VIRGINIA:
IN THE CIRCUIT COURT OF THE CITY OF RICHMOND
JOHN MARSHALL COURTS BUILDING
E-LABS, INC.,
Petitioner,
v. Case No.: CL22-640
VIRGINIA DEPARTMENT OF TAXATION, et al,
Respondents.
REINSTATEMENT ORDER
On February 10, 2025, through February 14, 2025, the parties appeared before the Court for a trial, without a jury, on the Petitioner's Application for a Correction of Erroneous or Improper Assessment of Taxes, under Va. Code Ann. § 58.1-3984. During the trial, the petitioner presented argument, evidence, and testimony from witnesses in support of its position. The Respondents then argued that the Petitioner had not met its burden, but otherwise presented no competing evidence or witnesses of their own. On February 14, 2025, at the conclusion of the trial, the Court issued a ruling in favor of the Petitioner. A short, written opinion reflecting the Courts oral ruling followed on March 27, 2025.
But on April 15, 2025, the Respondents filed a Motion for Reconsideration reiterating their argument that Petitioner E-Labs had not met its burden to show that the tax assessment is not the result of arbitrary, capricious, or unreasonable conduct attributable to Respondent Department of Taxation. The Court found the Motion to Reconsider sufficiently well-taken to merit suspension of the Final Order and reconsideration of the same.
Now, having reviewed and considered the Respondent's motion, the Court will maintain its decision.
The evidence in the record demonstrates that all of the Petitioner's purchases were used directly and exclusively in basic research, or research and development in the experimental or laboratory sense within the meaning of Va. Code Ann. § 58.l-609.3(5), making it more probable and more likely than not that later purchases were also consumed exclusively in basic research activities and eligible for the appropriate commercial and industrial exemption. This is further supported by the recurring purchases of common items such as screws, bolts, and grease. The evidence in the record is sufficient to convince the Court, in its role as factfinder that even the items for which the witness could not trace to a particular job, were similarly within the statutory exemption.
For that reason amongst others stated upon the record and in the Final Order, the Court relies upon its findings of fact its and analysis contained in the Final Order, and hereby REINSTATES the Final Order entered by this Court on March 27, 2025.
Noting the Petitioner's request for the Final Order to be unsealed, this matter shall remain on the active docket of the Court for sixty (60) days after the entry of this order, or until the Respondents make known their position on the issue.
The Clerk is directed to forward a certified copy of this Order to the parties.
IT IS SO ORDERED.
ENTER: 8/12/2025
C.N. Jenkins, Jr., Judge
VIRGINIA:
IN THE CIRCUIT COURT OF THE CITY OF RICHMOND, JOHN MARSHALL COURTS BUILDING
E-LABS, INC.,
Petitioner,
v. Case No.: CL22-640
VIRGINIA DEPARTMENT OF TAXATION, et al,
Respondents.
FINAL ORDER
From February 10, 2025, through February 14, 2025, E-Labs, Inc. ("Petitioner" or "E-Labs") and the Virginia Department of Taxation ("Respondent" or "Department") were present before the Court for a bench trial to determine whether the Department has issued erroneous or improper tax assessments against the Petitioner and whether the Petitioner is due a refund for its payment of the assessments. The Petitioner claims it has been improperly assessed taxes for which it should have been exempt under Va. Code Ann.§ 58.1-609.3(5). The assessments in question amount to $75,041.41.
All parties were present and represented by counsel. The Petitioner presented its case-in-chief and engaged in direct examination of witnesses and the submission of 97 exhibits to the Court on Monday, February 10, Wednesday, February 12, and Thursday, February 13, 2025.1 The Respondent did not present any evidence. Having considered the evidence and arguments of the parties the appropriate context of the applicable law, the Court makes the following findings and ruling, consistent with the oral ruling expressed on the record:
LEGAL STANDARD
The Court recognizes that ''any assessment of a tax by the Department [of Taxation] shall be deemed prima facie correct." LZM, Inc. v. Va. Dep’t of Taxation, 269 Va. 105, 109 (Va. 2005) (citing General Motors Corp. v. Dep'I of Taxation, 268 Va. 289, 292-93 (Va. 2005)). Furthermore, the Court is constrained from overturning the Department's decision unless the "assessment is contrary to law, an abuse of discretion, or [is] the product of arbitrary, capricious, or unreasonable behavior." Id at 110 (citing Dep't of Taxation v. Lucky Stores, 217 Va.121, 127 (Va. 1976)).
There exists a presumption of validity to the Respondent's tax assessment against the Petitioner, and the Petitioner bears the burden to show that the assessment was "the result of manifest error" or in "total disregard of controlling evidence." County of Mecklenburg v. Carter, 248 Va. 522, 526 (Va. 1994). In contemplating the burden placed upon the Petitioner, the Court acknowledges that taxation is favored, and ambiguity will be resolved in favor of the Department. Commonwealth v. Manzer, 207 Va. 996, 1000 (Va. 1967) ("[T]axation is the rule and not the exception . . . statutory tax exemptions are strictly construed against the taxpayer, with doubts resolved against the exemptions."); see also Dep 't of Taxation v. Wellmore Coal, 228 Va. 149, 154-54 (Va. 1984). Thus, it is clear the burden in this matter is upon the Petitioner to prove that it qualifies for the exemptions claimed. DKM Richmond Assocs. v. City of Richmond, 249 Va. 401, 407 (Va. 1995); Va. Code Ann.§ 58.l-1825(D) ("It shall be the burden of the applicant in any such proceeding to show that the assessment ... is erroneous or otherwise improper.").
TRIAL SUMMARY
This Petitioner brings this action appropriately under Va. Code Ann. § 58.l-1825(A), which permits "any person assessed with any tax ... and aggrieved by any such assessment" to apply to a circuit court for relief. This application must be made within three years of the assessment, or one year after a review and determination by the Tax Commissioner, pursuant to Va. Code Ann. § 58.1-1822. The parties stipulated that the Department issued notices of assessment on December 9, 2015, and that the Petitioner timely filed an application for correction with the Respondent. The parties further stipulated that the Department communicated the Tax Commissioner's decision addressing the application on February 16, 2021, finding that the Petitioner was not eligible for the claimed tax exemption under Va. Code Ann.§ 58.1-609.3(5). Finally, the parties stipulated that the Petitioner timely filed an application for correction with the Circuit Court for the City of Richmond.
During the trial the Petitioner presented two witnesses. The first was Mr. Kenneth Malley, the founder and corporate designee of the Petitioner, E-Labs. Mr. Malley was qualified as an expert for the purposes of discussing the contractual relationship between prime and sub-contractor relationships in contracts with which the Petitioner was involved. The Court noted Respondent's objection. The Petitioner's second witness was Karl Pates, Ph.D. Dr. Pates was qualified as an expert and permitted to testify on the contractual work relationships between prime contractors and sub-contractors. Unlike Mr. Malley, Dr. Pates was qualified to testify as to these relationships globally, rather than limited to the contracts of which he has or had a personal engagement. Pates was also qualified to testify as to how research and development unfolds in connection with division of labor in the prime contractor to sub-contractor ecosystem.2 To Pate's admission as an expert to this last category, the Respondent objected. This objection was noted on the record.
Through these witnesses, the Petitioner presented testimony and numerous exhibits indicating that the Petitioner would receive materials or parts from its clients for the purposes of conducting tests and providing results data, a test report, or both to the client. The Petitioner often conducted tests that evaluated a product or object's ability to withstand various conditions, such as temperature, pollution, impact, electrical current, and other stressors.
The Court heard testimony and evidence from Petitioner's witnesses that none of the research or testing conducted by the Petitioner involved quality control, environmental studies, or environmental analysis. Furthermore, the Petitioner represented and demonstrated that it did not test production units to determine whether they have been produced correctly.
While the Respondent did not present any evidence, the Respondent did present substantive argument regarding the presumed correctness of the Department's assessment. In support, the Respondent cited to Commonwealth v. Rsch. Analysis Corp., 214 Va. 161, 198 S.E.2d 622 (Va. 1973) and LZM, Inc. v. Va. Dep't of Taxation, 269 Va. 105, 606 S.E.2d 797 (Va. 2005). With regard to the Petitioner's witnesses, the Respondent elected to briefly cross-examine the first witness, and declined to cross-examine the second.
DISCUSSION
Definitions and Terminology
The Petitioner claims that certain contested purchases and assets should be exempt from sales and use tax under Va. Code Ann. § 58.1-609.3(5), which states the following:
The tax imposed by this chapter or pursuant to the authority granted in §58.l-605 and 58.1-606 shall not apply to ... (5) Tangible personal property purchased for use or consumption directly and exclusively in basic research or research and development in the experimental or laboratory sense.
§ 58.1-609.3(5) (emphasis added). In the interests of uniformity and consistency, the Court relied upon the definitions and explanations provided in Title 23 of the Virginia Administrative Code. The parties presented a stipulation representing that they recognized these definitions as applicable to this matter.
Beginning with the definition of Direct Use, 23 VA. Admin. Code § I 0-210-3070 describes "Direct Use" as:
[A[ctivities which are an integral part of basic research or research and development activities, including all steps of these activities, but not including secondary activities such as administration, general maintenance, product marketing, and other activities collateral to the actual research process.
Id. This differs from "Exclusive Use" which occurs "when items are used solely in basic research or research and development activities." Id
Turning now to "Basic Research," the following meaning is ascribed:
[A] systematic study or search in a scientific or technical field of endeavor with the ultimate goal of advancing knowledge or technology in that field. The development of a tangible product or process need not occur in basic research activities. Examples of basic research activities include medical, chemical, or biological experiments conducted in a laboratory environment.
Id. This chapter continues with its Definition of "Experimental Sense" to mean "work that is conducted through tests, trials, tentative procedures, or policies adopted under controlled conditions to discovery, confirm, or disprove something doubtful." Id. With regards to the term "Laboratory Sense," it is used to describe circumstances where "work is conducted in a place equipped for experimental study in a science and providing an opportunity for experimentation, observation, or practice in a field of basic scientific or traditional physical science research." Id. Independent references to the word "research" are construed to encompass both the definitions of "basic research" and "research and development" as defined by the Chapter cited by the Court. Finally, § 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 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.
Id. In addition to providing definitions to the terms used throughout this Chapter, § l0-210-3070 explicitly states that "[tax shall] not apply to tangible personal property purchased or leased and used directly and exclusively for research in the experimental or laboratory sense." This language mirrors that used in the exemption available under Va. Code Ann.§ 58.1-609.3(5).
Items that do not fit within the definition of research and are therefore excluded from this exemption are listed under § I0-210-3070:
Research does not include testing or inspection of materials or products for quality control; however, in the case of an industrial manufacturer, processor, refiner or converter, testing and inspection for quality control is deemed to be an exempt activity under 23VAC l 0-210-920. Additionally, research does not include environmental analysis, testing of samples for chemical or other content, operations research, feasibility studies. efficiency surveys, management studies, consumer surveys, economic surveys, research in the social sciences, metaphysical studies, advertising, promotions, or research in connection with literary, historical, or similar projects.
(emphasis added). As presented, these are the definitions the Court acknowledged as applicable when making its determination.
Analysis
Petitioner E-Labs argues that the tax assessment is erroneous and the result of arbitrary, capricious, and unreasonable conduct. In support, the Petitioner points to the Department's decision to send an "unqualified'' individual with insufficient engineering knowledge and experience to conduct an informed audit of the Petitioner's business. Petitioner E-Labs maintains that the items purchased for the activity it conducts are directly and exclusively used for Research and Development purposes. The auditor, with no experience in the field and no understanding of the government contractor/sub-contractor ecosystem was unqualified to make the determination that common hardware such as rubber seals, grease, screws, bolts, and other items can be exempt if used appropriately. In making this argument, the Petitioner emphasizes that the manner in which these items were used is more important than the nature of the items.
In opposition, the Respondent argues that it is difficult to determine whether the equipment purchased by Petitioner E-labs was used exclusively for Research and Development. Respondent characterizes the Petitioner's business as one hired to test parts or components of parts for customers. After providing a quote for the customer, the Petitioner then attaches an object to a fixture and runs tests. After testing is concluded, the Petitioner furnishes the customer with the test data and on certain occasions, a summary report. The controversy between the parties hinges upon whether these tests constitute research, development, or traditional research & development. Respondent argues that under Commonwealth v. Rsch. Analysis Corp., that research is scientific systematic study or search towards a new product or new understanding, while development is qualified as gradual transformation of new research or new understanding learned from the research stage towards a new product or new process. 214 Va, 161, 198 S.E.2d 622 (Va. 1973). The Respondent argues that the summary reports produced by the Petitioner for the Petitioner's clients do not address new knowledge towards a new product, or gradual transformation of new research towards new products or processes. For that reason, it is the Respondent's position that the Petitioner's tests constitute neither research nor development.
The Respondent suggests that the summary report findings are more akin to "pass/fail" tests commonly conducted in quality control testing to meet specific standard prior to production. The Respondent argues that this assertion is supported by the fact that the clients, even by the Petitioner's own admission, did not always desire the summary report, requesting the data or test certifications only. Under 23 VA. Admin. Code § 10-210-3070, the definition for research explicitly excludes testing or inspection of products for quality control. For example, as presented during the Petitioner's examination of Dr. Pates, there exists evidence showing that HDT Global had hired the Petitioner to conduct some tests prior to HDT Global's presentation of the finished product to the consumer-in this case, the government. The Respondent argues that this information, in conjunction with the absence of prime contractors' records explaining how the contractual relationship between Petitioner E-labs and the other contractors apportioned the work, supports conclusion that the Petitioner's activity constitutes quality control testing rather than Research and Development.
In making its determination, the Court again considers both the arguments and evidence presented by the parties. The Court identifies the controversy between the parties as tax assessments the Petitioner claims are improper. This controversy is resolved by determining whether the Petitioner is exempt from certain purchases for items directly and exclusively used in activities that constitute research, or Research and Development. Thus, the question before the Court now is whether the tests conducted by the Petitioner qualify as research or Research and Development, or one of the alternative categories suggested by the Respondent.
The Court agrees with the Respondent's characterization of the Petitioner's business, finding that the Petitioner accepts products from clients for the purposes of conducting tests. The results from the test data are provided to the client. While the Petitioner is always willing to provide a summary report, the Petitioner represents that clients are always interested in the raw data obtained from the tests, and often but not always interested in both the data and a summary report. Based on these facts, the Court is of the opinion that the Petitioner's business is providing test data and results for clients. The data is obtained through tests, and the tests are conducted in the facilities built by the Petitioner. These tests sometimes require the use of common hardware, such as screws, bolts, grease, etc. While the Respondent takes issue with the fact that many of the items purchased by the Petitioner had been purchased years prior to use, the Court acknowledges from the evidence presented by the Petitioner, that the Petitioner conducts different types of tests tailored to the needs of the client but within the scope of the Petitioner's capabilities. While the tests may be different, the types of tests conducted in the Petitioner's facilities involve nearly identical processes and have recurring needs. For that reason, the Court is not persuaded that an advance purchase of hardware effectively weakens the Petitioner's position. But the mere purchase of an item does not qualify it for an exemption. Whether an item purchase is eligible for an exemption is determined by way the item is used.3 This is a principle which the Court considers determinative in this matter. With regard to the items, the Court opines they were utilized in activities that fit squarely within the definition of experimental sense under § 10-210-3070.4
Because the Petitioner is in the business of providing test data to clients for parts and units not yet in the production phase, the Court finds that the Petitioner's activity constitutes Research and Development, specifically in the sense of "improving existing products" or progressing towards a "specific understanding of developing a new product" under § l 0-210-3070. 5 The evidence in the record supports the Petitioner's assertions and the Court's subsequent findings. The Petitioner's activities were conducted in the interests of obtaining a specific understanding of developing new products, and the improvement of existing products. For example, the Petitioner presented evidence in connection with the Petitioner's testing when the Petitioner represented that HDT Global, a prime contractor, engaged the Petitioner as a sub-contractor, and that the data provided by the Petitioner to HDT Global led to the creation of a new product. Although the Petitioner did not use the data to develop the new product, there is nothing before the Court indicating that the research is required to be conducted by the same entity implementing theresearch to build or configure new products. In fact, expert testimony shows conflicting particulars in regard to the division of labor in the contractor to sub-contractor ecosystem, where it is common for a prime contractor to consult a sub-contractor for research purposes to obtain data for use in further development.
Finally, the Court addresses the cases cited by the Respondent. Both are distinguishable from the facts in this case. In Commonwealth v. Rsch. Analysis Corp., the Supreme Court of Virginia considered tax exemptions claimed by Research Analysis Corporation ("RAC"). RAC had filed petitions for correction in the Circuit Court of Fairfax County. 214 Va. 161, 198 S.E.2d 622. RAC claimed an exemption under Va. Code Ann. § 58-441.6(q).6 The tangible property in question was a computer leased in years from 1966 through 1970. Id. RAC claimed that the computer was used directly and exclusively in research and development in the experimental or laboratory sense. Id. The Commonwealth disagreed and argued that the exemption was not intended to cover the type of activities RAC conducts. Id The evidence on the record showed that RAC leased the computer in connection with its work as a consultant fulfilling contracts with the United States Army. Id. at 162-63. While the bulk of RAC's work was comprised of analyzing simulated battlefield situations for the Army, evidence also showed that RAC conducted financial and practical feasibility studies for commercial aviation clients. Id. RAC offered expert testimony that this activity constitutes "Operations research," which is defined as the "the scientific study of the operations of an organization or system ... oriented towards providing managers or executives of the organization with ...solutions to problems involving interaction of the organizations components." Id at 163-64. Based on this presentation, the Supreme Court found that "RAC's primary activity of providing decision-making methodology ... was operations research or management studies," drawing a distinction between "research and development in the experimental sense" and "management studies." Id. Concluding that the legislature intended to only exempt "tangible personal property purchased or leased for use in research and development which generates new tangible products, or new processes, or the improvement of existing products," the Supreme Court agreed with the Department of Taxation's assessments regarding the computer were valid. Id at 164-65.
The Court, without contending the findings and reasoning of the Supreme Court, concludes that Commonwealth v. Rsch. Analysis Corp., is distinguishable from the case at bar on the grounds that there is no evidence in the record indicating that the Petitioner engaged in activity other than traditional research or research and development in the experimental or laboratory sense. In Commonwealth, RAC provided expert testimony that RAC was engaged in operations research and attempted to broaden the exemption to include operations research. Id. While both the language of the exemption and the expert witness's testimony include the word "research" the Supreme Court rejected this view, limiting the applicability of the exemption to the definitions provided by the legislature. Id at 165. This differs from the case at bar because the Petitioner's evidence and expert testimony instead demonstrates research or research and development in experimental or laboratory sense. Rather than attempting to broaden the exemption, the Petitioner presented evidence and argument showing activity congruous with the claimed exemption. For that reason, the Court does not find the facts of Commonwealth v. Rsch. Analysis Corp analogous to this instant case.
Turning now to LZM, Inc. v. Va. Dep't of Taxation, this is a case involving an assessment by the Department of Taxation following an audit of LZM's taxes for a period running from October 1, 1996, until September 30, 1999. 269 Va. 105, 606 S.E.2d 797 (Va. 2005). Appellant LZM was engaged in the business of leasing portable toilets, offering a pumping service to clients to maintain and the clear the toilets periodically. Id. at 108--09. Although LZM charges additional fees for pumping services, purchase of this service is not required to lease a toilet from LZM. Not all clients contracted for pumping services. Id.
Because the facts of LZM. Inc., are significantly different in terms of the product offered and the nature of the exemption claimed, the Court finds no reason to distinguish the case, as it addresses a different tax exemption claimed for maintenance contracts rather than exemptions for items purchased in the use of research or research and development. Although the application of the true object test used in LZM, Inc., would yield potentially useful findings, the Court will not, of its own volition analyze a point that is neither raised by the parties, nor imperative to determining the appropriate outcome of this case.
CONCLUSION
The Court FINDS that the Petitioner was engaged research or Research and Development in a laboratory or experimental sense. This finding is supported by the argument and evidence in the record. The Court further FINDS that the Petitioner's purchases are exempt under Va. Code Ann. 58.1-609.3(5) and is satisfied that the applicant was erroneously or improperly assessed with taxes in regard to the audit and Notice(s) of Assessment dated December 9, 2015, and that this erroneous assessment was not a product of the Petitioner's willful failure or refusal to furnish the Respondent Department of Taxation with the necessary information. The Petitioner has met its burden of showing the audit and determination was erroneous and the Court is persuaded that this assessment is the product of at least arbitrary and potentially unreasonable conduct. Accordingly, pursuant to the statutory authority expressed in § 58.1-1826, the Court ORDERS the assessment corrected. Because the assessment exceeds the proper amount, Petitioner E-labs shall be refunded by Respondent Virginia Department of Taxation in the amount of $75,041.41. Further, Petitioner E-labs has made a request for interest running from December 16, 2015, the date the Petitioner paid the assessments. The Court GRANTS the requested relief and ORDERS the Respondent to pay interest accruing from the date of the Petitioner's overpayment. The interest shall be calculated consistent with the provisions of § 58.l-1833(A) and § 58.1-15.
It is further ORDERED that this Final Order be SEALED, consistent with the Court's Order dated February I0, 2025.
Pursuant to Rule l:13 of the Supreme Court of Virginia, the Court dispenses with the parties' endorsement of this Order.
The Clerk is directed to forward a certified copy of this Order to the parties and to the Tax Commissioner.
IT IS SO ORDERED.
ENTER: 3/27/2025
C.N. Jenkins, Jr., Judge
1 Trial was scheduled to run five (5) days consecutively-Monday, February I 0, 2025, through Friday, February 14, 2025. Due to inclement weather, the Court was closed on Tuesday, February 11, 2025.
2 "Prime contractor to sub-contractor ecosystem" is a term used by the Petitioner to describe the network and transactional associations between contractors in the government contracting industry.
3 There was some contention between the parties in connection with a computer the Petitioner purchased and claimed as exempt. Without diverting attention from the Court's ruling and analysis, the Court briefly contemplates the concept of “de minimis usage," acknowledged under 23 VA. Admin. Code§ 10·210-3071, which states that "when research property is used in a taxable manner, it will continue to be exempt from the tax if the taxable use is de minimis in nature." De minimis use occurs when the non-tax-exempt activity does not involve (i) continuous or ongoing operation; (ii) does not follow a consistent pattern; and/or (iii) is occasional in nature, occurring no more than three times; and (iv) in total accounts for no more than three days. Because the administrative code explicitly uses computers in its demonstrative example and because the Respondent offered no evidence indicating that the Petitioner's use of the computer exceeded the de minimis threshold, the Court is positioned to accept the Petitioner's supported representation that the computer was primarily used for the Petitioner's research and development activity.
4 Work that is conducted through tests, trials, tentative procedures, or policies adopted under controlled conditions to discovery, confirm, or disprove something doubtful.
5 [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.
6 Although Va. Code Ann.§ 58·441.6(q) no longer exists as it did when the Supreme Court of Virginia conducted its appellate review of Commonwealth v. Research Analysis Corp.. the language of the exemption claimed under that statute is identical to the language in Va. Code Ann. § 58.1-609.3(5), which is the exemption the Petitioner in this instant matter claims. For that reason, the Court does not dispute any facet of the holding and analysis of the Supreme Court, despite the involvement of a different or previously existing statute.