Were reverse-engineering charges taxable when a firm disassembled an instrument and delivered vellum drawings, parts lists, and assembly instructions?

Plain-English summary

A customer supplied an instrument for a firm to disassemble and evaluate. The firm delivered vellum drawings, parts and materials lists, and assembly instructions that the customer could review before deciding whether to mass-produce the instrument.

California treated the reverse-engineering charge as a nontaxable service on stated assumptions: the drawings conveyed information rather than serving directly in manufacturing, and the parts lists and instructions reflected real engineering expertise.

The customer could later hire the same firm to mass-produce the instruments without retroactively making the completed reverse engineering taxable, as long as there was no production contract before the reverse-engineering work was completed.

If the parties were already contractually committed to production, the reverse engineering would generally be a taxable service that was part of the sale of the manufactured instruments.

What this means for you

Engineering and manufacturing firms

Separate sequencing and contracts supported service treatment; precommitted production tied the engineering work to the product sale.

Accountants and tax professionals

Review drawing use, engineering judgment, production aids, contract timing, dependency between phases, later manufacturer selection, and digital deliverables.

Common questions

Q: Was the reverse-engineering charge taxable?

A: No, under the stated assumptions.

Q: Did later production by the same firm make it taxable?

A: Not if no production contract existed before reverse engineering was completed.

Q: What if production was already required?

A: The engineering would generally be taxable as part of the manufactured-instrument sale.

Citations and references

• California Sales and Use Tax Regulation 1501
• Albers v. State Board of Equalization, 237 Cal.App.2d 494 (1965)

Source

• Annotated Legal Opinions collection: CDTFA Annotated Legal Opinions
• Annotation page: Annotation 515.0225
• Original supporting opinion: 515.0225 PDF

Original ruling text

State of California

Board of Equalization
Legal Division (MIC:82)

Memorandum
515.0225
To:

Mr. Mark Noack
San Jose Auditing

From:

David H. Levine
Tax Counsel

Subject:

O---, Inc.

Date:

April 25, 1988

SR -- XX-XXXXXX

This is in response to your memorandum dated March 23, 1988 regarding reverse engineering. O--- will be provided an instrument by one of their customers. O--- will disassemble the instrument and evaluate it, and will then prepare drawings on velum, which are needed by the customer to design printed circuit boards and for assembly. O--- also prepares a listing of parts and materials and assembly instructions for the instrument. The drawings, parts listings, and instructions are transferred to the customerl, and O--- makes a charge designated as for reverse engineering. The customer then examines the reverse engineering package and decides whether to begin mass production of the instrument. If it decides to proceed, the customer may have O--- or another manufacturer begin that production. O--- claims that the contracts for reverse engineering and mass production are separate, and one is not dependent upon the other. You ask whether the reverse engineering charges are subject to sales tax when O--- does not do any further manufacturing of the instruments and when O--- does manufacture the instruments. This is a question of the true object of the contract as discussed in Regulation 1501 and in Albers v. State Board of Equalization (1965) 237 C.A.2d 494. If the true object of the contract is for O--- to provide services requiring actual engineering expertise to transfer only information, we would regard O--- as rendering a service to its customer. On the other hand, if the true object of the contract was for the customer to acquire a drawing which would be used in the actual production of the instruments, we would regard O--- as selling that drawing, with its services being part of that taxable sale.

Mr. Mark Noack

-2-

April 25, 1988
515.0225

We assume that the drawings on velum are transferred to the customer for the purpose of conveying information and that those drawings are not used in the manufacturing of the instruments. We also assume that the assembly instructions are based on engineering expertise and are important aspects of the contract. These assumptions lead to the conclusion that O---’s reverse engineering is nontaxable service. When O--- also mass produces the instruments, the reverse engineering would still be regarded as nontaxable service provided that there was no contract between the parties to produce the instruments before completion of the reverse engineering. If there were such a contractual obligation, we would generally regard the reverse engineering as a service part of the sale of the instruments. If you have further questions, feel free to contact us again.

DHL:ss