Was a federal research-support contract principally a sale of specialty hardware rather than taxable services?

Subject

Federal research-support contract's true object was the sale of hardware

Plain-English summary

Virginia found that the federal contract was principally for sales of tangible research hardware, not operating services. The specialty manufacturer designed, fabricated, installed, repaired, and maintained equipment for federal research facilities. The government and contractor both operated it, and transferred equipment remained under federal control.

Property whose title passed to the federal government could be purchased for resale and then sold under the government exemption. The contractor's limited operating support was secondary.

The ruling did not exempt every direct cost. Cabling and other items incorporated into realty, property used in design or contract management, and items whose title did not pass remained contractor-use property unless a separate interstate-commerce, professional-service, construction, manufacturing, or experimental R&D exemption applied. The audit was returned for revision item by item.

What this means for you

• Federal-contract tax treatment turns on the contract's true object, not title passage alone.
• Government control and permanent transfer supported sale treatment here.
• Contractor-use and real-property materials remain outside resale treatment.
• Separate statutory exemptions must be proved for each remaining item.

Common questions

Was the contractor treated as providing services?

Not primarily. Virginia found the hardware sale and maintenance objective dominant.

Did all materials qualify for resale?

No. Contractor-use, design, management, real-property, and nontransferred items required separate analysis.

Citations and references

• 23 VAC 10-210-693 and 10-210-3071(E).
• Va. Code §§ 58.1-609.1(4), 58.1-609.10(4), 58.1-609.5(1), 58.1-610(A), and 58.1-609.3(2), (5).

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 09-135

Original ruling text

September 8, 2009

Re: § 58.1-1821 Application: Retail Sales and Use Tax

Dear *:

This is in response to your letter requesting correction of the retail sales and use tax assessment issued to * (the "Taxpayer") as a result of an audit for the period July 2002 through September 2006. I apologize for the delay in responding to your letter.

FACTS

The Taxpayer is a manufacturer of specialty electrical and mechanical products. At issue in this audit are various pieces of hardware and other tangible personal property produced for and/or delivered to the * (the federal government) for use in the government's research and development program. The products in question are fabricated and/or acquired based on the government's specifications, and installed in federal government research and development facilities.

The Department's auditor determined that the true object of the government's contract with the Taxpayer was for the provision of services based on the operational role indicated in the contract. The Taxpayer was assessed consumer use tax on all of the direct material costs associated with the contract. The Taxpayer contends, however, that the true object of the contract was for the production and sale of tangible personal property to the government and any services provided (such as design, engineering, fabrication, installation, repair and maintenance) are entirely ancillary to the sale of the tangible personal property.

The Taxpayer also claims that several different exemptions apply to the direct materials costs held in the audit.

DETERMINATION

The Department has traditionally held that in considering the tax treatment of federal government contracts, it must be determined whether the contract is for the sale of tangible personal property or for the provision of services. The "true object" test as applied in Title 23 of the Virginia Administrative Code (VAC) 10-210-693 is used to determine whether the contract is for the sale of tangible personal property or for the provision of some service.

If it is determined that a contract is for the provision of services, the contractor is deemed to be the taxable user or consumer of all tangible personal property used in performing its contractual services, even though title to some or all of the property may pass to the government. Conversely, if a contract is for the sale of tangible personal property, the contractor may purchase such property exempt from the tax for resale. The subsequent sale of the property to the government is deemed exempt under Va. Code § 58.1-609.1(4).

Pursuant to Section 4.0 of the contract, which lists the general technical support tasks, the Taxpayer is required to provide design, fabrication, modification, operation , and maintenance efforts toward completion of, and research with, lasers. The only other mention of an operational role is in Section 4.3 of the contract. Pursuant to such section, the Taxpayer is to specifically provide 1 technical support appropriate for maintaining vacuum systems and installing and operating cryogenic subsystems and instrument interfaces.

According to the scope of the contract in section 2.0, the Taxpayer is to serve in a support service role. This role as set out in the scope of the contract focuses primarily upon efforts related to design, fabrication installation, repair and maintenance of research hardware and the related equipment. There is no indication in the contract that the Taxpayer is to furnish facility operational services, nor does it appear from the contract language and the additional documentation presented that the Taxpayer is the sole operator of the equipment at issue. Both the federal government and the Taxpayer operate the equipment. Furthermore, there is no evidence of the Taxpayer leasing or renting any of the contested equipment with operators. Rather, it appears that all of the contested equipment was sold to the federal government and remained under the government's control after transfer. For these reasons, I must conclude that the true object of the contract at issue is for the sale of tangible personal property, and the minimal equipment operational role expected of the Taxpayer is of secondary importance to the provision and maintenance of tangible personal property. Accordingly, tangible personal property to which title passes to the federal government may be purchased exempt of the tax for resale.

The resale exemption will not apply to the Taxpayer's purchases of tangible personal property for: (1) cabling and cabling connectors or other items for installation into real property; (2) tangible personal property used by the Taxpayer in designing the laser system components or property used by the Taxpayer in managing the performance of the contract; and (3) tangible personal property to which title does not pass to the federal government (excepting items that may be exempt pursuant to a specific statutory exemption). The resale exemption does not apply in these instances because the Taxpayer is the taxable user or consumer of such property.

Where the resale exemption does not apply, items that the vendor delivered directly to the Taxpayer or the federal government outside of Virginia for use exclusively outside Virginia may be purchased exempt of the tax pursuant to the interstate commerce exemption of Va. Code § 58.1-609.10 4. No tax will apply to the direct material costs at issue that constitute only professional services pursuant to Va. Code § 58.1-609.5 1, or real property construction services pursuant to Va. Code § 58.1-610 A. To the extent that any of the direct material costs at issue constitute machinery, tools or supplies used directly and preponderantly in industrial manufacturing, such items may be purchased exempt of the tax pursuant to Va. Code § 58.1­609.3 2. To the extent that any of the direct material costs at issue constitute tangible personal property purchased by the Taxpayer only for its use directly and exclusively in research and development in the experimental or laboratory sense, such items may be purchased exempt of the tax pursuant to Va. Code § 58.1-609.3 5. Also see Title 23 VAC 10-210-3071 E.

CONCLUSION

The audit will be revised in accordance with this determination. If a balance is due after the revision is made, a revised bill, with interest accrued to date, will be sent to the Taxpayer. Any outstanding balance should be paid within 30 days of the bill date to avoid additional interest charges. The Taxpayer should remit its payment to: Virginia Department of Taxation, 3600 West Broad Street, Suite 160, Richmond, Virginia 23230, Attn: *. If you have any questions concerning payment of the assessment, you may contact at **.

The Code of Virginia sections and regulations cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions about this determination, you may contact * in the Department's Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

AR/1 -1281096998.R

1

This section also requires the Taxpayer to provide electro-mechanical support requiring experience in designing, fabricating and installing vacuum chambers, as well as, designing one-of-a-kind mechanical instrumentation required for research.