June 16, 2015
Re: § 58.1-1821 Application: Retail Sales and Use Tax
Dear *****:
This will reply to your letters in which you seek the correction of a retail sales and use tax assessment issued to ***** (the "Taxpayer") for the period December 2009 through November 2012. I apologize for the delay in responding to your appeal.
FACTS
The Taxpayer is a specialty fiber optics manufacturer and also contracts to perform research and development projects. The Department audited and assessed the Taxpayer use tax on various untaxed purchases. The Taxpayer maintains that the assessment is erroneous because the audit includes purchases that qualify for the manufacturing exemption or the research and development exemption. I will first address the application of the manufacturing exemption and then the research and development exemption to the contested purchases assessed in the audit.
DETERMINATION
Manufacturing
Virginia Code § 58.1-609.3 2 (iii) provides an exemption from the retail sales and use tax for "[m]achinery 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 ...." (Emphasis added.) The term "used directly" is defined in Va. Code § 58.1-602 as "those activities which are an integral part of the production of a product, including all steps of an integrated manufacturing or mining process, but not including ancillary activities such as general maintenance or administration."
The Department's manufacturing regulation, Title 23 of the Virginia Administrative Code (VAC) 10-210-920 B 2 interprets the term "used directly" as it applies to manufacturing activities and states:
The 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....
The integrated manufacturing process ... includes the production line of a plant, factory, mill, etc., starting with the handling and storage of raw materials at the plant site and continuing through the last step of production where products are finished or completed for sale and conveyed to a warehouse at the same plant site, and also includes production line testing and quality control.
Additionally, in the case of Commonwealth of Virginia v. Community Motor Bus Co., 214 Va. 155, 198 S.Ed.2d 619 (1973), the Virginia Supreme Court held that the use of the word "directly" in the manufacturing exemption statute was intended to narrow the scope of the exemption. The exemption applies only when an item is indispensable to actual production and is primarily used or consumed immediately in the actual production of products. This standard established by the Court is also reflected in Title 23 VAC 10-210-920 B 2, which states, "[i]tems of tangible personal property which are used directly in manufacturing and processing are machinery, tools and repair parts therefore, fuel, power, energy, or supplies which are indispensable to the actual production of products for sale and which are used as an immediate part of such production process." (Emphasis added.)
The Taxpayer has provided descriptions of how various items assessed in the audit are used in its manufacturing process. Based on the information provided and applying the legal authorities cited, my determination on the application of the tax to equipment and supplies used in the Taxpayer's manufacturing process follows.
Glassware Cleaning Equipment and Supplies
The Taxpayer uses glassware in its fiber optic production process. The glassware must be cleaned with acids and solvents and then rinsed with deionized water prior to production to prevent contamination and insure the quality of the finished product. The Taxpayer uses deionized water equipment and specialized filtering systems to clean the glassware. An oversized polyethylene container with tubing is also used in the Taxpayer's cleaning and purification process. After production has occurred, the glassware contains surface chemicals that must be removed. An ultrasonic cleaner and other specialized components are used to clean and remove the surface chemicals.
Teflon rods and polyethylene pans are used to clean and decontaminate the glassware used in production to ensure the integrity and quality of the IR gasses that are produced. The Teflon rods allow production personnel to clean areas of the production glassware that cannot be reached by hand. Polyethylene pans are used to contain spillage or leaks that occur during the cleaning process. The waste from the cleaning process is collected and stored in containers after the cleaning process is completed.
The Taxpayer contends that the various cleaning and purification processes performed on the glassware to prevent its contamination are necessary to ensure the quality and integrity of the finished fiber optic products.
The fact that an item is essential to production is not sufficient grounds for exemption. The use of an item must be an immediate part of the actual production of the product. The cleaning of the glassware is not an immediate part of the Taxpayer's production process. The glassware is cleaned prior to and after actual production. A similar issue is addressed in Public Document (P.D.) 02-140 (11/5/02). A semiconductor manufacturer was assessed use tax on a poly flow cleaner used to clean quartzware. The quartzware was used directly in the manufacturer's semiconductor production process. The poly flow cleaner sprayed acid on the quartzware and then rinsed the acid with deionized water. Without the cleaning process, the quartzware would contaminate the semiconductor wafers and degrade the finished product. The Tax Commissioner ruled that the poly flow cleaner was used to maintain exempt production equipment and such use was taxable.
Further, in P.D. 10-244 (10/21/10), a manufacturer used purging compounds to clean and remove different color resins from production machinery prior to each production run in which a product with a new color was manufactured. The Tax Commissioner ruled that this cleaning process was not an exempt part of production. The activity occurred between production runs so the use of the purging compounds was not an immediate part of production. This is also the case with the Taxpayer's cleaning of the glassware, which takes place before and after the production process.
Based on the above, the manufacturing exemption does not apply to the Taxpayer's purchase of equipment and supplies used to clean production glassware. Although the glassware cleaning processes are clearly essential to ensure quality control in the Taxpayer's production process, the purchases of equipment and supplies used to clean production glassware were properly assessed in the audit. Audit line item #s 5, 6, 18, 19 - 22, 32 and 40 were properly assessed in the audit.
Lab Jacks
The Taxpayer's production process uses customized oven systems that have heating zones made of ceramic tubes. The heating zones are positioned at different heights and angles to ensure the desired distillation process occurs. A glassware reactor is connected with vacuum lines to a vacuum pump. The vacuum pump is used to remove residual gas that would react with and contaminate the purified chemicals in the glassware. Lab jacks are used to maintain the heating zones and the vacuum lines in perfect position for various distillation processes. The lab jacks can be adjusted to various heights and positioned as required for each individual process. The Taxpayer contends that the lab jacks are a component part of the distillation and purification equipment used in production and qualify for the manufacturing exemption.
Title 23 VAC 10-210-920 B 2 states that:
Convenient or facilitative items, such as fuel storage tanks, platforms, structural steel, grating, equipment supports, special flooring, etc., or items which are essential to the operation of a business but not an immediate part of actual production, are not used directly in manufacturing or processing even though such items may be directly attached to exempt production machinery. (Emphasis added.)
P.D. 91-183 (8/26/91) sets out the Department's policy with respect to equipment supports. This determination letter states that supports must be attached to exempt production equipment in some manner to be considered a component part of such equipment or machinery. The lab jacks used in the Taxpayer's production process are not attached to the distillation and purification equipment in any manner that would make the jacks a component part of such equipment. Further, the lab jacks are not an immediate part of actual production. While I recognize the importance of the lab jacks to the Taxpayer's production process, line item #s 1 - 3, 27, 38, 39, 41, 42, 44 - 46, 49 and 50 were properly assessed in the audit.
Storage Cabinets
Storage cabinets are used to safely handle and store the glassware used in the Taxpayer's production process. The Taxpayer states that the glassware stored in the cabinets is a consumable item and a raw material that is essential to the production of the fiber optic products.
In accordance with Va. Code § 58.1-602, manufacturing is defined to include the handling and storage of raw materials. Cabinets, shelves and similar items used by manufacturers to store raw materials for production qualify for the industrial manufacturing and processing exemption. However, in the instant case, the glassware is not a raw material because it does not become a component part of the final product. The glassware is a manufacturing supply. Cabinets, shelves and similar items used to store manufacturing equipment, supplies, repair parts and similar items are not used directly in manufacturing and are taxable.
This conclusion is consistent with P.D. 10-105 (6/18/10), which states that a manufacturer's use of pipelines, tanks and other tangible personal property to store, handle and deliver natural gas (a manufacturing supply) to fuel ovens used in the manufacturing process do not qualify for exemption. Like the Taxpayer's cabinets, the equipment discussed in P.D. 10-105 was used to store and handle a manufacturing supply rather than raw materials. Based on the Department's established policy, line item #s 10, 11, 14 and 15 were properly assessed in the Department's audit.
Tables, Workbenches and Wire Shelves
The Taxpayer uses "80/20" tables and workbenches to support and attach production equipment. The 80/20 tables are specifically sized and designed to support and attach glass distillation ovens used in production. A heavy duty workbench is used to attach and support a heavy custom spooler that is used with optical fiber proof test and rewind equipment. This equipment is used to test optical fibers and is essential to measure the mechanical strength of the produced fibers. The Taxpayer purchased an adjustable height workbench that is used specifically to support a fiber optic tensile tester. The Taxpayer also purchased chrome wire shelves that are used to support temperature controllers and vacuum pumps used in production.
The Taxpayer asserts that the manufacturing exemption applies to the tables and the workbenches because the tables are a component part of the glass distillation ovens and the workbenches are a component part of the heavy custom spooler and the fiber optic tensile tester. The Taxpayer maintains that the wire shelves are part of the production process and qualify for exemption.
Similar to the lab jacks discussed earlier, the tables, workbenches and wire shelves are not used directly in the Taxpayer's production process. While essential to support the production equipment, these items are not a component part of the equipment. In addition, it is not clear how the optical fiber proof test and rewind equipment is used in the Taxpayer's production process. Testing equipment used for production line quality control is exempt from the tax. However, testing equipment that is used after production has ended is taxable because the equipment's use is not an immediate part of production. Accordingly, line item #s 7, 8, 9, 16 and line item # 2 from the contested research and development exceptions list were properly assessed in the audit.
Tools and Supplies
The Taxpayer contests the inclusion in the Department's audit of various tools used by production employees. The Taxpayer asserts that the use of these tools and supplies are essential to production and qualify for the manufacturing exemption.
Aluminum Wrench and Inspection Mirrors: A light weight aluminum wrench is used to tighten vacuum lines that are connected to the production glassware. The vacuum lines are located inside production glove boxes that have a limited amount of space in which to tighten the vacuum lines. The production employee can only use one hand to tighten the vacuum lines. Thus, the lighter weight of the aluminum wrench facilitates its use inside the glove boxes.
Production employees use inspection mirrors with telescoping handles inside the production glove boxes to view and inspect the production setup. The mirrors are necessary because the sight and reach of the production employee is limited inside the production glove box. This inspection procedure insures that production components are assembled correctly and that there are no visible problems. The Taxpayer states that the mirrors are also used to reach and pull out production parts inside the glove box for the production setup.
Based on the information provided, the aluminum wrench and the inspection mirrors are used prior to production. The vacuum lines must be tightened and the setup inside the glove box must be inspected before actual production begins. The activities in which the aluminum wrench and inspection mirrors are used are preproduction activities, which are taxable. These items must be an active and immediate part of production to meet the used directly requirement of the manufacturing exemption. The wrench and mirrors, listed in the audit as line item #s 17, 23 and 34, were properly assessed in the audit.
Stainless Steel Scissors: The Taxpayer uses a thermal insulation blanket called fiberfrax in part of its production process. Fiberfrax is wrapped around a glass ampule before subjecting the glass ampule to a final melting process that is performed in a furnace. Stainless steel wire is wrapped around the fiberfrax to help enclose and protect the glass ampule during the melting process. When the melting process is complete, the insulation blanket covering the hot glassware must be removed quickly so the molten glass can be quenched in water. The quality of the produced glass is highly dependent on the amount of time it takes to remove the fiberfrax and quench the glass ampule in water. Stainless steel scissors are used to quickly cut the stainless steel wire so the fiberfrax can be removed and the glass ampule quenched in water.
The stainless steel scissors are used by production employees during the actual production process. The process of cutting the wire with the scissors, removing the fiberfrax from around the glass ampule and placing the glass ampule in water is an integral part of the Taxpayer's production process. The scissors are not used for any other purpose and are an immediate part of the production process. The scissors are directly used in the manufacturing process and qualify for exemption. The Taxpayer's purchase of the scissors (line item # 26) will be removed from the audit.
Timers: Short period production processes are monitored and controlled with the use of timers by production personnel. The timers are used to monitor the quenching time of the molten glass in water, the baking time of the glassware and the stabilization time between production temperature adjustments. The timers are not used for any other purpose.
In this case, the timers alert production personnel to take a particular action during production, but do not control actual production. In P.D. 96-251 (9/27/96), a water treatment processing business used computer equipment and electronic controls to monitor and detect changes in water quality during the treatment process. The information relayed by this system triggered audible and visual alarms to alert personnel that the production equipment required adjustment. P.D. 96-251 explains that alarms, computers and warning systems must act on or control production in some manner to qualify for the manufacturing exemption. If such a system merely alerts production personnel to perform certain actions, the exemption does not apply. This is analogous to the Taxpayer's use of the timers. The timers are not used directly in the Taxpayer's production process because they do not automatically initiate any type of action to control, shut down or change the production process. The timers (line item #s 43 and 48) were properly assessed in the audit.
Video Borescope: A video borescope is used to view inside the fiber draw furnace and properly align double-crucible glassware for fiber production. It is essential that the fiber core and cladding are perfectly centered to meet the final fiber specifications. The Taxpayer contends that the borescope is an integral part of the fiber draw production process.
Like the wrench and inspection mirrors previously addressed, the video borescope appears to be used in a preproduction activity. The use of the borescope to align and set up the glassware in the furnace before the actual fiber draw production process begins is not an immediate part of production. If the borescope is used during production, like the timers, it must perform some type of action to correct or control the fiber draw production process to qualify for exemption. Thus, the borescope does not qualify for the manufacturing exemption because it is not used directly in the production process.
Blue Mats
Production employees that work in the clean room wear protective coverings to reduce the dust and contaminants that can be carried into the clean room. The Taxpayer purchased tacky blue mats that are placed in the gown room where production employees put on the clean room protective coverings prior to entering the clean room. The production employees step on the blue mat, which is similar to a sticky floor carpet. The blue mat removes any particles or contaminants from under the shoe covers that are worn in the clean room by production employees. The Taxpayer states that the use of the blue mats is essential to guarantee the integrity and quality of its fiber optic products.
While the blue mats are essential to ensure the integrity of the Taxpayer's fiber optic products, the mats are not used directly in production. Production employees step on the mats prior to entering the clean room. Production does not begin until after employees have entered the clean room. The blue mats are not an integral part of the production process and are not actively and continuously used during production. Although the blue mats are used for quality control, the mats do not satisfy the necessary criteria to qualify for exemption as quality control equipment. The blue mats, listed in the audit as line item #s 28 and 29, were properly assessed in the audit.
Custom Platform
A dehumidifier system is used to control the humidity level in the clean room during fiber draw production. The dehumidifier system protects the integrity of the fiber optic products during clean room production. The Taxpayer purchased a custom platform to support and attach the dehumidifier system, which must be located near the clean room ceiling to enhance the overall performance and reliability of the system. The Taxpayer states that the platform is not part of the realty and is a component part of the dehumidifier system.
Consistent with my response for the lab jacks, the custom platform is not used directly in the Taxpayer's production process. A photograph of the platform reveals that it is similar to a mezzanine with steps to access the platform on which the dehumidifier sets. The platform is not a component part of the dehumidifier system but serves a facilitative purpose. It supports the dehumidifier and provides access to the dehumidifier. P.D. 96-278 (10/15/96) addresses mezzanines and catwalks used by a commercial printing operation. This public document states that catwalks and mezzanines that provide access to production equipment are not used directly in manufacturing. While such structures are not attached to the realty and provide support for production equipment, the exemption does not apply. Based on the Department's established policy, the tax was properly assessed on the purchase of the custom platform (line item # 31).
Dynamic Elbow Socket
Chemicals are loaded inside production glassware through a socket. The socket is sealed after the chemicals are loaded inside the glassware. This purchase transaction was for the modification of an elbow glassware socket used in production. Based on the description provided by the Taxpayer, the socket is a component part of the glassware that is used in the production process. The socket was modified to increase the vacuum level in the glassware for quality control purposes. This transaction was not a general maintenance activity but a special modification to a production supply that is used directly in production. This transaction is analogous to the exempt repair of production equipment. The transaction, line item # 30, is exempt and will be removed from the audit.
Research and Development
The Taxpayer was assessed use tax on the purchase of software and a stage holder and contends that these items qualify for the research and development exemption.
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 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.
Bandsolve Software
The Taxpayer states that Bandsolve software was purchased for use in a research contract. The contract work was for the design and development of an innovative process using fiber optics. The software is used for modeling and processing of research data for the contract. The Taxpayer claims that the software is used directly and exclusively in research and development activities.
Based on the information presented, I am unable to determine if the software is used directly and exclusively in research and development activities. The research contract information must be reviewed to evaluate the scope and nature of the work performed by the Taxpayer using the Bandsolve software. The Taxpayer indicates that the contract at issue is available for the Department's review. Therefore, I will have the auditor review the contract information and also evaluate the use of the Bandsolve software in more detail to determine if the exemption is applicable.
Stage Holder
The Taxpayer purchased a specially designed stage holder for use in a research contract with a government agency. The contract requires the design, development and implementation of a novel fiber optic switch. As with the software above, more information is needed to determine if the stage holder qualifies for the research exemption. The contract and use of the stage holder must be reviewed in more detail. The auditor will also review any information the Taxpayer can provide for this item and adjust the audit, if warranted.
CONCLUSION
The audit will be referred to the appropriate field audit staff to review the contract information and the Taxpayer's research and development activities to determine if the software and stage holder qualify for exemption. The auditor will contact the Taxpayer to set up a mutually agreeable time to review this information. The audit will be revised based on this review. As set out in this determination, the appropriate items will be removed from the audit and the audit adjusted accordingly. The Department's records indicate that the Taxpayer paid the contested assessment
in full. A refund of the overpayment, plus applicable interest, will be issued to the Taxpayer based on the revision of the audit liability. The Taxpayer should pay the appropriate sales or use tax on the purchase of equipment and supplies deemed to be taxable in this determination.
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. If you have any questions concerning this determination, please contact ***** in the Department's Office of Tax Policy, Appeals and Rulings, at *****.
Sincerely,
Craig M. Burns
Tax Commissioner
AR/1-5633088099.S