BILL ANALYSIS                                                                                                                                                                                                    Ó



                                                                  AB 832
                                                                  Page  1

          Date of Hearing:  May 9, 2011

                     ASSEMBLY COMMITTEE ON REVENUE AND TAXATION
                                Henry T. Perea, Chair

                    AB 832 (Ammiano) - As Amended:  March 31, 2011

          Majority vote.

           SUBJECT  :  Property tax:  computer programs:  storage media. 

           SUMMARY  :  Codifies a portion of the State Board of 
          Equalization's (BOE) regulations relating to property taxation 
          of "embedded" computer programs and imposes a higher evidentiary 
          standard on taxpayers seeking to prove that the "single price" 
          paid for the computer or equipment included charges for 
          nontaxable software programs or services.  Specifically,  this 
          bill  :  

          1)Codifies subdivisions (d) and (e) of Property Tax Rule 152, 
            "Computer Programs Storage Media," issued by the BOE.  
            Specifically, it provides that:

             a)   The term "basic operational program" refers to a 
               "control program," as defined in Revenue and Taxation Code 
               (R&TC) Section 995.2, that is included in the sale or lease 
               price of the computer equipment.  

             b)   States that a computer program is considered to be 
               included in the sale or lease price of the computer 
               equipment if either of the following is met:

               i)     The equipment and the program are sold or leased at 
                 a single price. 

               ii)    The purchase or lease documents set forth separate 
                 prices for the equipment and the program, but the program 
                 may not be accepted or rejected at the option of the 
                 customer.

             c)   In valuing computer equipment that is sold or leased at 
               a single price not segregated between taxable property and 
               nontaxable programs, as defined in R&TC Section 995.2, the 
               county assessor, lacking evidence to the contrary, may 
               regard the total amount charged as indicative of the value 








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               of taxable tangible personal property. 

          2)Requires a person claiming that a "single price" sale or lease 
            includes charges for nontaxable programs and services to prove 
            by clear and convincing evidence, instead of the preponderance 
            of evidence, both of the following:

             a)   The existence of nontaxable programs and services.

             b)   The sales price, costs, or other information regarding 
               the nontaxable programs and services that will assist the 
               county assessor in making an informed judgment about the 
               proper value to be ascribed to taxable and nontaxable 
               components.



           EXISTING LAW  :

          1)Provides that all property is taxable unless explicitly 
            exempted by the California Constitution or federal law and 
            limits the maximum amount of any ad valorem tax on real 
            property at 1% of full cash value.  

          2)Authorizes the Legislature to classify personal property for 
            differential taxation or exemption by a statute approved by a 
            2/3 vote of the membership of each house of the Legislature. 
            However, the tax rate is limited to the 1% rate otherwise 
            applicable to real property. 

          3)Provides that personal property used in a trade or business is 
            generally taxable and is valued each lien date at current fair 
            market value.  Generally, the valuation of personal property 
            is based on the acquisition cost of the property, which is 
            used to estimate the reproduction cost new and the depreciated 
            reproduction cost of the property.  The reproduction cost new 
            less depreciation value becomes the table value of the 
            property for the fiscal year. 

          4)Specifies that production computers - computer-operated 
            machinery and equipment or computers embedded in machinery - 
            are valued as other types of machinery and equipment specific 
            to an industry.  

          5)Provides that, generally, computer programs, i.e. software, 








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            are not taxable for purposes of property taxation.  (R&TC 
            Section 995).  However, storage media for computer programs 
            must be valued for property tax purposes as if there were no 
            computer programs on the media except basic operational or 
            "control" programs.  Defines "basic operational programs" as 
            those programs that are fundamental and necessary to the 
            functioning of a computer.  (R&TC Section 995.2).  The 
            assessable value of storage media containing basic operational 
            programs includes the value of the storage media and the value 
            of the program embedded on it. 

          6)Exempts from property taxation application or processing 
            computer software, which is distinct from software that is 
            considered to be a basic operational program.  (R&TC Section 
            995.2).  

          7)Provides that, in valuing computer equipment that is sold or 
            leased at a single price not segregated between taxable 
            property, i.e. equipment and basic operational programs, and 
            nontaxable programs, i.e. application computer software 
            programs, the assessor, lacking evidence to the contrary, may 
            regard the total amount charged as indicative of the taxable 
            tangible property.  İProperty Tax Rule 152(e)]. 

          8)Requires taxpayers claiming that a single-price sale includes 
            charges for nontaxable programs and services to provide 
            information to the assessor to identify the nontaxable 
            property and services, and to supply sale prices, costs or 
            other information to enable the assessor to make an informed 
            judgment about the proper value to be ascribed to taxable and 
            nontaxable components of the sale.  İProperty Tax Rule 
            152(f)]. 

           FISCAL EFFECT  :  The BOE staff estimates that this bill will have 
          no direct impact on General Fund revenue. 

           

          COMMENTS  :   

           1)Author's Statement  .  The author states that, "Current law 
            requires the valuation and taxation of basic operational 
            software, but excludes the taxation of application software.  
            The administration and application of current law is 
            increasingly difficult for both the assessor and taxpayer 








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            because this law enacted in 1973 has not been updated to 
            consider the evolution of technology.  Additionally, the Court 
            of Appeals decision in Cardinal Health v. County of Orange 
            overturned established local assessment practices and created 
            the potential for the majority of the value attributed to 
            modern equipment and machinery to be excluded from property 
            taxation.  Unfortunately, the Cardinal Health case has 
            encouraged the business community to appeal all business 
            personal property containing software.  While some appeals are 
            legitimate, the fair and equitable practices of assessing 
            business personal property should not be exploited by attempts 
            to expand a very limited exclusion in current law. 

            "AB 832 would provide uniformity and substantive direction to 
            assessors, assessment appeal boards, and taxpayers.  This bill 
            is necessary to protect current revenue in California, not 
            generate new revenue.  In 2010 California's property taxes 
            generated nearly $50 billion.  K-12 education receives 
            approximately 52% of each property tax dollar generated.  
            Personal property tax accounted for approximately $3 billion 
            of that tax revenue.  Based on recently received personal 
            property tax appeals, and the lack of definite direction, the 
            potential loss of revenue to California's local governments, 
            special districts and k-12 education could approximate $1.35 
            billion.  California must have clarity in the assessment of 
            property to protect the taxpayer and the recipients of 
            property tax revenue. 
            
            "AB 832 establishes a clear and convincing standard so that 
            businesses have an exclusion when substantiated and are not 
            avoiding paying their fair share of taxes without 
            substantiating claims.  This bill would provide uniformity and 
            substantive direction to assessors, assessment appeal boards, 
            and taxpayers." 

           2)Arguments in Support  .  The proponents of this bill state that 
            AB 832 "is a modest solution to assist assessors in accurately 
            valuing complex computer equipment."  They argue that this 
            bill is needed to update existing law "to reflect the current 
            methodology for the assessment of software technology that did 
            not exist 37 years ago" and to provide "clarity to the 
            property tax code in response to a controversial and illogical 
            court decision" in Cardinal Health v. Orange County.  The 
            proponents assert that the Legislature never intended "to 
            exempt from assessment a significant portion of the value of 








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            expensive, high technology machinery and equipment" because 
            most equipment, without the basic operational software, would 
            be totally useless and non-functioning.  They state that AB 
            832 "makes clear that if a company claims an exemption İfor 
            nontaxable portion of the computer equipment] they must 
            provide İby] a clear and convincing İevidence] independent 
            data to validate their claims."  Finally, the proponents 
            caution that failure to enact this bill "will result in a 
            significant reduction in the assessed value of business 
            personal property and property tax revenues." 

           3)Arguments in Opposition  .  The opponents state that this bill 
            "would make it nearly impossible for taxpayers to establish 
            the existence of tax-exempt embedded software for personal 
            property tax purposes" because it will require taxpayers to 
            prove the existence and value of the embedded software by 
            "clear and convincing evidence," instead of the "preponderance 
            of the evidence," which is a general evidentiary standard 
            applicable in all property tax cases, except in very limited 
            circumstances.  The opponents also believe that this bill is 
            unnecessary since BOE has already promulgated regulations "to 
            provide guidance to assessors and taxpayers with respect to 
            valuation of embedded software."  They assert that the 
            "language of AB 832 is ambiguous," since it is not clear 
            whether the new "clear and convincing" standard "would apply 
            only in prescribing what must be shown to the assessor" or 
            would also apply in an appeals hearing.  Finally, the 
            opponents state that this bill will "significantly increase 
            taxes on businesses throughout the state, placing yet another 
            burden on California's already struggling business community."

           4)Computer Programs and Property Tax:  Background  .  Prior to 
            1969, computer software was traditionally viewed as an 
            integral part of the computer hardware unit.  However, since 
            IBM announced a separate pricing policy in 1969, there has 
            been much confusion surrounding the taxation of computer 
            software at the federal, state, and local levels.  (Property 
            Taxation of Computer Software, J. Fairchild, 82 A.L.R. 3d 
            606).  The courts are still struggling over the proper 
            classification of computer programs and services, seeking 
            analogies in other areas of law concerning intellectual 
            property.  

          Initially, computer hardware was viewed as taxable personal 
            property while computer software was viewed as intangible 








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            personal property exempt from property taxation.  However, in 
            the early 1970s, the Orange County Assessor included the value 
            of the computers' programs when valuing computers for property 
            tax purposes.  İHahn v. International Business Machines 
            Corporation (1999) 73 Cal.App.4th 985, 989].  In 1972, the 
            California Legislature quickly responded by enacting law that 
            stated that computer programs are not taxable but a computer's 
            storage media for computer programs shall be valued as if 
            "there were no computer program on such media except basic 
            operational programs."  (R&TC Section 995).  The phrase 
            "except basic operational programs" was added only after the 
            Governor had returned the original bill to the Legislature, at 
            the urging of the County Supervisors Association of 
            California.  İHahn, 73 Cal.App.4th at p. 993, citing Assembly 
            Final History, A.B. No. 438 (1972 Regular Session); Letter 
            from County Supervisors Association to the Governor, May 10, 
            1972].  As explained by the court in Hahn, the intent of the 
            amendment was to clarify that "the Assessors could include in 
            the value of the computer hardware the basic computer programs 
            that were "bundled" in the price of the computer, thereby 
            preserving the existing tax base."  (Ibid.)

          That same year, the BOE adopted regulations, i.e. Property Tax 
            Rule 152, "to define and demonstrate by way of examples the 
            distinctions between taxable 'basic operational programs' and 
            other, nontaxable computer programs within the meaning of 
            Section 995." (Id. at p.990).  In 1973, the Legislature 
            defined the term "basic operational program" as "fundamental 
            and necessary to the functioning of a computer."  (R&TC 
            Section 995.2.).  A basic operational program means a control 
            program that is included in the sale or lease price of the 
            computer equipment.  The assessable value of the storage media 
            containing basic operational programs includes the value of 
            the storage media and the value of the program embedded on it. 
             As an example, the basic operational programs in personal 
            computers and mainframe computers are the basic input output 
            system (BIOS) and licensed internal code (LIC or microcode). 

          A year later, in 1974, Property Tax Rule 152 was amended, but 
            then remained unchanged until 1996, when BOE clarified that a 
            "basic operational program" is not subject to property tax 
            unless it is included in the sale or lease price of the 
            computer equipment, i.e. "bundled" or "embedded" in the 
            equipment.  In other words, unbundled or non-embedded computer 
            programs may not be assessed as taxable property even if those 








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            programs qualify as "basic operational programs." 

          Until 2008, the assessors routinely assessed the computer 
            software that was embedded in the equipment and deemed 
            essential to the equipment's intended commercial operation.  
            The rationale for this assessment methodology was based on 
            Rule 152(e), which provides that, when the assessor values 
            computer equipment that is sold or leased at a single price 
            not segregated between taxable property and nontaxable 
            programs (i.e. when it is 'bundled' or 'embedded'), the 
            assessor may regard the total amount charged as indicative of 
            the value of the taxable property.  In September of 2008, 
            however, the Court of Appeal in Cardinal Health 301, Inc. v. 
            County of Orange (2008) 167 Cal.App.4th 219, overturned the 
            established local assessment practices.  In that case, the 
            court reiterated that "application" software, as distinct from 
            a basic operational program, is not valued for purposes of 
            property taxation and held that bundling by itself is not 
            dispositive of whether "application" software included in a 
            bundled programming package is taxable as "basic operational 
            programming" under R&TC Sections 995 and 995.2.  Rather, it 
            stated that, when application software is bundled into the 
            sale or lease price of computer equipment, the burden is on 
            the taxpayer to segregate out the value of nontaxable 
            application software from the otherwise taxable value of the 
            computer.  Thus, the court refused to adopt the assessors' 
            position that the fact of "embedding" or "bundling" of the 
            software in the equipment was dispositive in making the 
            otherwise nontaxable software taxable. 

           5)Is There a Problem  ?  In the last 40 years, software programs 
            have advanced in complexity and numbers to the extent that 
            they pervade virtually all aspects of our lives.  As most 
            modern machinery and equipment are sold primarily with bundled 
            software, determining the extent to which the bundled software 
            is "application" and not "basic operation" is difficult, if 
            not impossible in some cases.  The proponents of this bill 
            give an example of the airplane's embedded software necessary 
            to the aircraft's operation.  If the value of that software is 
            excluded from assessment, for all practical purposes, the 
            value of the aircraft would be little more than that of metal 
            fuselage. 

          Until the Cardinal Health decision, there was significant 
            clarity and mutual agreement between assessors and industry 








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            regarding the methodology for valuing complex equipment and 
            machinery.  Once the assessors' methodology for valuing 
            "embedded" software was declared invalid by the court in 
            Cardinal Health, a significant number of applications were 
            filed with the assessment appeals boards in various counties 
            challenging the valuation of software embedded in the 
            property.  According to the assessors, the evidence provided 
            in some of those appeals has been a simple three- or four-page 
            spreadsheet prepared by the assessee or its agent, with no 
            supporting invoices or valid documentation, and in one 
            instance, the data provided appears to have been fabricated.  
            By necessity, it seems that a determination of whether the 
            embedded software is non-taxable must be based on the 
            information provided to the assessor by the taxpayer, since 
            there is no market data for the assessor to value many types 
            of computer equipment.  Thus, unless the taxpayer submits 
            sufficient information for a proper valuation, an assessor is 
            not in the position to make that determination.  Even then, 
            assessors have no uniform standard to determine what 
            constitutes "sufficient" information; what may be "sufficient" 
            to overcome the presumption of correctness in one county may 
            not be sufficient in another.  

          In sum, as the assessors face the increased workload of 
            administrative appeals, they have very little guidance as to 
            the type and amount of information that the assessee is 
            required to submit to overcome the presumption of correctness 
            otherwise afforded to the assessor's valuation.  Property Tax 
            Rule 152(f) simply requires a person "claiming that a 
            single-price sale or lease includes charges for nontaxable 
            programs and services" to identify "the nontaxable property 
            and services" and to supply sales prices, costs, or other 
            information.  The Legislature has not provided any direction 
            since 1972, when R&TC Sections 995 and 995.2 were enacted.  
            And the court in Cardinal Health did not address the issue of 
            whether the information provided to the assessor by Cardinal 
            Health, Inc. to value the embedded software in question was 
            valid or sufficient.  

           6)The Proposed Solution  .  AB 832 proposes to address the problem 
            by requiring a person claiming that a single-price sale or 
            lease includes charges for nontaxable programs and services to 
            prove, by clear and convincing evidence, the existence of 
            those programs and services, as well as the sales price, 
            costs, and other information in order to assist the county 








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            assessor in making an informed judgment regarding the proper 
            value of the nontaxable property.  This bill is intended to 
            provide uniformity and substantive direction to assessors, 
            assessment appeals boards and taxpayers and to discourage 
            frivolous appeals. 

           7)The Burden of Proof in Property Tax Assessments.   Existing law 
            defines "burden of proof" as "the obligation of a party to 
            establish by evidence a requisite degree of belief concerning 
            a fact in the mind of the trier of fact or the court."  
            İEvidence Code (EC) Section 115].  The party with the burden 
            of proof is required to establish the existence or 
            nonexistence of a fact by producing evidence that satisfies a 
            required standard.  Generally, the evidentiary standard 
            applicable to assessment appeals hearings is the 
            "preponderance of the evidence."  This standard applies in 
            most civil cases and, effectively, is satisfied if the 
            proposition is more likely to be true than not true (i.e. 
            there is greater than 50% chance that the proposition is 
            true).  In contrast, the "clear and convincing evidence" 
            standard, which is a higher level of burden of persuasion, has 
            been held to require evidence "so clear as to leave no 
            substantial doubt in the mind of the trier of fact," and 
            "sufficiently strong to command the unhesitating assent of 
            every reasonable mind."  İSee Tannehill v. Finch (1986) 188 
            Cal.App.3d 224, 228; see also Lillian F. v. Superior Court 
            (1984) 160 Cal.App.3rd 314, 320].  The party with the burden 
            of proof must convince the trier of fact that it is 
            substantially more likely than not that the proposition is in 
            fact true. 

            An assessor is generally entitled to the presumption affecting 
            the burden of proof that he/she has properly performed his/her 
            duty to assess all properties fairly and on equal basis.  İEC 
            Section 664; Hunt-Wesson Foods, Inc. v. County of Alameda 
            (1974) 41 Cal.App.3d 163, 180].  In other words, the taxpayer 
            has the burden of proving the property was improperly 
            assessed.  İTexaco Producing v. County of Kern (1998) 66 
            Cal.App.4th 1029, 1046].  Thus, in a hearing before an 
            assessment appeals board, the taxpayer with the burden of 
            proof must present his/her evidence first.  İCalifornia Code 
            Regulations, Title 18, Section 313(c)].  However, a county 
            assessor has a burden of proof in certain types of assessment 
            appeals hearings that involve (a) the value of owner-occupied 
            single-family dwellings, (b) penalty assessments, (c) escape 








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            assessments; (d) non-enrollment of a purchase price, and (e) 
                                               when the county assessor intends to report a higher assessed 
            value than the one on the assessment roll.  In all of those 
            five types of assessment appeals hearings, the county assessor 
            must affirmatively establish, by a preponderance of evidence, 
            the correctness of his/her opinion of value or other 
            assessment action. 

            There is legal precedent, however, for the use of the stricter 
            "clear and convincing" standard in property tax law.  For 
            example, if the assessor, in valuing possessory interests, 
            uses a term of possession other than the stated term of 
            possession in a contract, the "clear and convincing evidence" 
            standard applies.  Similarly, the existence of a clerical 
            error in the determination of a base year value of property 
            must be proved by clear and convincing evidence if the 
            correction is made more than four years after the year of 
            enrollment.  (R&TC Section 51.5).  Other cases where the clear 
            and convincing evidence standard applies include presumptions 
            in R&TC Section 2512, relating to proof that an electronic 
            transmittal of a tax payment was made on a specific date and 
            time, and EC Section 662, providing that the owner of the 
            legal title is presumed to be the owner of the full beneficial 
            title.   

           8)Does the Solution Address the Problem?   As noted in Cardinal 
            Health, BOE Property Tax Rule 152(e) creates a de facto 
            presumption that equipment sold with bundled software may be 
            assessed on the total sales price, unless the assessor has 
            "evidence to the contrary."  It allows the taxpayer to 
            overcome this presumption by "identifying" what is nontaxable, 
            presumably, by a preponderance of the evidence.  AB 832 
            codifies the presumption, but raises the evidentiary standard 
            from "preponderance of the evidence" to "clear and convincing 
            evidence."  Usually, the clear and convincing evidence 
            standard applies only in cases involving civil fraud, punitive 
            damages, or other serious instances in which a very high 
            degree of certainty is required.  Thus, a question arises as 
            to whether this higher evidentiary standard is appropriate in 
            this case and whether it moves the state any closer to an 
            important goal of establishing a uniform process of valuing 
            embedded software. 

          Arguably, a higher evidentiary standard is required because the 
            taxpayer challenging the assessor's valuation is the one who 








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            either possesses, or is in a better position to obtain from 
            the manufacturer, the necessary information about the embedded 
            software.  Assessors, on the other hand, lack specialized 
            knowledge and information to determine the value of a 
            particular software program embedded in equipment and whether 
            it is essential to the equipment's commercial operation.  
            There are no uniform look-up tables for assessors to use as a 
            reference guide in such circumstances.  It seems that 
            assessors are currently facing an almost insurmountable task 
            of trying to ascertain and rebut, if necessary, the 
            credibility of the evidence presented by assesses on appeal. 
            This bill attempts to balance the taxpayer's right to exclude 
            embedded software from taxation with the requirement to come 
            forward with sufficient and credible evidence.

          It is unclear, however, what kind evidence would be deemed 
            "sufficient" to satisfy the "clear and convincing evidence" 
            standard.  Presumably, under the preponderance of the evidence 
            standard, a taxpayer wishing to challenge the assessor's 
            valuation of computer equipment will satisfy the burden of 
            proof by simply providing an itemized list of prices assigned 
            by the manufacturer to various components of the equipment, if 
            one is available.  It seems that, under the "clear and 
            convincing evidence" standard, the taxpayer would be required 
            to do something above and beyond simply providing an 
            itemization list.  Would an independent appraisal of the 
            equipment be necessary and would it suffice?  Is it fair to 
            ask the taxpayer to bear the additional costs of providing 
            evidence to satisfy the "clear and convincing evidence" 
            standard?  How likely is it that a higher evidentiary standard 
            will ensure uniformity amongst various counties and local 
            assessment appeals boards? 

          It is important to note that this bill does not confront the 
            issue of whether embedded software should be subject to 
            property tax, even though it has not been addressed by the 
            Legislature in the last 40 years, since the era of punch cards 
            and large computer rooms, and seems to be ripe for 
            consideration.  AB 832 does not seek to overturn the Cardinal 
            decision, which would require a 2/3 vote of the Legislature.  
            Instead, given the difficulty of garnering the support of a 
            2/3 vote of the Legislature, it simply tries to limit the 
            number of frivolous appeals by imposing a higher burden of 
            proof on taxpayers that decide to challenge the valuation of 
            property containing embedded software.  While the solution 








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            offered by this bill is not perfect, absent some sort of 
            legislative action, the assessors and the assessment appeals 
            boards will continue to struggle with a significant number of 
            embedded software cases that potentially may lead to a 
            sizeable revenue loss for local governments.

           9)BOE Comments  .  In the analysis of this bill, BOE staff notes 
            all of the following:

              a)   Mass appraisal  .  Existing law requires the annual 
               taxation of personal property used in a business or trade 
               at its current market value.  The assessment of that 
               property is by necessity a mass appraisal system, which is 
               based on the acquisition cost.  For example, the Vehicle 
               License Fee is imposed on the original total sales price of 
               the automobile, with no deduction or reduction of the sales 
               price for the value of the various computer programs that 
               operate the automobile.  
              
              b)   State-assessed property  .  The provisions of Property Tax 
               Rule 152 and R&TC Sections 995 and 995.2 apply equally to 
               the valuation of property subject to assessment by the BOE, 
               which means that state and locally-assessed property will 
               be treated similarly under this bill. 

              c)   Separate section for provisions related to application 
               software  .  While all three subdivisions of the proposed 
               R&TC Section 995.3 refer to "single price" sales, only 
               subdivision (a) is limited to basic operational computer 
               programs.  BOE staff suggests to move subdivisions (b) and 
               (c) into a separate section of the R&TC, in order to 
               minimize confusion. 

            REGISTERED SUPPORT / OPPOSITION  :   

           Support 
           
          California Assessors' Association
          Lawrence Stone, the Santa Clara County Assessor
          John R. Noguez, the Los Angeles County Assessor

           Opposition 
           
          George Runner, Member of the State Board of Equalization
          The California Taxpayer Association








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          California Chamber of Commerce
          Council on State Taxation
          Silicon Valley Leadership Group
          TechAmerica
           
          Analysis Prepared by  :  Oksana Jaffe / REV. & TAX. / (916) 
          319-2098