Was a contract to design, develop, and qualify onion-processing equipment a service contract when the customer was entitled to possess the prototype whether or not it succeeded?

Plain-English summary

A developer agreed to design, develop, and qualify a basic prototype unit for processing onions. It would receive $62,500 in progress payments, another $12,500 if the prototype was acceptable, and a possible $200,000 order for at least four units if the customer elected to proceed.

The contract entitled the customer to possession of the prototype whether or not it proved acceptable. California therefore treated the agreement as a sale of a specific item of tangible personal property rather than merely research-and-development services.

Because the developer was engaged in selling taxable property, it was a seller under section 6014 and had to hold a seller's permit. The source nevertheless said contract amounts were not taxable unless and until the developer became a retailer.

If the prototype failed, the consideration for it would be the progress payments after the contract's specified adjustments.

What this means for you

Prototype developers and equipment buyers

An unconditional contractual right to receive the prototype supported sale treatment even if development failed.

Accountants and tax professionals

Document possession and title rights, acceptance conditions, progress payments, success fees, future production options, seller permits, and when retail status begins.

Common questions

Q: Was the agreement merely for R&D services?

A: No.

Q: What fact drove the sale conclusion?

A: The customer received the prototype whether or not it was acceptable.

Q: Did the developer need a seller's permit?

A: Yes.

Citations and references

• California Revenue and Taxation Code § 6014
• California Sales and Use Tax Regulation 1501.1 (identified by the source's 2003 editorial note)

Source

• Annotated Legal Opinions collection: CDTFA Annotated Legal Opinions
• Annotation page: Annotation 515.0620
• Original supporting opinion: 515.0620 PDF

Original ruling text

State of California

Board of Equalization
Legal Division (MIC:82)

Memorandum
515.0620
To:

Los Angeles – District Principal
Auditor (JTQ)

Date:

June 28, 1965

See also new Reg. 1501.1 SPJarvis 10/6/03
From:

Tax Counsel (PM)

This is in reply to your memo of April 5 concerning the tax liability in connection with a prototype which the above company is developing for “X”. It is agreed in the contract between the parties that “T” “will design, develop and qualify a basic Prototype unit of equipment” for processing onions. “T” is to receive progress payments totaling
$62,500 plus an additional payment of $12, 500 if the prototype is acceptable. The agreement further provides that if a successful prototype is developed “X” will place a $200,000 order for at least four units of equipment, including the prototype, should “X” so elect. “T” does not hold a seller’s permit and apparently does not qualify as a retailer on account of any other operations. We believe it is clear that the contract between “T” and “X” calls for the sale of a specific item of tangible personal property rather than for the mere rendition of research and development services. Paragraph (6) of the contract entitles “X” to possession of the prototype whether or not it proves acceptable. Thus, in either event, “T” will make a sale of the prototype. Since it is engaged in the business of selling property of a type subject to tax, it is a “seller” under Section 6014 and is required to hold a seller’s permit. However, it will not be liable for tax on any amounts received under the contract unless and until it becomes a retailer. If the prototype is unsuccessful, the consideration will be the total amount of progress payments after the adjustments provided for in paragraph (7).

PM:ls

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