce the parts for a specific job.   At the time of the acquisition there were 67,750 such drawings, of which 42,000 were active.

The principal component of “manuals and procedures” was engineering specifications.   These were documents prepared by Solar's engineers as technical guidelines.   They included manufacturing process specifications, material and equipment specifications, test requirements and model specifications.   They also depicted many patented components.

“[W]ritten computer procedures” pertained to computer programs which were developed in-house and customized by Solar for use in all facets of its business operations.   About 95 percent of the programs were conveyed to Cat in the form of human readable source code supported by written documentation and logic contained in volumes kept in a locked library.   None of the programs were held for general or repeated sale.

After the acquisition, Cat listed the above items as intangible assets on its federal income tax returns.   On both federal and state income tax returns, Cat claimed straight line depreciation on these items, rather than the accelerated depreciation methods available for tangible assets.

IH filed a sales and use tax return for the third quarter of 1981 which reported a sales tax of $3,210,720 in connection with the sale of assets of its Solar Division to Cat.   In 1984 the Board audited the return and notified appellants of a sales tax deficiency of $3,072,479.16, due to its determination that the account items noted above were tangible property and therefore subject to sales tax.   After exhausting all available administrative remedies, appellants paid the assessment and filed this action in superior court for a refund.

The superior court found in favor of the Board and issued a judgment denying all relief.

APPEAL

I

The principal issue on this appeal is the proper characterization of the account items referred to above.   Appellants contend the items in question constituted intangible property because they were solely a means of conveying trade secrets from Solar to Cat.   The Board, on the other hand, maintains that because the items have value as physical objects and were not sold incident to any service performed by Solar, they constituted tangible personal property.

 In a suit for refund, the burden of proof is on the taxpayer.   (Capitol Records, Inc. v. State Bd. of Equalization (1984) 158 Cal.App.3d 582, 589, 204 Cal.Rptr. 802.)   Although the interpretation of a regulation, like the interpretation of a statute, is ultimately a question of law for the court, the Board's interpretation of its own regulations is entitled to great weight.  (Culligan Water Conditioning v. State Bd. of Equalization (1976) 17 Cal.3d 86, 93, 130 Cal.Rptr. 321, 550 P.2d 593 (Culligan ).)

 California imposes a sales tax on the privilege of selling tangible personal property.  (Rev. & Tax.Code,1 § 6051.)  “ ‘Tangible personal property’ means personal property which may be seen, weighed, measured, felt, or touched, or which is in any other manner perceptible to the senses.”  (§ 6016.)   On the other hand, even tangible property is nontaxable if the real purpose of the transaction is the rendition of services.   (Culligan, supra, 17 Cal.3d 86, 96, 130 Cal.Rptr. 321, 550 P.2d 593.)

Title 18, California Code of Regulations, section 1501 (Regulation 1501) promulgated by the Board explains that “[t]he 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[s] of the contract;  that is, is the real object sought by the buyer the service per se or the property produced by the service.   If the true object of the contract is the service per se, the transaction is not subject to tax, even though some tangible personal property is transferred.”  (Emphasis added.)

 Clearly the transfer of the account items does not qualify as the sale of personal property incident to a service contract under the “true object” test described above.  “Service” in this context has been defined as the “ ‘performance of labor for the benefit of another.’ ”  (Culligan, supra, 17 Cal.3d 86, 96, 130 Cal.Rptr. 321, 550 P.2d 593, quoting Webster's New Internal. Dict. (2d ed., unabridged).)   Cat did not contract for Solar's services in manufacturing turbine engines.   Cat purchased Solar “lock, stock and barrel” for $505 million.   Appellants suggest that the acquisition agreement may properly be described as a contract for the future services of Solar's employees, citing the testimony of former Cat Chief Executive Officer George Schaefer that retention of Solar's employees was essential in enabling Cat to carry on in the turbine manufacturing business.   However, no employee of Solar was bound to do anything under the acquisition agreement.   The fact that Cat hoped that it would be successful in persuading Solar's employees to work for it and eventually help it build turbine engines did not convert the acquisition agreement into a service contract.  (See A & M Records, Inc. v. State Bd. of Equalization (1988) 204 Cal.App.3d 358, 373, 250 Cal.Rptr. 915 [master tapes purchased by record company constituted taxable property notwithstanding declaration by its president that true object was to secure the personal services of the artists].)

 Appellants' central argument is based on a subsequent portion of Regulation 1501 which indicates that tangible personal property which is used solely as the medium for the expression of an idea or concept is nontaxable, regardless of whether it is provided in connection with the rendition of a service.   This passage reads as follows:  “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․”

Appellants contend that the manuscript example in Regulation 1501 demarcates a third category which is neither tangible personal property nor property supplied incident to a service contract and that the account items in question fall into that category.   According to appellants the drawings, engineering specifications and computer programs at issue here were merely the method by which Solar's trade secrets were conveyed to Cat just as the author's manuscript constitutes a means of conveying the intellectual content of his creation.   Just as the manuscript has no value except as a vehicle for presenting the author's ideas to the typesetter, say appellants, Cat did not value the items for themselves but only as a means of acquiring the technology and know-how to manufacture turbine engines.

 We agree with appellants' premise that there exists a kind of personal property which is neither tangible nor provided incident to a service.   In Simplicity Pattern Co. v. State Bd. of Equalization (1980) 27 Cal.3d 900, 906, 167 Cal.Rptr. 366, 615 P.2d 555 (Simplicity Pattern ) the California Supreme Court describes intellectual property as “an ‘intangible incorporeal right’ existing separately from the physical medium that embodies it.   [Citation.]”  A patent or a customer list would fall within this category.   Likewise, the author's manuscript, when used solely for purposes of conveying the intellectual content of his creation would be nontaxable.²

Simplicity Pattern furnishes particular guidance here because the taxpayer attempted to rely on the manuscript example to claim an exemption from sales tax.   The items sought to be taxed as tangible property were film negatives and master recordings which were used to produce audiovisual training materials for medical personnel.   Citing the manuscript example, the taxpayer claimed that these items were nontaxable because “the purchaser's primary interest was not in the physical objects but rather in the right to exploit the intellectual products they embodied.”  (Simplicity Pattern, supra, 27 Cal.3d 900, 906, 167 Cal.Rptr. 366, 615 P.2d 555.)

After describing the product/service distinction set forth in the first portion of Regulation 1501, the Simplicity Pattern court acknowledged that the manuscript example did not neatly fit the regulation's “ ‘transfer of tangible personal property incidental to the performance of a service’ ” category, since there is no indication therein that the author contracts to provide anything other than the manuscript itself.  “Yet by no means does the regulation support plaintiff's broad theory that a sale becomes nontaxable whenever its principal purpose is to transfer the intangible content of the physical object being sold.”  (Simplicity Pattern, supra, 27 Cal.3d 900, 909, 167 Cal.Rptr. 366, 615 P.2d 555, emphasis added.)

Simplicity Pattern distinguished the manuscript example from the sale there because “a manuscript is used solely for its intellectual content” (Simplicity Pattern, supra, 27 Cal.3d 900, 909, 167 Cal.Rptr. 366, 615 P.2d 555) whereas the film negatives and master recordings were physically useful in making finished products.   The court held that as long as the item is (1) not solely the embodiment or expression of an idea, (2) physically useful in the manufacturing process and (3) not supplied as an incident to providing a service, it is taxable as tangible personal property.  (Id. at p. 912, 167 Cal.Rptr. 366, 615 P.2d 555.)

We think Simplicity Pattern disposes of appellants' claim that the account items must be deemed intangible property as illustrated in the manuscript example.   Cat was not paying $68 million for “trade secrets” in a vacuum.   The drawings depicted the process of manufacturing and assembling the parts that make up the turbine engines.   These drawings enable the manufacturing engineer to produce a set of shop drawings and an operational instruction sheet telling the production crew how to produce the parts for a specific job.   The manuals and procedures consisting primarily of engineering specifications describe the manufacturing process in detail.   In the words of Solar's manager of engineering services, these documents describe “how to prepare a drawing, how to weld a part, how to brace a part, and so on․”  Years of testing and engineering research had gone into creating these documents, which had been developed, modified and remodified by Solar's engineers.   Unlike the author, Solar cannot be deemed a mere consumer of the paper on which the drawings, designs and engineering specifications were recorded.   On the contrary these documents, once created, had intrinsic value.   They were not only physically useful but crucial to the process of manufacturing turbine engines.

 We see no substantive distinction between the account items here and the master tapes and film negatives used to produce audiovisual materials in Simplicity Pattern.   In both cases, the items were not supplied incident to a service, are not the pure expression of an idea or an incorporeal right and are useful in the manufacturing process.   The fact that the items were unquestionably valued primarily for their intellectual content does not preclude their being taxed as tangible property based on their entire worth.   (Simplicity Pattern, supra, 27 Cal.3d at pp. 906, 909, 167 Cal.Rptr. 366, 615 P.2d 555;  see also Capitol Records, Inc. v. State Bd. of Equalization, supra, 158 Cal.App.3d 582, 596, 204 Cal.Rptr. 802 [master tapes “manifestly useful in the manufacturing process” and “not furnished as incidents to any service” properly taxed as tangible property].)

 Appellants nevertheless insist that the subject property must be not only physically but immediately useful in producing saleable merchandise, such as a printing plate, mold or a template.  Simplicity Pattern, however, sets forth no requirement of “immediate” usefulness, nor does it make sense that tax treatment should depend upon the amount of human intervention which must occur for the property to be put to use.   Finally, we believe the adoption of an “immediately useful” requirement would create a dangerous loophole in the tax laws by exempting thousands of tangible items whose primary value lies in the ideas they communicate.

II

Appellants also claim that the computer programs produced in-house by Solar and purchased by Cat were exempt from sales tax under the “custom computer program” exception set forth in section 6010.9 and Regulation 1502 (Cal.Code Regs., tit. 18, § 1502).   Section 6010.9, subdivision (d) excludes from sales tax a “[c]ustom computer ․ program prepared to the special order of the customer.”   Such programs, however, do not include prewritten or “ ‘canned’ ” programs which are held for general or repeated sale.  “Custom computer programs” and “prewritten programs” are defined in more detail in Regulation 1502.

Appellants argue that all computer programs are either custom programs or canned programs.   Since Solar's in-house developed programs were not canned (i.e., held for general or repeated sale), appellants conclude that they must be custom programs and therefore exempt from taxation.   We disagree.

 First, the express purpose behind section 6010.9 was to codify preexisting case law which held that specially ordered computer programs are exempt from taxation because the creation of such software is considered the rendition of a service rather than the manufacture of a product.  (Touche Ross & Co. v. State Bd. of Equalization, supra, 203 Cal.App.3d 1057, 1062–1064, 250 Cal.Rptr. 408 (Touche Ross );  see Stats.1982, ch. 1274, § 1, p. 4706.)   Solar's programs were not prepared to anyone's special order, but created by Solar for its own use.   Likewise, Cat was not buying Solar's services in creating the programs—the programs were already fully developed and in place when Cat purchased them, along with all the other assets of Solar.

Touche Ross is squarely on point and fatal to the argument raised here.   There, pursuant to a liquidation plan, Kaiser Industries sold all the assets of its engineering division to another company.   Included among the assets was an extensive library of customized computer programs which had been developed by Kaiser for internal business use.   Kaiser challenged the Board's determination that the transfer of the software library was a taxable transaction, claiming that the programs were exempt under section 6010.9.

 The Court of Appeal rejected that claim.   After noting that none of the programs were developed to the special order of the purchaser, the Touche Ross court stated:  “In the enactment of section 6010.9 the Legislature has recognized that the design, development or creation of a custom computer program ․ is primarily a service transaction and, for that reason, not subject to sales tax.   However, once the program has been created and in the possession of the original customer, the design or development service has been completed, and the program itself has become a tangible personal asset of the customer.   A subsequent sale of that program by the initial customer can no longer be characterized as a ‘service’ transaction, but rather is a transfer of a tangible personal asset produced by the original programmer's services.   As such, it is subject to sales tax.  (§ 6051.)”   (Touche Ross, supra, 203 Cal.App.3d 1057, 1064, 250 Cal.Rptr. 408, emphasis added.)

If there were any further doubt on the issue, subsection (b) of Regulation 1502 lays it to rest.   That provision defines a “prewritten” (taxable) program to include not only one held for repeated or general sale but “also ․ a program developed for in-house use which is subsequently offered for sale or lease as a product.”   Solar's software library, developed for internal use and subsequently sold to Cat in toto as part of the acquisition agreement, clearly qualifies as a prewritten program under that subsection.

III

Appellants additionally argue that the trial court erred in failing to accord controlling weight to the fact that Cat and IH treated the account items in question as intangible assets for federal and state income tax purposes (Treas.Reg. 1.167(a)–3;  18 Cal.Code Regs. § 24349(c)) with the consent and approval of the taxing authorities.   This claim is without merit.

 It is the function of the courts to apply the statutes and regulations in determining whether the sale was taxable.  (See Simplicity Pattern, supra, 27 Cal.3d 900, 905, 167 Cal.Rptr. 366, 615 P.2d 555.)   While the parties' treatment of the items on their income tax returns may be relevant in arriving at this determination, the courts are not bound to accept such characterization in applying the sales tax statutes.

McConville v. State Bd. of Equalization (1978) 85 Cal.App.3d 156, 149 Cal.Rptr. 194, cited by appellants, is not to the contrary.   There, the trial court considered the taxpayer's treatment of breeding horses as capital assets subject to depreciation as militating against her claim that they were held solely for resale.  (Id. at p. 161, 149 Cal.Rptr. 194.)   Nothing in McConville suggests that the taxpayer's treatment of assets on an income tax return should be the sole criterion for determining taxability under the sales and use tax statutes.   Here the trial court allowed appellants to introduce evidence of income tax treatment, while nevertheless rejecting their claim of exemption under the sales and use tax statutes.   No error occurred.

IV

Years after the sale, the Internal Revenue Service performed an audit of Cat's tax returns and concluded that a significant amount of the purchase price allocated by the parties to manuals and procedures should be reclassified as goodwill.   Appellants argue that, at the least, they are entitled to the benefit of this reallocation in the form of a reduction in their sales tax.   They are mistaken.

 “The agreed price, as opposed to market value or some subsequently revealed price, dictates the appropriate sales and use tax treatment.   [Citation.]”  (Wallace Berrie & Co. v. State Bd. of Equalization (1985) 40 Cal.3d 60, 70, 219 Cal.Rptr. 142, 707 P.2d 204.)   The Board correctly computed the sales tax on the account items based on the price paid for them pursuant to appellants' own allocation.   Appellants must accept the consequences of the form of the business transaction which they selected.  (United States Lines, Inc. v. State Bd. of Equalization (1986) 182 Cal.App.3d 529, 539–540, 227 Cal.Rptr. 347.)

DISPOSITION

The judgment is affirmed.

FOOTNOTES

FN1. All further statutory references are to the Revenue and Taxation Code..  FN1. All further statutory references are to the Revenue and Taxation Code.

2.   Of course some manuscripts may constitute taxable property because of their worth as physical objects in and of themselves.   For example an original James Joyce manuscript is valuable not merely for the ideas it contains, but for its significance as an historical artifact.

SMITH, Associate Justice.

KLINE, P.J., and PHELAN, J., concur.