Tax Type
Retail Sales and Use Tax
Description
Taxation of software sales to manufacturing businesses/Cloud computing.
Topic
Manufacturing Exemption
Date Issued
03-20-2014
March 20, 2014
Re: Request for Ruling: Retail Sales and Use Tax
Dear *****:
This will reply to your request for a ruling regarding the application of the manufacturing exemption to software sales made by ***** (the "Taxpayer"). I apologize for the delay in responding to your request.
FACTS
The Taxpayer sells computer software to various types of businesses, including customers in manufacturing industries. Some of the Taxpayer's manufacturing customers have claimed the manufacturing exemption on purchases of software. The Taxpayer seeks the Department's position regarding the taxation of software sales to manufacturing businesses. The Taxpayer also inquires as to whether the Department has issued any policy documents or information with respect to "cloud computing."
RULING
Manufacturing Exemption
There is no general exemption from the sales and use tax for all purchases made by manufacturing businesses. Virginia Code § 58.1-609.3 2 iii provides an exemption from the sales and use tax for "machinery or tools or repair parts therefor or replacements thereof, fuel, power, energy, or supplies, used directly in processing, manufacturing, refining, mining or converting products for sale or resale ...." In order to qualify for the manufacturing exemption, the machinery, equipment or supplies must be used directly in the production process. Title 23 of the Virginia Administrative Code (VAC) 10-210-920 B interprets the term "used directly" to mean that the machinery, equipment or other property must be indispensable to the actual production process and must be used as an immediate part of the production process.
Title 23 VAC 10-210-920 C 2 lists examples of taxable and exempt production items and provides that computer hardware and software used to direct or control production line and/or quality control operations is exempt. This is in contrast with computer hardware and software used to monitor production operations, e.g., computers used to produce production reports, make production information available to plant personnel, monitor the efficiency of production machinery, etc. These activities are deemed to be administrative in nature and are taxable. The Taxpayer may wish to refer to Public Document (P.D.) 07-173 (11/14/07) and P.D. 12-118 (7/23/12) for more information regarding the application of the sales and use tax to computer software used by manufacturers and industrial processors.
Manufacturing - Preponderance of Use
When a manufacturing or industrial processing business uses an item in both taxable and exempt production activities, the Department relies on a preponderance of use test to determine whether that item qualifies for the manufacturing exemption. Title 23 VAC 10-210-920 D addresses the preponderance of use rule and states that:
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- When a single item of tangible personal property is put to use in two different activities, one of which is an immediate part of the industrial production process (exempt) and the other of which is not (taxable), the sales and use tax shall apply in full when the preponderance of the item's use (fifty percent or more) is in non-exempt activities. Likewise, the item will be totally exempt from tax if the preponderance of its use is in exempt production activities.
Based on the preponderance of use rule, if the Taxpayer's software is written for use by a customer for primarily administrative or other nonmanufacturing functions, the sale of the software in tangible form is taxable. However, software written for use in various functions of a manufacturing business, some of which satisfy the direct use requirement for the manufacturing or industrial processing exemption, may qualify for the exemption if the preponderance of use of the software is in the exempt manufacturing activities. In such cases, the manufacturer or processor that purchases the software should furnish the Taxpayer a valid Form ST-11, which is the Department's manufacturing exemption certificate used by manufacturers to claim the exemption. The box for the manufacturing exemption should be checked on the Form ST-11 and the remainder of the form filled out completely. The use of exemption certificates is discussed in more detail later in this response.
Software Exemptions
Virginia Code §§ 58.1-609.5 6 and 58.1-609.5 7 provide separate exemptions from the sales and use tax for modifications to prewritten software and for custom software, respectively. The exemptions for software modifications and for custom software would apply to sales made by the Taxpayer regardless of whether the customer qualifies for the manufacturing exemption on the purchase. The Taxpayer's records must indicate that one of the exemptions is applicable to each exempt sales transaction.
Virginia Code § 58.1-609.5 6 exempts from the sales and use tax "[a]n amount separately charged for labor or services rendered in connection with the modification of prewritten programs as defined in § 58.1-602." 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." Absent another exemption, prewritten software programs are generally taxable when sold in tangible form. Only charges for modifications made to prewritten software programs qualify for exemption under Va. Code § 58.1-609.5 6.
Virginia Code § 58.1-609.5 7 provides an exemption from the tax for “[c]ustom programs as defined in § 58.1-602." 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."
If the Taxpayer specifically designs and develops a software program for one customer based on the software needs of that customer, then the programming constitutes a custom program and the exemption applies. Likewise, if the Taxpayer performs programming services that constitute modifications to an existing software application and the programming is customized for the customer, the charges for the modifications only qualify for exemption if separately stated on the customer's invoice. The Taxpayer should note that the software exemptions discussed above apply to sales made to any customer. The Taxpayer must maintain adequate documentation in its records that supports exempt sales made under either exemption.
Electronic Transfer of Software
Virginia Code § 58.1-609.5 1 provides an exemption from the retail sales and use
tax for:
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- Professional, insurance, or personal service transactions which involve sales as inconsequential elements for which no separate charges are made and services not involving an exchange of tangible personal property which provide access to or use of the international network of computer systems commonly known as the Internet and any other related electronic communication service, including software, data, content and other information services delivered electronically via the Internet.
Based on this statutory exemption, transactions for the access of data online or for information sent via the Internet are nontaxable service transactions. The exemption applies to sales of software, whether custom or prewritten, when the software is transferred electronically to the customer. P.D. 05-44 (4/04/05) and P.D. 09-83 (5/28/09) discuss the application of the tax to transactions involving the electronic transfer of software. These documents address the minimum documentation requirements that must be met to prove that electronically delivered software products qualify for exemption. These documents also note that transactions in which a software product is delivered electronically but is also furnished in tangible form are taxable, absent another exemption.
Exemption Certificates
Title 23 VAC 10-210-280 A states that lain sales, leases and rentals of tangible personal property are subject to the tax until the contrary is established. The burden of proving that the tax does not apply rests with the dealer unless he takes, in good faith from the purchaser or lessee, a certificate of exemption indicating that the property is exempt under the law." Title 23 VAC 10-210-280 B then states that "[r]easonable care and judgment must be exercised by all concerned to prevent the giving or receiving of false, fraudulent or bad faith exemption certificates. An exemption certificate cannot be used to make a tax free purchase of any item of tangible personal property not covered by the exact wording of the certificate."
The Department has issued P.D. 98-29 (2/20/98), which sets out the Department's policy that the absence of an exemption certificate at the time of a sales transaction indicates that the certificate was not accepted in good faith. Thus, exemption certificates received by the seller after the start of an audit are subject to greater scrutiny because they were not taken in good faith prior to or at the time of the sale. Such certificates are acceptable only if the Department can verify that the customer's use of the certificate was valid and proper for the specific transaction identified in the audit.
To support the manufacturing exemption for software sales transferred to customers via a tangible medium, the Taxpayer should obtain a valid manufacturing exemption certificate, Form ST-11, from the customer. The exemption certificate should be completed in full and must be valid on its face. In cases where the type of software sold by the Taxpayer can only be used in taxable manufacturing activities, i.e., the software is written for administrative functions or other nonmanufacturing functions only, a Form ST-11 issued by a customer is not valid on its face and should not be accepted.
Cloud Computing Services
The Taxpayer has inquired about the Department's position regarding the sales and use taxation of cloud computing services. Generally, cloud computing services are treated in the same manner as the electronic transfer of software products. There is typically no transfer or provision to customers of cloud computing services via a tangible medium. For this reason, transactions for cloud computing services are an exempt service and are not subject to the retail sales and use tax. The Department has issued two public documents that address cloud computing services, P.D. 12-191 (11/29/12) and P.D. 13-182 (10/18/13).
This response is based on the facts provided as summarized above. Any change in the facts or the introduction of new facts may lead to a different result. 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 Laws, Rules and Decisions section of the Department's web site. If you have any questions concerning this response, please contact ***** in the Department's Office of Tax Policy, Appeals and Rulings, at *****.
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- Sincerely,
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Craig M. Burns
Tax Commissioner
AR/1-5202244415.S
Rulings of the Tax Commissioner