Tax Type
Retail Sales and Use Tax
Description
Licensed software used in computer assembly
Topic
Manufacturing
Taxability of Persons and Transactions
Date Issued
07-06-2000
July 6, 2000
Re: § 58.1-1821 Reconsideration: Retail Sales and Use Tax
Dear *********************
This is in response to your letter requesting reconsideration of the department's prior determination issued on November 24, 1998, to ***** as a result of a sales and use tax audit of its subsidiary, ***** (the "Taxpayer"). I apologize for the delay in responding to your letter.
FACTS
The Taxpayer protests the use tax assessed on licensed software programs used to install operating systems on customized computers assembled for sale. According to the facts presented, the Taxpayer "constructed each computer system from various component parts, such as motherboards, memory chips, video controllers, power switches, cabling and brackets acquired from original equipment manufacturers ("OEMs"), and it assembled customized systems according to each client's specifications. The process included soldering, taping and connecting of the materials by trained employees."
The Taxpayer further states that "[c]ustomers would order one or more computer systems constructed to their individual specifications. They would choose the type of operating system to be installed." At the customer's direction, the Taxpayer would encode the operating system onto the hard drive of the computer from a master CD-ROM provided by Microsoft. It used a master CD-ROM to avoid the time and expense associated with removing individual shrink-wrapped copies of the Microsoft software from the boxes, and installing each operating system from the unique disks. The Taxpayer would include "a set of floppy disks containing the same software that had been copied onto the hard drive of the computer." The Taxpayer also included owner's manuals and a hardcopy of the License Agreement with a unique serial number in the box with the computer. The computer and assorted peripherals were then shipped to the customer. Thus, the customer was given a means to re-install the operating system if the system crashed.
The prior protests submitted by the Taxpayer only raised the resale exemption issue for the master licensed software. In the original determination and the prior reconsideration issued to the Taxpayer, the department denied the resale exemption for the master CD-ROM containing the licensed software.
The Taxpayer now raises a new issue by maintaining that the master CD-ROMs at issue qualify for the industrial manufacturing exemption. Therefore, the Taxpayer requests reconsideration of this case and a refund of the taxes previously paid with respect to the master licensed software.
DETERMINATION
You cite several administrative and court cases in support of your position. In particular is the case of County of Fairfax v. DataComp Corp., At Law No. 128829, 36 Va. Cir. 60 (1995), in which the circuit court determined that assembling of computer parts constituted "manufacturing" for business, professional and occupational license ("BPOL") tax purposes. Based on that court ruling, the department issued Public Document 98-154 (10/16/98), holding that a company assembling parts and programming software into computers or as part of a network was providing a manufacturing activity which qualified for exemption from the BPOL tax.
It is important to note that the BPOL statutes do not define the term "manufacturing." Rather, the term "manufacturing" for BPOL tax purposes has been defined by the courts. However, a similar situation does not exist for the retail sales and use tax. Rather, the term "manufacturing" for retail sales and use tax purposes is defined by statute at Code of Virginia § 58.1-602.
Of additional importance is the phrase "As used in this chapter" set out at the introduction of Code of Virginia § 58.1-602. This phrase clearly demonstrates the legislature's intent to limit the "manufacturing" definition in Code of Virginia § 58.1-602 to the Virginia Retail Sales and Use Tax Act. This restrictive treatment is embraced in the Opinion of the Attorney General on December 28, 1983 (copy enclosed), which sets out that there is no interaction between the BPOL and retail sales and use tax statutes. Accordingly, I must conclude that the courts' definition of manufacturing for BPOL tax purposes has no bearing on the statutory definition of "manufacturing" set out in Code of Virginia § 58.1-602. As such, none of the cited BPOL cases are applicable to the administration of the retail sales and use tax or the issues raised in this case.1
Treatment under the Retail Sales and Use Tax
Code of Virginia § 58.1-609.3(2)(iii) provides an exemption from the retail sales and use tax for "machinery . . . tools . . . or supplies, used directly in . . . manufacturing . . . products for resale." In Golden Skillet Corporation v. Commonwealth, 214 Va. 276 at 278 (1973), the Virginia Supreme Court stated, reading the above statute as a whole, that: "it is intended . . . to provide exemption for machinery and tools used in . . . manufacturing . . . products for sale or resale only in the industrial sense."
In light of the above statute and Golden Skillet, the Taxpayer must first produce products for sale or resale and second, the production must be industrial in nature in order for the manufacturing exemption to apply.2 Since the Taxpayer produced computers for sale, the first part of the test for exemption is satisfied. Thus, it must be determined whether the Taxpayer's production activities are industrial in nature.
The manufacturing definition set out by Code of Virginia § 58.1-602 and the provisions set out by Title 23 of the Virginia Administrative Code (VAC) 10-210-920 (B)(1) provide that any business classified in codes 10-14 and 20-39 of the Standard Industrial Classification ("SIC") Manual will be entitled to the industrial manufacturing exemption under Code of Virginia § 58.1--609.3(2).
The Taxpayer maintains that the correct SIC code for its business operations is SIC code #3571. Under the North American Industrial Classification System (NAICS), which replaced the SIC Manual, the Taxpayer maintains that NAICS code #334111 also applies to its business operations. These classification codes apply to establishments primarily engaged in manufacturing and/or assembling electronic computers.
Based upon the facts presented, I must recognize the fact that the Taxpayer constructs "custom configured computers for sale primarily to government and commercial users." (Emphasis added.) According to the NAICS, the customized assembly of computers is not recognized as an industrial manufacturing process. Rather, NAICS treats the customized assembly of computers as a retail trade activity and classifies such activities under NAICS code #44312 (copy enclosed).3
The cited case law and statute require that we look to the industrial classifications to determine whether the Taxpayer's activities qualify as industrial in nature. Although the customized assembly of computers may be considered manufacturing, such activity does not fall within the prescribed classification codes for designation as "industrial in nature."
Furthermore, I am not persuaded by the circuit court decision rendered in OId Dominion Camera Shop, Inc. v. Department of Taxation, 38 Va. Cir. 374 (1996). In that case, minilab photo processing was found to be industrial in nature and not an incidental part of the retailer's business. In the instant case, however, the customized assembly of computers by the Taxpayer is classified as a non-industrial activity by the NAICS. Moreover, there appears to be no significant comparison between the Taxpayer's custom computer assembly and the photo finishing process performed in Old Dominion.
Based on consideration of all of the foregoing, I must conclude that the customized assembly of computers for sale or resale does not constitute an industrial operation. Therefore, the manufacturing exemption at Code of Virginia § 58.1--609.3(2) does not apply to the master licensed software at issue.
This decision is governed by the rule of strict construction established by the Virginia courts. The Virginia Supreme Court has consistently held that "exemption from taxation is the exception and where there is any doubt the doubt is resolved against the one claiming exemption." See Golden Skillet Corporation, supra.
If you should have any questions about this response, please contact *****.
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/21572R
1For the same reason, the other cited BPOL court cases of Dickerson, Inc. v. Commonwealth, 206 Va. 229, and Luck Stone Corporation v. County of Loudoun, Law No. 12188 (Cir. Ct. of Loudoun County, 1992), do not pertain to the Virginia retail sales and use tax and therefore have no bearing on the issues raised in this case.
2 See also Title 23 of the Virginia Administrative Code (VAC) 10-210-920(A).
3 See Cross-References section of NAICS code #54151 (copy enclosed).]
Related Documents
Rulings of the Tax Commissioner