Document Number
06-35
Tax Type
Retail Sales and Use Tax
Description
Tax on untaxed purchases of tangible personal property, including software royalties
Topic
Assessment
Date Issued
04-04-2006


April 4, 2006



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 for the period January 1999 through December 2001. I apologize for the delay in responding to your appeal.


FACTS


The Taxpayer operates a software development business and sells services and prepackaged software primarily to government agencies. An audit resulted in the assessment of tax on untaxed purchases of tangible personal property, including software royalties, software license fees, and software maintenance.

The Taxpayer disputes the assessment and maintains that the eight contested software licenses are used directly and exclusively in exempt research and development activities. The Taxpayer also maintains that certain other purchases are fully or partially exempt from the retail sales and use tax.

DETERMINATION


Research and development exemption

Virginia 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."

Title 23 of the Virginia Administrative Code ("VAC") 10-210-765 A broadly interprets the research and development exemption as applied to computer software:
    • Tangible personal property used directly and exclusively in computer software research and development activities is generally exempt from the tax. Exempt research and development activities are those that have as their ultimate goal the advancement of computer software technology, the development of new computer software products, the improvement of existing computer software products, or the development of new uses for existing computer software products. An example of exempt tangible personal property used in a research and development activity is computer hardware and software used in programming and other developmental activities with respect to new computer software products, including the testing of such new products.

In Public Document (P.D.) 01-45 (4/16/01), the Department ruled, "Merely merging the software with another product or reproducing the software is not sufficient to be considered a research and development function." The ruling also recognized the right to redistribute software as "a nonresearch and development function." In that case, the taxpayer failed to establish that the software license agreement qualified for the research and development exemption.

Notwithstanding the treatment of the redistribution right in P.D. 01-4.5, the Department determined in P.D. 02-11 (02/15/02) that licensed computer software may be eligible for the research and development exemption when the licensee is provided the right to modify and improve the licensed software with the ultimate goal of marketing a new derivative product. In P.D. 02-11, the contested software was only used to develop new software products in which significant programming changes and improvements were made to the vendor's source code. Accordingly, alteration of the source code for the purpose of developing a new derivative software product for marketing purposes is an exempt research and development activity. Although a distribution (marketing) right was conveyed under the license agreement, such distribution cannot occur unless the vendor's software is developed. Accordingly, the distribution right does not prevent the application of the research and development exemption because the intent of the agreement was to develop new software for marketing purposes.

Contested software license agreements

You claim that the intent of the contracts at issue is to use the software for exempt research and development purposes. You also indicate that only a portion of the vendor's source code is ever used in developing a new derivative product. Based on the language of the contracts at issue, I have made the following determinations:

***** (Vendor A) OEM license and distribution agreement. This contract grants the Taxpayer the rights to develop, market and sell a solution that "incorporates, embeds, or integrates the [Vendor A] Software into the [Taxpayer's] own proprietary software." Clause 1.2 of the contract grants the Taxpayer a development license "to integrate or embed the [Vendor A] Software object code into the [Taxpayer's] own proprietary software for the purpose of developing the Customer Product." Clause 1.3 of the contract grants the Taxpayer a distribution license "to reproduce, demonstrate, display, market and distribute to End Users, sub-distributors and resellers, the [Vendor A] Software object code solely as part of the Customer Product." Clause 1.10 of the contract states that the Taxpayer shall not "modify, merge or compile all or any portion of the source code of the [Vendor A] Software" and "shall have no right to use, distribute or copy the [Vendor A] Software, for [Taxpayer's] internal, non-revenue producing use."

Based on these stated requirements, the intent of the contract is clearly for the development of a new software product. Although the contract does not expressly allow the Taxpayer to modify Vendor A's source code, the language of the contract restricts the software's use to the development of a new software product. Furthermore, unlike P.D. 01-45, the contract language establishes that the Taxpayer is not merely reproducing the software but is integrating it into a new derivative product for software development purposes. Based on these requirements and the internal use restriction expressed in the contract, the license fees of this contract will be removed from the audit.

***** (Vendor B) Software OEM Agreement. Recital B of this contract states that the Taxpayer "is developing and intends to market and distribute" a certain proprietary commercial computer software product. Pursuant to clause 1.1 of the contract, the Taxpayer is given the right "to make copies of the [Vendor B] Products to be distributed under this Agreement only from the Master Copies" furnished by [Vendor B]. Clause 1.2 of the contract states that the Taxpayer "is responsible for properly combining the installation of the [Vendor B] Products and the [Taxpayer's] Products into a single installation." Clause 2.1 of the contract grants the following rights:
    • [Vendor B] grants to [Taxpayer] a . . . license (a) to reproduce exact copies of the [Vendor B] Products pre-installed onto the media containing [the Taxpayer's] Products and (b) to market and distribute the [Vendor B] Products; provided that (i) copies of the [Vendor B] Products are marketed and distributed with Licensee Products as a single commercial unit (i.e., the Product Bundle), for a single price, and not as a stand-alone product.

As with the Vendor A contract noted above, the intent of the Vendor B contract is to develop a new software product. This contract restricts the software's use to the development of a new software product. Unlike P.D. 01-45, the contract language establishes that the Taxpayer is not merely reproducing the software but is integrating it into a new product for software development purposes. Based on these requirements and absent any right for internal taxable usage, the Vendor B royalty fees will be removed from the audit.

***** (Vendor C) Software license agreement. Recital B of the contract states that the Taxpayer "desires to modify and thereafter bundle a version of the Software with the License Product . . . for sub-license to third party end users." Clause 2.1 A of the contract grants a license to the Taxpayer to "[m]odify the Source Code only to the extent necessary to enable the Software to operate (in Modified Object Code form) as part of and bundled with the [Taxpayer's] Product in the Royalty Product [i.e., the Taxpayer product bundled together with the modified object code]." Clause 2.1 B of the contract permits the Taxpayer to "[m]ake and sub-license to end users a copy of the Modified Object Code solely as a component of and bundled with each copy of the [Taxpayer's] product . . . ." Clause 2.3 of the contract provides that the Taxpayer "may make not more than two (2) copies of the Source Code in order to facilitate the modifications thereto under Section 2.1 A . . . ." Based on these requirements and absent any right for internal taxable usage, the intent of the contract is clearly to develop a new derivative software product. The contract fees will be removed from the audit.

***** (Vendor D) Value-Added Reseller Agreement. The opening statement of this contract states that the Taxpayer [as the VAR] "desires to license certain products from [Vendor D] . . . for the purpose of packaging the [Vendor D] Deployment Product(s) in combination with certain of VAR's software products as an application bundle, and to sublicense that application bundle to end users for their internal use." Section 2 (a) of the contract grants to Taxpayer a license "(i) to copy and use the [Vendor D] Product(s) in VAR's internal development, (ii) to copy the [Vendor D] Deployment Product and package them in combination with one or more VAR Product(s) as an Application Bundle, [and] (iii) to market and distribute the [Vendor D] Deployment Product(s) as contained in such Application Bundle to End Users." A limitation clause is provided in section 2 (c) of the contract in which the Taxpayer agrees:

not to use the [Vendor D] Products) for VAR's internal productive purposes, except when used in accordance with a valid license agreement,
not· to copy, market or distribute the [Vendor D] Products) except as part of an Application Bundle, and
not to copy or sublicense the [Vendor D] Products) on a stand-alone basis or for use with any software other than the VAR Product(s).

Based on these requirements, the restrictions imposed by the contract, and absent any, right to use the vendor's software for internal taxable usage, I find that the intent of the contract is to develop a new software product. The contract fees will be removed from the audit.

***** (Vendor E) Value-Added Remarketer Agreement. This contract grants the Taxpayer as Licensee "a (a) . . . license to incorporate (and copy for the purposes of distribution to Customers) the Technical Data and Software Products into Licensee Products and to distribute such Licensee Products to Customers and (b) the right to grant a Reseller the rights in (a) of this section 2.1, provided that:

the· Software Products may only be distributed to third parties as part of License Products to which Licensee has added significant value; [and]
· the Licensee Products must be sufficiently different from the Software Products that the Licensee Products are not sold in direct competition with the Software Products as they are licensed by Licensee.

Based on these requirements and absent any right to use the vendor's software for internal taxable usage, the intent of the contract is to develop a new derivative software product. The contract fees will be removed from the audit.

***** (Vendor F) Software OEM Agreement. This contract has similar development requirements and restrictions as used in the foregoing contracts. Accordingly, the contract fees will be removed from the audit.

***** (Vendor G) Independent Software Vendor (ISV) agreement. This contract states that the Taxpayer "wishes to embed [Vendor G's two software editions] into the [Taxpayer's] Suite of packaged software products (the "Integrated Product"), in exchange for certain consideration . . . ." It also states that "[Vendor G] grants [the Taxpayer] development licenses for four (4) servers." The contract goes on to grant the Taxpayer "additional temporary but fully functional unlimited client licenses for Quality Assurance and Test purposes, including scalability testing."

Section 1.4 of the contract defines "independent software vendor (ISV)" as a "person or business entity actively involved in the development of application software or systems integration, seeking to embed [Vendor G] Products as an integral part of their finished products/services."

Section 2.1 of the contract lists the rights granted under the contract, some of which are as follows:

Embed the Products, which will be provided in object form only, transparently into 'Integrated Product.'
Use the Products for testing internally and embed, market and distribute the Products as part of the Integrated Product and to the [Taxpayer's] end user customers . . . .
Customize the installation of Product binaries that are to be embedded in the Integrated Product using the silent installer.

Section 2.3.1 of the contract provides that the Taxpayer "shall not distribute or otherwise transfer to third parties the Programs in stand-alone form or outside the context of the 'Integrated Product."' Obviously, the intent of the contract is for the development of a new software product or new uses for existing software products. Based on these requirements and absent any right to use the vendor's software for internal taxable usage, the intent of the contract is to develop a new software product. The license fees and the related software maintenance fees will be removed from the audit.

***** (Vendor H) OEM Object Code License Agreement. Section 2.1.1 of this contract grants the Taxpayer [as the OEM] a license to "(i) incorporate the Object Code into an OEM Product to create a Bundled Product, (ii) reproduce and have reproduced the Object Code as incorporated in a Bundled Product as reasonably needed for inactive backup or archival purposes and to distribute in the Territory to employees of OEM and for use by such employees for OEM's internal business purposes, and (iii) reproduce, have reproduced, and license or otherwise distribute the Object Code as incorporated in a Bundled Product in the Territory." Pursuant to section 2.2.3 of the contract, the Taxpayer may not distribute the [Vendor H] Software as stand-alone product. Further, pursuant to section 2.2.4 of the contract, the Taxpayer may "not modify. . . or otherwise attempt to derive the Source Code" from the [Vendor H] Software.

Under the definitions section of the contract, section 1.1 defines "Bundled Product(s)" to mean "one or more of the products or product groups . . . which has been or will be developed by OEM and which incorporates in the OEM Product in any manner any portion of the [Vendor H] Software." This definition further provides, "A Bundled Product must represent a significant functional and value enhancement to the [Vendor H] Software such that the primary reason for an End User Customer to license such Bundled Product is other than the right to receive a license to the functionality of the
[Vendor H] Software included in the Bundled Product."'

Based on these terms, the intent of the contract is to use Vendor H's software for the development of a new software product; however, I am not convinced that this contract satisfies the exclusivity use criteria of the research and development exemption. For example, the phrase "internal business purposes" used in section 2.1.1 of the contract is problematic because it allows the Taxpayer to make a taxable use of the vendor's software. Although you claim that the Taxpayer's usage is limited to the development process; the Department must rely upon the language used in the contract. For these reasons, I find insufficient basis to extend the research and development exemption to this contract.

Other issues

Based on the documentation presented, I find grounds for removing the following contested purchases: (Vendor I), (Vendor J) and (Vendor K). For the contested purchases with (Vendor L) and (Vendor M) evidence that establishes the percentage of items distributed outside Virginia should be submitted to the Department's auditor for further analysis.

For the contested purchase from the sales invoice (Vendor N) describes the transaction as "[p]hotography of stylized light bulb for use in corporate identity" and lists charges for studio photography time, retouching labor, a color digital file, and a CD with the imaged file. The Taxpayer's purchase justification form further describes the transaction as merely "replicating a photograph." These facts are indicative of a transaction that does not involve the planning or creation of media advertising services, as intended by the advertising exemption of Va. Code § 58.1-609.6 5. Furthermore, no evidence has been presented that this particular image was purchased for use only in a specific media advertising campaign. Accordingly, the total charge for this transaction is taxable.
CONCLUSION

The assessment will be adjusted in accordance with this determination. An auditor will soon contact you to arrange for the receipt of the requested information within sixty (60) days of the date of this determination letter. If such evidence is no longer available or is not presented to the auditor within the time allotted, no further adjustments will be made.

Upon revision of the audit, a consolidated bill, with interest accrued to date, will be mailed to the Taxpayer. The outstanding balance must be paid within 30 days from the date of the consolidated bill to avoid the accrual of additional interest. In addition, failure to submit full payment within this 30-day period may also result in the imposition of an additional 20% penalty on the tax due under the terms of the Virginia Tax Amnesty Program. See the enclosure entitled "Important Payment Information."

Payment should be remitted to: Virginia Department of Taxation, 3600 West Broad Street, Suite 160, Attn: *****, Richmond, Virginia 23230. If you have any questions concerning payment of the assessment, you may contact ***** at *****. If you have any questions about this determination, you may contact ***** in the Department's Office of Policy and Administration, Appeals and Rulings, at *****.
                • Sincerely,


                • Kenneth W. Thorson
                  Tax Commissioner




AR/44453R



Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46