Tax Type
Retail Sales and Use Tax
Description
A developer and marketer of software solutions.
Topic
Appropriateness of Audit Methodology
Exemptions
Taxability of Persons and Transactions
Date Issued
02-15-2002
February 15, 2002
Re: § 58.1-1821 Application: Retail Sales and Use Tax
Dear *****:
This is in response to your letter in which you seek correction of the retail sales and use tax assessment issued to ***** (the "Taxpayer") as a result of an audit by this department. I apologize for the delay in responding to your letter.
FACTS
The Taxpayer is a developer and marketer of software solutions imaging for public and private sector clients. An audit for the period February 1997 through January 2000 resulted in the assessment of sales tax on untaxed sales and use tax on untaxed purchases of tangible personal property.
The Taxpayer takes exception to the use tax assessed on royalties paid in connection with software licensing agreements that included the tangible software. The Taxpayer maintains that the third party software obtained from ***** ("Party 1") and ***** ("Party 2") qualifies for the research and development exemption.
DETERMINATION
Code of Virginia § 58.1-609.3(5) provides an exemption from the retail sales and use tax 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.]
In order to qualify for the exemption, tangible personal property must satisfy all of the requirements of the exemption, i.e., the item must be for "direct and exclusive use" in a "research and development" process conducted in the "experimental" sense. Failure to satisfy all of these requirements, as defined in Title 23 of the Virginia Administrative Code (VAC) 10-210-3070 (copy enclosed), will deny the exemption.
If the goal is to improve an existing computer software product or develop a new computer software product, the department recognizes that modifications made to a computer software program under experimental or laboratory conditions may constitute a research and development activity and that software used directly and exclusively in such activity is exempt. See 23 VAC 10-210-765(A); copy enclosed.
In Public Document (P.D.) 01-45 (4/16/01), the department denied the research and development exemption for licensed software because it was not proven to be used directly and exclusively in an actual research and development process. The Taxpayer maintains that its circumstances are distinguishable from those in P.D. 01-45 (4/16/01).
Like the taxpayer in P.D. 01-45, the Taxpayer in the instant case is given the right to redistribute the third party software at issue. However, unlike the taxpayer in P.D. 01-45, the Taxpayer in the instant case is not allowed to redistribute the software of Party 1 in an unaltered state or largely unchanged condition. The license agreement with Party 1 clearly establishes that the Taxpayer must modify and improve the Party 1 software in order to produce and market a new derivative product. Under these circumstances, the Party 1 software appears to be used directly and exclusively in exempt research and development activities.
The same treatment does not apply, however, to the contested software from Party 2. A review of the software license agreement with Party 2 reveals that the Taxpayer is given the right to reproduce copies of licensed software in machine readable form to include in the Taxpayer's derivative products. Unlike the contract with Party 1, this agreement does not prevent the redistribution of the licensed product in an unaltered state. Although enhancements may be made to the licensed software by the Taxpayer, there is nothing in the agreement to prevent the Taxpayer from reproducing the software for distribution on an unaltered basis.
As explained in P.D. 01-45, "merely merging the software with another product or reproducing the software is not sufficient to be considered a research and development function." As mere reproduction of the software may occur according to the terms of the agreement with Party 2, I must conclude that Party 2's software fails the "exclusive use" requirement of the research and development exemption. Consequently, the tax was properly applied to the royalties paid on this software.
Based on this determination, the contested royalty fee charged in connection with Party 1 will be removed from the assessment. This will reduce the tax portion of contested bill ***** from *****. The associated interest charged in connection with the abated tax will also be removed from the assessment.
A revised bill reflecting the above adjustments, with interest accrued to date, will be mailed to the Taxpayer. No additional interest will accrue provided the outstanding assessment is paid within 30 days of the date of the revised bill.
If you have any questions regarding this determination, you may contact ***** in the Office of Policy and Administration, Appeals and Rulings, at *****.
Sincerely,
Danny M. Payne
Tax Commissioner
AR/36016R
Rulings of the Tax Commissioner