Tax Type
Retail Sales and Use Tax
Description
Is taxpayer eligilbe for research and development exemption
Topic
Credits
Property Subject to Tax
Taxability of Persons and Transactions
Date Issued
12-04-2001
December 4, 2001
Re: Request for Ruling: Retail Sales and Use Tax
Dear *****
This is in response to your letter of September 12, 2001, and subsequent phone conversations with my staff, concerning the application of the retail sales and use tax to an unidentified client (the "Taxpayer"). At issue in this case is the availability of the research and development exemption and the industrial manufacturing exemption.
FACTS
The Taxpayer, located in Virginia, develops prototypes of electronic components for a third-party out-of-state customer (the "Customer"). As I understand the process, the Customer creates preliminary designs for a new product (the electronic components) and outsources the development of the prototype to the Taxpayer. To this end, the Taxpayer purchases parts, materials and equipment. A prototype is developed and tested by the Taxpayer to make sure the Customer's design is free from any technical flaws. This development and testing process continues until a perfect prototype is developed.
You indicate that in order to develop the perfect prototype, the prototype units are manufactured in high volume, ranging from several hundred to several thousand for each design. The interim prototypes, (i.e., those not meeting the design requirements), are retained by the Taxpayer. The suitable prototypes are delivered to the Customer where they receive final approval. At that point, the new product is shipped by the Customer to a high volume manufacturing facility outside the country.
The Taxpayer charges the Customer: (1) an hourly rate for testing, development and design services, and (2) a fixed price per unit of prototype production.
The Taxpayer concludes that its purchases of parts and materials used to develop and manufacture the prototypes are exempt from sales and use tax because they are either purchased as raw materials for resale or are purchased for consumption directly in research and development. Further, the Taxpayer concludes that either the manufacturing exemption or the research and development exemption would apply to machines and equipment used to develop and test the prototypes.
RULING
Research and Development
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." (Emphasis added.) The department interprets this statute in Title 23 of the Virginia Administrative Code (VAC) 10-210-3070 through 3074. These regulations define "research and development" as "a systematic study or search directed toward a 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 ultimate goal of exempt research and development must be the development of new products, the improvement of existing products, or the development of new uses for existing products.
By way of contrast, the regulations provide that exempt research does not include secondary activities such as administration, general maintenance, and other activities collateral to the actual research. Further, in order to qualify for the exemption, tangible personal property must be used directly and exclusively in an actual research process.
I have some concerns in determining that the Taxpayer's activities qualify for this exemption. Although the Customer is seemingly engaged in an exempt activity (i.e., the improvement of its product), the Taxpayer's role appears to be primarily fabricating a product that has previously been designed. In effect, it is not clear that the Taxpayer is itself engaged in an actual research process. Accordingly, the Taxpayer's activities may be analogous to those described in Public Document 99-8 (1/8/99). In that determination, the taxpayer used certain computer hardware and software to design, develop and test new products based on the customer's specific needs. The Tax Commissioner found that the taxpayer's activities in that case more closely represented engineering and design services and not exempt research and development. The provision of engineering services is not taxable, but the service provider is liable for the tax on all purchases of tangible personal property used to provide those services to its customers.
As set out in 23 VAC 10-210-540, exemptions from the sales and use tax are strictly construed. Based on the information currently before me, I cannot determine that the Taxpayer's prototype development and testing activities are exempt research and development as set out in Code of Virginia § 58.1-609.3(5).
Notwithstanding the above, I believe that the issues in this case would benefit from an on-site inspection of the Taxpayer's facility. This would allow the department to better understand the Taxpayer's role in the research and development process. At your option, this inspection may be arranged as discussed below.
Industrial Manufacturing
Code of Virginia § 58.1-609.3(2) provides an exemption from the retail sales and use tax for "machinery or tools or repair parts therefor or replacements thereof ... used directly in processing, manufacturing, refining, mining or converting products for sale or resale." Such property may be purchased exempt of the tax by an industrial manufacturer or processor for direct use in producing products for sale or resale. See 23 VAC 10-210-920.
In Golden Skillet Corporation v. Commonwealth, 214 Va. 276, 199 S.E.2d 511 (1973), the Virginia Supreme Court held that the manufacturing exemption was intended to exempt machinery and tools used in manufacturing products for sale or resale only "in the industrial sense." Further, for purposes of the manufacturing exemption, the term "industrial in nature" is defined in Code of Virginia § 58.1-602 to include, "those businesses classified in codes 10 through 14 and 20 through 39 published in the Standard Industrial Classification Manual ...."
Generally, businesses engaged in manufacturing and classified under the SIC manufacturing codes are involved in transforming raw materials into useful and marketable products within a factory, plant or mill environment using power-driven machinery and materials handling equipment. Such transformation is usually carried on for the wholesale market, for interplant transfer, or "to order" for industrial users, rather than for direct sale to the domestic consumer.
It appears that the Taxpayer's activities may be appropriately classified under Major Group 87 (which includes engineering, research and related services) and Industry Nos. 8731 (commercial research) and 8734 (testing laboratories). However, these classification codes do not account for the Taxpayer's potential high volume manufacture of prototype units. I am concerned that this manufacture may be a part of the service provided to the Customer as opposed to being exempt manufacturing in "an industrial sense." However, like the research and development issue, a different determination regarding the application of the manufacturing exemption to the Taxpayer's activities may benefit by an on-site inspection of the Taxpayer's facility.
Summary
Based on the information before me, I cannot at this time agree that the Taxpayer's purchases of materials, equipment and supplies are exempt from the tax under Code of Virginia §§ 58.1-609.3(5) or 58.1-609.3(2). Rather, it appears that the Taxpayer is providing engineering and design services to the Customer. However, I will certainly reconsider the determination in this case based on an on-site inspection of the Taxpayer's facility.
If you have any questions regarding this letter, or if you are interested in scheduling an on-site tour, please contact ***** in the department's Office of Policy and Administration, Appeals and Rulings, at ***** @tax.state.va.us or at *****.
Sincerely,
Danny M. Payne
Tax Commissioner
AR/36837I
Rulings of the Tax Commissioner