California Supreme Court lets stand sales tax on the full price of cellphones bundled with a service plan

Editors: Brian Hagene, CPA, CGMA, and Mark G. Cook, CPA, CGMA

The Supreme Court of California recently denied an appeal in Bekkerman v. California Dep’t of Tax and Fee Administration, No. S284476 (Cal. 5/29/24). That case was decided by the California Court of Appeal earlier this year (Bekkerman, 318 Cal. Rptr. 3d 680 (Cal. Ct. App. 2024)). The Court of Appeal ruling agreed with the application of Cal. Code Regs. tit. 18, Section 1585 (Regulation 1585) by the California Department of Tax and Fee Administration (CDTFA) on the applicability of sales tax to bundled sales of cellular phones (or pagers or other wireless telecommunications devices) with a service contract.

In the cellphone world, a common sales technique is to grant a significant discount on the price of the phone coupled with a contract for nontaxable services with a term of a year or more. Regulation 1585(b)(3) states, “Tax applies to the gross receipts from the retail sale of a wireless telecommunication device sold in a bundled transaction, measured by the unbundled sales price of that device.” In upholding the application of Regulation 1585, the Court of Appeal overturned the trial court decision, which had agreed with the taxpayer and paused enforcement of Regulation 1585, holding that tax would be applied only to the discounted price of the cellphone.

Multiple approaches to bundled transactions

Four general approaches to bundled transactions have been identified, where states and taxpayers address mixed transactions involving items both taxable and nontaxable: (1) taxing the entire transaction; (2) the true-object test; (3) ignoring de minimis items; and (4) attempting an allocation between the items where not separately stated. There are even multiple competing motivations for choosing among the approaches, such as practicality for retailers, ease of administration for tax collectors, and, of course, whether the taxable or nontaxable items constitute more of the sale. (See Hellerstein, State Taxation ¶19A.04, “Tax Base Simplification” (WG&L 1993)).

The true-object test is discussed by many states in similar terms. California discusses the test in Cal. Code Regs. tit. 18, Section 1501 (Regulation 1501). Taxability hinges on whether the property involved is the true object of the transaction or merely incidental to the true object of a service. Regulation 1501 provides an example of an author selling an original manuscript to a publisher and the publisher then selling the work to readers. The author may transfer the manuscript on paper, but the true object between an author and publisher is the service of writing the manuscript. This is contrasted with the sales by the publisher of the manuscript as a book to readers. The true object in that transaction would be the copy of the book. Though the publisher has performed some services in printing, binding, and marketing, these are seen as incidental to the sale of the physical book.

Clarification of an old issue: History of Regulation 1585

California’s State Board of Equalization promulgated Regulation 1585 in 1998 to apply to pagers, cellular phones, and other portable communication devices. Regulation 1585 applies to sales of a portable communication device that requires activation by a provider of wireless telecommunications services or a seller of utility services. When the communication device is sold in the same transaction as the service to operate that device for longer than a month, the transaction is considered a bundled transaction under Regulation 1585. It is a bundled transaction whether or not the invoice states one price for both the device and service or two separate prices for these (Regulation 1585(b)(3)).

This is in contrast to the typical application of bundled-sales rules that apply or “kick in” only when a seller sells a (taxable) item of tangible personal property alongside (nontaxable) services but consolidates the two items on the invoice into one lump-sum charge. In such cases, as a general rule, if the value of the total sale rests predominantly with the taxable tangible personal property, the entire charge is considered taxable, regardless of the nontaxable sales element.

In Bekkerman, the plaintiffs argued essentially that the discounted price of the cellphone is the agreed-upon price between buyer and seller, and that discounted price should be the taxable amount. Unfortunately for the plaintiffs, the Court of Appeal held that the sales tax is to be applied in this bundled transaction to the full retail price of the device, even though devices are usually sold with a discount when bundled.

While this application appears contrary to the typical application of the bundled-sales rules (leading to multiple California cases litigating the issue), the state has other motivations to carve out this exception in the world of cellphones: Sales tax from these transactions under Regulation 1585 provides a great deal of revenue to California. The California School Employees Association estimated in 2015 that the regulation was responsible for more than $300 million in annual tax revenue to California.

Litigation history of Regulation 1585

In Yabsley v. Cingular Wireless, LLC, 165 Cal. App. 4th 1526 (2008), a class-action certification was denied against a cellular service provider for allegedly misleading customers by advertising a discounted phone price but charging sales tax on the full price. In Bower v. AT&T Mobility, LLC, 196 Cal. App. 4th 1545 (2011), a class action was again denied certification. Any alleged injury was found to be hypothetical because the plaintiff could not have purchased a phone bundled with a service contract from any other provider in California without paying sales tax on the full price.

In a line of cases ultimately decided in Adame v. Apple Inc., No. D073567 (Cal. Ct. App. 12/31/19), the plaintiff was able to form a class covering five years of purchases. In the years at issue, Apple stores displayed signage on the sales tax applying to the unbundled iPhone price starting in 2009. Walmart, which also sold the phones, did not charge tax on the unbundled price of a device until November 2014 due to an issue with its point-of-sale system. The plaintiff alleged that despite the signage in the Apple store, she would have shopped around for a retailer who was not charging sales tax on the unbundled price. A class was certified in 2013, with the class ultimately including sales of iPhones from 2009 through 2014. The class was also unsuccessful in this case: It was ultimately decertified in 2017. Apple eventually was able to have the entire case dismissed.

The current case: Bekkerman

The case was originally brought by four plaintiffs who paid sales tax on the full price of their phones when bundled with a service contract. One of the plaintiffs paid sales tax on the full price of $599.99 for a cellphone. The phone was discounted to $249.99 when coupled with a service contract for two years.

At the trial court level, the plaintiff alleged that the taxable price of the phone should be the discounted price. That is the price that the buyer and seller agree on, separately stated on the sales invoice. The plaintiff alleged that attempting to impose sales tax on a price greater than the invoice price is an attempt to tax the nontaxable service of providing cellphone coverage.

The CDTFA countered that the sales tax should be applied to the full price of the phone as sold in a stand-alone transaction. It argued that the regulation taxes this full price because the discounted price does not fully cover the value of the phone to the buyer.

In its ruling, the trial court said that Regulation 1585 exceeds the delegation granted from the state legislature to the CDTFA. The trial court held that by attempting to tax the full value, the CDTFA was ignoring the statutory definition of sales price enacted by the state legislature and that the CDTFA is not empowered to do so. The trial court held that the CDTFA was not allowed to enforce the regulation. The CDTFA appealed.

The Court of Appeal overruled the trial court for several reasons. In response to the plaintiffs’ argument that the bundled transaction approach in Regulation 1585 should be ignored because the buyers and sellers agree to prices and that agreement should be honored, the Court of Appeal first noted that the sales tax system is “intensely detailed and fact-specific,” and governs “an enormous universe of transactions.” Accordingly, to deal with the intricacy of the system, the California legislature delegated the power to the CDTFA to adopt rules and regulations to elaborate the meaning of key statutory terms.

The court took special note of the common sales pattern where the discounted price is paid upfront, while the price for the services is billed monthly throughout the contract period. In this scenario, according to the Court of Appeal, the discounted price is not a “true discount” because the seller is compensated for the full price of the product by the monthly payments in a bundled transaction. Furthermore, the many challenges to Regulation 1585 and the CDTFA’s lack of changes to the regulation and its interpretation, in addition to the multiple (unsuccessful) legislative attempts made to overrule Regulation 1585, strengthened the CDTFA’s argument that the sales tax should be applied to the full price of the phone.

Case instructive for future challenges

Though Regulation 1585 takes an approach to bundled transactions uncommon in other areas of sales tax, higher courts in California have not provided any indication that they are persuaded by traditional sales tax concepts to override this unique approach. Many challenges have been brought against Regulation 1585 since its inception and remain unsuccessful. While the litigation in Bekkerman is unique in that it forced a brief pause to the enforcement of Regulation 1585, ultimately, concerns such as practicality, ease of administration, revenue, and consistent enforcement have ruled the day.

Taxpayers may still have opportunities in the future to challenge the unique approach to bundled transactions found in Regulation 1585 but should take note of the arguments in Bekkerman to better understand not only the arguments that find a receptive ear at the trial court level but also the arguments that must be overcome at the appellate level.

Editor Notes

Brian Hagene, CPA, CGMA, is partner/owner at Mathieson, Moyski, Austin & Co. LLP in Lisle, Ill., with CPAmerica. Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact thetaxadviser@aicpa.org.

Contributors are members of or associated with CPAmerica or SingerLewak LLP.