Tax Type
Retail Sales and Use Tax
Description
Software royalties and maintenance agreements; Lab equipment; Asset vs expenses
Topic
Property Subject to Tax
Taxability of Persons and Transactions
Date Issued
04-16-2001
April 16, 2001
Re: § 58.1-1821 Application: Retail Sales and Use Tax
Dear ****
This is in response to your letter requesting correction of the retail sales and use tax assessment issued to ***** (the "Taxpayer"). Copies of cited sources are enclosed. I apologize for the delay in responding to your appeal.
FACTS
The Taxpayer is a manufacturer of telecommunications equipment. An audit for the period June 1996 through May 1999 resulted in the assessment of tax on untaxed sales and purchases of tangible personal property.
The Taxpayer takes exception to tax assessed on several assets and other purchases of tangible personal property, including certain maintenance contracts and software royalties, and maintains that such items are not taxable.
DETERMINATION
It is my understanding that certain items initially coded as operating supplies, and then transferred to a resale inventory, have been removed from the department's audit based on the additional information furnished. It is also my understanding that the Taxpayer was provided a copy of the revised audit report. The remaining items contested have not been removed from the department's audit and are addressed below.
Maintenance Contracts
The Taxpayer maintains that the software maintenance agreement at issue is a "labor only" contract associated with an exempt software development effort. However, a review of the contract reveals that it covers telephone support, error resolution assistance, standard software updates, and communications including newsletters and other publications provided by the maintenance provider.
There is no condition stated in the software maintenance agreement to indicate that software updates and publications are to be transferred by electronic means only. Absent such condition, I must conclude that software updates and publications may be provided in tangible form, i.e., by disc or CD, in printed form, or by some other tangible medium, at least part of the time or all of the time. Consequently, the software maintenance agreement is considered a "parts and labor" contract, such as those addressed under Title 23 of the Virginia Administrative Code ("VAC") 10-210-910(D).
As this is a "parts and labor" contract, it is my understanding that tax has been assessed on fifty percent of the total charge of such maintenance contract in accordance with the 1996 law change for "parts and labor" contracts. See Code of Virginia § 58.1-609.5(9).
Although the Taxpayer also claims that the research and development exemption applies to the maintenance contract, the Taxpayer has not furnished any documentation to establish that the covered software was used directly and exclusively in exempt research and development activities. Rather, it is my understanding that the Taxpayer has booked this contract under an engineering charge rather than a research and development charge. Absent evidence to the contrary, this software maintenance contract remains taxable.
Software Royalties
Based on the information presented, the Taxpayer designed a new network management software product and incorporated an existing software product ("licensed software") licensed by a third party into its new software product. At issue is the software license agreement which requires the Taxpayer to pay (1) royalty fees for the right to redistribute the software in binary form and (2) maintenance fees for providing support of the software. The Taxpayer claims that the licensed software, and thus the software license agreement, qualifies for the research and development exemption.
The facts presented do not support the application of the research and development exemption to the licensed software. The research and development exemption provided under Code of Virginia § 58.1-609.3(5) requires that an item is directly and exclusively used to develop a new product, improve an existing product, or develop new uses for existing products. The Taxpayer has not shown how it may have used the software "directly' in research and development activities. Merely merging the software with another product or reproducing the software is not sufficient to be considered a research and development function. Nor do the facts presented establish that the software is used exclusively in research and development activities. Although the Taxpayer may use this software in some research function, I must recognize that the Taxpayer is given the right to redistribute the software, i.e., to perform a nonresearch and development function.
To gain the research and development exemption, the property must take an active and immediate role in a research and development process, and such use must be an exclusive use in such process. The Taxpayer has not established that the software license agreement at issue qualifies for the research and development exemption.
Assets of the Verification Lab
The Taxpayer takes exception to the tax on equipment used in its Verification Lab. The Taxpayer maintains that this lab equipment is used as an integral part of exempt research and development activities, such as for product design development and other related research activities. According to the Taxpayer, the lab equipment is used to test prototype products of both the Taxpayer and other manufacturers. The purpose of the testing is to determine functionality and compatibility and includes environmental analysis, comparison tests, and other tests. The Taxpayer maintains that its Verification Lab supports the design development process beginning with the engineering feasibility studies stage. It is my understanding that the Verification Lab is separately organized and operated from the Taxpayer's research and development unit.
Pursuant to 23 VAC 10-210-3070(B), property used to conduct the Taxpayer's feasibility studies, environmental analysis, or comparison testing does not qualify for the research and development exemption. As these activities are not within the scope of the exemption, they demonstrate that the Taxpayer's Verification Lab is not exclusively devoted to research and development activities as contemplated under the exemption.
Moreover, the property must be purchased or leased by the person, firm, corporation, or other entity that actually will perform research activities in order to qualify for the tax exemption for items used directly and exclusively in research. See 23 VAC 10-210-3071(E). In this case, I must recognize the fact that the Taxpayer performs testing for not only itself but also for other manufacturers. In this regard, the Taxpayer has not established that it actually developed other manufacturer's products. Rather, the information presented indicates that the Taxpayer does not develop all of the products that it tests. Consequently, the lab equipment at issue cannot be considered "used exclusively" in research and development activities of the Taxpayer.
Although the testing performed by the Taxpayer may be an extension of its research and development process, it appears that the same testing equipment may be used to conduct tests for other manufacturers. As the research and development exemption is only available when property is used directly and exclusively for research and development purposes, and the property must be owned or leased by the same person conducting the research, I must conclude from the facts presented that the equipment at issue does not qualify for the exemption.
Asset versus Expense Item
The Taxpayer claims that certain purchases from a third party are for engineering services related to the conversion of seven integrated circuits ("IC") used on the Taxpayer's product boards. The purpose of the conversion was to replace old technology with newer technology. As the nature of the development was to result in a new component of a product, the Taxpayer maintains that these transactions represent research and development work and should, therefore, be exempt from the tax.
It is my understanding, however, that the Taxpayer booked these transactions as fixed assets. The documentation presented describes the project as replacement tooling consisting of certain IC chips. The documentation also shows that the Taxpayer hired the vendor to design and provide several prototype units.
In order to determine whether a particular transaction which involves both the rendering of a service and the provision of tangible personal property constitutes an exempt service or a taxable retail sale, the "true object" of the transaction must be examined. If the object is to secure services and the tangible personal property transferred is not critical to the transaction, then the transaction may constitute an exempt service. However, if the object is to secure the property which the service produces, then the entire charge, including the charge for any services provided, is taxable. See 23 VAC 10-210-4040(D).
Although a significant amount of engineering work may be involved in these transactions, it is evident from the facts presented that the true object of these transactions is for the sale of tangible personal property. Undoubtedly, the engineering services are essential. However, without a suitable end product, the services would not have been needed.
In addition, it appears that the Taxpayer has mistakenly assumed the research and development exemption would apply to these purchases. The Taxpayer has not furnished any evidence that it used the IC chips directly and exclusively in exempt research and development activities. Although the vendor may have performed certain exempt research and development activities in furnishing the products to the Taxpayer, such exemption does not extend to the Taxpayer in these transactions, as it was not the one researching and developing the IC chips.
Conclusion
Based on all of the foregoing, I must conclude that the assessment is correct as previously revised. Under separate cover, the Taxpayer will receive an updated bill for the outstanding liabilities.
If you should have any questions about this response, please contact **** of the department's Office of Tax Policy at ****.
Sincerely,
Danny M. Payne
Tax Commissioner
Re: § 58.1-1821 Application: Retail Sales and Use Tax
Dear ****
This is in response to your letter requesting correction of the retail sales and use tax assessment issued to ***** (the "Taxpayer"). Copies of cited sources are enclosed. I apologize for the delay in responding to your appeal.
FACTS
The Taxpayer is a manufacturer of telecommunications equipment. An audit for the period June 1996 through May 1999 resulted in the assessment of tax on untaxed sales and purchases of tangible personal property.
The Taxpayer takes exception to tax assessed on several assets and other purchases of tangible personal property, including certain maintenance contracts and software royalties, and maintains that such items are not taxable.
DETERMINATION
It is my understanding that certain items initially coded as operating supplies, and then transferred to a resale inventory, have been removed from the department's audit based on the additional information furnished. It is also my understanding that the Taxpayer was provided a copy of the revised audit report. The remaining items contested have not been removed from the department's audit and are addressed below.
Maintenance Contracts
The Taxpayer maintains that the software maintenance agreement at issue is a "labor only" contract associated with an exempt software development effort. However, a review of the contract reveals that it covers telephone support, error resolution assistance, standard software updates, and communications including newsletters and other publications provided by the maintenance provider.
There is no condition stated in the software maintenance agreement to indicate that software updates and publications are to be transferred by electronic means only. Absent such condition, I must conclude that software updates and publications may be provided in tangible form, i.e., by disc or CD, in printed form, or by some other tangible medium, at least part of the time or all of the time. Consequently, the software maintenance agreement is considered a "parts and labor" contract, such as those addressed under Title 23 of the Virginia Administrative Code ("VAC") 10-210-910(D).
As this is a "parts and labor" contract, it is my understanding that tax has been assessed on fifty percent of the total charge of such maintenance contract in accordance with the 1996 law change for "parts and labor" contracts. See Code of Virginia § 58.1-609.5(9).
Although the Taxpayer also claims that the research and development exemption applies to the maintenance contract, the Taxpayer has not furnished any documentation to establish that the covered software was used directly and exclusively in exempt research and development activities. Rather, it is my understanding that the Taxpayer has booked this contract under an engineering charge rather than a research and development charge. Absent evidence to the contrary, this software maintenance contract remains taxable.
Software Royalties
Based on the information presented, the Taxpayer designed a new network management software product and incorporated an existing software product ("licensed software") licensed by a third party into its new software product. At issue is the software license agreement which requires the Taxpayer to pay (1) royalty fees for the right to redistribute the software in binary form and (2) maintenance fees for providing support of the software. The Taxpayer claims that the licensed software, and thus the software license agreement, qualifies for the research and development exemption.
The facts presented do not support the application of the research and development exemption to the licensed software. The research and development exemption provided under Code of Virginia § 58.1-609.3(5) requires that an item is directly and exclusively used to develop a new product, improve an existing product, or develop new uses for existing products. The Taxpayer has not shown how it may have used the software "directly' in research and development activities. Merely merging the software with another product or reproducing the software is not sufficient to be considered a research and development function. Nor do the facts presented establish that the software is used exclusively in research and development activities. Although the Taxpayer may use this software in some research function, I must recognize that the Taxpayer is given the right to redistribute the software, i.e., to perform a nonresearch and development function.
To gain the research and development exemption, the property must take an active and immediate role in a research and development process, and such use must be an exclusive use in such process. The Taxpayer has not established that the software license agreement at issue qualifies for the research and development exemption.
Assets of the Verification Lab
The Taxpayer takes exception to the tax on equipment used in its Verification Lab. The Taxpayer maintains that this lab equipment is used as an integral part of exempt research and development activities, such as for product design development and other related research activities. According to the Taxpayer, the lab equipment is used to test prototype products of both the Taxpayer and other manufacturers. The purpose of the testing is to determine functionality and compatibility and includes environmental analysis, comparison tests, and other tests. The Taxpayer maintains that its Verification Lab supports the design development process beginning with the engineering feasibility studies stage. It is my understanding that the Verification Lab is separately organized and operated from the Taxpayer's research and development unit.
Pursuant to 23 VAC 10-210-3070(B), property used to conduct the Taxpayer's feasibility studies, environmental analysis, or comparison testing does not qualify for the research and development exemption. As these activities are not within the scope of the exemption, they demonstrate that the Taxpayer's Verification Lab is not exclusively devoted to research and development activities as contemplated under the exemption.
Moreover, the property must be purchased or leased by the person, firm, corporation, or other entity that actually will perform research activities in order to qualify for the tax exemption for items used directly and exclusively in research. See 23 VAC 10-210-3071(E). In this case, I must recognize the fact that the Taxpayer performs testing for not only itself but also for other manufacturers. In this regard, the Taxpayer has not established that it actually developed other manufacturer's products. Rather, the information presented indicates that the Taxpayer does not develop all of the products that it tests. Consequently, the lab equipment at issue cannot be considered "used exclusively" in research and development activities of the Taxpayer.
Although the testing performed by the Taxpayer may be an extension of its research and development process, it appears that the same testing equipment may be used to conduct tests for other manufacturers. As the research and development exemption is only available when property is used directly and exclusively for research and development purposes, and the property must be owned or leased by the same person conducting the research, I must conclude from the facts presented that the equipment at issue does not qualify for the exemption.
Asset versus Expense Item
The Taxpayer claims that certain purchases from a third party are for engineering services related to the conversion of seven integrated circuits ("IC") used on the Taxpayer's product boards. The purpose of the conversion was to replace old technology with newer technology. As the nature of the development was to result in a new component of a product, the Taxpayer maintains that these transactions represent research and development work and should, therefore, be exempt from the tax.
It is my understanding, however, that the Taxpayer booked these transactions as fixed assets. The documentation presented describes the project as replacement tooling consisting of certain IC chips. The documentation also shows that the Taxpayer hired the vendor to design and provide several prototype units.
In order to determine whether a particular transaction which involves both the rendering of a service and the provision of tangible personal property constitutes an exempt service or a taxable retail sale, the "true object" of the transaction must be examined. If the object is to secure services and the tangible personal property transferred is not critical to the transaction, then the transaction may constitute an exempt service. However, if the object is to secure the property which the service produces, then the entire charge, including the charge for any services provided, is taxable. See 23 VAC 10-210-4040(D).
Although a significant amount of engineering work may be involved in these transactions, it is evident from the facts presented that the true object of these transactions is for the sale of tangible personal property. Undoubtedly, the engineering services are essential. However, without a suitable end product, the services would not have been needed.
In addition, it appears that the Taxpayer has mistakenly assumed the research and development exemption would apply to these purchases. The Taxpayer has not furnished any evidence that it used the IC chips directly and exclusively in exempt research and development activities. Although the vendor may have performed certain exempt research and development activities in furnishing the products to the Taxpayer, such exemption does not extend to the Taxpayer in these transactions, as it was not the one researching and developing the IC chips.
Conclusion
Based on all of the foregoing, I must conclude that the assessment is correct as previously revised. Under separate cover, the Taxpayer will receive an updated bill for the outstanding liabilities.
If you should have any questions about this response, please contact **** of the department's Office of Tax Policy at ****.
Sincerely,
Danny M. Payne
Tax Commissioner
Rulings of the Tax Commissioner