Document Number
09-136
Tax Type
Retail Sales and Use Tax
Description
Assists businesses and organizations with the development of new technologies.
Topic
Exemptions
Nonprofits
Tangible Personal Property
Date Issued
09-08-2009


September 8, 2009





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") for the period June 1999 through September 2003. I apologize for the delay in responding to your letter.

FACTS


The Taxpayer is a private, nonprofit organization that assists certain United States government agencies in identifying, acquiring and deploying cutting edge technologies. In addition to delivering technology solutions to its customers, the Taxpayer's business plan includes investing in businesses, universities and research labs that produce technologies with potential capabilities to benefit the government agencies. The Taxpayer then assists the businesses and organizations it invests in with the development of these technologies.

The Taxpayer contests the assessment of use tax on purchases from fifteen vendors with which the Taxpayer was engaged in investment and product development activities. The Taxpayer cites various authorities to support its contention that the contested purchases were erroneously assessed.

DETERMINATION


Research and Development Exemption

The Taxpayer asserts that the research and development exemption applies to many of the purchases held taxable in the audit. Virginia Code § 58.1-609.3 5 provides an exemption from the retail sales and use tax for:
    • Tangible personal property purchased for use or consumption directly and exclusively in basic research or research and development in the experimental or laboratory sense.

The terms "basic research" and "research and development" are defined in Title 23 of the Virginia Administrative Code (VAC) 10-210-3070 (A). The ultimate goal of basic research is to advance knowledge or technology in a particular scientific or technical field. The ultimate goal of research and development is to transform newly found knowledge into a usable new product or process, an improved product, or a new use for an existing product. This regulation states that modification of a product merely to meet customer specifications does not qualify as research and development, unless the modification is carried out under experimental or laboratory conditions in order to improve the product generally or develop a new use for the product.

Title 23 VAC 10-210-3071 E explains the application of the research and development exemption to equipment purchased or leased for use by other companies:
    • Tangible personal 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. If the research equipment is purchased or leased by a person and is subsequently donated or loaned to another person to perform research for either party, the equipment is taxable to the person making the purchase, even if the other party is a nonprofit organization, governmental entity, or is otherwise exempt from sales and use tax. [Emphasis added.]

The Taxpayer identifies and tests software and other products obtained from potential vendors to determine if the products meet the needs of the Taxpayer's customers. If a product is approved by the Taxpayer and its customer, the vendors perform the actual product development function by modifying and changing the product based on the Taxpayer's test results and specifications. The development process continues as different versions of the modified product are provided to the Taxpayer for further testing. This process continues until the final product is accepted or rejected by the Taxpayer and its customer.

In discussions with the Department's audit staff, a representative of the Taxpayer confirmed that the Taxpayer does not perform software programming or engage in the modification of products, but rather the vendors perform these activities. The Taxpayer also uses subcontractors to beta test the products provided by vendors to determine whether the criteria of a predetermined problem set are met. The development process is described in the Taxpayer's appeal letter. On page 3, the appeal letter states that the Taxpayer researches the release and creates a written assessment for the vendor, detailing the laboratory team's findings and specific suggestions for refinement. The letter continues by stating that the third party vendor uses the assessment to further modify the software and develop subsequent versions that are sent to the Taxpayer for analysis.

In P.D. 01-45 (4/16/01), a taxpayer's claim for the research and development exemption was not allowed. The taxpayer in P. D. 01-45 used lab equipment to perform prototype product testing for other manufacturers that were engaged in product development activities. In this case, the research and development exemption was denied because the taxpayer did not develop all the products it tested. While the taxpayer in this case performed prototype testing, the actual product development was performed by the manufacturers. Thus, the lab equipment was not used directly and exclusively in research and development as required by Va. Code § 58.1-609.3 5.

P.D. 01-9 (2/6/01) is also on point with the Taxpayer's activities. In this determination, a government contractor performed various activities, such as system analysis, performance studies and analysis, technical analysis, technology activities assessment and monitoring, software modification analysis, interface requirements and planning coordination and similar activities. These activities were deemed to be primarily performed to meet and satisfy customer requirements and specifications and did not qualify for the research and development exemption.

The Taxpayer also uses subcontractors to perform product testing and uses vendors to perform the actual product development activities, such as the modification of software. Some of the deliverable assessments state that products were provided to the Taxpayer's customers for further or concurrent testing. Applying the requirements in Title 23 VAC 10-210-3071 E to the fact the Taxpayer provides the property to third parties for testing, the Taxpayer has not met the exclusive use test required to qualify for the research and development exemption.

In addition, there are instances in which the Taxpayer's initial purchases of canned software and other products are not used exclusively in research and development activities, but rather to determine whether to invest in a particular business. A key component of the Taxpayer's business model is the testing and evaluation of products and technologies for the purpose of determining whether to invest in the business that markets the product or technology. This activity is not performed for research or research and development purposes. Any purchases of tangible personal property purchased for this purpose do not qualify for exemption as they are not for exclusive use in research and development activities.

Based on the above, the Taxpayer more accurately manages the research and development process rather than conducting the research and development itself. While it appears that the Taxpayer performs some testing and product analysis, the Department has ruled that these activities do not rise to the level of research and development for purposes of the sales and use tax exemption. Based on the Taxpayer's activities, the Taxpayer is not eligible for the research and development exemption in Va. Code § 58.1-609.3 5.

Software Customization and Modification Labor

Virginia Code § 58.1-602 defines a "prewritten program" as "a computer program that is prepared, held or existing for general or repeated sale or lease, including a computer program developed for in-house use and subsequently sold or leased to unrelated third parties." Generally, the sale of a prewritten program in tangible form is a taxable transaction. In contrast, a "custom program" is defined in Va. Code § 58.1-602 as:
    • A computer program which is specifically designed and developed only for one customer. The combining of two or more prewritten programs does not constitute a custom computer program. A prewritten program that is modified to any degree remains a prewritten program and does not become custom.

The sale of a custom program in any form is exempt from the sales and use tax. Virginia Code § 58.1-609.5 6 also provides an exemption for "[a]n amount separately charged for labor or services rendered in connection with the modification of prewritten programs as defined in § 58.1-602."

Many of the computer programs initially purchased by the Taxpayer are prewritten computer programs. These programs were held by vendors for general sale and were not developed specifically for the Taxpayer. The Taxpayer typically identifies the existence of such programs prior to purchasing the software. While the purchase of prewritten software in tangible form is generally taxable, the programming labor to customize the software applications constitutes modifications to prewritten programs and is exempt in accordance with Va. Code § 58.1-609.5 6. The modification charges must be separately stated to qualify for exemption. Therefore, any charges in the audit for labor and services to modify prewritten computer programs qualify for exemption, if such charges are separately stated.

In many cases, the Taxpayer initially purchased prewritten programs and then contracted with vendors to develop the products. The vendors issued progress billings to the Taxpayer for the subsequent modifications made to the software. Under the cited authorities, separate charges for the modification labor are exempt but any initial purchases of prewritten programs are taxable, absent another applicable exemption. Some of the charges in the audit are for various software releases that have been modified based on the Taxpayer's continuous testing of previous versions. These charges are clearly for modifications, as the prewritten software has previously been purchased by the Taxpayer. The deliverable assessment forms provided by the Taxpayer confirm that the charges are for software modifications and related services.

The audit assessment will be revised to reflect the removal of charges for modifications made to prewritten software. Based on a review of the audit report and the information provided by the Taxpayer, the following transactions listed as audit exceptions will be removed: line items 4, 5, 6, 10 through 12, 15, 19 through 21, 26, 28 through 33, 36, 38 and 39.

Because the research and development exemption, or any other exemption, is not applicable to the Taxpayer's purchases of prewritten software, line items 1, 3 and 40 are taxable based on the information in the audit and provided by the Taxpayer.

Resale Exemption

When performing product analysis and evaluation, the Taxpayer often loads software applications onto servers at its business location. The software was typically delivered in tangible form to the Taxpayer. In one case, the Taxpayer maintains that the software was delivered to it but was then transferred to its customer. The Taxpayer maintains that no use was made of the software prior to its transfer to the customer as evidenced by the fact that the software was not loaded onto its servers. Thus, the Taxpayer contends that the software purchase qualifies for the resale exemption. The Taxpayer also contracted with some vendors to deliver other types of tangible products, such as a computer system. The Taxpayer asserts that in cases where computer hardware or other tangible products were received, the property was either delivered directly to or transferred immediately to its customer. Thus, the resale exemption should apply to these purchases.

Virginia Code § 58.1-604 imposes the sales or use tax on retail sales. Retail sale is defined in Va. Code § 58.1-602 as "a sale to any person for any purpose other than for resale …." A review of the deliverable assessment forms provided by the Taxpayer confirms that certain products were either delivered directly to the Taxpayer's customer or received and subsequently turned over to the customer by the Taxpayer. As such, purchases of these items qualify for the resale exemption. The purchase transactions listed as line items 17, 18 and 25 will be removed from the audit. The Taxpayer should note that the purchase of a tangible software product that is loaded on its server or stored in its facility, is not a resale transaction if a separate copy is provided to a customer.

It appears that line items 13, 14, 22, 23 and 24 may qualify for the resale exemption. However, sufficient documentation has not been provided to confirm this. The Taxpayer should provide the Department with additional information, such as shipping documents, invoices or similar items that indicate the audit exceptions in question were drop-shipped or transferred to the Taxpayer's customer. If this information is not provided, the assessment of tax on line items 13, 14, 22, 23 and 24 will be considered correct.

No Tangible Personal Property Received

The Taxpayer maintains that some purchases listed in the audit were for services performed in the vendors' locations outside Virginia. In these transactions, neither the Taxpayer nor the Taxpayer's customer took possession of any tangible personal property in Virginia. Based on a review of the deliverable assessment forms, the products and services in question consisted of a software configuration and test plan, a research agreement and related reports, training, demonstrations, market surveys and software that remained in an out-of-state location. The deliverable assessment forms confirm that the transactions at issue were primarily services performed in locations outside Virginia. Based on this information, these transactions were not retail sales of tangible personal property to the Taxpayer. Line items 2, 8, 9, 34 and 35 will be removed from the audit.

Maintenance and Support Agreements

Several charges in the audit relate to software maintenance and support agreements. The Taxpayer maintains that the maintenance and support is for exempt software modifications only, and does not include support for canned or prewritten software. Thus, the charges should qualify for the exemption for software modifications in Va. Code § 58.1-609.5 6.

Virginia Code § 58.1-609.5 9 provides that maintenance contracts which provide both repair or replacement parts and labor are taxable at one-half the total charge of the contract. I note that one of the maintenance and support charges in the audit was taxed at one hundred percent. This charge, listed as line item 16 in the audit, will be reduced by fifty percent to *****. The Taxpayer has not provided sufficient information to support its claim that the remaining maintenance and support charges are solely for software modifications. It is possible these charges include support for prewritten software because the development projects often start with a canned or prewritten version of software. The Department will review any additional documentation the Taxpayer can provide to support its claim that line items 7, 16, 27, 29 and 37 qualify for this exemption. If the documentation indicates that the support charges are for labor only agreements or relate solely to software customization and modifications, the audit will be adjusted accordingly.

CONCLUSION


Based on the foregoing, the audit will be adjusted and the assessment revised as noted above. The Taxpayer has 45 days from the date of this letter to provide the requested additional documentation to support the removal or adjustment of other items in the audit. After this time, the Taxpayer will receive a revised bill that reflects the adjustments made to the audit and updated interest. The Taxpayer should remit payment for the outstanding balance shown on the revised bill within 30 days from the date of the bill to avoid the accrual of additional interest.

The Code of Virginia sections, regulations and public documents cited, along with other reference documents, are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions about this determination, you may contact ***** in the Department's Office of Tax Policy, Appeals and Rulings, at *****.
                • Sincerely,


                • Janie E. Bowen
                  Tax Commissioner



AR/54962.S


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46