Tax Type
Retail Sales and Use Tax
Description
Government contractor; Computer aided design (CAD) system
Topic
Taxability of Persons and Transactions
Date Issued
05-18-2000
May 18, 2000
Re: § 58.1-1821 Application: Retail Sales and Use Tax
Dear ****
This will reply to your letter in which you seek the correction of retail sales and use tax assessments issued to ***** (the "Taxpayer") for the period September 1995 through September 1998. I apologize for the delay in responding to your appeal.
FACTS
The Taxpayer is a manufacturer of goods that are sold under contract to the United States government. The Taxpayer was audited by the department and maintains that the assessment is erroneous for several reasons
The Taxpayer claims that use tax was assessed in error on computer equipment and software (CAD systems) used in research and development activities. The Taxpayer disagrees with the assessment of tax on a supply item known as a tube traveler card that is used in its manufacturing process. The Taxpayer maintains that certain account balances were improperly included in the extrapolation of the audit sample and asks for the removal of these balances from the sample calculation. The Taxpayer does not agree with a separate sample performed on purchases made under a procurement card program instituted by the Taxpayer during the audit period and requests a detailed audit of these purchases. The Taxpayer claims that a credit is due in the audit for an overpayment of sales tax on maintenance contracts which include the provision of both parts and labor. The Taxpayer requests an exemption from sales and use tax on certain items used for the processing of federal government contracts, as they relate to government compliance auditing standards. Lastly, the Taxpayer asks for waiver of compliance penalty associated with the untaxed purchases made through the use of the new procurement card program.
DETERMINATION
Computer Hardware and Software
The Taxpayer purchased certain computer equipment and software that is part of CAD systems used in research and development activities. The Taxpayer's engineers use the CAD systems to create structural designs and detailed drawings. The designs and drawings are used to manufacture component parts of the Taxpayer's products. The CAD systems are used to analyze designs for structural strength and functionality at environmental extremes. After a particular design is approved, electronic files from the CAD systems are transmitted to the Taxpayer's vendors, who manufacture the components to the specifications described in the Taxpayer's design. The Taxpayer believes the CAD systems qualify for the research and development exemption since they are used to develop new products.
Code of Virginia § 58.1-609.3(5) provides a sales and use tax exemption for "[t]angible personal property purchased for use or consumption directly and exclusively in basic research or research and development in the experimental or laboratory sense." The enclosed copy of Title 23 of the Virginia Administrative Code (VAC) 10-210-3070(A) defines "research and development" as "a systematic study or search directed toward new knowledge or new understanding of a particular scientific or technical subject and the gradual transformation of this new knowledge or new understanding into a usable product or process." The exemption for research and development is limited to tangible personal property used directly and exclusively in an actual research process. When an item is used in both taxable and nontaxable activities, the item does not meet the exclusive use test as required by the statute and is considered taxable.
Based on the information provided, the CAD systems are used primarily for research and development of the Taxpayer's products. However, the CAD systems are also used to create product designs and drawings for use by outside vendors to manufacture the components that make up the Taxpayer's products. Based on this usage, the Taxpayer does not use the CAD systems exclusively in research activities as required by the statute. The CAD systems and related software were properly held taxable in the audit.
Tube Traveler Cards
A "tube traveler card" is mated with each product at the beginning of the manufacturing process and contains a bar code label with an identification number that is unique to each product in production. The bar code is scanned prior to each step in the production process to insure the product has met product specifications established for the previous stage of production. The tube traveler card remains with the product until all steps of production are completed. The specifications at each stage of production for each product are recorded based on the identification number contained on the bar code label. The bar code label is removed from the tube traveler card and attached to the product at the end of production. If the product is later returned due to defects, the Taxpayer can refer to the specifications recorded during production of the product to help determine the cause of the defect.
The Taxpayer states that the use of the tube traveler cards insures that each customer's order meets certain quality performance parameters. The cards also enable the Taxpayer to maintain a record of the performance specifications for each product. The Taxpayer states that the tube traveler cards are needed for quality control and testing purposes and are required for compliance with United States government contract standards.
Code of Virginia § 58.1-609.3(2)(iii) provides an exemption from sales and use tax for "machinery or tools or repair parts therefor or replacements thereof, fuel, power, energy, or supplies, used directly in processing, manufacturing, refining, mining or converting products for sale or resale..." The enclosed copy of Title 23 VAC 10-210-920(B)(2) states that the term "used directly" includes "those activities that are an integral part of the production of a product, including all steps of an integrated manufacturing process, but not including incidental activities such as general maintenance, management, and administration."
Included in the scope of the manufacturing and processing exemption are production line testing and quality control activities. To qualify for exemption, supplies used for production line testing and quality control must be indispensable to the actual production process and must be used as an immediate part the production process. The fact that the use of a particular item may be required by federal, state, or local law does not by itself satisfy the requirement of direct usage in manufacturing and processing. Based on the information presented, the tube traveler cards primarily serve an administrative function because they are used to record production information for the Taxpayer's products. Although the tube traveler cards are used on the production line, they are not an immediate or indispensable part of production. The audit assessment with respect to the tube traveler cards is correct.
Audit Sample
The Taxpayer requests the elimination of several accounts from the population of accounts used to extrapolate the purchases sample. The Taxpayer has provided the department a list of account balances which it believes should be removed from the sample. At the time the audit sample was calculated, these account balances were not available so a larger population was used in the sample extrapolation. Based on a review of the accounts provided, I will have the department's auditor contact the Taxpayer to arrange a mutually agreeable time to review these accounts in more detail and recalculate the sample.
The Taxpayer also asks for a detailed audit of purchases made through the use of a new procurement card program that was implemented during the audit period. The purchases made under the procurement card program were sampled over a one-year period, and the resulting error factor was extrapolated against monthly balances charged to the procurement card account. The Taxpayer states that it is unfair to sample one vendor.
Sampling is an audit technique of significant value that is widely used in both the public and private sectors. The department uses sampling in sales and use tax audits where a detailed audit would not prove beneficial to either the auditor or the taxpayer. When sampling techniques are properly applied, the result should be within a narrow percentage range of the actual amount that would be determined by a detailed audit.
The Taxpayer has not presented evidence showing that the sample of the procurement card purchases is flawed in any manner. The Taxpayer suggests that only one vendor was sampled. The audit exceptions list indicates that this is not the case. The Taxpayer's procurement card program is administered by one credit card vendor who was listed on the audit exceptions list; however, purchases charged to the credit cards were made from different vendors. Based on the above, there is no basis to adjust the sample of procurement card purchases.
Request for Credit
The Taxpayer requests a credit in the audit for an overpayment of sales tax on an annual parts and labor maintenance contract. The Taxpayer notes that sales tax was paid to the vendor on the total annual charge for the contract. Effective January 1, 1996, one-half the total charge for maintenance contracts that provide for both parts and labor is exempt from sales and use tax. If the Taxpayer can provide a copy of the maintenance contract showing that it is a parts and labor contract and can show that sales tax was paid on the total annual charge after January 1, 1996, a credit will be allowed in the audit for one-half the tax paid on the contracts. This information can be provided to the auditor for verification.
Request for Exemption
The Taxpayer requests an exemption from sales and use tax for goods purchased in connection with the processing of contracts with the United States government. The taxpayer must purchase items such as computer software to comply with federal government auditing standards.
There is no general exemption available for purchases of tangible personal property used by businesses to meet certain federal government auditing standards. Although the Taxpayer may be required by law or contract to meet certain government auditing standards, there is no exemption from sales and use tax on purchases made to comply with federal government rules and regulations.
Penalty
The Taxpayer requests the waiver of some of the compliance penalty assessed in the audit. During the audit period, the Taxpayer began using a credit card procurement program for business purchases. Because adequate controls were not in place to monitor the payment of sales and use taxes on untaxed purchases, the Taxpayer incurred a substantial liability in this area. The Taxpayer asks for waiver of the penalty associated with purchases made under the procurement card program. The Taxpayer has implemented changes to the procurement card program to insure the proper payment of use tax on purchases made through this program.
Title 23 VAC 10-210-2032(A)(6) allows the waiver of penalty on audit deficiencies occurring in new areas not covered by previous audits. Based on the circumstances presented, I will agree to waive the compliance penalty attributable to purchases made through the Taxpayer's procurement card program.
Summary
The department's auditor will contact the Taxpayer to arrange a mutually agreeable time to review the Taxpayer's records and address the issues discussed in this determination. The audit will be revised based on this review, and an updated assessment will be issued to the Taxpayer. I note that the Taxpayer has not paid any of the assessment. Due to the delay in responding to the Taxpayer's appeal, I will allow the Taxpayer thirty days to submit a payment for credit against the assessment. Interest will accrue on any outstanding balance that remains after the audit is revised. Payment may be mailed to ***** in the Office of Tax Policy, P. O. Box 1880, Richmond, Virginia 23218-1880. If the Taxpayer has any questions, please contact ***** at *****.
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/22656S
Rulings of the Tax Commissioner