Does Texas use tax apply to circuit-board prototypes an out-of-state semiconductor manufacturer ships into Texas for a customer to test, and are the customer's separate design-facility and design-library charges taxable too?

Plain-English summary

An out-of-state semiconductor company (referred to in the ruling as "Company A") asked the Comptroller whether Texas tax applies to two different things tied to its custom integrated-circuit ("ASIC") business: (1) prototype chips it manufactures in California, ships to its customers for testing, and (2) design services its customers perform themselves using Company A's design facilities and software libraries. The Comptroller's response addressed both, reaching two different answers.

1. The prototypes are taxable. Company A designs and builds mask "tooling" used to mass-produce custom chips in Japan, and first produces working prototypes/engineering samples in California that get shipped to the customer (including customers in Texas) for testing and final approval before mass production begins. The Comptroller held that shipping these prototypes into Texas for the customer's testing and approval is a taxable "use" of tangible personal property under Tex. Tax Code § 151.011, which defines "use" as the exercise of a right or power incidental to ownership over tangible personal property. Because "sales price" under Tex. Tax Code § 151.007 is the total contracted amount without any deduction for labor, materials, or services, the full agreed contract price for the prototypes — including Company A's own engineering and design labor charges that went into producing them — is taxable, not just some discounted or cost-based amount.

2. Separately-stated design-facility and design-library charges are not taxable. The company described four "levels" of customer involvement in the design process, with roughly 97% of activity happening at "Level 3" — where the customer uses Company A's product-design software libraries on the customer's own computer-aided-design (CAD) equipment at the customer's own location, with a Company A engineer mainly answering technical questions. The Comptroller ruled that charges separately stated for the customer's use of Company A's design facility, and for use of Company A's design libraries on the customer's own CAD tools (Levels 2 and 3), are not taxable.

The ruling notes it is based on the specific facts presented and that other, similar-looking facts could lead to a different result.

What this means for you

Manufacturers shipping prototypes or samples into Texas

If you're an out-of-state manufacturer that ships prototypes, engineering samples, or pre-production units into Texas for a customer to test or approve before you begin volume production elsewhere, that shipment can itself be a taxable "use" in Texas — even though the item isn't the final mass-produced product and even though title/ownership arrangements (e.g., retaining ownership of the mask tooling) may differ. The tax applies to the full contract price, and you can't back out your own engineering, design, or labor costs from that price under § 151.007.

Businesses billing for design services separately from hardware

This ruling illustrates a useful structuring point: charges for a customer's use of your design facility or software design libraries — where the customer does the design work on its own equipment at its own location — can be treated as nontaxable if they are separately stated from the taxable hardware (the prototypes). Bundling everything into one lump-sum price could risk pulling those service charges into the taxable "sales price" as well.

Common questions

Q: Why are the prototypes taxable if they're not the final product being sold?
A: The Comptroller's answer turns on the definition of "use" under Tex. Tax Code § 151.011 — the exercise of a right or power incidental to ownership over tangible personal property. Shipping the prototypes to the customer in Texas for testing and approval was enough to trigger that "use," regardless of whether the prototypes were the ultimate item being sold to end customers or whether Company A kept ownership of the underlying mask tooling.

Q: Can the manufacturer exclude its engineering and design labor costs from the taxable amount?
A: No. Tex. Tax Code § 151.007 defines "sales price" as the total contracted amount, without any deduction for the cost of the item itself, materials, labor or services employed, interest, losses, other expenses, or transportation. So the full contract price for the prototypes — including the engineering and design labor that went into producing them — is the taxable amount.

Q: Are the design-facility and design-library charges always exempt?
A: In this ruling, they were not taxable only when separately stated and tied to the customer using Company A's design facility or software libraries on the customer's own CAD tools at the customer's own location (the ruling's "Level 2" and "Level 3" scenarios). The ruling doesn't address what happens if those charges are bundled with the taxable prototype price rather than stated separately.

Q: Does this ruling set a general rule for all engineering-services companies?
A: No. The letter explicitly states the opinion is based on the specific facts presented and that other, similar facts may produce a different result. It also is only binding on the Comptroller as to the taxpayer it was issued to.

Citations and references

Statutes:

• Tex. Tax Code § 151.011 (definition of "use" as exercise of a right or power incidental to ownership of tangible personal property)
• Tex. Tax Code § 151.007 (definition of "sales price"/"receipts," including the rule against deducting the cost of the item, materials, labor, services, or transportation)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9303L1232A01

Original ruling text

March 16, 1993

Dear **:

This is in response to your letter concerning the taxability of
engineering services for the design of mask tooling and manufacturing
of prototypes. The tooling is used to produce working prototypes or
engineering samples at your ****, California manufacturing
facility and are then shipped to your customers for testing and final
approval before the tooling is used to manufacture the custom
integrated circuits in Japan. I have restated your fact situation
below followed by my response:

FACT SITUATION

Application Specific Integrated Circuits (ASIC) products come in various
gate sizes, made up of unconnected P and N channel transistors on a
silicon wafer. The wafers are diced" up into sizes ranging from 1000
gates to over 200,000 gates. Digital design functions (logic gates) in
various combinations (cells and macrocells) are developed in software by
Company A and are supplied to customers who down load this to computer
work stations. Using the generic computer work stations with the Company
A developed cell libraries, the customer designs and stimulates a unique
electronic design for a given application that is proprietary to the user
only. The customer elects to do "customized" designs to develop leading
edge electronic items for applications ranging from consumer, automotive,
military or industrial market places.

Company A currently has ASIC "design centers" located in several states
(including ***, Texas) that are used to assist customer design
engineers during the design cycle when they select Company A as their
ASIC supplier. These design centers are technology resource
centers equipped with the appropriate computer aided design (CAD) tools,
software and personnel to represent and support Company A products to the
customer. The following outline summarizes the attached material from
our ASIC brochure. The chart marked "Development Flow and Customer
Interface" is summarized as follows:

LEVEL 1 Customer relies on Company A design center for the majority of
the design development. This represents less than 2% of the total design
center activity.

LEVEL 2 The customer uses the local Company A design facility to develop
the design. This represents approximately 1% of the total design center
activity.

LEVEL 3 Customer uses Company A's product design libraries on customers'
CAD tools at customer location to develop the design. This represents
approximately 97% of the total design center activity.

LEVEL 4 Customer goes through the layout process using Company A internal
place and route tools. This represents 0% of the design center activity.

In the Level 3 design, the Company A design engineer serves mainly as a
resource in answering technical questions relating to Company A's processes,
product performance and software support. The customer is responsible for
all of the activities defined in the attachment labeled "Design Support
Flow." The local Company A design center acts as liaison between the
Company A fabrication facility in **, California and/or in Japan,
insuring that the design proceeds as defined by Company A during the sales
presentation. The physical activities of auto placement, routing, delay
simulation, test tape generation, mask making and prototype development
are all done at the manufacturing location in California or Japan.

You believe that the following facts separate your case from the fact
situations provided in two documents cited by the auditor regarding
engineering services:

1) The purpose of the engineering services (NRE) is to create a mask
(tooling) that will be used to mass produce the custom ASIC product in
Japan. The object of value and the primary purpose of the engineering
service is to create the mask which remains the property of Company A
(unless specifically stated otherwise in the agreement).

2) The prototypes are not the "finished product" but are used to
confirm that the mask (tooling) will meet the customer's requirements.
The circuits are computer tested through simulations by Company A but
only after the customer has tested and approved the prototypes will
production begin in Japan.

3) The first 10 engineering samples (physical parts in the customer's
selected package) are supplied to the customer as part of the total NRE
charge. Additional engineering samples are invoiced separately and are
usually priced from 1.5 to 3 times the "low volume production price"
quoted for the device. You believe that this pricing methodology can be
used to determine the "tax" due on the original 10 prototypes.

RESPONSE

The sale of the prototypes for delivery or "use" in Texas is taxable.
"Use" is defined as "... the exercise of a right or power incidental to
the ownership of tangible personal property over tangible personal
property" (Texas Tax Code 151.011). "Sales price" of a taxable item is
defined in 151.007 of the Texas Tax Code as follows:

(a) Except as provided by Subsections (c) and (d) of this section,
"sales price" or "receipts" means the total amount for which a
taxable item is sold, leased, or rented, valued in money, without a
deduction for the cost of:

(1) the taxable item sold, leased, or rented;

(2) the materials used, labor or service employed, interest, losses, or
other expenses;

(3) the transportation of tangible personal property; or

(4) transportation incident to the performance of a taxable service.

Therefore, the sales price of the prototypes is the agreed contract
price, which includes any labor (i.e., engineering and design charges by
your employees) related to the production of the prototypes.

Separately-stated charges for the customer's use of the Company A design
facility and Company A's product design libraries on customer's CAD tools
at the customer's location to develop the design (Level's 2 and 3), would
not be taxable.

This opinion is based on the facts presented. Other facts though similar
may provide a different result.

If you have other questions or need more information, you may call me at
1-800-531-5441, extension 3-4502. The regular number is 512/463-4600.
You may also write to Tax Administration Division at the above address.

Sincerely,

Gilbert Mora
Tax Administration Division