Quick Points – Property Taxation and Software in California

(This article originally was published in Vol. 25, No. 4 of the California Lawyers Association’s California Tax Lawyer.)

Section 995 and 995.2 of the California Revenue & Taxation Code exempt all software except for basic operational programs from property taxation. Basic input output systems, known as BIOS, draw the line between the taxable and nontaxable. BIOS, which by definition is necessary to the operation of the computer, handles primitive functions such as turning the computer on and off. BIOS is taxable. Everything else, such as operating systems like Windows, is not taxable. (Property Tax Rule 152; Cardinal health 301 Inc. v. County of Orange (2008) 167 Cal.Appl.4th 219.) Often, computers or other electronic devices are sold with nontaxable software (i.e., non-basic operating systems or application software) preloaded onto the device. When there is no separate sales price for the nontaxable software, it is termed “bundled” or “embedded” software. Embedded software is not taxable. Id.

In the case of embedded software, the taxpayer must (1) identify the nontaxable software and (2) provide “sale prices, costs or other information that will enable to assessor to make an informed judgment concerning the proper value to be ascribed to the taxable and nontaxable components.” Rule 152(f). While the Rule simply requires sufficient proof to enable an informed value judgment, the level of proof required by Rule 152 has been heavily disputed between assessors and taxpayers.

There are significant tax dollars at issue. Not only is embedded software found in nearly all electronic devices from computers, phones and servers to equipment of virtually all types, but it is also frequently one of the most valuable parts of the device.

As the debate carries on, the State Board of Equalization (BOE) has begun to step in, most notably by issuing Letter to Assessors No. 2014/18, which outlines several valuation methodologies that the BOE has accepted as proof of the separate value of the nontaxable software. Among the accepted methodologies are: (1) identification of the separate market price for the hardware without any nontaxable software; (2) identification of the cost to manufacture the hardware without any nontaxable software; and (3) submission of vendor representations concerning the separate value of the nontaxable software. It should be noted that notwithstanding the BOE’s acceptance of vendor representations, certain local assessors regularly reject such proof.

Locally assessed taxpayers who wish to enforce this exemption will need to file application for changed assessment by either September 15 or November 30, depending on the county. The filing deadlines are provided in Letter to Assessors No. 2016/13, available on the BOE’s website.