02-155 | Virginia Tax

Tax Type

Retail Sales and Use Tax

Description

Royalties charged in connection with the software license

Topic

Exemptions

Date Issued

12-16-2002

December 16, 2002

Re: § 58.1-1821 Final Application: Retail Sales and Use Tax

Dear *****:

This is in response to your letter seeking reconsideration of the Department's determination of February 15, 2002. That determination upheld, in part, the contested tax assessment issued to ***** (the "Taxpayer") for the period February 1997 through January 2000. I apologize for the delay in the Department's response.

FACTS

In the prior determination, the Department agreed to remove one of the two contested software license agreements from the audit. The royalties charged in connection with the software license agreement with ***** [the "Vendor"] were held taxable because the software failed the exclusivity test of the research and development exemption. In this regard, the agreement does not prevent the Taxpayer from making a taxable use of the software.

You contend that the research and development exemption applies to this Vendor agreement. You maintain that the agreement does prohibit distribution of the product in an unaltered state because the authority to reproduce is limited to situations in which the Vendor software program is included in the Taxpayer's derivative products. In this regard, you maintain that "the research and development process in which [the Taxpayer] created new products was far more involved than the mere copying, cutting or pasting, or reproduction of the [Vendor] software into the new [Taxpayer] software. In fact, a mere ‘cut and paste’ job would be impossible as an application developer must develop significant new analytics to incorporate even a portion of an existing third-party software program into a new software product."

You also claim that the Taxpayer did not use the software on an "as-is" basis. You assert that "[t]he mere fact that the agreement may have contemplated such usage should not taint the transaction if, in fact, no such taxable use was ever made." You maintain that "for purposes of the exemption, the Department should look to actual use, rather than potential use."

DETERMINATION

Va. Code § 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."

For any exemption from the retail sales and use tax, the Department must follow the doctrine of strict construction set out by the courts and Title 23 of the Virginia Administrative Code (VAC) 10-210-540. In other words, if there is any doubt as to the application of an exemption, the Department must follow the construction denying the exemption.

In this case, you maintain that the software at issue meets both the direct use and exclusive use tests of the research and development exemption. Although the contested software may be used directly in research and development, the Department has denied the exemption because the language of the agreement does not establish that the software was to be used exclusively for research and development.

For example, section 7.4.2 of the agreement expressly provides that the Taxpayer may at its discretion add additional features and enhancements to the Vendor's software product. Pursuant to section 11 of the agreement, the Vendor is required to provide master disks to the Taxpayer to allow the Taxpayer to reproduce copies of the Vendor's software products so that they may be included in the derivative product. Pursuant to these provisions, the agreement does not require the Taxpayer to use the Vendor's software for development purposes only.

Accordingly, the contested agreement does not satisfy the exclusivity test of the research and development exemption and is, therefore, taxable. This treatment is consistent with the Department's long-standing policy to look to the language of the agreement to determine the rights conveyed to the licensee.

Based on the foregoing, the assessment is correct. A consolidated bill, with interest accrued to date, will be issued to the Taxpayer. No additional interest will accrue provided the outstanding assessment is paid within 45 days from the date of this letter.

The Code of Virginia sections and regulations cited are available online in the Tax Policy Library section of the Department of Taxation's web site, located at www.tax.state.va.us.

This is the department's final determination on this matter. If you have any questions about this final determination, you may contact ***** in the Department's Office of Policy and Administration, Appeals and Rulings, at ***************.

- - - - Sincerely,

- - - - Kenneth W. Thorson
        Tax Commissioner

AR/39025R

Rulings of the Tax Commissioner