BILL ANALYSIS                                                                                                                                                                                                    ”



                                                                  AB 832
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          ASSEMBLY THIRD READING
          AB 832 (Ammiano)
          As Amended  March 31, 2011
          Majority vote 

           REVENUE & TAXATION  5-3                                         
           
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          |Ayes:|Beall, Charles Calderon,  |     |                          |
          |     |Cedillo, Fuentes, Gordon  |     |                          |
          |     |                          |     |                          |
          |-----+--------------------------+-----+--------------------------|
          |Nays:|Donnelly, Harkey,         |     |                          |
          |     |Nestande                  |     |                          |
          |     |                          |     |                          |
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           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; or, 

               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.








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             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 
               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; and, 

             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.



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

           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 
          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 








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          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." 

           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 301, Inc. v. County of Orange 
          (2008) 167 Cal.App.4th 219.  The proponents assert that the 
          Legislature never intended "to exempt from assessment a 
          significant portion of the value of expensive, high technology 
          machinery and equipment" because most equipment, without the 
          basic operational software, would be totally useless and 
          non-functioning.  They state that this bill "makes clear that if 
          a company claims an exemption ›for nontaxable portion of the 
          computer equipment] they must provide ›by] a clear and 
          convincing ›evidence] 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 








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          revenues." 

           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 
          the 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."

           Computer programs and property tax:  background .  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 Property Tax 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 Appeals 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 








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          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. 


           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 
          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 








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          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 to value the embedded software in 
          question was valid or sufficient.  

           The proposed solution  .  This bill 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 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. 

           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."  (Evidence 
          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 a 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."  (See Tannehill v. Finch (1986) 188 








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          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.  (EC 
          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.  (Texaco 
          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.  (California 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 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.   

           Does the solution address the problem  ?  As noted in Cardinal 
          Health, BOE Property Tax Rule 152(e) creates a de facto 








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          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.  This bill 
          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 
          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 assessees 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 








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          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.  This 
          bill does not seek to overturn the Cardinal Health decision, 
          which would require a two-thirds vote of the Legislature.  
          Instead, given the difficulty of garnering the support of a 
          two-thirds 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 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.

           
          Analysis Prepared by  :    Oksana Jaffe / REV. & TAX. / (916) 
          319-2098 


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