Navistar Internat. Transportation Corp. v. State Bd. of Equalization, S032195

• Citation: 35 Cal.Rptr.2d 651,8 Cal.4th 868,884 P.2d 108
• Decision Date: 28 November 1994
• Docket Number: No. S032195,S032195
• Court: United States State Supreme Court (California)
• Parties: , 884 P.2d 108, 63 USLW 2364 NAVISTAR INTERNATIONAL TRANSPORTATION CORPORATION et al., Plaintiffs and Appellants, v. STATE BOARD OF EQUALIZATION, Defendant and Respondent.

Page 651

35 Cal.Rptr.2d 651

8 Cal.4th 868, 884 P.2d 108, 63 USLW 2364

NAVISTAR INTERNATIONAL TRANSPORTATION CORPORATION et al., Plaintiffs and Appellants, v. STATE BOARD OF EQUALIZATION, Defendant and Respondent.

No. S032195.

Supreme Court of California,

In Bank.

Nov. 28, 1994.

Pillsbury, Madison & Sutro, C. Douglas Floyd, Jeffrey M. Vesely and Craig A. Becker, San Francisco, for plaintiffs and appellants.

Elizabeth C. Burton and Kendall L. Houghton, Washington, D.C., as amici curiae on behalf of plaintiffs and appellants.

Daniel E. Lungren, Atty. Gen., and Richard F. Finn, Deputy Atty. Gen., for defendant and respondent.

KENNARD, Justice.

California imposes a sales tax on the retail sale of tangible personal property (Rev. & Tax. Code, § 6051), ¹ but excludes from taxation the transfer of intangible property and the transfer of a "custom computer program" (§ 6010.9). The issues here are:

1. When a company's trade secrets or other intellectual work product are embodied in documents, is the sale of those documents a transfer of tangible personal property and thus taxable, or does the intellectual content of the documents render the sale a nontaxable transfer of intangible property?

2. When a company develops a computer program for its own use and later sells the program, is the sale nontaxable as the transfer of a "custom" computer program?

As explained below, we conclude that in both of these instances the sale of the property is a taxable event.

I.

In 1981, Navistar International Transportation Corporation (Navistar), then known as International Harvester Company, sold all of the assets of its Solar Division to Solar Turbines, Inc., a wholly owned subsidiary of Caterpillar Inc. (Caterpillar), for $505 million. Navistar's Solar Division was at that time a leading manufacturer of industrial turbine engines. The design and production of industrial turbine engines is a technologically sophisticated process involving a number of trade secrets and other intellectual work product.

At the time of the sale, Navistar and Caterpillar agreed to allocate the purchase price among the various assets to be transferred. The assets that are the subject of the tax dispute in this case fall into three categories: drawings and designs, manuals and procedures, and computer programs. ²

Drawings and Designs

The drawings and designs at issue here embodied the technology developed by Navistar's Solar Division for the manufacture of turbines. They set forth confidential trade secrets and depicted patented components. They were proprietary to the Solar Division and were the subject of strict in-house security.

Experimental engineers created the drawings and designs from which manufacturing engineers produced a series of shop drawings, known as operational instruction sheets, which detailed the manufacturing process of the turbine engines. These operational instruction sheets enabled machine operators to fabricate the appropriate parts.

Manuals and Procedures

The manuals and procedures involved in the sale contained the engineering specifications prepared by Navistar's Solar Division engineers, who used them as technical guidelines. Like the drawings and designs, they reflected the turbine technology developed by Navistar's Solar Division over a period of many years, they contained trade secrets, they were proprietary to the Solar Division, and they were the subject of rigorous in-house security.

Computer Programs

The computer programs at issue here had been developed by Navistar's Solar Division for use in its own business. Approximately 74 percent of the programs were business system programs pertaining to financial accounting, business operation planning, and economic forecasting; roughly 18 percent of the programs were engineering programs, such as design and testing programs; and approximately 8 percent of the programs were "distributed computing systems," such as computer-aided design programs, basic research programs, and programs that controlled automated machinery operations. The computer programs also contained trade secrets.

After the sale of its Solar Division to Caterpillar, Navistar filed a sales and use tax return for the third quarter of 1981. Following its audit in 1984 of Navistar's return, the State Board of Equalization (hereafter Board) determined that, contrary to Navistar's position, the drawings and designs, the manuals and procedures, and the written computer programs that Navistar had sold to Caterpillar were tangible personal property subject to sales tax. The Board assessed a deficiency.

In November 1986, after the Board's denial of Navistar's "Petition for Redetermination," Navistar paid the Board the assessed deficiency. In May 1987, Navistar requested a refund, which the Board denied. Thereafter, Navistar, Caterpillar and Solar Turbines, Inc. (Caterpillar's wholly owned subsidiary) filed in the superior court this action for a refund. ³ The court ruled in favor of the Board. The court found that the drawings and designs, the manuals and procedures, and the computer programs were tangible personal property that had been transferred as part of a sale and therefore were taxable.

Following the Court of Appeal's affirmance of the trial court's judgment, we granted Navistar's petition for review. Navistar contends that the sale of its drawings and designs, as well as its manuals and procedures, was a transfer of nontaxable intangible assets. According to Navistar, when the objective of a purchaser is primarily to acquire the intellectual content embodied in a physical object, such as a document, the sale is not taxable even though the physical object itself is tangible personal property that otherwise would be taxable under section 6051. With regard to the sale of the computer software, Navistar contends it was "custom" software and therefore not taxable under section 6010.9, which exempts custom computer programs from taxation.

II.

California law imposes a tax on the retail sale of tangible personal property (§ 6051), but not on the sale of intangible personal property or on the performance of services (see §§ 6006, 6007).

Of these three concepts, only tangible personal property is defined by statute. It means "personal property which may be seen, weighed, measured, felt, or touched, or which is in any other manner perceptible to the senses." (§ 6016.)

Although there appears to be no comprehensive definition of intangible property (Cowdrey, Software and Sales Taxes: The Illusory Intangible (1983) 63 B.U.L.Rev. 181, 200-203), such property is generally defined as property that is a "right" rather than a physical object. (Roth Drug, Inc. v. Johnson (1936) 13 Cal.App.2d 720, 734, 57 P.2d 1022; Black's Law Dict. (6th ed. 1990) p. 809, col. 1.) As the court in Roth Drug, Inc. v. Johnson, supra, 13 Cal.App.2d at page 734, 57 P.2d 1022 observed: "Tangible property is that which is visible and corporeal, having substance and body as contrasted with incorporeal property rights such as franchises, choses in action, copyrights, the circulation of a newspaper, annuities and the like." An intangible right may be evidenced or represented by a physical object such as a promissory note or a certificate of stock. When an intangible right is so represented, the physical object representing the particular right, while capable of perception by the senses, is nevertheless considered intangible property for tax purposes. Thus, for purposes of the law of taxation, intangible property is defined as including personal property that is not itself intrinsically valuable, but that derives its value from what it represents or evidences. (See, e.g., Fla.Stat.Ann. § 199.023, subd. (1) (West 1994); Dilley v. Ketchikan Gateway Borough (Alaska 1993) 855 P.2d 1335, 1336-1337; Black's Law Dict., supra, p. 809, col. 1.)

The third concept, service, has been defined by this court as the performance of labor for the benefit of another. (Culligan Water Conditioning v. State Bd. of Equalization (1976) 17 Cal.3d 86, 96, 130 Cal.Rptr. 321, 550 P.2d 593.)

When the transferred or sold assets involve not only tangible personal property, which is taxable, but also the performance of a service, which is not taxable, their classification is determined by the "true object" test as set forth in title 18, California Code of Regulations, section 1501 (regulation 1501): "The 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 objects 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 property is transferred."

Navistar asserts that regulation 1501's "true object" test should be applied here. According to Navistar, its sale to Caterpillar of the drawings and designs, as well as the manuals and procedures, involved the transfer of intangible property, because Caterpillar's "true object" in purchasing those documents was not to obtain them for their own sake, but to acquire the intangible trade secrets and similar information contained in the documents.

In support of its argument, Navistar points to certain language, commonly referred to as the "manuscript example," in regulation 1501: "[A]n 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. ...