Are software project-management fees taxable, and does giving away product samples from a tax-free inventory trigger use tax?

Plain-English summary

A company that supplies high-precision cleaning products and services to high-tech industries was assessed use tax on two things: software contracts it hadn't paid sales tax on, and product samples it pulled from its resale inventory and gave to customers free of charge for "cleaning trials." The Tax Commissioner sorted the items out and mostly upheld the assessment, with one reduction.

Software project-management fees are taxable. Under Va. Code § 58.1-602, a taxable "sales price" includes services that are part of the sale. The company argued that project-manager and implementation charges (billed as a 27% allocation) were nontaxable labor. But the exemption for installation labor (§ 58.1-609.5 2) covers only actual installation services, and the invoices didn't show the charges were for installation. Following P.D. 18-106, the Commissioner treated the project-management fees as taxable services provided in connection with the sale of the software — so those charges stayed in the audit.

A maintenance contract is half-taxable. One invoice was a one-year maintenance contract. Under Va. Code § 58.1-609.5 9, maintenance contracts covering both parts and labor are taxed on one-half of the total charge, so that item was adjusted to 50%.

Free samples from a tax-free inventory owe use tax, and don't qualify for the R&D exemption. The company claimed its free cleaning samples were exempt research and development property under Va. Code § 58.1-609.3 5. The Commissioner disagreed: that exemption covers property used directly and exclusively in basic research or R&D, and these samples were used to demonstrate the products and help customers select a cleaning agent — a sales and marketing function, not R&D (23 VAC 10-210-3070). Separately, 23 VAC 10-210-490 provides that anyone who withdraws property from a tax-free (resale) inventory for their own use — including giving it away free — must pay use tax on its cost. So the samples were correctly taxed.

Because the taxpayer had paid the assessment and only the maintenance contract was reduced, it receives a refund of the resulting overpayment with interest.

What this means for you

Businesses that give away samples or promotional goods

If you buy inventory tax-free for resale and then pull items out to give away — as samples, demos, or promotional freebies — Virginia treats that as a taxable use, and you owe use tax on your cost of those items. Calling them "R&D" or "trials" doesn't help unless the property is genuinely used directly and exclusively in research; demonstrating a product to help a customer choose is marketing, not R&D.

Buyers of software and technology services

Watch how implementation and project-management labor is billed. Virginia exempts actual installation labor if it's identifiable, but bundled "project management" or implementation fees tied to a software purchase are generally taxable services connected to the sale. Keep documentation that separately and clearly identifies true installation labor if you want to claim that exemption. And remember that a parts-and-labor maintenance contract is taxed on half its price.

Common questions

Q: I gave away free samples I bought for resale — do I owe tax?
A: Yes. Withdrawing property from a tax-free resale inventory for your own use, including giving it to customers free, triggers use tax on the cost of those items.

Q: Are software implementation or project-management fees taxable?
A: Generally yes, as services connected to the sale of the software. Only actual installation labor is exempt, and you have to be able to show the charge is really for installation.

Q: How is a maintenance contract taxed?
A: If it covers both parts and labor, Virginia taxes one-half of the total charge.

Q: Why didn't the free cleaning samples qualify for the R&D exemption?
A: Because they were used to demonstrate the products and help customers pick a cleaning agent, not directly and exclusively in basic research or R&D, which is what the exemption requires.

Citations and references

Statutes, regulations, and public document:

• § 58.1-602 ("sales price" includes services that are part of the sale)
• § 58.1-609.5 2 (installation labor exemption — actual installation only)
• § 58.1-609.5 9 (maintenance contracts taxed on one-half of the charge)
• § 58.1-609.3 5 (research and development exemption — property used directly and exclusively in R&D)
• 23 VAC 10-210-4040 (services), 23 VAC 10-210-3070 (definitions of research and development), and 23 VAC 10-210-490 (use tax on property withdrawn from a tax-free inventory)
• P.D. 18-106 (6/6/2018) (project-management charges are taxable services, not exempt installation labor)

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 20-117

Original ruling text

July 7, 2020

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

Dear *:

This is in reply to your letter in which you seek correction of the retail sales and use tax assessment issued to * (the “Taxpayer”) for the period October 2010 through June 2013. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayer is a provider of high precision cleaning products and services for high technology industries. As a result of the Department’s audit, the Taxpayer was assessed use tax on (1) untaxed asset purchases, and (2) samples removed from a resale inventory and provided to customers free of charge.

The Taxpayer contests the tax assessed on asset purchases and contends that the charges involve tax-exempt labor for the modification of a software program. The Taxpayer further contends that the maintenance agreement assessed in the audit should be taxed at 50% of the total charge. In addition, the Taxpayer contests the tax assessed on product samples withdrawn from inventory and provided to customers free-of-charge for use in cleaning trials, contending the transactions qualify for the research and development exemption. The Taxpayer has paid the assessment and seeks a refund of the assessed use tax for the contested invoices and the samples withdrawn from inventory.

DETERMINATION

Fixed Assets

The auditor assessed the use tax on software contracts for which the Taxpayer was not charged the sales tax on the invoice. The software contracts and the majority of the corresponding invoices are in German. It is my understanding that the Taxpayer was unable to provide the documentation to the auditor in English. Therefore, the auditor translated the documentation as best as possible. I will address the contested items below.

Contract #* : The auditor listed the lump sum charge for the software contract in the exceptions. The Taxpayer provides three separate invoices that represent the lump sum charge of the contract.

Invoice 1 : The Taxpayer agrees that this invoice represents the cost of the software modules purchases and is properly assessed.

Invoice 2 : The invoice represents a 27% allocation charge to the Taxpayer for services provided by the project manager for the implementation project. The Taxpayer claims that the charges are for implementation services of the software and are considered non-taxable labor charges.

Virginia Code § 58.1-602 defines “sales price” to mean “the total amount for which tangible personal property or services are sold, including any services that are a part of the sale.

The Department has previously ruled with regard to the application of the sales tax to project management fees. In Public Document (P.D.) 18-106 (6/6/2018), the taxpayer argued that the tax assessed on project management charges qualified as exempt installation labor pursuant to Virginia Code § 58.1-609.5 2, and as an exempt service under Title 23 of the Virginia Administrative Code (VAC) 10-210-4040. The Tax Commissioner ruled that the project management by a technician of an audiovisual project was not an installation service as intended in Virginia Code § 58.1-609.5 2. Rather, the management charges, described as labor costs for an on-site technician were taxable services provided in connection with the sale of tangible personal property, the audiovisual systems and equipment.

In this instance, it is not clear from the description provided on the invoice if the labor charges are for the actual installation services performed. In accordance with P.D. 18-106, the Department recognizes the exemption only for actual installation services performed. Lacking sufficient evidence that the charges are actual installation services, the labor charges related to the project manager are considered a taxable service in connection with the sale of the software. Accordingly, the auditor correctly assessed the use tax on the project manager fees.

Invoice 3 : The invoice is for a one year maintenance contract.

Virginia Code § 58.1-609.5 9 provides that “maintenance contracts, the terms of which provide for both repair or replacement parts and repair labor, shall be subject to tax upon one-half of the total charge for such contracts only . . . ." The purchase at issue represents the purchase of a maintenance agreement that qualifies for treatment under Virginia Code § 58.1-609.5 9. Accordingly, this transaction will be adjusted by 50%.

Contract #* : The invoice provided represents a 27% allocation charge to the Taxpayer for 112 hours for services provided by the project manager. Because it is not clear that the labor charges are for the actual installation services performed, the labor charges are considered services in connection with the sale of the software and are taxable. Therefore, this item will remain in the audit.

Research and Development

Virginia Code § 58.1-609.3 5 provides an exemption from the retail sales and use tax for "[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.” The terms "basic research" and "research and development" are defined in Title 23 VAC 10-210-3070 A. The ultimate goal of basic research is to advance knowledge or technology in a particular scientific or technical field. Whereas, the ultimate goal of research and development is to transform newly found knowledge into a usable new product or process, an improved product, or a new use for an existing product. The regulation, however, states that modification of a product merely to meet customer specifications does not qualify as research and development, 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.

Section B of this regulation explains what does not constitute research:

Research does not include testing or inspection of materials or products for quality control. . . . 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.

With respect to the research and development exemption, "direct use" is defined in Title 23 VAC 10-210-3070 A as "those activities 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. "Exclusive use" applies to those items that are used solely in basic research or research and development activities.

A search of the Taxpayer’s website shows that the Taxpayer provides free of charge cleaning trials for customers at its technical centers. With a comprehensive selection of cleaning machines, the Taxpayer can assist and guide the customer with selecting the most suitable machine type and most effective engineered cleaning agent for the customer’s process. As part of the cleaning trials, the Taxpayer conducts analytical cleanliness assessments confirming the cleanliness results achieved. Following all tests, the customer receives a comprehensive technical report detailing all test results, process recommendations and critical process operating parameters.

Based on the above authorities, the cleaning samples are not an integral part of basic research or research and development activities. Rather, the cleaning samples removed from the Taxpayer’s inventory and provided free of charge to its customers for use in cleaning trials are to demonstrate the use of the products and assist the customer with selecting the most effective engineered cleaning agent for their process. Because the cleaning samples are not solely used in basic research or research and development activities, the cleaning samples do not qualify for the research and development exemption in Virginia Code § 58.1-609.3 5.

Title 23 VAC 10-210-490 provides that “[a]ny person who withdraws an item of tangible personal property for his own use from an inventory of property on which no tax has been paid must report tax on the cost price of all property withdrawn for purposes other than sale. . . .”

In accordance with the cited authorities, the Taxpayer is liable for the use tax on the cleaning samples withdrawn from a tax free inventory and provided to its customers free of charge for cleaning trials. Accordingly, the tax assessed in the audit for the cleaning samples is correct.

CONCLUSION

The audit will be returned to the appropriate field audit staff for revision based on this determination. The Taxpayer has paid the audit assessment in full. After revision of the audit and the resulting liability is adjusted, a refund of the overpayment, with applicable interest, will be issued to the Taxpayer as soon as practical.

The Code of Virginia sections, regulations and public document 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 concerning this determination, please contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1211.T

Related Documents

18-106