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Assessing Embedded Software Remains a Challenge
in California

by Kevin Kamfar, Irvine, March 2014

 

California's Property Tax Code regarding bundled nontaxable software, commonly called embedded software, is more than 40 years old. It was written back when blank punch cards, tapes and discs were used to store application software in a large stand-alone computer.

 

Nowadays, software is embedded in all sorts of machinery and equipment from medical devices to communication technologies. The outdated statute makes it extremely difficult for assessors to employ mass appraisal methods and accurately back out the value of embedded software.

 

Software is Exempt

 

In 1972, the California Legislature enacted Revenue and Taxation Code 995, which essentially provides that all computer software, except basic operational programs, is exempt from property taxes.

 

When computer or other equipment is bundled together with application software for purchase at a single price, Rule 152 allows the county assessor, lacking evidence to the contrary, to simply value the property at its acquisition cost.

 

Taxpayers have the right to provide hard evidence to prove the taxable and nontaxable components of their purchase price. The rule puts the burden on taxpayers to provide the data, and leaves it to the county assessor and the assessment appeals board to decide the data's accuracy.

 

Courts Weigh In

 

One issue involved in segregating the value of embedded software was resolved in the 2008 case of Cardinal Health 301, Inc. v. Orange County. The court found the assessor wrong in valuing medical equipment at its total cost, including the cost of embedded software, solely on the grounds that the software was bundled into the sale or lease price of the computer equipment.

 

Still, the decision left several issues unaddressed. First, even though taxpayers may theoretically be in a better position to have knowledge of the value of their embedded software than an assessor, in practice they may not have the necessary information.

 

Also, while the Cardinal case resolved a narrow issue of interpretation, the court could not consider the unimaginable progress that has occurred in computer technology over the past few years.

 

Inconsistent Application

 

The State Board of Equalization recently reported results of a questionnaire regarding how assessors in different counties approach the valuation of bundled nontaxable software.

 

The responses show:

 

  • There is a lack of uniformity from one county to the next. For example, about half of the counties have made adjustments to remove bundled nontaxable software from the cost of machinery and equipment, while others have not.

  • Some counties allow assessment adjustments based on invoices, studies, or vendor letters of recommendation, while other reject such documentation.

  • Many counties use a percentage approach to ascertain the value of nontaxable bundled software relative to the cost of the equipment, but others don't.

  • There are many different methodologies used by assessors. Some may be appropriate for one industry and inappropriate for another.

 

Furthermore, the research shows that the number of appeals regarding embedded software are growing. In 2005-2007, 53 appeals were reported in 12 counties. In 2012-2013, 285 appeals were filed, as reported in 15 counties. However, the numbers may be deceiving. Many of the filings represent multiple appeals by the same taxpayer.

 

Documentation is Key

 

Obtaining the necessary valuation documentation on imbedded software may be tricky for some taxpayers, and impossible for others.

 

Manufacturers of the products that contain application software consider their data confidential and of proprietary nature. They are extremely reluctant to provide the breakdown cost information, even to the companies that purchase their product.

 

Nevertheless, it's a worthwhile pursuit for taxpayers to provide assessors any documentation possible about the value of embedded software in their equipment and machinery. Until standardized statewide guidelines are put in place, it may be the only sure way to get a tax break on embedded software products.