Tax Type
Retail Sales and Use Tax
Description
CD-ROM manufacturer; Equipment used to design software
Topic
Exemptions
Taxability of Persons and Transactions
Date Issued
08-31-2000
August 31, 2000
Re: Ruling Request:
Retail Sales and Use Tax
Dear ****
This will reply to your letter in which you request a ruling and submit a protective claim for refund on behalf of ***** (the "Taxpayer") in regard to the Taxpayer's eligibility for the manufacturing exemption from the Virginia retail sales and use tax. I apologize for the delay in responding to your letter.
FACTS
The Taxpayer is in the business of developing performance management software products. According to the Taxpayer, such products constitute commercial, off-the-shelf ("COTS") software and are sold in finished form. The Taxpayer states that it does not engage in customization or modification of the products for specific customers.
The Taxpayer's software developers use desktop computers, mainframe computers and an in-house client/server network to input, write and test computer code integral to the development of a specific software product. When fully developed, the software product is stored on a master tape and sent in this form to a subcontractor to be converted in mass to a CD-ROM medium. The CD-ROMs are then returned to the Taxpayer for final product packaging and delivery.
The Taxpayer requests a ruling to the effect that its operations constitute an integrated manufacturing process qualifying for the industrial manufacturing exemption set out under Code of Virginia § 58.1-609.3(2). The Taxpayer believes that it is entitled to a direct refund for the sales tax paid to vendors on personal and mainframe computers, monitors, servers, printers, magnetic tapes, CD-ROMS, packaging equipment and materials, and product manuals.
RULING
Innovative High Technology ("IHT") Regulation
In general, Title 23 of the Virginia Administrative Code (VAC) 10-210-765 sets forth the availability of the industrial manufacturing and research and development exemptions to businesses that: (1) manufacture high technology products, and/or (2) conduct research and development activities in technologically innovative fields. The regulation interprets the existing exemptions for industrial manufacturing and research and development found in Code of Virginia § 58.1-609.3(2) and (5), respectively. The regulation also references longstanding policies reflected in 23 VAC 10-210-920 (Manufacturing and processing) and 23 VAC 10-210-3070 through 10-210-3074 (Research or Research and Development).
In regard to the manufacturing exemption, subsection A of 23 VAC 10-210-765 states that "[t]he production of computer software in tangible form for sale or resale generally constitutes industrial manufacturing." (Emphasis added). Although the industrial manufacturing exemptions set out in 23 VAC 10-210-920 are generally applicable to such production, the manufacturing exemptions "are not available for persons who produce computer software for purposes other than for sale or resale." (Emphasis added). The manufacturing exemptions are available, however, for "computer hardware and software used to encode magnetic tapes or other storage medium or to otherwise produce finished software products. Also exempt is the tangible medium that the finished products will take (tapes, disks, etc.)."
In regard to the research and development exemption, the regulation states that "[t]angible personal property used directly and exclusively in computer software research and development activities is generally exempt from the tax." (Emphasis added). The regulation specifically states that the "development of new computer software products" is a research and development activity. By example, the regulation provides that the research and development exemption applies to "computer hardware and software used in programming tend other development activities with respect to new computer software products, including the testing of such new products." (Emphasis added).
Generally, persons engaged in the production of products resulting from research or research and development are industrial manufacturers entitled to the manufacturing exemptions. Similar statements are found at the end of sections B, C, D and E of 23 VAC 10-210-765.
Based on the established policies set out in the IHT regulation, it is apparent that computer software research and development activities were not intended to be incorporated within the integrated manufacturing process of computer software production. Rather, the research and development exemption and the industrial manufacturing exemption are properly treated as separate and distinct exemptions within the IHT regulation. Existing law allows no different treatment. Clearly, the IHT regulation does not change the requirements to qualify for the industrial manufacturing exemption or the research and development exemption.
Industrial Manufacturer Classification
Title 23 VAC 10-210-920 (A) sets out that "for a business to obtain the (industrial manufacturing) exemption, it first must be manufacturing or processing products for sale or resale and secondly, such production must be industrial in nature." (Insert added for clarity). Both of these criteria must be satisfied.
After completing its programming efforts, the Taxpayer will produce a master tape containing the new software coding. The Taxpayer uses the master tape to store the program and to provide it to an independent subcontractor to use in encoding the CD-ROM software products. The encoded CD-ROMs constitute the finished products to be sold by the Taxpayer. As the master tape is not sold by the Taxpayer and is not the finished product sold by the Taxpayer, the Taxpayer fails to satisfy the first criteria set out above.
The determination of whether any manufacturing or processing activity is "industrial in nature" is based on whether the business is substantially similar to an establishment classified within major group codes 20 through 39 of the Standard Industrial Classification Manual ("SIC Manual") issued for 1972 or thereafter. These codes classify those establishments which generally constitute traditional manufacturers, i.e., those establishments engaged in the mechanical, physical or chemical transformation of materials, substances or components into new products.
The 1987 edition of the SIC Manual lists the manufacture of blank computer software tapes and disks under SIC code #3695 and the manufacture of prepackaged computer software under the nonindustrial service code #7372. SIC code #7372 also includes those businesses which are engaged as prepackaged computer software publishers.
Further clarification is found in the North American Industry Classification System ("NAILS") which replaced the SIC Manual in 1997. The NAILS classifies traditional manufacturing activities in industry sector codes 31-33 only. Establishments which are primarily engaged in the mass reproduction of computer software are classified in NAICS industry code 33461 (a manufacturing code). Under this industry classification is U.S. industry code 334611 (Software Reproducing) which provides the following:
This U. S. industry comprises establishments primarily engaged in mass reproducing computer software. These establishments do not generally develop any software, they mass reproduce data and programs on magnetic media, such as diskettes, tapes, or cartridges. Establishments in this industry mass reproduce products, such as CD-ROMs and game cartridges.
Establishments that are primarily engaged in designing, developing, and publishing prepackaged software are classified under NAICS industry code 51121 (i.e., a non-manufacturing code). The Taxpayer's activities would appear to more closely resemble computer software publishing as classified under NAICS industry code 51121. Based on the foregoing, the Taxpayer's activities cannot be considered "industrial in nature" and, therefore, do not satisfy the second criteria for being classified as an industrial manufacturer.
Software Development Activities: Not Immediate Part of Production
In Webster Brick Company. Inc. v. Department of Taxation, 219 Va. 81, 245 S.E.2d 252 (1978), the court set forth the principle that in order to be exempt, an essential item must be an "immediate part of actual production" to be considered used directly in the production process. Thus, an essential item which is not an immediate part of actual production is not used directly in the exempt production process. See 23 VAC 10-210-920 (B)(2).
Software development activities generally end when the code is ready to be copied onto a master tape to be used in producing the final product, i.e., the encoded CD-ROM. Thus, even if the Taxpayer engaged in developing and reproducing computer software for sale, its software development activities are preproduction and therefore would not constitute an immediate part of the integrated manufacturing process.
Subprocessing activities generally begin when a newly-developed coding is copied onto master tapes for mass sale or resale. The main manufacturing process would generally involve encoding blank CD-ROMs with a new saleable coding. As the Taxpayer does not perform the software reproductions and does not mass produce master tapes for sale, the master tape production does not constitute subprocessing within the scope of the industrial manufacturing exemption.
Other considerations
P.D. 96-174. You cite P.D. 96-174 (7/19/96) as a basis for exemption of the Taxpayer's software development activities. However, the taxpayer in that case was actually producing the software product to be sold and was exempt on computers, monitors, and printers used in the "production" of computer software. The reference to the "development of canned computer software programs" as used in that case only applies to the actual production of final software products (as explained above).
Other states. You indicate that other states have adopted positions to view software development activities as constituting part of an integrated production process. Although Texas recently amended its laws to include computer software design and writing activities as the beginning point of exempt computer software production, and New York recently amended its laws to exempt computer hardware used directly and predominantly in the design and development of computer software for sale, it is apparent that neither state's legislature had previously recognized such software development activities as part of an exempt integrated manufacturing process. Currently, Virginia does not have similar statutory provisions.
Typesetters. You indicate that the Taxpayer's software development activities are similar to electronic prepress activities performed by typesetters. However, typesetters are engaged in producing typesetting products for sale. In addition, typesetting has long been recognized as a traditional manufacturing process. Typesetting establishments which engage in typesetting for the printing trade fall under the SIC code 2791 (i.e., manufacturing). Included under that same SIC classification are hand composition for the printing trade, machine composition, photocomposition, phototypesetting, typesetting for the printing trade, and computer controlled typesetting.
In most respects, typesetting is a conversion process. The Taxpayer's software development process is not a conversion process, and therefore cannot be considered analogous to a typesetting process. Clearly, the Taxpayer does not take client provided copy or data and convert it into a final copy or reformatted data. Rather, the Taxpayer inputs coded instructions to create and develop a new software product. Therefore, I find no comparison between the Taxpayer's activities and those of a typesetter.
Packaging
Based on the information furnished, I find no basis to exempt packaging equipment used by the Taxpayer to package the final product. However, the resale exemption would apply to the packaging materials, provided such materials are marketed with the product and become the property of the purchaser. See 23 VAC 10-210-400. The resale exemption would also apply to labels which are used solely for packaging products for sale and become part of the product for sale. See 23 VAC 10-210-800.
Conclusion
Based on all of the foregoing and the information presented, I find no basis for the industrial manufacturing exemption to apply to the Taxpayer's operations. Therefore, I must deny your protective claim and request for refund in this matter.
Alternatively, equipment used in the Taxpayer's software development activities may qualify for the research and development exemption, provided such equipment is used directly and exclusively in exempt research and development activities.
If you have questions about this response, please contact ***** of the Office of Tax Policy at *****.
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/21078R
Rulings of the Tax Commissioner