Burroughs Corp. v. State Bd. of Equalization

• Decision Date: 30 March 1984
• Citation: 153 Cal.App.3d 1152,200 Cal.Rptr. 816
• Court: California Court of Appeals Court of Appeals
• Parties: BURROUGHS CORPORATION, Plaintiff and Appellant, v. STATE BOARD OF EQUALIZATION, Defendant and Respondent. Civ. 22579.

Page 816

200 Cal.Rptr. 816

153 Cal.App.3d 1152

BURROUGHS CORPORATION, Plaintiff and Appellant, v. STATE BOARD OF EQUALIZATION, Defendant and Respondent.

Civ. 22579.

Court of Appeal, Third District, California.

March 30, 1984.

Ehrman, Flavin & Morris, Inc., Robert H. Morris and Sean Flavin, Monterey, for plaintiff and appellant.

John K. Van De Camp, Atty. Gen., Edward P. Hollingshead, Deputy Atty. Gen., for defendant and respondent.

SPARKS, Associate Justice.

In this case we review a challenged application of the "Sales and Use Tax Law" (Rev. & Tax.Code, § 6001 et seq.) to the computer industry. Plaintiff Burroughs Corporation appeals from a judgment of the Superior Court of Sacramento County which rejected its claim for a refund of nearly $800,000 for use taxes paid in the period between July 1, 1972, and December 31, 1975. This dispute arises from Burroughs' use of computer components, manufactured by itself, for purposes of testing other computer components which it also manufactured. Burroughs contends that since the components used for testing (referred to as "captive components" or "captives") were ultimately refurbished and sold or leased at full price, it should not be liable for the use tax levied on its use of the components for testing. The State Board of Equalization (Board) contends that the first use of captives to test and evaluate other components coming off the assembly line constitutes a taxable intervening use of the captives. The Board alternatively contends that the captives are taxable under the primary purpose test. We hold that the primary purpose test, defined by case law and promulgated by regulation, applies here. Judged by that test, Burroughs was liable for use taxes levied on the materials used to manufacture the captive components. Accordingly, we shall affirm the judgment.

FACTS

This dispute arose from Burroughs' manufacture of computer systems during the period in question. Burroughs operated four manufacturing plants in California. These plants are referred to as the Santa Barbara plant, the Westlake plant, the Pasadena plant, and the Mission Viejo plant. Each of the plants was responsible for a different aspect of Burroughs' manufacturing activity. The components from the different plants would be brought together to form a complete computer system.

A computer system consists of a family of components which, when brought together into a single entity, will perform the data processing functions the system was intended to accomplish. Within the different components of a system there are numerous options which may be selected by a customer. When a customer selects a computer system, the various manufacturing plants in turn receive an order for the component with the options necessary to complete the system. As each component is completed it must be tested. Due to the nature of the industry, it is not sufficient that a component be tested by itself. A computer component which itself operates properly may not be compatible with other components of the system it is intended to be operated with. In other words, it may not be able to communicate or "interface" with the other components. One of the main reasons for this is the constant change in the design of the computer components. The designs utilized are in a constant state of flux. As new designs are incorporated into various components, a problem may develop in the way other components interface with them. For this reason each component must be subjected to "interactive" testing, that is, as each component Burroughs utilized what it refers to as "captive components" or simply "captives" for interactive testing. There were several reasons for using captives for testing: First, captives served the special function, not served by other testing equipment, of testing an entire system for compatibility. Second, because Burroughs engineering group was located in its manufacturing plants, and field engineers who installed the systems were not necessarily qualified to isolate and resolve the engineering or design problems, testing was best done at the plant. Third, there was the risk that in attempting to resolve a problem a field engineer might create unique and incompatible machines in customers' offices. Fourth, the cost of shipping the various components to the same place for interactive testing was prohibitive. For these reasons captives were employed and components of the system tested at the plant before they came together for the first time in the field for installation.

is completed it must be connected to other components of a complete system to ensure that it will be compatible with the other components with which it must operate.

Captive and customer orders were handled identically within Burroughs. The manufacturing branch would get an order from the marketing department requesting a specific captive configuration. Some captives were manufactured in the same plant requesting the captive. Others were manufactured at one of Burroughs' three other plants. A captive would be a complete unit in that it could have been shipped to a regular customer except that it was generally ordered without power cables because Burroughs had permanent cables in their plants. The captives would have "skins" (covers) on them but these were usually removed once they were installed for testing in order to facilitate testing and adjustment.

Once the captive itself was tested for compatibility with other Burroughs' components, it became a known entity which could be used to test unknown entities, the newly manufactured components. Captives were used over and over again to test newly manufactured equipment. Burroughs' policy was that captives should be rotated once every 12 months. In practice, the majority of captives rotated between one and two years, but some were held for considerably longer periods of time, in one instance for eight years. The 12-month captivity period was believed to be the optimum balance between costs of shipping and installing captives, on the one hand, and the risk of obsolescence, on the other. During the period of captivity engineering changes were made in the captives so that they would be up to date.

As a percentage of total production, the number of captives in use at the four manufacturing plants for the years 1972 through 1975 varied from year to year and plant to plant: Pasadena--14.1 to 7.3 percent; Mission Viejo--26.4 to 20.4 percent; Santa Barbara--15.5 to 8.5 percent; and Westlake--6.6 to 4.3 percent.

When a captive was rotated it was sent back to its plant of manufacture and a new captive was installed. The old captive would be refurbished, outstanding engineering changes would be incorporated into it, and ultimately it would be sold or leased at full value. The costs of refurbishment and modification averaged 30 percent of the standard cost of the unit at all but the Westlake plant, where it averaged 32 percent.

For accounting purposes Burroughs kept a special account for captives. Although an investment credit was claimed on the captive account, the captives were not depreciated. Under Burroughs' accounting policy, a captive not rotated within 12 months was transferred to another account and capitalized and depreciated. At trial it appeared that 85.3 percent of the units used as captives were rotated, refurbished, and sold or leased. ¹

When Burroughs purchased the materials used to construct the components it gave the vendors resale certificates and no sales tax was paid at that time. ² When a component was designated as a captive Burroughs, under protest, paid a self-assessed use tax based upon the value of the materials used to construct the captive. Burroughs then brought a timely action for a refund of the amounts paid as use taxes for the captives which were ultimately rotated and returned to marketing for sale or lease. (See Rev. & Tax.Code, § 6933.) In the refund action, Burroughs' principal contention was that because it had to pay a sales tax when the captives were finally sold or leased to consumers, it should not also have been required to pay a use tax for the material incorporated into the testing captives. Burroughs argued that captives were manufactured primarily for sale or lease, and not for testing.

The trial court applied the primary purpose test, most recently reaffirmed in Kaiser Steel Corp. v. State Board of Equalization (1979) 24 Cal.3d 188, 198, 154 Cal.Rptr. 919, 593 P.2d 864, and concluded that there were two substantial purposes for purchasing the materials which ended up in captives, "neither of which categorically and objectively can be designated as 'primary.' " The court pointed out that the burden of proving one primary purpose was on Burroughs, and that it had failed to carry that burden. ³ Accordingly, the court denied the claim for a refund of use taxes. This appeal followed.

DISCUSSION

Revenue and Taxation Code section 6051 imposes a sales tax on all retail sales. ⁴ The tax, computed as a percentage of gross receipts, is imposed upon all retailers for the privilege of selling tangible personal property at retail. (Lockheed Aircraft Corp. v. State Bd. of Equalization (1978) 81 Cal.App.3d 257, 265, 146 Cal.Rptr. 283.) Section 6007 defines a "retail sale" or "sale at retail" as "a sale for any purpose other than resale in the regular course of business in the form of tangible personal property."

Section 6201 alternatively imposes a use tax upon storage, use or consumption in this state of tangible personal property purchased from any retailer for the purpose of storage, use or consumption in this state. ⁵ The use tax, like the sales tax, is not imposed upon tangible personal property held for resale in the regular course of business. (§§ 6008, 6009.)

The sales tax and the use tax are designed to be complementary. ⁶ Consequently, transactions subject to sales tax are exempt from the use tax. (§ 6401.) "As property covered by the sales tax is exempt...