Tax Type
Retail Sales and Use Tax
Description
Documentation need to establishes claims; Labor Charges; Fabricator
Topic
Taxable Transactions
Exemptions
Penalties
Penalties and Interest
Records/Returns/Payments
Date Issued
12-21-2012
December 21, 2012
Re: § 58.1-1821 Application: Retail Sales and Use Tax
Dear *****:
This will reply to your letter in which you seek correction of a retail sales and use tax assessment issued to ***** (the "Taxpayer"), as the result of an audit for the period September 2007 through August 2010. This also responds to your June 21, 2012 request for waiver of the compliance penalty assessed on a second bill issued for the uncontested issues identified in the same audit. I apologize for the delay in this response.
FACTS
The Taxpayer is a licensed mechanical contractor that installs and repairs process piping and exhaust systems for various industrial and commercial customers. The Taxpayer also removes and installs machinery used in customers' manufacturing and processing operations and provides other similar contract services. The Taxpayer was audited and assessed sales tax on lump sum charges billed to customers for the performance of its contract work. Some of the lump sum billings included fabrication labor charges for various contract jobs.
The Taxpayer maintains that the Department's assessment is erroneous because the audit includes exempt labor charges that were separately stated on customers' invoices. In addition, the Taxpayer states that some of the charges in the audit were invoiced for exempt real property construction services. The Taxpayer also seeks the waiver of compliance penalties assessed in the audit on both the contested and noncontested issues.
DETERMINATION
True Object Test
The Taxpayer asserts that the audit includes transactions that are exempt services based on the application of the "true object test." The Taxpayer claims that the tangible personal property transferred to customers is incidental to the skilled engineering services provided for these transactions. The application of the true object test is discussed in Title 23 of the Virginia Administrative Code (VAC) 10-210-4040 D, which states in part:
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- In order to determine whether a particular transaction which involves both the rendering of a service and the provision of tangible personal property constitutes an exempt service or a taxable retail sale, the "true object" of the transaction must be examined. If the object of the transaction is to secure a service and the tangible personal property which is transferred to the customer is not critical to the transaction, then the transaction may constitute an exempt service. However, if the object of the transaction is to secure the property which it produces, then the entire charge, including the charge for any services provided, is taxable.
The Taxpayer is in the mechanical contracting business. Based on the descriptions of the contract work performed by the Taxpayer, it is unlikely that the true object of the majority of the Taxpayer's contract work is the provision of exempt services. With regard to the design and installation of process piping, exhaust systems and similar types of jobs, the Taxpayer's services may be highly specialized. However, the true object of transactions that involve the provision or replacement of process piping, exhaust systems and similar industrial systems is the tangible personal property that makes up the system furnished and installed under the contract. The property is a critical component of the contract work performed by the Taxpayer. If the Taxpayer is providing engineering or installation services only, i.e., there is no transfer of tangible personal property in connection with the service, the transaction is an exempt service. The transfer of tangible personal property that constitutes a process piping, exhaust or similar type system is not incidental to the contract work performed and, in such cases, the transaction is not an exempt service.
Treatment as a Fabricator
The Taxpayer contends that the auditor improperly treated it as a fabricator for contract work in which it did not provide any fabrication services. The Taxpayer states that it performed exempt installation, application, remodeling and repair services for many of the contracts at issue but these charges were treated as taxable fabrication labor in the audit. As a result, the audit improperly includes charges invoiced to customers for separately stated exempt labor charges.
The term "sale" is defined in Va. Code § 58.1-602 to include charges for the fabrication of tangible personal property. "Sales price" is defined in Va. Code § 58.1-602 to include "the total amount for which tangible personal property or services are sold, including any services that are a part of the sale ...." Title 23 VAC 10-210-560 A defines fabrication to be "[a]n operation which changes the form or state of tangible personal property." Based on the statute and regulation cited, charges for fabrication labor or services are generally subject to the retail sales and use tax.
The Department has traditionally held that tangible personal property that is cut, sawed, shaped, bent, threaded, welded, bored, drilled, punched, machined, sheared, or otherwise subjected to an operation that changes the form or state of the property is considered to have been "fabricated." Based on a review of the Taxpayer's business activities on its website, it is clear the Taxpayer is a fabricator with respect to some of the contract work it performs. The website states that the Taxpayer provides custom metal fabrication services and fabricates transfer chutes, hoppers, hoods, filters, tanks, conveyors and many other items. The fabrication services listed on the Taxpayer's website are consistent with services commonly provided by mechanical contractors.
Contrary to the Taxpayer's contention, the labor charges at issue were not included in the audit based solely on the fact that the Taxpayer is a fabricator. A review of the exceptions list from the audit report shows the auditor reviewed numerous job folders and invoices that contained charges billed to customers described as fabrication services. The auditor's review of the Taxpayer's records showed only lump sum charges for the various contract billings that are listed as exceptions in the audit. If the description of the lump sum charges billed to customers included materials or fabrication services, the entire charge was deemed taxable. This treatment was not an attempt to tax all charges because the Taxpayer is a fabricator. Rather the Taxpayer's charges were taxable because they were billed as a lump sum and the contract work was described as including taxable materials and taxable services. Any exempt services billed were not separately stated as required by the exemption statute.
Virginia Code § 58.1-205 1 provides that any tax assessment issued by the Department is deemed prima facie correct. This means that the burden of proving that the tax does not apply is upon the Taxpayer. Based on the audit information available with respect to this issue, the inclusion in the audit of charges described as being fabrication services is correct. However, I will agree to review any documentation the Taxpayer can provide that demonstrates the audit includes charges for services that do not meet the definition of "fabrication," as the term is defined in Title 23 VAC 10-210-560 A, and that would otherwise qualify for exemption from the tax. The Department must be able to verify that the audit includes charges that were improperly treated as taxable fabrication services before the audit and the assessment can be adjusted.
Separately Stated Labor Charges
The Taxpayer contends that charges for the repair, installation, application and remodeling of tangible personal property were improperly assessed in the audit. The Taxpayer correctly notes that Va. Code § 58.1-609.5 2 exempts installation, application, remodeling or repair services when these charges are separately stated on the record of the sale. However, exempt charges are subject to the tax when combined and billed in a lump sum with charges for tangible personal property or taxable services such as fabrication labor. The Taxpayer states that the auditor was provided a breakdown of the separately stated charges that were billed on customer invoices. In spite of providing this information, the exempt charges were not removed from the Department's audit.
Based on the definition of sales price in Va. Code § 58.1-602, services billed in connection with a sale are considered part of the sales price of the tangible personal property or taxable services sold. However, certain charges are exempt by law when separately stated, including those cited by the Taxpayer. As previously stated, the auditor's review of the Taxpayer's records showed only lump sum charges for various contract billings that were listed as exceptions in the audit. Because the charges were not separately stated as required by the exemption statute, the entire contract charge was assessed in the audit. Again, I will allow the Taxpayer to provide documentation that exempt labor charges were billed separately to customers and were improperly assessed in the audit. The audit and assessment will be adjusted if warranted.
Real Property Contracts
The Taxpayer acknowledges that it performed some fabrication services that were assessed in the audit. However, the Taxpayer maintains that the fabrication services were provided in connection with real property contracts and are not subject to the tax. The Taxpayer cites Title 23 VAC 10-210-410 D to support its position. This regulation addresses fabricators that primarily fabricate tangible personal property for use or consumption in real property construction contracts and states, in part:
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- A fabricator who contracts to perform services with respect to real estate construction, and in connection therewith to furnish tangible personal property for incorporation in real estate construction thereby causing it to lose its identity as tangible personal property by becoming real property, is classified as a using or consuming contractor and must pay the tax on the cost price of the raw materials which make up such fabricated property.
- A fabricator who contracts to perform services with respect to real estate construction, and in connection therewith to furnish tangible personal property for incorporation in real estate construction thereby causing it to lose its identity as tangible personal property by becoming real property, is classified as a using or consuming contractor and must pay the tax on the cost price of the raw materials which make up such fabricated property.
The Taxpayer also cites P.D. 06-148 (12/8/06), which addresses a steel fabrication business that primarily fabricated steel for use in real property construction projects. This determination states that the cost for fabrication labor performed by the taxpayer with respect to real property projects was not subject to the use tax. This decision was based on the application of the primary purpose rule discussed in Title 23 VAC 10-210-410 E, which provides that "[a]ny person who is principally fabricating tangible personal property for his own use or consumption in real property construction contracts shall apply the tax according to subsection D above." (Emphasis added). The primary purpose rule uses a gross receipts test to determine if a fabricator is principally engaged in the fabrication of tangible personal property for sale or for the fabricator's own use or consumption. Title 23 VAC 10-210-410 D states that fabricators who perform real property construction services are using and consuming contractors and must pay the tax on the cost price of raw materials that make up the fabricated property provided under real property contracts.
The Taxpayer must also provide documentation to support its claim that the policy set out in P.D. 06-148 applies to fabrication charges included in its audit. First, the Taxpayer must establish that it was principally fabricating tangible personal property for use in real property construction. This must be done by applying the primary purpose rule to the Taxpayer's business operations. The Taxpayer must also establish that the contracts at issue were for real property construction services rather than for sales of tangible personal property.
Compliance Penalty
This was the Taxpayer's second audit. The Taxpayer seeks the waiver of compliance penalty assessed on two bills issued for this audit. One bill was issued for the contested issues and the other issued for the uncontested issues that were identified in the audit. The compliance penalties were assessed in accordance with Title 23 VAC 10-210-2032 B 1, which states that "[t]he application of penalty to audit deficiencies is mandatory and its application is generally based on the percentage of compliance determined by computing the dealer's compliance ratio." For second generation audits, the regulation states that the penalty will generally be applied unless a taxpayer's compliance ratios meet or exceed 85% for sales tax and 60% for use tax. Because the Taxpayer did not meet the required compliance ratios, the penalties were assessed.
Title 23 VAC 10-210-2032 B 8 provides certain exceptions to the assessment of compliance penalty and states, in part, that:
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- Penalty generally will not be applied to audit deficiencies occurring in new areas not covered by prior audit(s), provided the application of the tax is not clearly established under existing law, regulations or other published documents of which the taxpayer reasonably should have had knowledge, or areas where the taxpayer has relied on prior correspondence with the Department that has not been superseded by a law change, a change in regulations, or other published documents of which the taxpayer reasonably should have had knowledge. Deficiencies in these areas will not be included in compliance ratio computations.
The Taxpayer claims that compliance penalties should not have been assessed in this audit due to the amount of time that elapsed since the last audit and because the issues in the current audit are new. The Taxpayer notes that the fabrication labor charge issue is fact specific and not clearly established as a matter of law. As the fabrication labor charges were not an issue in the prior audit when the Taxpayer's operations were substantially the same as its current operations, the compliance penalties should not have been assessed,
Based on a review of the workpapers from the previous audit performed by the Department in 1993, I agree that the fabrication labor charges, separately stated labor charges and lump sum contract billings should be treated as new issues in the current audit. However, I do not agree that the waiver of the compliance penalty assessed on bill #***** is warranted. The Taxpayer requested waiver of this penalty in a second letter submitted to the Department. This penalty was related to untaxed purchases made by the Taxpayer that were used and consumed in the performance of its contract work. These purchases are not new issues and were not contested for the current audit. Similar purchases were identified and assessed in the Taxpayer's previous audit and included tools, job materials, supplies, equipment and similar items used by the Taxpayer. The Department's policy with respect to the taxable use of tools, supplies and equipment by real property contractors and persons providing repair and installation services is well established and longstanding.
In summary, I find no basis to waive the compliance penalty of ***** assessed on bill # *****. In addition, contested bill # ***** includes a compliance penalty of ***** that is not related to new issues in the current audit. The penalty relates to untaxed purchases of materials and supplies that were used and consumed by the Taxpayer in the performance of its contract work. There is no basis for waiver of this penalty.
Post-Amnesty Penalty
In accordance with Va. Code § 58.1-1840.1 F 1, an additional 20% penalty may be applied to any tax liability that was eligible for amnesty benefits under the 2009 Virginia Tax Amnesty program and was not paid. The revised 2009 Virginia Tax Amnesty Guidelines, Section VI, number 7, provides for waiver of the amnesty penalty for:
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- Any assessment generated from a field audit of a business for an amnesty eligible period in cases where the audit is a second or subsequent audit of the taxpayer, provided that the Compliance Ratio is greater than 85 percent for sales tax and greater than 60 percent for use tax, no penalty has been applied to the tax deficiency, any uncontested liability is paid within 30 days from the date of assessment, and payment for any contested liability remaining upon resolution of an appeal under Va. Code §§ 58.1-1821 or 58.1-1825 is paid within 30 days from the date of the Tax Commissioner's or the court's final determination.
Based on the above, the Taxpayer is liable for the post-amnesty penalty. With respect to bill # ***** the Taxpayer is eligible for waiver of the post-amnesty penalty if the contested liability on this bill is paid within 30 days from the date of this determination. If the audit is revised based on this determination and the tax liability is reduced, the post-amnesty penalty will be recalculated based on the revised tax amount. Any remaining liability on bill # ***** must be paid within 30 days from the bill date of the revised bill to receive waiver of the revised post-amnesty penalty.
With respect to bill # ***** the Taxpayer does not meet all the required conditions for waiver of amnesty penalty. The Taxpayer did not meet the required compliance ratio for second generation audits. The uncontested liability was not paid within 30 days from the date of assessment. The amnesty penalty of ***** assessed on bill # ***** is due and payable.
CONCLUSION
Based on this determination, I will allow the Taxpayer 45 days from the date of this letter to provide the Department documentation that establishes that separately stated exempt labor charges were improperly assessed in the audit. The Taxpayer will also provide documentation that fabrication labor charges in the audit were related to real property contract work or were improperly classified as fabrication. The Taxpayer must provide contracts, customer invoices, contract billings and similar supporting documentation that support the removal from the audit of nontaxable labor and fabrication charges.
The Taxpayer should contact ***** of my Appeals and Rulings staff when this information is available for review. ***** will then arrange for a member of the Department's audit staff to contact the Taxpayer to set up a mutually agreeable time to review the documentation. The audit and the assessment will be adjusted based on a review of the documentation that is provided. When this review is complete, the Taxpayer will be sent an updated bill that reflects the discharge of the compliance penalty noted above and that includes accrued interest on the revised assessment amount. No additional interest will accrue and the amnesty penalty will be waived provided the Taxpayer pays the revised bill within 30 days of the date on the bill. If the Taxpayer does not provide the requested information within 45 days, the assessment will be considered correct and an updated bill will be issued to the Taxpayer. The bill should be paid within 30 days to avoid the accrual of additional interest.
Bill # ***** is now due and payable. An updated bill that reflects accrued interest will be sent to the Taxpayer and should be paid within 30 days to avoid the accrual of additional interest.
The Code of Virginia sections, regulations and public documents cited, along with other reference documents, are available on-line at www.tax.virginia.gov in the Laws, Rules and Decisions section of the Department's web site. To arrange for the review of documentation or if you have any questions concerning this determination, please contact ***** in the Office of Tax Policy, Appeals and Rulings, at *****.
Sincerely,
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- Craig M. Burns
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- Tax Commissioner
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- Craig M. Burns
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AR/1-4886320897.S
Rulings of the Tax Commissioner