Dan Walters: California's sales-tax loophole should be closed

05/28/2013 12:00 AM

05/28/2013 8:08 AM

About a quarter-century ago, the California Legislature punched a very large loophole in the state's sales tax law by exempting custom computer software from taxation.

It meant that if a custom software purveyor such as Peoplesoft were to create a specialized personnel, payroll or inventory management program for a corporate client and charged $1 million for the disks containing its bits and bytes, it would not be considered "tangible personal property" and therefore would not be subject to state and local sales taxes.

At the behest of the custom software industry, the loophole measure was carried by John Vasconcellos, a Democratic legislator who represented Silicon Valley at the time – and, ironically, a liberal who frequently decried the lack of state revenue for health and welfare services.

Carving out custom software, however, meant that off-the-shelf software disks such as Quicken, Turbo Tax or Microsoft Office, purchased by ordinary consumers, would remain a taxable commodity.

Unfair? Irrational? Absolutely. But it has remained on the books, costing state and local coffers many billions of dollars since its enactment, and underscoring the very arbitrary nature of tax policy.

This bit of relatively ancient taxation history is offered not only for its illustrative quality, but because what software is taxable and what's not has emerged as an issue of sorts vis-à-vis the latest state budget.

It seems that a series of court decisions has created some doubt as to whether the sale of off-the-shelf software is a transfer of taxable personal property, because another section of state law says that a "technology transfer agreement" is not taxable.

The State Board of Equalization has been involved in some litigation with taxpayers over defining a technology transfer agreement and lost one case, thereby encouraging other taxpayers to assert that all software, even non-custom software, may be a technology transfer and therefore exempt from taxation.

It turns out that there's no law specifically saying that non-custom software is taxable, but that the Board of Equalization and retailers have just assumed that it is – in part because the Legislature, with the Vasconcellos bill, specifically said that custom software is tax-free.

To remove all doubt, Gov. Jerry Brown's administration is asking the Legislature, as part of the budget, to declare flatly that off-the-shelf software is taxable.

The situation does beg for some clarifying legislation.

However, the appropriate response would be to remove the illogical and unconscionable loophole that allows purchasers of multimillion-dollar custom programs to evade taxes while ordinary consumers have to cough up taxes amounting to hundreds of millions of dollars.

It's an opportunity to right a wrong.

Call The Bee's Dan Walters, (916) 321-1195. Back columns, www.sacbee.com/walters. Follow him on Twitter @WaltersBee.

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