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Nortel Networks Inc v. State Board of Equalization

January 18, 2011


APPEALS from a judgment of the Superior Court of Los Angeles County. Terry A. Green, Judge. (Los Angeles County Super. Ct. No. BC341568)

The opinion of the court was delivered by: Boren, P.J.


Affirmed in part and reversed in part.

This appeal requires an interpretation of the Sales and Use Tax Law. (Rev. & Tax. Code, § 6001 et seq.)*fn1 Nortel Networks Inc. sells telephone switching equipment in California. Income from switch hardware sales is indisputably taxable by the State of California. The question is whether sales tax is imposed on the software that Nortel licenses to operate the switching equipment. The State Board of Equalization (the Board) determined that Nortel owes sales tax on software it licensed between January 1994 and December 1997. Nortel paid the tax then sued for a refund.

We conclude that the software licensed by Nortel is exempt from sales tax under the Technology Transfer Agreement (TTA) statutes because it (1) is copyrighted, (2) contains patented processes, and (3) enables the licensee to copy the software, and to make and sell products--telephone calls--embodying the patents and copyright. (§§ 6011, subd. (c)(10)(D), 6012, subd. (c)(10)(D).) The Board's attempt to limit the scope of the TTA statutes by excluding prewritten computer programs is an invalid exercise of its regulatory power. The TTA statutes encompass "any" transfer of an interest subject to a patent or copyright, which includes prewritten programs licensed by Nortel.


Nortel Designs, Manufactures and Sells Switch Hardware

Nortel manufactured and sold switches to Pacific Bell Telephone Company. Each switch processes telephone calls, and handles features such as conference calling, call waiting, and voice mail. A switch is hardware, comprised of computer processors, frames, shelves, drawers, circuit packs, cables, and trunks. A "line card" for each Pacific Bell customer is contained within the switch. The line card is attached to cables that eventually connect to a subscriber's home or business. When the subscriber picks up the telephone to make a call, the audible dial tone is generated by the computer in the switch.

Pacific Bell houses its switches in California at over 200 buildings or central offices. A switch for a dense urban area such as downtown Los Angeles is large enough to fill a bowling alley or small auditorium. Each location requires different equipment. Nortel's engineers inspect the site where the switch is to be located and write hardware specifications in order to design and build a new switch.*fn3

Nortel Licenses Software Programs for the Switches

Nortel and Pacific Bell entered licensing agreements giving Pacific Bell the right to use Nortel's software programs in the switches. There are two types of licensed software. First, there are prewritten operator workstation programs (that connect customers to operators), data center programs (that connect customers to directory assistance), and switch-connection programs (that allow switches to communicate). Second, there are switch-specific programs (SSP's) that operate the switch and enable it to process telephone calls. Each SSP is unique, is created for a particular switch, and cannot be used to operate any other switch.

Owing to their uniqueness, SSP's are "never" offered for general sale, or for repeated sale or lease. Instead, they are "created on an as-needed basis." The Board agrees that each switch and each program to operate a switch is "unique."

Nortel copyrights its SSP's: each program is "an original work of authorship created by the Nortel software programmers." The SSP itself incorporates one or more processes that are subject to--and implement--Nortel's patent interests. Nortel holds between 200 and 500 patents on inventions related to switches. For example, one patented invention melds caller identification with call waiting, enabling a person who is already on the telephone to view the name or telephone number of an incoming caller.

Nortel's licensing agreements forbid Pacific Bell from giving a copy of the SSP to third parties. Although Pacific Bell could theoretically sell the switch hardware to another company without the SSP, "the hardware is of no use to anybody without the software running on it." If Pacific Bell wants to use a different vendor at the end of the licensing period, it would have to tear out all of Nortel's hardware, then install new hardware and software.

The Creation of an SSP

The foundation for Nortel's SSP's is a basic code, a component of the software for every switch. The basic code has been in use for at least three decades, and is still being developed. It is "a starting point or subset of instructions necessary to operate a specific switch." The basic code itself cannot operate a switch or process a telephone call. Nortel takes portions of the basic code and merges it into translations, parameters and instructions designed specifically for a given installation, resulting in an SSP. The newly created SSP operates the switch, enabling it to process telephone calls and operate features.

The available basic code is a "library" of information so large that, if printed out, it would fill several warehouses. It encompasses various geographic areas, such as North America, Central America, and Europe. Within a geographic area, there are customers like Pacific Bell that want local calling capability, while a company such as AT&T would want only long distance capability. The basic code is "never" available for general sale or lease. Nortel did not license to Pacific Bell the right to use the basic code.

Nortel's marketing materials suggest that there is no need to refine switch software because purchasers can selectively activate the basic code features that they wish to use. Despite the marketing language, Nortel's sophisticated telecommunications customers understand that the basic code will not operate a switch without the addition of instructions derived from translations, parameters, and hardware specifications. Without this additional information, the switch cannot process telephone calls or operate features. In short, the basic code--without more--is incomplete and unusable.

To create a switch, Nortel extracts from the basic code information pertaining to the customer's geographic area, and the type of telecommunications service the customer will provide (local versus long distance). The basic code has evolved over the years, and newer versions of the basic code contain new features. Common "features" include call waiting, caller identification, call forwarding, voice mail and music-on-hold. "Parameters" refers to information used to determine the amount of memory needed, software resources, and the timing of events and optional features. Parameters vary depending on population size and the type of subscriber, whether business or residential, rural or suburban. Approximately 300 to 400 parameters are used for an SSP.

Translations for each switch are determined by physical location, area code, and the range of telephone numbers the switch will serve. For example, if a residential subscriber in Los Angeles dials a number in North Carolina, the switch translates the call as non-local and routes it to another switch that will send the call out of state and determine how the call needs to be billed to the subscriber. Additional instructions are needed when creating an SSP to ensure that calls are made in the manner prescribed by the California Public Utilities Commission; for example, the PUC dictates whether the area code must be dialed when making a local call, or just the seven digit phone number.

Creating a new SSP for a Pacific Bell location, using the basic code as a foundation, requires some 400 hours of work. A Nortel expert stated that "there's thousands and thousands of pieces of information you have to put in there." Another expert described the work as "lots of programming."

At the outset of the project, a Nortel applications engineer obtains from the customer information regarding the type and quantity of equipment for a new switch, as well as the projected population growth of the area served, and develops hardware specifications. A Nortel software systems engineer obtains from the customer information regarding switch-specific parameters. Without this information, Nortel cannot create a new SSP. The Nortel software engineer enters the customer data into "tools." Tools are not part of the basic code. Rather, they are prewritten computer programs used by Nortel to create SSP's. Through "significant processing," the tools integrate the basic code with the customer's ...

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