DELL, INC. v. THE SUPERIOR COURT

Filed 1/31/08

CERTIFIED FOR PUBLICATION

IN THE COURT OF APPEAL OF THE STATE OF CALIFORNIA

FIRST APPELLATE DISTRICT

DIVISION FOUR

Several consumers brought actions contesting imposition of sales and use taxes on optional service contracts sold with computers. In this action, plaintiffs sued Dellfor unfair and deceptive business practices for collecting tax on the service contracts, and Dell cross-complained against the California State Board of Equalization (SBE) for a refund of the disputed taxes Dell remitted to the tax agency.^[1] (Bus. & Prof. Code,  17200; Civ. Code,  1770; Rev. & Tax. Code,  6901.) The parties agreed to a bench trial on the discrete issue of whether the sales of service contracts to plaintiffs were subject to California sales or use tax. The trial court concluded that the sales were not subject to tax. Dell and the other defendants petitioned this court for a writ of mandate. Defendants asked us to review and to reverse the trial courts decision.

We have reviewed the decision and, following briefing and oral argument, conclude that the trial court correctly found that the sales were not taxable. California taxes the retail sale and use of tangible personal property but not the sale or use of intangible personal property or the performance of services. (Rev. & Tax. Code,  6051, 6201.) Dell and SBE concede that optional service contracts are not tangible personal property and are generally exempt from taxation. Dell and SBE claim that taxation of Dell service contracts is nevertheless proper because Dell sells its computers and service contracts for a single lump-sum price, without a separate statement on the invoice of the charge for the service contract.^[2] We reject the claim.

While Dell computers and service contracts are sold concurrently for an aggregate price, they are distinct consumer items and each is a significant object of the transaction. Dell service contracts have readily ascertainable values, even without itemized invoices. Accordingly, SBE cannot decree that the exclusive means to establish a tax exemption for an optional service contract sold together with a taxable product is that its value be separately stated on the retailers invoice, absent a statute, regulation, or consistent administrative interpretation of the laws mandating a separate statement of value.

I. facts^[3]

Dell sells computer systems and services to individuals, businesses, and governmental agencies. Dell operates on a direct-sales business model, rather than through traditional retail outlets. Customers primarily order products directly from Dell by telephone, over an Internet website, or by other direct means. Dell products are marketed in various packages, which consist of hardware, software, a warranty, and a service contract. Each configuration bears a single, lump-sum price: the components are itemized but not separately priced. The customer has the option of changing the configuration of a package by switching hardware, software, or service contract components in exchange for an increase or decrease in the lump-sum price. The price effect of such changes is identified in Dell advertising or interactive computer screens in the format of  add an x for $y  or  delete the x and reduce the package price by $y  or  substitute an x for the z for a price change of $y.  For example, add an extended service contract for $119, or substitute a 100 gigabyte hard drive with a 250 gigabyte hard drive for an additional $49. After the changes to the package configuration are selected, the revised lump-sum package price is stated to the customer without a breakdown of individual prices for the various components.

The statement of the purchase price to the customer is either an acknowledgement of the purchase if the customer pays in full at the time of the order, or an invoice if money is due. An invoice or acknowledgement identifies the computers components and states the total sales price for the aggregate of the components selected by the customer. The invoices and acknowledgements generally do not list separate unit prices for the computers various components (e.g., memory, hard drive, monitor, service contract). Internally, Dell does assign unit prices to many of the computer systems components. Those unit prices appear, among other places, in price lists and Dells computerized record database.

Computer systems sold by Dell are warranted at no additional cost to the customer. The warranties cover defects in materials and workmanship in Dell-branded products. The warranties are return to facility warranties requiring the consumer to return the defective product or part to Dell for repair or replacement. Computer systems sold by Dell also typically include computer service contracts. Many such service contracts provide for the dispatch of an on-site repair technician, while others provide for repair or replacement within certain time frames.

A standard service contract is included in every initial package (the package before the customer customizes its configuration). A customer can eliminate this standard service contract from the package and receive a reduction of the lump-sum purchase price. Extended service contracts are available that vary in duration, coverage and benefits. The selection of an extended service contract will have a varying effect on the lump-sum price based upon the contracts duration and other terms. It is not necessary that any of these extended service contracts be included in order for a customer to purchase a package of hardware, software, and basic warranty. Dells internal price list specifies a particular dollar figure for each type of standard and extended service contract. On every invoiced sale, Dell keeps records showing a separate and exact amount for the service contract.

On May 4, 2001, plaintiff Diane Mohan purchased a computer package from Dell. Dells then-current option selection catalog, which was available to customers, stated that the one-year service contract could be upgraded from one to three years for an additional $119 over the basic package price. Mohan upgraded the basic service contract to three years. The service contract would be performed by a third party corporation, defendant BancTec. Dell sells these third party service contracts as an agent of BancTec. Dells internal product price allocation for the aggregate three-year service contract (one-year basic plus a two-year extension) was $233. The invoice for the Mohan package stated a lump-sum price of $898 plus a $95 shipping charge. The customer invoice did not specify an itemized price for the service contract. At the time of the Mohan transaction, Dell was not registered with the State to collect sales and use tax on its own sales to California purchasers. However, BancTec was a registered seller in California and Dell collected sales and use tax on BancTecs behalf. The Dell invoice stated a taxable amount of $233 (Dells internal valuation of the service contract) and a tax of $19.23. The amount stated for the tax was paid and remitted to SBE, as the States tax collection agency.

On October 29, 2003, plaintiff DeMarco Enterprises, Inc. (DeMarco) purchased a computer package from Dell that included a three-year service contract and  Gold Technical Support,  which is a three-year technical support contract. Dell, not a third party, was the service provider on the DeMarco service contract. The invoice to DeMarco stated a lump-sum price of $1,037, without a separate price for the contracts for service and technical support. DeMarco was taxed $85.58 on the entire lump-sum invoice price, which amount was remitted to SBE.

Ii. procedural history

This action is one of three consumer actions coordinated in the trial court for resolution.^[4] (Cal. Rules of Court, rule 3.521.) One of the other actions was voluntarily dismissed, and the other was dismissed following demurrer. We recently affirmed the latter dismissal. (Computer Service Tax Cases (Dec. 10, 2007, A115868) [nonpub. opn.].)

This action was initiated in April 2003. The operative third amended complaint by plaintiffs Mohan and DeMarco states four causes of action: (1) unlawful competition and deceptive practices in the sale of consumer goods (Civ. Code,  1770); (2) unfair business practices (Bus. & Prof. Code,  17200); (3) fraud and intentional misrepresentation; and (4) negligent misrepresentation. Plaintiffs want the action certified as a class action and seek equitable relief, including an order adjudging Dell service contracts intangible property exempt from any California sales or use tax. Plaintiffs also ask that defendants be enjoined from further charging and collecting from California residents a purported tax on the purchase of optional service contracts. Additionally, plaintiffs seek restitution, damages, and attorney fees.

Defendants filed a cross-complaint against SBE. Defendants assert their belief that plaintiffs claims are meritless but, to account for the possibility that the Court could agree with Plaintiffs and grant plaintiffs relief, defendants cross-complained against SBE to recover taxes collected from plaintiffs (and others similarly situated) and remitted to SBE. Defendants operative first amended cross-complaint alleges eight causes of action for: (1) refund of use taxes paid; (2) refund of sales taxes paid; (3) indemnity; (4) equitable indemnity or partial equitable indemnity; (5) involuntary trust; (6) unjust enrichment; (7) money paid; and (8) money had and received.

In an effort to streamline resolution of the action, the parties stipulated to a bifurcated trial on the taxability of Dell service contracts. The parties agreed to a bench trial on the discrete issue of whether the sale by one or more of the retailer defendants of a service contract to Mohan in May 2001, or to DeMarco in October 2003, was subject to California sales or use tax.

In June 2007, the trial court issued its ruling and statement of decision on the taxability issue. The court found that all of the service contracts (standard and extended) are optional. The court further found that the service contracts are intangible property, i.e.[,] rights to future labor for repair or maintenance. As intangible property, the purchase of a service contract is neither a sale nor a use of property subject to taxation. The trial court considered SBE and Dells reliance on the so-called separate statement rule, under which sales and use tax will be charged on all items in a bundled transaction unless the price for any non-taxable component is separately stated. The court found the rule consistent with common sense and common practice within and beyond California, but inconsistent with the relevant tax statutes which do not contain a separate statement rule covering computer service contracts. The court concluded that service contracts of the two plaintiffs herein were not subject to California sales and/or use taxes. After ruling on the taxability issue, the trial court entered an order stating that appellate review of its statement of decision through a writ proceeding will materially advance the conclusion of this complex litigation. (Code Civ. Proc.,  166.1.)

Dell filed a petition for a writ of mandate in this court asking us to review and to reverse the trial courts decision. On August 22, 2007, we issued an alternative writ directing the trial court to show cause why the petition should not be granted. Real parties in interest, SBE and plaintiffs, filed briefs responsive to the petition, and Dell filed a reply brief. Oral argument was heard and the matter submitted for decision.

Iii. discussion

California applies sales and use tax to tangible personal property but not to intangible property and services. (Rev. & Tax. Code,  6051, 6201 [all further section references are to this code, except as noted].) Dell computers are taxable tangible personal property. Service contracts are nontaxable intangible property or services. The question presented here is whether a mixed sale in which a Dell computer and service contract sold at the same time, for a single undifferentiated price on the invoice, is wholly taxable (as Dell and SBE claim) or only partially taxable (as plaintiffs claim). We conclude that the transaction is only partially taxablethe computer is taxed and the service contract is not taxed. A service contract for a Dell computer is a distinct and separately identifiable component of the transaction entitled to individual tax treatment. Guiding principles of tax law lay the path to that conclusion.

General overview of sales and use taxes

California, like most states, imposes a state-wide retail sales tax.^[5] ( 6051 et seq.) The California sales tax is imposed upon retailers for the privilege of conducting business, and is measured by the retailers gross receipts from sales of all tangible personal property sold in this state. ( 6012, 6051; City ofPomona v. State Bd. of Equalization (1959) 53 Cal.2d 305, 309; Brandtjen & Kluge, Inc. v. Fincher (1941) 44 Cal.App.2d Supp. 939, 942.)

For purchases of personal property located outside California, the state imposes a tax upon consumers for the storage, use, or other consumption in this state of tangible personal property. ( 6010.5, 6201.) While use taxes are the obligation of the consumer ( 6202., subd. (a)), retailers with a nexus to California must collect use tax from the purchaser and remit it to SBE. ( 6203, 6204; Cal. Code Regs., tit. 18,  1684, subd. (a).) The use tax complements the sales tax by preventing the sales tax from  result[ing] in an unfair burden being placed upon the local retailer engaged solely in intrastate commerce as compared with the case where the property is purchased [out-of-state] for use or storage in California and is used or stored in this state. The two taxes are complemental to each other with the aim of placing the local retailers and their out-of-state competitors on an equal footing.  (Union Oil Co. v. State Bd. of Equalization (1963) 60 Cal.2d 441, 449, italics omitted.)

The United States Supreme Court summarized the interplay of Californias sales and use taxes: The [sales tax] levies a tax upon the gross receipts of California retailers from sales of tangible personal property; the [use tax] imposes an excise on the consumer at the same rate for the storage, use or other consumption in the state of such property when purchased from any retailer. As property covered by the sales tax is exempt under the use tax, all tangible personalty sold or utilized in California is taxed once for the support of the state government. (Southern Pacific Co. v. Gallagher (1939) 306 U.S. 167, 171.)

The measure of sales and use taxes

The measure of both sales and use taxthe base against which a percentage rate is appliedis generally the consideration paid for goods sold. Sales tax is imposed on California retailers as a percentage of their gross receipts from sales of tangible personal property. ( 6051.) Use tax is imposed on consumers as a percentage of the sales price of tangible personal property stored, used, or consumed in California. ( 6201.) Both gross receipts for assessing sales tax and the sales price for assessing use taxes are similarly defined by the amount of the sale. ( 6011, subd. (a), 6012, subd. (a); see Preston v. State Bd. of Equalization (2001) 25 Cal.4th 197, 212 [statutory definitions of  gross receipts  and  sales price  are mirror images.].)

Taxable transactions under California law

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 [citation], such property is generally defined as property that is a right rather than a physical object. . . . [] The third concept, service, has been defined by [the California Supreme Court] as the performance of labor for the benefit of another. (Navistar Internat. Transportation Corp. v. State Bd. of Equalization (1994) 8 Cal.4th 868, 874-875 (Navistar).)

The taxation of bundled and mixed transactions

Drawing the line between taxable sales of tangible property and nontaxable sales of services or intangibles is sometimes difficult, especially where property that was largely created by personal services is transferred. (Hellerstein, State Taxation (3d ed. 2007)  12.08[1], p. 1.) Where services and tangible property are inseparably bundled together, determination of the taxability of the transaction turns upon whether the purchasers true object was to obtain the finished product or the service. (Cal. Code Regs., tit. 18,  1501; Navistar, supra, 8 Cal.4th at p. 875; California State Bd. of Equalization v. Advance Schools, Inc. (Bankr. N.D.Ill. 1980) 2 B.R. 231, 235 (Advance Schools) [applying California law].)

As an example, the true object in purchasing a sculpture is acquisition of the finished product, and thus the transaction is taxable without reduction for the service embodied in the product. (Cal. Code Regs., tit. 18,  1501.) In contrast, the true object in purchasing tax advice is the performance of a service, so the entire transaction is not taxable despite the incidental furnishing of forms, binders or other tangible property. (Ibid.) In Culligan Water Conditioning. v. State Bd. of Equalization (1976) 17 Cal.3d 86, 96, the court held that the true object of a water conditioning contractin which water softening equipment is attached to a customers home plumbing and periodically servicedis the furnishing of the tangible equipment which, by itself and without requiring any performance of human labor, softens the water.

The above examples involve so-called bundled transactions in which goods and services are inextricably intertwined in a single sale. (Hellerstein, State Taxation , supra,  12.08[1][c], pp. 6-8.) For bundled transactions of goods and services, the true object test applies and the entire transaction is generally taxed or not taxed as a whole. (Cal. Code Regs., tit. 18,  1501; Advance Schools, supra, 2 B.R. at pp. 235-236.) In bundled transactions where the purchasers true object is to obtain a finished product and services are incidental, services may be considered part of the sale of tangible property and thus subject to sales or use tax. ( 6011, subd. (b)(1), 6012, subd. (b)(1); see Rylander v. San Antonio SMSA Ltd. (Tex. Ct. App. 2000) 11 S.W.3d 484, 487 (Rylander) [court considers essence of transaction to determine whether service is part of sale of bundled goods].)

Tax rules sometimes allow allocation between taxable and nontaxable items bundled together if the value of the nontaxable item is separately stated. (Hellerstein, State Taxation, supra,  17.03[4] pp. 1-2 &  19A.04[2][a][iv], pp. 1-2, 5.) In California, for example, separately stated charges for specified transportation costs of goods are statutorily exempted from sales and use tax. ( 6011, subd. (c)(7), 6012, subd. (c)(7).) Transportation charges are regarded as separately stated only if they are separately set forth in the contract for sale or in a document reflecting that contract, issued contemporaneously with the sale, such as the retailers invoice. (Cal. Code Regs., tit. 18,  1628, subd. (a).)

California views sales of tangible property bundled with intangibles, rather than services, differently. The regulatory true object test, by its terms, applies only to transactions involving the performance of a service.  (Preston v. State Bd. of Equalization, supra, 25 Cal.4th 197, 209.) The California Supreme Court has thus rejected the position that a transfer of tangible property is not taxable if the transfer is incidental to the transfer of intangible property. (Ibid.; Navistar, supra, 8 Cal.4th at p. 877) In Navistar, the court held that the transfer of drawings and designs embodying technology for the manufacture of industrial turbine engines was taxable even if the principal object of the sale was to transfer the intangible or intellectual content embodied in the documents. (Navistar, supra,at p. 877.) Navistar did not articulate the precise manner for determining the taxation of concurrent transfers of tangible and intangible property. (Hellerstein, State Taxation, supra,  13.08[3], pp. 3-4.) However, the courts holding that documents containing intangible trade secrets were fully taxable as a sale of tangible property was based in part on the absence of a separate and distinct transfer of an intangible property right.  (Preston v. State Bd. of Equalization, supra, at p. 220, discussing Navistar, supra, at pp. 877-878.) In short, the court was concerned with a truly bundled transaction in which taxable and nontaxable items were inextricably intertwined.

Bundled transactions are distinguishable from transactions in which goods and services are sold together yet are readily separableso-called mixed transactions. (Advance Schools, supra, at pp. 235-236; Rylander, supra, 11 S.W.3d at pp. 487-488; Hellerstein, State Taxation. supra,  12.08[1], p. 8 &  19A.04[2][a][iv], pp. 1-3.) One respected commentator has stated that a mixed transaction involving separately identifiable transfers of goods and services can and should be distinguished from a bundled transaction involving goods and services that are inextricably intertwined in a single sale. (Hellerstein, State Taxation, supra,  12.08[1], p. 7[c] &  19A.04[2][a][iv], pp. 1-3.)

Unlike bundled transactions, the goods and services in a mixed transaction are distinct (not intertwined) and each is a significant object of the transaction (not one incidental to the other). (Rylander, supra, 11 S.W.3d at pp. 487-488.) In mixed transactions, the separate elements of the transaction are analyzed as separate transactions for tax purposes. (Id. at p. 488.) The tangible property aspect of the transaction is taxed and the service aspect of the transaction is not taxed. (Ibid.)

Several examples of mixed transactions are illustrative. In Overly Mfg. Co. v. State Bd. of Equalization (1961) 191 Cal.App.2d 20, 21-28, the court found that a lump-sum contract for steel door frames and doors was divisible into taxable tangible property (the manufactured frames) and nontaxable services (installation of the doors). The court noted the dual nature of the contract, which supplied products and provided separate services, and contrasted the transaction from those where an entire bundled transaction is taxable because service is incidental to the sale of goods. (Id. at pp. 26-28.)

In Advance Schools, an out-of-state correspondence school provided California students with both educational services and lesson materials in the form of books, printed lessons, training kits, and tools. (Advance Schools, supra, 2 B.R. at pp. 232, 237.) The school charged a single tuition fee, with no separate charge for the lesson materials. (Ibid.) The court held the school liable for use taxes on that portion of the tuition attributable to the sale of the lesson materials. (Id. at p. 238.) The court rejected the schools argument that the entire transaction was not taxable because a students true object in paying tuition was to obtain educational services. (Id. at pp. 235-236.)

The federal bankruptcy court in Advance Schools noted that California recognizes three possible situations with regard to mixed sales of services and property. (AdvanceSchools, supra, 2 B.R. at p. 235; see In re Los Angeles Internat. Airport Hotel Associates (Bankr. 9th Cir. 1996) 196 B.R. 134, 138 [approving Advance Schoolss analysis].) First, tangible property is the primary item or true object of the transaction, in which case tax applies to the entire sales price. (Advance Schools, supra, pp. 235-236.) Second, service is the primary item or true object of the transaction, in which case no tax applies to the transaction. (Ibid.) Third is the truly mixed transaction, where property and services are distinct and consequential elements of the transaction, in which case the transaction is severable into its taxable and nontaxable components. (Ibid.) The schools reliance on the true object test was misplaced because that test applies only to the first two described situations where services rendered are inseparable from the property transferred. (Id. at p. 235.) The court found the lesson materials provided by the school to be separate from the educational services, and both the materials and services significant aspects of the transaction. (Id. at p. 237.) The court severed the transaction for tax purposes, and allocated tax upon the market price of the materials. (Id. at pp. 237-238.)

A Texas appellate court likewise allocated taxes to telecommunications equipment separate from engineering services sold on a single invoice in Rylander, supra, 11 S.W.3d at pp. 485-490. The tax agency assessed sales tax on the entire transaction upon the contention that the engineering services were a  part of the sale  of the telecommunications equipment. (Id. at pp. 486-487.) Texas, like California, considers the ultimate object of the sale in determining whether a nontaxable service bundled with a taxable sale of goods is a part of the sale and thus taxable. (Id. at p. 487.) In accord with the Advance Schools court that applied California law, the Texas Court of Appeal discerned three categories of transactions: (1) the real object of the transaction is the purchase of tangible property and services are incidental (all taxable); (2) the real object is the purchase of services and the property is incidental (all nontaxable); and (3) the real object is both services and property and the two elements are distinct and identifiable (property alone taxable). (Id. at pp. 487-488.) The court held that the engineering services were readily separable from the purchase of equipment and thus not  a part of the sale  of tangible personal property and consequently not subject to sales tax. (Id. at pp. 489-490; see New England Tel.& Tel. Co. v. Clark (R.I. 1993) 624 A.2d 298, 300-302 (Clark) [readily separable services not taxed as part of sale of telecommunications equipment])

Story continues as Part II

Publication courtesy of California pro bono legal advice.

Analysis and review provided by La Mesa Property line Lawyers.

^[1] Dell is a collective term for defendants Dell, Inc., Dell Catalog Sales L.P., and Dell Marketing L.P. Additional defendants are QualxServ LLC, and BancTec, Inc. (BancTec), which provide computer support services for Dell products. All defendants are represented by the same counsel.

^[2] Consumer law requires retailers to disclose the terms of a service contract, and to conspicuously state [a]ll fees, charges, and other costs that the buyer must pay to obtain service. (Civ. Code,  1794.4, subds. (a), (c)(4)(I); accord 15 U.S.C.  2306, subd. (b).) We have no occasion here to consider whether Dells failure to separately state the price of its service contract is an inadequate disclosure of the contracts terms or service charges. We are concerned solely with the tax consequences of Dells business practice.

^[3]The facts stated here are based on the trial courts statement of decision and evidence submitted at trial.

^[4] Consumers in other states have also brought actions against Dell for its practice of collecting sales tax on its service contracts. (E.g. Stenzel v. Dell, Inc. (Me. 2005) 870 A.2d 133.) To our knowledge, this case is the first to reach the substantive taxability issue.

^[5]The only states that do not impose a state-wide sales tax are Alaska, Delaware, Montana, New Hampshire, and Oregon. (L. Blatt, When are Warranties and Service Contracts Subject to Sales Tax?, 59 CCH State Tax Review No. 12, p. 16 (March 23, 1998.)