March 20, 2018
Re: Appeal of Final Local Determination
Taxpayer: *****
Locality Assessing Tax: *****
Business, Professional and Occupational License (BPOL) tax
Dear *****:
This final state determination is issued upon the application for correction filed by you on behalf of ***** (the “Taxpayer”), with the Department of Taxation. You appeal the denial of refunds of Business, Professional and Occupational License (BPOL) tax paid to the ***** (the “County”) for the 2011 through 2014 tax years.
The BPOL tax is imposed and administered by local officials. Virginia Code § 58.1-3703.1 authorizes the Department to issue determinations on taxpayer appeals of BPOL tax assessments. On appeal, a BPOL tax assessment is deemed prima facie correct, i.e., the local assessment will stand unless the taxpayer proves that it is incorrect.
The following determination is based on the facts presented to the Department summarized below. The Code of Virginia sections, regulations 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.
FACTS
The Taxpayer, originally classified as a business service provider, sought to be classified as a wholesale business. The County conducted an audit and concluded that the Taxpayer failed to substantiate the amount of refunds claimed. The Taxpayer appealed to the County, asserting that it sold data storage equipment to commercial and governmental entities. The equipment came installed with a proprietary operating system, which was licensed for the customers' use. The Taxpayer also licensed additional software to customers and sold certain related services, such as installation, training, consulting and support. The Taxpayer's office in the County focused mainly on sales and support for that region.
In its final determination, the County held that the Taxpayer's primary business was developing software and, therefore, it should remain classified as a business service provider. The Taxpayer appealed to the Department, contending that it was a wholesaler during the tax years at issue, and the refunds were the result of the recalculation of its BPOL tax liability based on such classification.
ANALYSIS
Classification
The BPOL tax is imposed on businesses and professionals for the privilege of doing business in a locality. The tax is imposed at different rates according to the classification of an enterprise. See Virginia Code § 58.1-3706 A. These classifications are regulated under Title 23 of the Virginia Administrative Code (VAC) 10-500-10 et seq. Classification of a specific business must be determined based on consideration of all the facts and circumstances. Some of the factors to be considered include:
- What is the nature of the enterprise's business?
- How does the enterprise generate gross receipts?
- Where does the enterprise conduct its business?
- Who are the enterprise's customers?
- How does the enterprise hold itself out to the public?
- What is the enterprise's North American Industry Classification System (NAICS) code?
Title 23 VAC 10-500-350 C provides that businesses that sell goods to government, institutional, business or industrial entities for their consumption, use or incorporation in an assembly, manufacturing or processing operation are typically subject to the BPOL tax on wholesalers. The use of “or” in this regulation means that consumption and use are separate from “incorporation in an assembly, manufacturing or processing operation.” Typically, if the products are not being incorporated into an assembly, manufacturing or processing operation, they would be used or consumed by such entities for business needs as supplies or equipment. In contrast with retail sales which are typically made to individual consumers to satisfy their own wants or needs, wholesale sales involve sales of goods to be used for such business purposes. See Roland Electrical Co. v. Walling, 326 U.S. 657, 674, 66 S.Ct. 413, 421 (1946). In addition, selling products in quantity at a discount or contracting with a purchaser prior to making a sale are consistent with wholesale sales. See Public Document (P.D.) 0259 (4/19/2002).
The Taxpayer's customers were government, institutional, business or industrial entities with whom the Taxpayer had contracts. Therefore, to the extent the Taxpayer was selling goods to such customers, it was conducting wholesale trade for purposes of the BPOL tax. The Taxpayer contends that it was a wholesaler because it primarily sold hardware, and any included software and services were ancillary to such sales. The County, however, contends that the Taxpayer was not primarily selling goods at wholesale, rather it was selling software and services to such an extent that it should have been classified as a business service provider.
Under Title 23 VAC 10-500-500, “computer and systems development services” are classified as “business services” and may be subject to the BPOL tax as set forth in Virginia Code § 58.1-3706 A 4. Also, see P.D. 99-296 (11/17/1999). In P.D. 04-183 (10/08/2004), however, a taxpayer engaged in the business of selling computer hardware and software was classified as a retail or wholesale business.
The County is correct that to the extent a taxpayer develops custom software applications for business clients, licenses the software for their use and provides ongoing training and support, the taxpayer is conducting business service activities. See P.D. 14-117 (7/23/2014), upheld upon reconsideration in P.D. 15-19 (2/11/2015). The taxpayer in P.D. 14-117, however, did not sell any hardware to customers, except perhaps the memory sticks on which the software was transmitted to the client. The ultimate goal of the sale, however, was not to sell the customer a memory stick, rather a customized software application for the customer's use. Although the point was not made in P.D. 14-117, it would be reasonable to conclude that any sale of the memory stick on which the software was transmitted was ancillary to the sale of the software itself. That is because the memory stick served only as a method of transmitting the primary object of the sale, the software. Presumably, the software would then be installed on the business's other devices.
Research into the Taxpayer's history shows that, unlike the taxpayer in P.D. 14117, the Taxpayer sold hardware that institutional, commercial, industrial or governmental customers used for data storage. Although precise definitions can be elusive in the rapidly changing technology industry, “hardware” has been defined as “machines and other physical equipment directly involved in performing an industrial, technological, or military function.” See American Heritage Dictionary 594 (2nd Col. Ed. 1985). The company was best known for a product known as a “filer,” a physical product customers used to store large amounts of electronic data. This product was intended to be used for organizations with large storage needs, a fact reflected in the customer lists provided by the Taxpayer. In fact, some of the products currently offered for sale by the Taxpayer are capable of storing more than a petabyte of data, a unit of data size approximately equal to one million gigabytes. These products meet the definition of hardware.
In addition, consistent with the Taxpayer's representations, the Department's research has shown that these storage products came with a proprietary operating system well known in the data storage industry. While hardware consists of the physical components of the machine, an operating system is software essential to the machine's use. Whether found on a personal computer, storage system or other electronic device, operating systems provide the interface in which the user interacts with the machine. Software applications such as word processing programs or web browsers may allow the user to perform specific tasks using the machine, but the operating system provides centralized control of the machine, including its hardware components.
The County concluded that the sale of hardware was ancillary to the development, sale and support of the software. As indicated above, operating systems allow customers to use the hardware. The hardware was not ancillary to its operating system. Without hardware on which to be installed, an operating system would have been nothing but code with nothing to operate.
Sample contracts provided by the Taxpayer are master purchase agreements of a general nature and cover the sale of hardware and services and the licensing of software to customers. Based on the contracts alone, it is impossible to discern the proportion of sales attributable to any particular category, but the representative invoices provided show the sale of tangible storage devices, software and related services.
Further information provided to the County indicates that software sales were divided into three categories: (1) the operating system that came installed on the storage equipment; (2) software that allowed the customer to download updates to the operating system; and (3) standalone licensing of the Taxpayer's data storage and management software to customers who did not use the Taxpayer's hardware. The Taxpayer states that the third category of software distribution began in November 2014 and comprised a very small percentage of the Taxpayer's overall revenue. Installation, training, consulting and other services were also provided. The Taxpayer explains that such services involved the installation of the hardware, training customers on its use, and consulting to enable the customers to use the equipment in their networks effectively. The sample purchase agreements and invoices provided are consistent with the described business model of selling hardware, licensing related software and providing related services. The explanation of the business model is also consistent with the provided accounting reports that separated the combined sales of hardware and software from the various categories of services provided, including installation, support, training and consulting.
In its response to the Taxpayer's appeal to the Department, the County makes a number of arguments why the Taxpayer should remain classified as a business service provider. Each of these arguments will be considered in turn. First, the County asserts that it has a continuing service contract with the County that includes software and hardware support and maintenance. The County contends that this contract supports its finding that the Taxpayer was a business service provider. The County, however, failed to analyze whether the contract was ancillary to a wholesale sale the Taxpayer previously made to the County. A proper analysis of whether the contract was ancillary requires an understanding of the context in which the Taxpayer and the County entered into the contract.
The Department requested a copy of the County's continuing service contract with the Taxpayer. In response, the County submitted an explanation from an employee of the County's public school system regarding its dealings with the Taxpayer, together with representative invoices. The explanation indicates that the Taxpayer's storage devices were purchased through a third party. Charges for the hardware, operating system software and services such as installation and consulting were separately stated. Based on our examination, the invoices provided by the County are similar to the representative invoices provided by the Taxpayer.
Second, the County states that certain items reported on the Taxpayer's Business Tangible Personal Property (BTPP) tax returns were located in data centers in the County. The County believes that the Taxpayer provided equipment to one of the data centers at no cost. According to the County, the data center explained that the main object of its contract with the Taxpayer was not the hardware, but rather licensing software to maximize its storage capabilities and manage efficient storage and backup processes. The County concludes from this explanation that the software was an integral part of the service delivery and was not ancillary to the hardware.
It is not possible, however, to reach a definite conclusion without reference to the context in which the Taxpayer and the data center entered into the contract. Regardless, the County's explanation raises more questions than it provides answers. It is unclear, for example, on what basis the data center explained that the main purpose of its contract with the Taxpayer was software, not hardware. In addition, the Taxpayer admits that it began selling standalone software beginning in November 2014, so it is possible the data center was referring to one of these sales. In any event, a third party's conclusions as paraphrased by the County is hearsay evidence of little value without resort to direct statements attributable to that customer and most importantly, documentation regarding the transaction.
Third, the County concludes that separately stating line item charges for the hardware and software components indicates the software was not an embedded system. The County defines an embedded system as a microprocessor used in technology such as a cell phone, digital camera or household appliance. The Taxpayer, however, does not argue that its software should be considered a microprocessor.
Next, the County argues that if the Taxpayer had provided samples of billing information and shipping documentation, it could determine that the hardware and software was itemized and billed separately, making the software independent from the hardware and not ancillary. The County's argument, however, is in direct contradiction to the Department's BPOL regulations which state, “[a]n activity for which no separate charge is made is presumed to be ancillary to the activity for which a charge is made, but separately stating charges for different activities does not create a presumption that each such activity is a separate business.” See Title 23 VAC 10-500-110.
Finally, the County reasoned that the sample contracts were needed to validate how the Taxpayer conducted business in the County and who the Taxpayer's customers were. The County stated that it seemed that some of the Taxpayer's customers were end users and not resellers. The County should be aware, however, that the distinction between end user and reseller is not determinative of whether a taxpayer is conducting a wholesale business for BPOL tax purposes. If a customer is an institutional, commercial, industrial or governmental entity, the sale may be wholesale even if the entity is the end user. This issue was discussed at length in P.D. 15-145 (6/30/2015) and P.D. 15-159 (8/13/2015).
The Department acknowledges that BPOL classification issues can be challenging. Taxpayers can conduct many activities, even at the same location, that if taken individually, could be classified separately for BPOL tax purposes. In addition, questions such as what activities are ancillary to others are frequently arguable. In light of such practical challenges in determining classification, in the Department's opinion, the overall nature of a taxpayer's business is of paramount importance. Ultimately, the goal in the administration of the BPOL tax is not to divide every separately identifiable business activity into separate businesses for classification purposes or to selectively pick and choose what activities give the best classification rate and ignore the rest or come up with justifications about how other activities giving a less favorable rate are ancillary. Both taxpayers and localities have incentives to try to divide activities up or select certain activities as primary over others in an effort to achieve the most favorable classification rates.
An additional complication in this case is the rapidly evolving technology industry. It is certainly possible that a classification that was appropriate in previous years may no longer be the case because of changing business models. Also, it is possible that a taxpayer may begin or end separate lines of business over time, and it may be necessary to add or eliminate separate business classifications as circumstances dictate. While changes can and do occur in any industry, taxpayers in the technology industry and the localities in which they operate should be especially mindful of how changing business models may affect their local tax obligations.
Multiple Businesses
Virginia Code § 58.1-3703.1 A 1 provides that a separate license shall be required for each definite place of business and for each business a taxpayer is operating. The gross receipts generated under each license are subject to tax in accordance to the rates provided for each business classification. See Virginia Code § 58.1-3706 A.
Local tax officials are responsible for making the determination as to whether a taxpayer is engaged in a single business or in two businesses, each of which could operate independently of the other. In order to make this determination, the local tax official must be provided with documentation demonstrating the substantiality of each business. See 1994 Op. Va. Att'y Gen. 99.
In order to obtain multiple licenses, a business must be engaged in clearly identifiable separate business activities and not merely activities ancillary to the primary business. In P. D. 97-257 (6/11/1997), the Department concluded that the term “ancillary” refers to business activities that are subordinate, subservient, auxiliary, or in aid of the business' principal business activity. Distinguishing between an ancillary activity and an activity that rises to the level of a separate business can often be accomplished by determining if the activity under scrutiny exists independently of the principal business. In general, an activity for which no separate charge is made will be presumed to be ancillary to the activity for which a charge is made, but separately stating charges for different activities will not create a presumption that each such activity is a separate business. See Title 23 VAC 10-500-110 B.
The fact that the Taxpayer began selling standalone software unrelated to its hardware installations raises a question whether the Taxpayer began to operate another business separately classified as a business service. The Taxpayer represents that this line of business did not begin until November 2014, so gross receipts derived from such activities would be attributable to the 2015 tax year.
Situs
The general rule for establishing situs for the BPOL tax is that whenever the tax is measured by gross receipts, “the gross receipts included in the taxable measure shall be only those gross receipts attributed to the exercise of a privilege subject to licensure at a definite place of business within [the] jurisdiction.” See Virginia Code § 58.1-3703.1 A 3 a. For BPOL tax purposes, “gross receipts” are defined as “the whole, entire, total receipts, without deduction.” See Virginia Code § 58.1-3700.1. The County taxes wholesalers based upon their purchases. Purchases are attributed to the definite place of business at or from which deliveries of the goods are made to customers. See Virginia Code § 58.1-3703.1 A 3 a 2.
The vast majority of the Taxpayer's products were shipped from a distribution center not located in the County. The Taxpayer, however, concedes that a small stock of products was kept on hand in the County office so local customers could test the products. Sometimes, the products were later purchased. The Taxpayer concedes that any such purchases made during the tax years at issue should be sitused to the County.
DETERMINATION
Considering the history of the Taxpayer's business and the information and evidence provided, the Department concludes that the Taxpayer would properly be classified as a wholesaler for purposes of the BPOL tax for the 2011 through 2014 tax years. The Taxpayer concedes that it made some wholesale sales out of its office in the County during the tax years at issue. The Taxpayer should provide information to the County within 30 days of the date of this letter regarding these sales so the County can compute the appropriate refund amounts.
The Department also concludes that the licensing of the operating system and other software related to the hardware installations together with the sale of services such as installation, training and support were ancillary to its wholesale sales of hardware during the tax years at issue. The Taxpayer, however, began licensing standalone software unrelated to its hardware installations in November 2014. Gross receipts derived from such activities would be attributable to the 2015 tax year. Although it is likely these sales would be considered business services, the Department expresses no opinion concerning whether such activities rose to the level of becoming a separately licensable business for BPOL tax purposes beginning with the 2015 tax year.
If you have any questions regarding this determination, you may contact ***** in the Office of Tax Policy, Appeals and Rulings, at *****.
Sincerely,
Craig M. Burns
Tax Commissioner
AR/1292.M