04-192 | Virginia Tax

Tax Type

Corporation Income Tax

Description

Maintenance charges should be attributed in the sales factor

Topic

Appropriateness of Audit Methodology

Assessment

Date Issued

10-29-2004

October 29, 2004

Re: § 58.1-1821 Application: Corporation Income Tax

Dear ***********:

This will reply to your letter in which you seek correction of the corporate income tax assessments issued to ***** (the "Taxpayer) for the taxable years ended December 31, 1998 and 1999. I apologize for the delay in the Department's response.

FACTS

The Taxpayer is a corporation that manufactures network data systems, develops software, and provides consulting services and maintenance contracts on hardware and software for the taxable years at issue. During the taxable years at issue, the Taxpayer's primary activities in Virginia consisted of selling and servicing these systems. The Taxpayer treated all of its product and maintenance service sales as sales of tangible personal property in its sales factor. Subsequently, the Taxpayer decided that the maintenance services should have been treated as sales other than sales of tangible personal property and apportioned pursuant to Va. Code § 58.1-416.

Before filing amended returns, the Taxpayer was contacted by the Department and audited for the taxable years 1998 and 1999. The Taxpayer indicated that information concerning the allocation of maintenance revenue was provided to the auditor. At that time, the auditor did not accept the Taxpayer's proposed adjustment, concluding that maintenance fees were sales of tangible personal property. The Taxpayer contests this finding and requests that the sales factor be adjusted to remove the maintenance revenue from the numerator of the sales factor because the greater proportion of the income-producing activity associated with the maintenance services is performed outside Virginia.

DETERMINATION

Virginia Code § 58.1-416 provides that sales, other than sales of tangible personal property, are deemed in Virginia if:

1. The income-producing activity is performed in Virginia; or
2. The income-producing activity is performed both in and outside Virginia and a greater proportion of the income-producing activity is performed in Virginia than in any other state, based on costs of performance.

The term "cost of performance" is defined in Title 23 of the Virginia Administrative Code (VAC) 10-120-230 as "the cost of all activities directly performed by the taxpayer for the ultimate purpose of producing the sale to be apportioned."

The Taxpayer maintains its systems with remote monitoring, diagnostic, repair and maintenance services are designed to identify and correct problems with minimal customer impact. The vast majority of these services are provided from outside Virginia through network connections with the Taxpayer's diagnostic equipment. Maintenance services provided by the Taxpayer are for ongoing support as well as modifications and upgrades. These services are primarily provided from outside Virginia through the networked systems.

In Public Document 88-253 (9/8/88), the Department addressed an issue where a fixed fee was charged for leasing hardware, access to the software network, and maintenance of the hardware. Because the charge for leasing tangible personal property and the charge for services were not separately stated, the Department presumed that the greater portion of the cost associated with the hardware and maintenance occurred at the customer's location, and the entire fixed monthly fee was included in the numerator if the hardware was located in Virginia. Public Document 88253 further explained how the access portion of the fee would be apportioned based on the cost of performance if that portion of the fee were separately stated.

In applying Public Document 88-253 to the Taxpayer's situation, the auditor concluded that, because the ruling separately addressed the access fee and not the maintenance fee, maintenance charges are considered sales of tangible personal property for purposes of determining the Virginia sales factor. In Public Document 95236 (9/6/95), however, the Department determined that sales of custom software, implementation services, maintenance fees, and training not involving the sale of tangible personal property are to be apportioned based on "costs of performance."

In the Taxpayer's case, the Taxpayer makes a separate charge for system maintenance that does not involve the sale of tangible personal property. The maintenance services are provided from outside Virginia through the networked systems. Accordingly, based on the specific facts in this case, the maintenance charges should be attributed in the sales factor based on the provisions of Va. Code § 58.1-416.

The audits have been adjusted in accordance with this determination. Copies of the revised audit reports are enclosed for your records. A refund will be issued as soon as possible.

The Code of Virginia sections and public documents cited, along with other reference documents, are available on-line in the Tax Policy Library section of the Department's web site, located at www.tax.state.va.us. If you have any questions about this determination, you may contact ***** in the Department's Office of Policy and Administration, Appeals and Rulings, at *****.

- - - - Sincerely,

- - - - Kenneth W. Thorson
        Tax Commissioner

AR/43485E

Rulings of the Tax Commissioner