Document Number
09-84
Tax Type
Retail Sales and Use Tax
Description
Government contractor specializes in IT solutions, program support, and systems integration
Topic
Appropriateness of Audit Methodology
Government Contractor
Manufacturing Exemption
Date Issued
05-28-2009
May 28, 2009



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") as a result of the Department's audit for the period January 2001 through May 2005. I apologize for the delay in responding to your letter.

FACTS


The Taxpayer is a government contractor that specializes in information technology solutions, program support, and systems integration. An audit resulted in the assessment of consumer use tax on fixed assets and other purchases. The Taxpayer concedes the tax amount assessed in connection to the fixed assets.

The Taxpayer, however, takes exception to taxed purchases made in connection with several federal government contracts. The Taxpayer maintains that these contracts are Indefinite Delivery/Indefinite Quantity (ID/IQ) contracts. As such, and in accordance with the Department's established policy on ID/IQ contracts, the true object should be applied to the task order level to determine whether the order is for the sale of tangible personal property or the provision of services to the government. The Taxpayer maintains that these purchases were made pursuant to orders for the sale of tangible personal property to the government.

The Taxpayer also contests the purchases held in connection with a subcontract with a prime contractor (Contractor). The Taxpayer indicates that it is engaged in manufacturing custom components for customers of the Contractor. As such, it maintains that the industrial manufacturing exemption provided in Va. Code § 58.1­609.3(2) (i) applies to the subcontract purchases.

The Taxpayer also contests a number of other issues. According to the Department's auditor, the Taxpayer installs monitoring systems in hospitals pursuant to service contracts. However, pursuant to certain task orders, the Taxpayer claims that the monitoring systems are sold to nonprofit entities that are entitled to an exemption on their purchases pursuant to Va. Code § 58.1-609.11. The Taxpayer also takes issue with the sampling methodology used in connection with monitoring system purchases on the basis that the actual liability is far less than the projected liability estimated in the audit. Of final concern, the Taxpayer plans to pursue a refund of any state tax assessed and paid pursuant to this audit under any relevant enterprise zone relief.

DETERMINATION


For the audit period at issue, the general policy for determining the application of the retail sales and use tax to government contracts is to apply the true object test to the overall contract, rather than to individual task or delivery orders issued under those contracts. See Title 23 of the Virginia Administrative Code (VAC) 10-210-693.

An exception to this general policy is found in Public Document (P.D.) 01-6 (1/4/01) and 04-53 (8/18/04). In these instances, it was not possible to determine the true object of the underlying ID/IQ contract because there was little or no clear evidence of the government's true object. The government was under no obligation to purchase any goods or services from the contractor until a delivery order was executed. Thus, only when the government issued an individual task or delivery order to the contractor did the contractor learn of the government's specific needs. Under these circumstances, the true object is appropriately applied to the task or delivery order level rather than to the overall contract.

I will address the contracts at issue in light of this policy.

Contract ***** (GSA Contract 1)

The contract documents provided show that this contract is with the General Services Administration (GSA) and is designated an ID/IQ contract. Although task order #15076 is an order for tangible personal property, the quote attached to the order shows that the items were purchased from two manufacturers that are not listed in the audit's purchase exception list. Accordingly, it appears that the items presented for removal were not assessed in the audit. However, if you have other contract documents or task orders to establish that certain items related to this contract were erroneously included in the audit and were purchased pursuant to a task or delivery order for the sale of tangible personal property, you may furnish such evidence to the auditor.

Contract ***** (GSA Contract 2)

The contract documents provided reveal that this GSA contract is designated an ID/IQ contract. Task order #16050 is an order for tangible personal property. Based on the documentation provided, I am not certain whether any of the items included in the order were assessed in the audit. Accordingly, to the extent items purchased pursuant to this task order have been included in the audit, they will be removed from the audit. The auditor will need to verify whether such items were actually included in the audit and revise the audit as necessary.

I understand that the Taxpayer concedes the tax applied to purchases associated with task order #16049.

Contract ***** (GSA Contract 3)

The contract documents provided reveal that this GSA contract is designated an ID/IQ contract. Task order #26081 is for deployment planning labor, travel, IT hardware, and technical support services for implementation of the LAN/WAN solution for 30 sites. Based on the task order requirements, I find that the true object is the exempt sale of tangible personal property to the government, i.e., the sale of an IT solution consisting of hardware, software and services sold as a complete package. Although the services are significant in cost, they are incidental to the sale of tangible personal property.

The true object of task order #26600 is for the design, procurement and installation of a new information system. As such, it is an exempt sale of tangible personal property to the government.

Based on the documentation provided, however, I am not certain whether any of the items included in the two orders were assessed in the audit. Accordingly, I will have the auditor take the same action as described for the GSA Contract 2 above.

Contract ***** (GSA Contract 4)

The contract documents provided reveal that this GSA contract is designated an ID/IQ contract. Based on the Statement of Work (SOW) provided, task order #28013 provides for the necessary hardware, software and related products needed to provide government field staff with capability and accessibility to the government's databases and email. The planning, design, configuration, installation, maintenance, training, and other related services facilitate the sale of tangible personal property. Accordingly, I find that the true object of task order #28013 is for the exempt sale of tangible personal property to the government. Notwithstanding, I am not certain as to whether any of the items included in this order were assessed in the audit. Accordingly, I will have the auditor take the same action as described for the GSA Contract 2 above.

I understand that the Taxpayer concedes the purchases associated with task order #29033.

Other Government Task Orders

According to the Taxpayer, task orders #901202 and #901207 were issued to acquire materials not directly related to any contract. The Taxpayer concedes the purchases associated with these task orders.

Subcontract Issue

Subcontract. In July 2002, the Taxpayer entered into a subcontract ordering agreement with the Contractor to provide integration and deployment services to customers of the Contractor. Per section C (SOW) of the contract, the Taxpayer agrees to furnish all personnel, material, supplies and services required to perform the work identified in accordance with the scope and SOW as specified in each individual delivery order. Specific task descriptions are to be included in each delivery order. Section G.2 of the subcontract establishes either a time and material or firm fixed price subcontract as mutually agreed by both parties for each delivery order. Per Section G.3 of the subcontract, no value or funding is obligated arising from the award of the subcontract. Rather, funding is only obligated upon the issuance of each delivery order by the Contractor. Per Section G.4 of the subcontract, full and complete compensation for services performed by the subcontractor is set forth in the delivery orders.

Proposal. The subcontract also incorporates the Taxpayer's final proposal for deployment services. The proposal offers a three-phase solution (acquisition, installation, and sustainment) for meeting expected deployment needs. This solution is indefinite because the third phase (i.e., sustainment services consisting of professional services and help desk support) is optional. If the option were elected, it would include not only the provision of network, hardware and procurement technicians but also include the provision of clinical systems technicians, healthcare technicians, a telemedicine specialist, and the associated experts.

Request for proposal (RFP). Section G.1 of the subcontract sets out the following:
    • Except for the subcontractor's proposal to Contractor incorporated herein, this subcontract supersedes all prior written or oral agreements and constitutes the entire agreement between the parties hereto with respect to this subcontract.

Although the Taxpayer claims that a 2006 RFP fully describes the program under which the Taxpayer has been operating, there is no reference to any similar RFP in the subcontract or the proposal. Furthermore, the RFP makes no mention of sustainment services or any professional services as noted in the proposal. Because of these differences between the 2006 RFP and the proposal, and the fact that an RFP is not a contract, the actual subcontract must be relied upon as the entire and controlling agreement between the parties.

True object test. Although the proposal incorporated into this subcontract provides an overview of the nature of this transaction, the options set out by the proposal create uncertainty as to the extent of work required by the subcontract. Furthermore, based on the SOW for this subcontract, the nature of the work is not revealed until a delivery order is issued for a specific task. Thus, it is impossible to determine the true object of the overall subcontract based only on the subcontract ordering agreement. For all of these reasons, I find that the true object test for this subcontract should apply to the task or delivery order level. Thus, if the order is for professional services, the Taxpayer would be liable for the sales and use tax on all tangible personal property purchased pursuant to the order. On the other hand, the resale exemption would generally apply to purchases made by the Taxpayer pursuant to an order for which the true object is for the sale of tangible personal property.

Sales. With respect to sales made by the Taxpayer to the Contractor, the resale exemption would not apply when the Contractor purchases items for use in the performance of its remote critical care services. In such instances, the Taxpayer should be registered to collect, report and remit the sales tax on such taxable sales. In this case, however, the Taxpayer was audited for consumer use tax purposes only. As such, no taxable sales were included in this audit.

The Taxpayer maintains that it sold equipment to third parties (e.g., customers of the Contractor). However, I am unable to make a determination of this issue for any specific item based on the few facts provided. Sales transactions would normally be taxable when title to the property transfers to the Contractor in Virginia pursuant to a service contract. When title to the equipment transfers from the Taxpayer directly to a third party and the sale is completely independent of any provision of services by the Contractor, then the sale may constitute a retail sale to the third party. In such instances, the sale is taxable unless it qualifies for some exemption. For example, it may constitute an exempt sale in interstate commerce when the equipment is delivered directly to the purchaser outside Virginia. See Title 23 VAC 10-210-780. If the sale is to a nonprofit hospital in Virginia, it may be exempt from the tax provided the purchaser furnished a valid exemption certificate to the Taxpayer.

Purchase orders. The Taxpayer presents copies of documents claimed to be task orders #61522 and #61564 issued under this subcontract. A review of these documents reveals that they are not actually task or delivery orders issued by the Contractor to the Taxpayer. Rather, they are purchase orders issued by two hospital customers for the purchase of tangible personal property.

Other than an email accompanying one of these purchase orders, it is impossible to determine based on the documentation provided as to whether these purchase orders relate to any task or delivery order issued by the Contractor or otherwise relate to any purchases of material held taxable in the audit. For instance, the 'new issues' section of the audit only lists materials purchased by the Taxpayer from various vendors.

If the Taxpayer can document that the two hospital purchase orders represent the entire request made pursuant to the Contractor's task or delivery order and that the items ordered were included as purchases in the audit, then such items may be removed from the audit, provided the professional service option was not exercised in connection with the Contractor's order.

Manufacturing Exemption

With respect to the Taxpayer's claim that it is entitled to the industrial manufacturing exemption for custom components under the Subcontract, insufficient information and basis has been provided to justify such a claim. Further, the auditor was never allowed a site tour to observe the Taxpayer's operations to note whether such custom assembly process was entitled to the exemption.

Although Title 23 VAC 10-210-760 states that any person producing a high technology innovative product, including systems, for sale or resale is generally entitled to the industrial manufacturing exemption, the Taxpayer still must establish its qualifications for such exemption pursuant to Title 23 VAC 10-210-920. For a business to obtain the exemption, it must be manufacturing or processing products for sale or resale and secondly, such production must be industrial in nature. Pursuant to Va. Code § 58.1-602, industrial in nature "shall include, but not be limited to, those businesses classified in codes 10 through 14 and 20 through 39 published in the Standard Industrial Classification (SIC) Manual for 1972 and any supplements issued thereafter."

A review of the SIC Manual shows that establishments primarily engaged in providing expertise in the field of information technology through planning and designing computer systems that integrate computer hardware, software, and communication technologies are classified under SIC #7373. This SIC code cross-­references to Industry Group 54151 of the North American Industrial Classification System (NAICS), U.S. 2002. Under the NAICS Industry Group 54151, the NAICS treats the customized assembly of computers as a retail trade activity under the cross reference made to NAICS Industry Group 44312. Moreover, the Department previously ruled in P.D. 00-124 (7/6/00) that the customized assembly of computers for sale or resale does not constitute an industrial operation. Based on the non-manufacturing classification rendered by the NAICS and the Tax Commissioner's prior ruling, I must conclude that the Taxpayer's custom computer assembly activities should not be classified as "industrial in nature" for purposes of the industrial manufacturing exemption.

Sample Methodology

The Taxpayer claims the sample should be more representative of the actual activity levels. If the Taxpayer establishes the actual activity level of all purchases made by the Taxpayer during the audit in connection with the Subcontract, then the sample extrapolation may be revised so as not to exceed the actual liability incurred, provided the auditor is able to verify the extent of the actual liability amounts under the Subcontract.

Urban Enterprise Zone (UEZ)

The state sales tax exemption for UEZ refunds was enacted under Va. Code § 59.1-282. This statute was amended by the 1995 Virginia General Assembly (Acts 2005, c. 792) to include the following provision:
    • No business firm designated as a qualified business firm on or after July 1, 1995, shall be entitled to such exemption.

In effect, the amendment repealed the state sales tax exemption for companies that qualified for enterprise zone benefits on or after July 1, 1995. Companies that qualified for such benefits before July 1, 1995, could continue to claim the exemption only for the remaining portion of their five-year benefit as limited by the statute.

CONCLUSION


In accordance with the issues discussed in this letter, the assessment is correct. However, the assessment may be revised provided the auditor is able to verify that the resale exemption applies to certain contract purchases included in the audit. The purchase sample for the Subcontract items may be revised provided the Taxpayer is able to accurately establish the actual purchase liability of the Subcontract items. The auditor will contact the Taxpayer to arrange for the receipt of any further records needed to complete the final review of this matter. Such records must be made available to the Department within 60 days of the auditor's request for such records. If no additional records are offered within the time allotted, this letter will serve as the final determination in this matter.

Upon completion of the auditor's review or in the event that no additional records are offered, a revised and updated bill with interest accrued to date will be sent to the Taxpayer. The outstanding balance should be paid within 30 days of the revised bill date to avoid additional interest charges. The Taxpayer should remit its payment to: Virginia Department of Taxation, 3600 West Broad Street, Suite 160, Richmond, Virginia 23230, Attn: *****. If you have any questions concerning payment of the assessment, you may contact ***** at *****.

The Code of Virginia sections, regulations and public documents cited 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/1-976857233.R


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46