August 29, 2016
Re: § 58.1-1821 Application: Retail Sales and Use Tax
Dear *****:
This is in response to your letter submitted on behalf of ***** (the “Taxpayer”), in which you seek correction of the retail sales and use tax assessment issued for the period January 2012 through February 2014. I apologize for the delay in responding to your appeal. The assessments at issue have been paid in full.
FACTS
The Taxpayer is in the business of manufacturing and selling meters that control or monitor the flow of gases and liquids. In accordance with Va. Code § 58.1-609.3 2, the Taxpayer is entitled to the manufacturing exemption regarding its purchases of tangible personal property used directly in the production process. During the audit period, the Taxpayer purchased fencing materials to repair damage to a fence at its facility caused by a tornado. Because the auditor viewed these expense purchases as related to the Taxpayer's normal facility maintenance, the purchases were included in the audit purchase sample for purposes of the error factor computation and the extrapolation calculation in accordance with Public Document (P.D.) 01-28 (3/28/01) and P.D. 02-103 (6/24/02).
The Taxpayer disagrees with the inclusion of the purchases in audit sample because the purchases were made for a one-time occurrence. To support its position, the Taxpayer contends that due to the circumstances (the tornado), the expenses were covered by its insurance carrier and are not considered part of its normal activity or operations. The Taxpayer maintains the expenses should be removed from the purchases sample and taxed on a detailed basis.
In addition, the auditor assessed the tax on purchases of equipment used in the development of a lower pressure reading gauge related to a research and development project in the Taxpayer's engineering department. The auditor concluded that the purchases did not meet the requirements of the research and development exemption. Instead, the auditor determined that the purchases were related to repair activities. The Taxpayer contends that the purchases are not related to repair activities and should be considered research and development expenses exempt of the tax in accordance with the research and development exemption provided in Va. Code § 58.1-609.3 5.
DETERMINATION
Purchases for Fencing
Sampling is an audit technique of significant value that is widely used in both the public and private sectors for all types of audits where a detailed audit would not prove beneficial either to the auditor or the client. When sampling techniques are properly applied, the final results are usually within a narrow percentage range of the actual amount that would have been determined by a detailed audit. For an item to be removed from the audit sample, the taxpayer must show that the transaction was isolated in nature and not a normal part of the taxpayer's operation.
The Tax Commissioner has addressed the issue of transactions that are isolated in nature and not a normal part of the taxpayer's operation in a number or prior determinations.
Regarding the two public documents cited by in support of the auditor's position, P.D. 01-28 addresses a government contractor. The taxpayer contested the inclusion of software purchases in the sample, stating that the value of one of the purchases in the sample was extremely high in relation to the other purchases. The Tax Commissioner denied the taxpayer's request to remove the transaction from the sample because while infrequent, purchases of software appeared to be an integral part of the taxpayer's provision of its services. P.D. 02-103 addresses a furniture manufacturer. The taxpayer contested the inclusion of the purchase of promotional pens in the sample as a recurring expense and in the extrapolation calculation. The Tax Commissioner determined that while the taxpayer may not have normally engaged in this type of specific advertising purchase, it was likely that the taxpayer made other advertising purchases. The Tax Commissioner further held that because the taxpayer had an advertising budget, the purchase of advertising items was an integral and normal part of the taxpayer's business activity.
After reviewing the cited public documents and the facts in the Taxpayer's case, I agree that the public documents are not applicable. The Taxpayer made purchases during the audit period to repair/replace fencing that had been damaged by a tornado. While the Taxpayer would certainly make repairs to its facilities, the Taxpayer is not in the business of facility maintenance. Therefore, I find that making fencing repairs is not a normal part of the Taxpayer's business operations, the manufacturing and selling of meters. The purchases at issue differ from those made in the aforementioned public documents because they are not integral to or related to the Taxpayer's normal business operations. A tornado is an unusual event and the purchases were made for the specific purpose of repairing fence damage resulting from a tornado, a one-time occurrence during the audit period. As such, I find that the purchases should not have been included in the audit sample.
It seems that the auditor also included these purchases in the sample based on the fact that the Taxpayer did not capitalize and depreciate the purchases. The cited public documents, as well as similar prior documents, do not set forth a requirement that a taxpayer must capitalize property and treat such property as depreciated assets in order for the property to be removed from the sample and audited on a detailed basis.
The audit will be returned to the appropriate field audit staff, the purchases related to the fence repairs will be removed from the sample and the tax will be separately applied to the purchases in the audit. The Taxpayer will receive a refund plus refund interest accrued to date in regard to these purchases.
Research and Development
Virginia Code § 58.1-609.3 5 states that the retail sales and use tax does 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 of the Virginia Administrative Code (VAC) 10-210-3070 A 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 the gradual transformation of this new knowledge or new understanding into a usable product or process. Research and 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. Research and development does not include the modification of a product merely to meet customer specifications 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. [Emphasis added.]
Title 23 VAC 10-210-3070 B states that “The tax does not apply to tangible personal property purchased or leased and used directly and exclusively in the experimental or laboratory sense.”
Based on additional information provided by the Taxpayer, it is my understanding that the project at issue, *****, is a part of the Taxpayer's product development roadmap. The product development roadmap is used by the Taxpayer to develop new products based on market needs. In this instance, based upon a change in the law regarding cryogenic tanks in *****, the Taxpayer determined that a new product was needed to provide low pressure reading gauges for cryogenic tanks for its customers in *****. The Taxpayer further provides that a new product was developed, and the new product is being sold to its ***** customers that require the low pressure reading gauges for cryogenic tanks.
In accordance with the Title 23 VAC 10-210-3070 A definition of “research and development,” the project at issue qualifies as research and development because the ultimate goal was the development of a new product. In order for the research and development exemption to apply to the purchases of tangible personal property at issue, the property must be used or consumed “directly and exclusively in basic research or research and development in the experimental or laboratory sense” in accordance with Va. Code § 58.1-609.3 5 and Title 23 VAC 10-210-3070 B.
Accordingly, the Taxpayer will need to provide documentation or other information demonstrating that the equipment at issue was used directly and exclusively in the research and development project at issue. The Taxpayer will be contacted by the appropriate field audit staff to determine the type of information needed and to establish the manner in which the information will be provided. The information must be provided to the audit staff within 45 days from the date of the contact by the audit staff. The information will then be reviewed to determine if the criteria of the cited authorities are met, and adjustments will be made to the audit as warranted. If adjustments are warranted, the Taxpayer will receive a refund, plus refund interest accrued to date for these purchases.
The Code of Virginia sections, regulation and public documents cited 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 about this determination, you may contact ***** in the Office of Tax Policy, Appeals and Rulings, at *****.
Sincerely,
Craig M. Burns
Tax Commissioner
AR/1-6050006070.P