05-21 | Virginia Tax

Tax Type

Retail Sales and Use Tax

Description

Tangible personal property used in the pre-production activity

Topic

Accounting Periods and Methods

Property Subject to Tax

Date Issued

03-02-2005

March 2, 2005

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

Dear ********:

This is in response to your letter submitted on behalf of ***** (the "Taxpayer") in which you seek correction of the retail sales and use tax assessment issued for the audit period of May 2001 through January 2002. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayer produced prototype cellular phones for its customer. The customer held title to all units produced, and the vast majority of those units were shipped to the customer outside Virginia for analysis and approval. Once customer approval was received, the units were reshipped by the customer to one of the Taxpayer's facilities located outside Virginia for mass production of the final products.

An audit by the Department resulted in the assessment of tax on the purchase of equipment used to test the prototype cellular phones. The Taxpayer maintains that both the industrial manufacturing and the occasional sale exemptions apply to the purchase of the equipment. With regard to the industrial manufacturing exemption, the Taxpayer contends the test equipment was used directly in the production process, and the testing occurred on the production line while the phones were being manufactured. With regard to the occasional sale exemption, the Taxpayer represents that it acquired the contested equipment when it purchased its customer's prototype manufacturing division. The Taxpayer contends that because its customer did not use the assets in a registerable activity, but rather used the assets for its own internal use, the purchase of the contested test equipment qualifies for the occasional sale exemption. On the contrary, the, auditor contends the customer used the contested equipment to manufacture both prototype and production cellular phones.

DETERMINATION

Industrial Manufacturing Exemption

Virginia Code § 58.1-609.3 2(iii) provides that the retail sales and use tax shall not apply to "machinery or tools or repair parts therefor or replacements thereof, fuel, power, energy, or supplies, used directly in processing, manufacturing, refining, mining or converting products for sale or resale."

Pursuant to Title 23 of the Virginia Administrative Code (VAC) 10-210-920 B 2, "[t]he term 'used directly' refers to those activities that are an integral part of the production of a product, including all steps of an integrated manufacturing process, but not including incidental activities such as general maintenance, management, and administration." It further states that items of tangible personal property that are used directly in manufacturing and processing are machinery, tools and repair parts therefor, fuel, power, energy, or supplies that are indispensable to the actual production of products for sale and used as an immediate part of such production process.

Pursuant to Title 23 VAC 10-210-920, it is the Department's long-standing policy that pre-production activities are taxable because they are not an immediate part of actual production. For example, in Public Document 99-21 (3/4/99), the taxpayer was a manufacturer of high-speed machinery. At issue was the tax assessed on the taxpayer's purchase of a computer-aided design (CAD) system. The CAD system was used to create drawings to show the exact dimensions and specifications of a particular part. The drawings were then used to produce the part. The taxpayer contended that the; CAD system was exempt because it was an integral part of the manufacturing process. The Department held that the CAD system was used in a pre-production activity because it was used to make the drawings from which the end product was ultimately made.

In this instance, the Taxpayer manufactures prototype cellular phones for its customer. Once the customer approves a prototype, the prototype is sent to another of the Taxpayer's facilities for mass production. The prototype manufacturing represents a preproduction activity. Items of tangible personal property used in the pre-production activity are subject to the tax. Accordingly, the test equipment purchased by the Taxpayer does not qualify for the industrial manufacturing exemption in Va. Code § 58.1-609.3 2.

Occasional Sale Exemption

Virginia Code § 58.1-609.10 2 provides that the retail sales and use tax does not apply to an occasional sale. Virginia Code § 58.1-602 defines occasional sale as

- a sale of tangible personal property not held or used by a seller in the course of an activity for which he is required to hold a certificate of registration, including the sale or exchange of all or substantially all the assets of any business and the reorganization or liquidation of any business, provided such sale or exchange is not one of a series of sales and exchanges sufficient in number, scope and character to constitute an activity requiring the holding of a certificate of registration.

Title 23 VAC 10-210-1080 C states that any person who purchases an item in a transaction that is deemed an occasional sale is not liable for any use tax on such purchase.

A review of the audit reveals that the Taxpayer's customer used the contested equipment to manufacture both prototype and production cellular phones for sale. This constitutes use of the contested equipment, by the Taxpayer's customer, in an activity that required the Taxpayer's customer to hold a certificate of registration. Accordingly, the test equipment purchased by the Taxpayer from its customer does not qualify for the occasional sale exemption.

CONCLUSION

In a recent sales tax case decided by the Virginia Supreme Court, LZM, Inc. v. Virginia Dept. of Taxation, ___ Va. ___, 606 S.E.2d 797 (2005), the Court recited the standard burden of proof for taxpayers to demonstrate that the transaction is not taxable.

- Exemptions of property from taxation are to be strictly construed against: the taxpayer. Va. Const., art. X, § 6(f). See, e.g., Department of Taxation v. Wellmore Coal, 228 Va.149, 153-54, 320 S.E.2d 509, 511 (1984). The taxpayer has the burden of establishing that it comes within the terms of an exemption. DKM Richmond Assocs. v. City of Richmond, 249 Va. 401, 407, 457 S.E.2d 76, 80 (1995). LZM, ___ Va. at ___, 606 S.E.2d at 799.

In this case, the taxpayer has not met that burden.

Based on the foregoing, the assessment is correct. The Taxpayer will receive an updated bill with interest accrued to date. The bill should be paid within 30 days to avoid the accrual of additional interest. Failure to submit full payment within this 30-day period may also result in the imposition of an additional 20% penalty on the tax due under the terms of Virginia's recent Amnesty. See the enclosure entitled "Important Payment Information."

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

- - - - Sincerely,

- - - - Kenneth Thorson
        
        Tax Commissioner

AR/43580P

Rulings of the Tax Commissioner