13-11 | Virginia Tax

Tax Type

Retail Sales and Use Tax

Description

Assessment, erroneously includes exempt production and R & D activities.

Topic

Appropriateness of Audit Methodology

Records/Returns/Payments

Date Issued

01-31-2013

January 31, 2013

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

Dear *****:

This reply is in response to your letter submitted on behalf of ***** (the "Taxpayer"), in which you request correction of the retail sales and use tax assessment issued for the period July 2005 through August 2008. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayer designs, develops and manufactures electronic measuring devices that monitor power quality and electrical usage. These handheld devices are primarily used by electric companies to gather customer usage for billing purposes and to monitor the quality of power being transmitted to its customers.

An audit by the Department resulted in the assessment of tax, penalty and interest. The Taxpayer appeals the assessment, contending it erroneously includes purchases used in exempt manufacturing and industrial production and exempt research and development activities. Additionally, the Taxpayer argues that the assessment also includes items that were: (1) drop shipped to out of state locations; (2) correctly taxed at the time of purchase; or (3) erroneously included in the calculation of taxable amounts.

The Taxpayer also protests the sample size and period used to review expense purchases, maintaining it is unrepresentative of its purchasing activity during the audit period. Finally, the Taxpayer states the use of sales to extrapolate expense purchases is faulty because the Taxpayer's sales activity does not vary directly with purchases made during the audit period.

DETERMINATION

Manufacturing and Industrial Processing

Virginia Code § 58.1-609.3 2 (i) provides that industrial materials, machinery, tools or repair parts used directly in the manufacturing process or which become a component part of the manufactured product are exempt of the tax.

Title 23 of the Virginia Administrative Code (VAC) 10-210-920 B 2 states that "used directly" refers to activities that are essential and integral parts of production including all steps of the integrated manufacturing process. The regulation provides that the integrated manufacturing process starts with the handling and storage of raw materials and continues through the last step of production where the completed product is conveyed to a warehouse at the same plant site. Integrated manufacturing also includes production line testing and quality control.

Title 23 VAC 10-210-920 D provides that when a single item is used in both industrial processing and a taxable activity, the sales and use tax shall apply when the preponderance of the item's use (fifty percent or more) is in the taxable activity. Alternatively, the same item is exempt of the tax if the preponderance of its use is in exempt production.

In its appeal, the Taxpayer argues that several purchases qualify for the manufacturing exemption because they are an integral part of production. The Virginia courts have consistently required strict construction of exemptions, i.e., where there is any doubt as to the application of an exemption, the doubt is resolved against the one claiming the exemption. Keeping the cited authorities in mind, I will address each contested purchase below.

Production Drying and Exhaust System

The Taxpayer contends that the exhaust system is used in the production of meter socket recorders by providing a moving air exhaust system. The auditor states the machine is used to reduce odors emitted by the recorder during the manufacturing process. Additionally, the purchase invoice provided during the appeal describes the item as a "ductless exhaust purification hood." Further product description states that the hood safely removes a wide array of fumes to allow safe indoor release of exhaust.

Although the hood may be essential to the production process, it is not used directly in the manufacturing process and not part of actual production. The hood reduces fumes in the manufacturing plant but it does not directly affect the product or the industrial process. Based on the foregoing, I find this item was correctly assessed.

Electronic Work Benches

The Taxpayer uses these benches in both production and engineering when building or designing products. The benches ground the electrical current and provide a non-conductive work surface, thereby avoiding shorting electrical currents.

It appears that the benches may be essential to the manufacturing process and product design or development. However, it is not clear as to their use in the Taxpayer's facility. Therefore, I am unable to determine the preponderance of their use and thus the proper application of the tax. Accordingly, I recommend an on-site visitation to the Taxpayer's facility to assist in the determination. The visit will allow the Department to better understand the Taxpayer's manufacturing process and assist in determining if the purchases qualify for exemption.

Circuit Board Assembly Cart and Trays

The Taxpayer's measuring devices include one or more electronic circuit board assemblies. The Taxpayer uses anti-static carts and trays to hold these electronic circuit board assemblies while in production. The boards must be held in anti-static trays during production, as static will cause the circuit boards to malfunction and render the Taxpayer's measuring devices faulty. Although the carts, may be used in production, I am unable to determine if they are also used in other non-taxable activities. Accordingly, I recommend an on-site visitation to determine the preponderance of use of these items.

CD Duplicator

This duplicator is used in production to burn and print the Taxpayer's software CDs and business cards. The Taxpayer estimates the duplicator is used roughly 50% of the time for CD production and 50% for business card production.

In accordance with Title 23 VAC 10-210-920 C 1, tangible personal property used in the administrative capacity of a taxpayer's business is subject to the tax. Administration includes management, selling, marketing and nonoperational aspects of manufacturing.

Based on the Taxpayer statements, the duplicator is used equally in an exempt and taxable activity. Therefore, as there appears to be no predominant exempt activity, based on the strict construction doctrine of sales and use tax exemptions, I find that this item was correctly assessed and there is no basis to remove it from the audit.

Printer

The printer is used by the Taxpayer to print reports that are packaged with the final products. The reports assure the customer that its specifications have been met. The printer is not an integral part of the manufacturing process. Accordingly, I find this item does not qualify as exempt and was correctly assessed in the audit.

Computer Disk

The Taxpayer uses this disk to write software that allows tree customer to program its CD. Based on the information presented, I am unable to determine how the CD is used in the manufacturing process or the final product. Therefore, I recommend an on-site visitation to the Taxpayer's facility to determine the CD's use and qualification for the exemption.

Research and Development

Virginia Code § 58.1-609.3 provides that the tax shall not apply to "[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 VAC 10-210-3070 defines research and development as a:

- systematic study or search directed toward new knowledge or new understanding of a particular scientific or technical subject and gradual transformation of this new knowledge or new understanding into a usable product or process. Research development must have as its ultimate goal: (i) the development of new products; (ii) the improvement of existing products; or (iii) the development of new uses for existing products.

Title 23 VAC 10-210-3071 provides that the exemption for tangible personal property used in research and development is limited to direct and exclusive use. An item used in both exempt research and nonexempt activities fails the "exclusively" requirement and does not qualify for the exemption. Title 23 VAC 10-210-3072 lists examples of taxable and exempt items used in research activities.

The Taxpayer argues that the assessed purchases are used in research and development and thereby qualify for the exemption. However, based on the foregoing authorities, to qualify for the exemption, the item must be used directly and exclusively in basic research or research and development in the experimental or laboratory sense. I will address each purchase category separately.

3D Printer and Supplies

The Taxpayer states the 3D printer is used to create 3D prototypes from engineering CAD drawings. These prototypes are solid mechanical pieces used for engineering testing and design evaluation.

Equipment and supplies used to produce items that are used directly in research activities are subject to the tax as provided by Title 23 VAC 10-210-3072. Accordingly, as the printer is used to produce the prototypes used in research and development, neither it, nor its supplies qualify for the exemption. I find these items were correctly assessed and there is no basis for removal from the audit.

Printed Circuit Boards

The Taxpayer orders custom circuit board prototypes that it uses to create circuit board designs. Electronic parts are attached to the boards and the design is tested and evaluated for product development. The Taxpayer states the boards are used directly and exclusively in research and development. However I am unable to determine if they are a component part of the actual measuring devices sold by the Taxpayer. Although the boards may not qualify for the research and development exemption, if a component part of the final product, the items may qualify for the manufacturing exemption in accordance with Title 23 VAC 10-210-920 A 1. Therefore, I recommend an on-site visitation of the Taxpayer's facility to determine if the assessed circuit boards qualify for either the research and development or manufacturing exemptions.

Specialized Computers

The Taxpayer uses specialized or "ruggedized" computers, designed specifically for outdoor use, to test its software for compatibility. These computers are also evaluated for resale.

Based on the foregoing authorities, these items do not qualify for the research and development exemption. The Taxpayer is not using these computers exclusively for the development of a new product or product knowledge. The Taxpayer's software is being tested for compatibility with the computer and the computers are being evaluated for possible resale. As neither activity qualifies as research and development, I find these items were properly assessed and there is no basis to remove them from the audit.

Revolution Prototype Housing

Prototype plastic enclosures are created for the Taxpayer by outside vendors. The Taxpayer states the prototypes are used by the Taxpayer to test the enclosure design during product development. Based on the information provided, I am unable to determine if they are used exclusively and directly in research and development. Therefore, I recommend an on-site visitation of the Taxpayer's facility to determine the enclosures' use.

Development Kits

Development kits are electronic kits designed to demonstrate or facilitate the development of a product using a particular product or device. The Taxpayer uses these kits to test the circuitry or design of outside providers to determine if the products are suitable for its use. Based on the information provided, I am unable to determine if these products are used exclusively and directly in research and development. Therefore, I recommend an on-site visitation of the Taxpayer's facility to determine the development kits' use.

Mantis Vision System

The Taxpayer states that it uses these specialized magnification lenses to examine solder joints and circuit boards during product development. However, these lenses may also be used in production or pre-production activities. Because the lenses are not used exclusively in research and development, they do not qualify for the exemption based on the foregoing authorities. However, as previously discussed, Title 23 VAC 10-210-920 provides that machinery, tools and supplies used directly in the manufacturing process are exempt of the tax. I recommend an on-site visitation of the Taxpayer's facility to determine the lenses' preponderance of use as it related to the manufacturing exemption.

Belew

The Taxpayer tests this handheld computer device to determine its compatibility with the software the Taxpayer uses in its handheld devices. Based on the foregoing authorities, this item does not qualify for the research and development exemption. The computer is merely being tested for the possibility of resale. Therefore, I find the purchase was correctly assessed and there is no basis for its, removal from the audit.

Field PC Development

The Taxpayer tests this handheld computer device to determine its compatibility with the software the Taxpayer uses in its handheld devices. Although the Taxpayer states this product is used in product development, I cannot agree. The product is being evaluated for resale and although there is tooling or modification involved, I do not agree that the product qualifies for the research and development exemption. Therefore, I find the item was correctly assessed and there is no basis for removal from the audit.

Network Equipment

This equipment is used by the Taxpayer to design the networking interface used in network products. Based on the information presented, I am unable to determine if this equipment is used directly and exclusively in research and development. Accordingly, I recommend an on-site visitation of the Taxpayer's facility to determine the network equipment's use.

Emulators

These prototypes are used by the Taxpayer for design testing in new product development. Based on the foregoing authorities, these purchases may qualify for the research and development. I recommend an on-site visitation of the Taxpayer's facility to determine the emulators' use.

1205 Sweet

This handheld device is used by the Taxpayer to record powerline noise to assist in research and development. Based on the information presented, I am unable to determine if this equipment is used directly and exclusively in research and development. Accordingly, I recommend an on-site inspection of the Taxpayer's facility to determine the device's use.

Battery Pack

Although the Taxpayer states this part is used in the research and development of the stray voltage monitor, no support for this assertion has been presented. As such, I find there is no basis to remove this purchase from the audit.

Innovative High Technology Industry

Title 23 VAC 10-210-765 provides "[t]hat the production of computer software in tangible form for sale or resale generally constitutes industrial manufacturing. Therefore, the industrial manufacturing exemptions set forth in Title 23 VAC 10-210-920 are generally applicable to such production." The regulation continues and states:

- 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.

Title 23 VAC 10-210-760 states that the exemption for research and development activities in the experimental or laboratory sense that have as their ultimate goal the advancement of technology, the development of new products or processes, or the improvement of existing products or processes is generally entitled to the research exemption set forth in Title 23 VAC 10-210-3070 through Title 23 VAC 10-210-3074.

Software Development Tools

The Taxpayer uses microprocessors to operate the software embedded in its measuring devices. The Taxpayer states that the software development tools are compilers. The compilers are used by the Taxpayer to convert the computer programming code written by its engineers into the machine language required by the microprocessor to execute the embedded software. Based on the information provided by the Taxpayer, the tools may qualify for the manufacturing exemption. However, I am unable to determine their exact use. Accordingly, I recommend an on-site visitation of the Taxpayer's facility to determine the tools' use.

Server

The Taxpayer states that its engineers use this server to host software development. The server may qualify for the research and development exemption. However, I am unable to determine such based on the information presented. Accordingly, I recommend an on-site visitation of the Taxpayer's facility to determine the server's use.

Engineering Software

The Taxpayer states that it uses this software for web software development. However, I am unable to determine if this item qualifies for the research and development exemption based on the information presented. Accordingly, I recommend an on-site visitation of the Taxpayer's facility to determine the software's use.

Recordkeeping

Virginia Code § 58.1-633 provides that every dealer required to file a sales and use tax return or collect tax must keep and preserve suitable records of the sales, leases, or purchases, as the case may be, subject to the tax.

The Taxpayer provides both a faxed statement and an itemization of the charges and tax paid on its purchase of a plasma television. Each document exhibits a different amount of sales tax charged with the purchase. Although the itemized charges are presented on the letterhead of the vendor, there is no invoice number, sale date or customer information included. The Taxpayer states that it is unable to provide a sales invoice for the purchase.

Based on the foregoing, the Taxpayer has failed to properly substantiate its payment of the correct sales tax on its purchase of the television. Accordingly, I find the Taxpayer was correctly assessed in the audit for this item and there is no basis for its removal from the assessment.

Application of Use Tax

Virginia Code § 58.1-602 defines a "sale" to mean "any transfer of title or possession, or both, exchange, barter, lease or rental, conditional or otherwise, in any manner or by any means whatsoever, of tangible personal property." The same statute defines "use" to mean, "the exercise of any right or power over tangible personal property incident to the ownership thereof, except it does not include the sale at retail of that property in the regular course of business."

Virginia Code § 58.1-603 imposes sales tax on persons who engage "[i]n the business of selling at retail or distributing tangible personal property in this Commonwealth ...who stores for use or consumption in this Commonwealth ...or who leases or rents such property within this Commonwealth."

Virginia Code § 58.1-604 imposes use tax on "[t]he use or consumption of tangible personal property outside the Commonwealth for use or consumption in this Commonwealth..."

Title 23" VAC 10-210-780 provides that the tax generally does not apply to sales of tangible personal property in interstate or foreign commerce. A sale in interstate or foreign commerce occurs only when title or possession to the property being sold passes to the purchaser outside of Virginia and no use of the property is made within Virginia. In determining the application of the Virginia sales and use tax, one key factor is where the transfer of title or the transfer of possession, actual or constructive, occurs. The Taxpayer protests several assessed purchases it argues were delivered or used outside Virginia. I will address each purchase individually.

Pop Exhibits

The Taxpayer purchased a two-story exhibit for tradeshow use. Based on the purchase invoice presented by the Taxpayer, the exhibit was shipped to another state by the Taxpayer's vendor where it was initially stored and used for the first eight months of the Taxpayer's possession.

In Public Document 96-84 (5/9/96), the taxpayer purchased videos that were delivered outside of Virginia. The taxpayer used the videos for convention presentations and subsequently brought the items to Virginia. The Tax Commissioner determined that the videos were subject to the tax because they were stored in Virginia within the first six months of purchase.

In the Taxpayer's case, the exchange of title and possession occurred outside Virginia and the exhibit was not shipped into Virginia during the first eight months of possession. Therefore, based on the foregoing authorities, I will agree to remove this item from the audit. Accordingly, Line 107 on the Asset Exception List will be deleted.

Ties

Based on a purchase invoice presented by the Taxpayer, it purchased ties that were shipped to another state. The title and possession of the items passed outside Virginia. Accordingly, Lines 107 and 108 on the Purchases Exception List will be removed.

Trade Show Booth Repairs

The Taxpayer purchased items that were used to repair its trade show booth. Although the Taxpayer contends the repairs were made to the booth outside Virginia, it presents no documentation to support its argument. Therefore, this amount was properly assessed in the audit and there is no basis to remove it.

Miscellaneous

Software Maintenance

'The Taxpayer purchased a software maintenance contract that it asserts only includes labor. However, the purchase invoice states the Taxpayer is buying a "Service Contract Including Parts."

Pursuant to Title 23 VAC 10-210-910 B 3, maintenance contracts that combine software upgrades in the form of tangible personal property with services are subject to the tax computed on 50% of the charge for the contract. Accordingly, I will agree to remove 50% of the assessed amount from Line 283 of the Purchases Exception List.

Business Cards

In accordance with Title 23 VAC 10-210-3010, administrative supplies, including business cards, are subject to the tax when sold at retail. Accordingly, I find this item was properly assessed in the audit.

Wallet Calendars

Virginia Code § 58.1-609.6 4 provides an exemption for printed material, when stored in Virginia for 12 months or less and distributed out-of-state. Additionally, Title 23 VAC 10-210-3010 H states that calendars qualify as exempt printed material. Although the Taxpayer's wallet calendars appear to qualify as exempt printed material, the Taxpayer is unable to determine the amount of calendars distributed outside of Virginia within one year. Accordingly, I find the purchase of these items was properly assessed in the audit.

Removed or Reduced Items

The following items will also be removed or reduced in the audit.

***** - Title 23 VAC 10-210-4040 provides that professional services that include sales as an inconsequential element are exempt of the tax. Based on the information provided, Line 86 of the Asset Exception List will be removed.

***** - This is an audio sales conference that is exempt of the tax pursuant to Title 23 VAC 10-210-4040. Accordingly, Line 265 of the Purchase Exceptions List will be removed.

***** - This item should have been deleted from the workpapers as it was marked as excluded by the auditor. Accordingly, Line 21 of the Asset Exception Listing will be removed.

***** - These items should have been removed from the workpapers as it was marked as excluded by the auditor. Line 75 and Line 76 of the Asset Exceptions List will be removed.

***** - This portable tool should have been deleted from the workpapers as it was marked as excluded by the auditor. Accordingly, Line 88 of the Asset Exceptions List will be removed.

***** - This purchase of artwork, should have been deleted from the workpapers as it was marked as excluded by the auditor. Line 120 and Line 121 of the Asset Exception List will be removed.

***** - The cost of this item was listed incorrectly. The audit will be revised to reduce the assessed amount on Line 216 of the Purchases Exception List by $100 to reflect the correct purchase amount.

***** - The Taxpayer presents a Paypal receipt to substantiate its protest of the assessment of this item. As I am unable to determine the nature of the purchase, it will remain in the audit.

Sampling

Although the Taxpayer initially agreed to the three-month sample period during the audit, it now protests the period as statistically insignificant when compared to the 37 month audit period. The Taxpayer argues the sampling methodology does not reflect the seasonality of its purchases, large variances in its monthly sales or nonrecurring purchases such as those made for machinery and equipment.

Sampling is an audit technique of significant value that is widely used in the public and private sectors. The Department uses sampling in all types of sales and use tax audits where a detailed audit would not prove beneficial to either the auditor or the taxpayer. When sampling techniques are properly applied, the final result should be within a narrow percentage range of the actual amount that would be determined by a detailed audit.

The Taxpayer's argument that the sample period is insignificant in comparison to the audit period is not persuasive. The Department has a long-standing policy of using a three to six month sample period to test a taxpayer's sales and purchase activities. Additionally, the Taxpayer's business description does not lend itself to seasonal fluctuations in sales as the Taxpayer sells products that are used throughout the year. the year. Finally, machinery and equipment purchases are not included in the sample, as these are assets and not included in the sample of expenses used to calculate the error factor. Accordingly, I find the sampling methodology used in the audit is proper.

Sales were used in the extrapolation of the error factor because the Taxpayer failed to provide the purchase information requested during the audit. However, based on additional information provided during the appeal, I will agree to recalculate the extrapolation using the Taxpayer's purchase records.

CONCLUSION

The audit will be returned to the audit staff to make the revisions set forth in this determination. In addition, the audit staff will contact the Taxpayer within 30 days of the date of this letter to schedule a mutually convenient time to allow the audit staff to inspect the Taxpayer's facility. Based on the results of the inspection and the purchasing information provided, the audit staff will make the appropriate revisions, if warranted. After the revisions have been completed, the Taxpayer will receive the revised audit report and a bill with updated interest.

The Code of Virginia sections and regulations cited are available on-line at www.tax.virginia.gov in the Laws, Rules and Decisions section of the Department's website. If you have any questions about this determination, you may contact ***** in the Office of Tax Policy, Appeals and Rulings at *****.

- - - - Sincerely,

- - - - Craig M. Burns
        Tax Commissioner

AR/1-4571026180.M

Rulings of the Tax Commissioner