When a company sells taxable equipment below its cost to get customers to sign up for a non-taxable service, is sales tax based on the low price the customer pays or on the company's cost?

Plain-English summary

A company sells a non-taxable service (redacted in the published ruling) and requires customers to sign a one-year contract and buy certain equipment, available only from the company or its authorized dealers. The company buys the equipment from out-of-state suppliers (using a resale certificate), then sells it below its own cost to dealers/consumers as an inducement to sign up for the service. It asked how to tax four sale structures.

The core holding (Scenario A): tax is computed on the company's cost, not the discounted price. When taxable equipment is sold below cost as an inducement to buy a non-taxable service, computing sales tax only on the low price would let the seller artificially shift the equipment's value into the untaxed service and dodge tax. So, absent evidence to the contrary, the Department presumes the taxable price is at least the company's cost to acquire the equipment. Neither the company nor the dealer owes use tax. This is consistent with how use tax works when a retailer pulls inventory for its own marketing (e.g., free samples, the "bank toaster" — IBM v. Charnes), and the converse statutory rule for discounted cell phones bundled with taxable wireless service (tax on the discount price, no use tax — §§ 39-26-102(7)(b), 39-26-202(1)(c)), which works only because that service is itself taxable.

Two key assumptions behind the holding: (1) the dealer "commission" is not a manufacturer's rebate (a rebate would be added to the taxable price); and (2) the company hasn't shifted into the service more than its cost of the equipment. The Department looks to the substance, not the labels in the contracts. The ruling is also limited to where the discount is expressly contingent on buying the non-taxable service — it does not apply to "buy one, get one" or below-cost sales not tied to another purchase.

How the tax is collected:
- Company sells both equipment and service: the company is the retailer and collects tax computed on its cost.
- Dealer sells equipment, company sells service: the dealer collects sales tax on the price it charges the consumer, and the company collects sales tax on the difference between its cost and the dealer's price (as a one-time charge or prorated over installments). The dealer here acts as the company's agent for selling the service.

The other three scenarios:
- Scenario B (company sells to dealer, then directly to consumer, with a credit memo back): three transactions — company→dealer is a sale for resale (exempt), company→consumer is a taxable retail sale, and the credit memo is a repurchase = sale for resale (exempt). Same tax treatment as Scenario A.
- Scenario C (dealer sells/installs to an out-of-state consumer): Colorado imposes no sales tax on goods delivered to a destination outside Colorado, and no use tax on a consumer using the goods out of state.
- Scenario D (company sells to an out-of-state consumer, equipment sourced via a dealer with a credit memo): no Colorado tax on the out-of-state sale, and the company↔dealer transfers are sales for resale (exempt).

What this means for you

Sellers who discount hardware to sell a service

This is the central lesson: if you sell taxable equipment below cost to land a customer for a non-taxable service, expect Colorado to tax the equipment on at least your acquisition cost, not the bargain price the customer pays. You can't move the equipment's real value onto the untaxed service line and shrink the tax. (If the bundled service were itself taxable, the analysis flips — like discounted phones with taxable wireless service, where tax follows the discounted price.)

Watch the "commission" vs. "manufacturer's rebate" line

If what you call a dealer "commission" is in substance a manufacturer's rebate, it gets added to the taxable price. The Department decides this by substance, weighing factors like whether the equipment can be bought separately at a higher price and whether the commission is paid regardless of whether the consumer buys the equipment. Document why your payment is a service commission, not a rebate.

Multi-party collection mechanics

When a dealer sells the equipment and you sell the service, split the collection: the dealer taxes its sale price; you tax the gap up to your cost (lump sum or prorated on the installment billings). Build this into your systems so the full cost-based tax actually gets collected.

Interstate and resale points

Equipment sold and delivered to out-of-state customers isn't subject to Colorado sales/use tax. Company-to-dealer sales (and credit-memo repurchases) are sales for resale and exempt. And remember Colorado's self-collected home-rule cities run their own taxes (DRP 1002).

Common questions

Q: We sell the device below cost to sign customers to a service. What's the tax base?
A: At least your cost to acquire the device. The Department won't let you compute tax on a below-cost price when the discount is an inducement to buy a non-taxable service, because that shifts value into the untaxed service.

Q: Do we (or our dealer) owe use tax on the discounted portion?
A: No. The Department treats the whole thing as a sales-tax transaction (tax on cost) rather than splitting it into a sale plus a use-tax liability.

Q: What if our service were taxable instead?
A: Then the bundled-discount rule for taxable items applies — like discounted cell phones sold with taxable wireless service, tax is computed on the discounted price and there's no use tax on the difference.

Q: Does this apply to "buy one, get one" or other below-cost sales?
A: No. This ruling is limited to discounts expressly contingent on buying a non-taxable service. It doesn't cover tying two taxable items together or below-cost sales not conditioned on another purchase.

Q: What about sales to customers outside Colorado?
A: Colorado doesn't tax equipment sold and delivered to an out-of-state destination, and doesn't impose use tax on a consumer using the goods out of state.

Q: Can my business rely on this ruling?
A: No. A private letter ruling binds the Department only for the taxpayer and exact facts it was issued to, is premised on full and accurate disclosure, and can't be relied on by anyone else. Home-rule city taxes aren't covered.

Citations and references

Statutes and cases:
- § 39-26-104(1)(a), C.R.S. — sales tax on retail sales; tax computed on purchase price
- § 39-26-102(5), (7)(a), C.R.S. — definitions of "sale" and "purchase price"
- § 39-26-102(7)(b), C.R.S. — discounted cell phone bundled with taxable wireless service is taxed on the discount price
- § 39-26-202(1)(c), C.R.S. — no use tax on the discounted portion of such a cell phone
- International Business Machines v. Charnes, 601 P.2d 622 (Colo. 1979) — use tax on inventory used for the retailer's own marketing
- DRP 1002 — list of self-collected home-rule jurisdictions

Persuasive out-of-state authorities cited by the Department (not Colorado law): Mass. Regs. Code 64H.1.4(1) ex. 5; Mercury Cellular Telephone Co. v. Calcasieu Parish, 773 So. 2d 914 (La. 2000); Texas Comptroller's Decision No. 47,362 (2006); Nebraska Revenue Ruling 1-98-1 (1998); North Carolina Sales & Use Technical Bulletin No. 21-3 (2007).

Bundling / tax-base / marketing-use cousins: [[gil-09-019-use-tax-display-items]], [[gil-09-021-pet-recovery-services]], [[gil-09-016-percentage-tax-v-sales-tax-charts]].

Source

• Landing page: Colorado Sales & Use Tax Letter Rulings
• Original PDF: PLR-08-002.pdf

Original ruling text

Office of Tax Policy
P.O. Box 17087
Denver, CO 80217-0087
[email protected]

PLR-08-002

December 22, 2008
XXXXXXXXXXXXXXXXX
Attn: XXXXXXXXXXXXX
XXXXXXXXXXXXXXXXX
XXXXXXXXXXXXXXXXX
Re: XXXXXXXXXXXXXX
Dear XXXXXXXXXXXXX,
You submitted on behalf of XXXXXXXXXXXXXXXXXXXX (“Company”) a request for a private letter
ruling. This letter is the department’s private letter ruling.
Issue
What is the proper tax treatment of wholesale and retail sales of equipment whose price is discounted
as an inducement for the consumer to enter into a contract for XXXXXXXXXX [a non-taxable
service]?
Background
The Company is a provider of [a non-taxable service] with offices located outside of Colorado. The
Company markets and sells its [service] both directly to consumers and through third-party agents
(“Dealers”). Use of the Company’s [service] requires consumers to sign a one-year contract and
purchase certain equipment. A consumer can purchase the required equipment only from a
Company authorized Dealer or the Company. The Company purchases components of the
equipment from suppliers who are located in states outside of Colorado where it is fabricated. The
Company then issues its suppliers a resale certificate, takes ownership and briefly maintains an
inventory of equipment in warehouses outside of Colorado. Equipment is shipped from these
warehouses to Dealers both inside and outside of Colorado.
The Company requests guidance on the following four scenarios.

Scenario A
The Company purchases the equipment from its suppliers for a total cost of [Price A] and issues a
resale certificate to each supplier. The Company sells the equipment to a Dealer for [Price B, which
is less than Price A]. The Dealer provides the Company with a resale certificate and the Company
does not charge Dealer Colorado sales or use tax.
A Colorado consumer is signed up for [the service] either directly through a Dealer, or through the
Company which refers the new consumer to a Dealer. Dealer sells the equipment to the consumer
for [Price B], installs the equipment at consumer’s location, and bills, collects and remits all applicable
Colorado sales and use taxes for equipment and installation service. Although not expressly stated
in your letter, I presume that the tax collected by the Dealer from the consumer is based on the sales
price of [Price B]. The Company compensates the Dealer with a commission. The Company bills
consumers for [the service] over the period of the contract.
Scenario B
The Company purchases the equipment from its supplier for a total cost of [Price A] and issues a
resale certificate to each supplier. A Colorado consumer signs up for [the service] directly with the
Company. The Company sells equipment to the Colorado consumer for [Price B]. An authorized
installer obtains the equipment from the nearest Dealer and installs the equipment at consumer’s
location. The Company submits a credit memo to the Dealer for the equipment originally purchased
by Dealer. The Company bills, collects, and remits all applicable Colorado state and local sales and
use taxes for equipment and installation service based upon the sales price of [Price B]. The
Company bills the consumer for [the service] over the period of the contract.
Scenario C
The Company purchases equipment from its supplier for a total cost of [Price A] and issues a resale
certificate to each supplier. The Company sells equipment to a Dealer for [Price B]. The Dealer
provides the Company with a resale certificate and the Company does not charge the Dealer sales
and use taxes on the purchase.
A consumer outside of Colorado signs up for [the service] either directly through a Dealer or through
the Company, which refers the new consumer to the Dealer. The Dealer sells equipment to the
consumer for [Price B], installs the equipment at consumer’s location outside of Colorado, and bills,
collects, and remits all applicable out-of-state sales and use taxes for equipment and installation
service based upon the sales price of [Price B]. The Company compensates the Dealer with a
commission. The Company bills the consumer for [the non-taxable service] over the period of the
contract.
Scenario D
The Company purchases the equipment from its suppliers for a total cost of [Price A] and issues a
resale certificate to each supplier. A consumer outside of Colorado signs up for [the service] directly
with the Company. The Company sells the equipment to consumer for [Price B]. An authorized
installer obtains the equipment from the nearest Dealer and installs the equipment at consumer’s
location outside of Colorado. The Company submits a credit memo to the Dealer for the equipment
originally purchased by Dealer. The Company bills, collects, and remits all applicable out-of-state
sales and use taxes for equipment and installation service based upon the sales price of [Price B].
The Company bills consumer for [the service] over the period of the contract.
Discussion
Scenario A

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The fundamental question posed in this scenario is the tax consequence, if any, that attaches to the
transfer of equipment to the consumer at a price below the Company’s cost of acquisition. Resolution
of this scenario requires us to consider a number of sales and use tax issues.
As an initial matter, we note that a sales tax liability is created when tangible personal property is
transferred to another in exchange for consideration. §39-26-104(1)(a) and 102(5) and (7)(a), C.R.S.
In general, tax is computed on the purchase price paid by the consumer. §39-26-104(1)(a), C.R.S.
In the present case, the transfer of tangible personal property (equipment) to the consumer for
consideration creates a sales tax liability for the consumer.
We also begin by noting generally that a retailer incurs use tax liability when it uses property in its
inventory for its own purposes, such as for marketing. Thus, for example, a distributor who gives
away free samples of its inventory to retailers and consumers as a marketing strategy is liable for use
tax calculated on its costs of acquiring the sample from its supplier. See, International business
Machines v. Charnes, 601 P.2d 622 (Colo. 1979). Similarly, a bank that gives away a toaster to new
consumers who agree to engage the bank’s services is liable for use tax on the acquisition costs of
the toaster (assuming the bank has not previously paid sales tax when it purchased the toaster). In
Scenario A, the Company arguably has given away a significant portion the equipment to the
consumer as a marketing effort to induce the consumer to purchase the Company’s [non-taxable
service]. The donated portion is the difference between the price paid by the consumer and, at a
minimum, the cost paid by the Company to the supplier.
Having considered the interplay of these and other related issues discussed below, the department
concludes that sales tax paid by the consumer in Scenario A should be computed on the Company’s
cost (i.e., the price the Company paid the supplier for the equipment). The department further
concludes that neither the Company nor Dealer is liable for use tax on the equipment. These
conclusions are premised on the assumptions that the commission paid by the Company to the
dealer is not a manufacturer’s rebate, and that the Company has not shifted to the [non-taxable
service] a value of the equipment that exceeds the Company’s cost of acquiring the equipment. We
reach our conclusions for the following reasons.
The Company’s marketing strategy of selling equipment below cost is sustainable in the long term
only if that portion of the Company’s costs for the equipment not reflected in the price paid by the
consumer is recovered in the price of the [service]. Shifting some or the entire price of the equipment
to the price for [the service] would not be an issue if [the service] itself was subject to sales tax
because sales tax would also be collected on the price of [the service]. However, [sales of the
service] are not subject to sales tax in Colorado. Thus, by allocating some portion of the price for
taxable equipment to the non-taxable [service], the sales tax obligation of this transaction is artificially
reduced and improperly avoided.
We further acknowledge that a retailer is generally free to price its goods and services as it best sees
fit and the tax consequences are then determined based on how the retailer structures its sales.
However, a retailer cannot distort sales tax obligations by shifting the price of taxable goods to nontaxable goods (or services) by bundling the sale of these items and reducing or eliminating the price
of the taxable goods. The structure adopted by the Company here results in a distortion of the sales
tax.
The issue, then, is how to calculate sales tax in such cases. For the reasons outlined above, we will
presume, in the absence of evidence to the contrary, that the price of the taxable item on which sales
tax is computed is at least the Company’s cost to acquire the goods from its supplier. This is
consistent with how use tax is computed in the similar case when a retailer uses an item from its

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inventory for marketing, such as when it gives away a taxable item as a sample (use tax is based on
retailer’s cost of acquisition).1
Some states2 that have addressed this issue assess use tax on the retailer on the theory that the sale
at a below-market price does not constitute a sale and, therefore, the retailer is not entitled to
purchase the goods free of tax from its supplier.3 The department is reluctant to adopt the position of
some of these states that a sale does not occur if the price the retailer sells the item is more than a
nominal price, but less than its costs.4 For example, a retailer who sells its goods during a liquidation
sale is incurring sales tax liability even if the price of those goods is below the company’s cost of
acquiring the goods but more than a nominal price. Other states have created a presumption that a
sale at a price which is 25% of the retailer’s cost is presumed not to be a sale but merely a
promotional give-a-way that subjects the retailer to use tax.5 Such a presumption does have merit,
but the approach does not capture that portion of the price of the taxable item that is recovered in the
price of the non-taxable item or service.
We note that our analysis is consistent with Colorado law that applies in the converse case of the
sale of discounted taxable items sold in conjunction with taxable services. Sections 39-26-102(7)(b),
C.R.S. provides that sales tax cell phones sold at a discount and bundled with taxable wireless
telecommunications services is calculated on the discount price charged the consumer. The seller
does not incur use tax on that portion of the cell phone price not reflected in the cell phone price.
§39-26-202(1)(c), C.R.S. This approach is presumably premised on the fact that the portion of the
value of the cell phone not reflected in the cell phone price is recovered in the price of the taxable
wireless telecommunications services.
Other states impose a use tax liability on retailers who sell goods at a price below its cost of
acquisition.6 The consumer pays sales tax on the discounted purchase price and the retailer pays
use tax on the difference between the price paid by the consumer and the retailer’s cost of
acquisition. This approach is consistent with what appears to be the economic realities of the
transaction: the sale represents both a sale to a consumer and a use by the retailer. However, this
approach is somewhat unusual in that it splits a transaction into a sales tax and use tax liability.
Although we do not reject the idea that such an approach is not possible, we elect to treat the
transaction as subject only to sales tax.
At least one state requires the retailer to calculate sales tax based on the fair market value of the
item.7 The fair market value is the price that the retailer sells the item separate from any other
purchase. This approach has the effect of eliminating any inappropriate shift in pricing of taxable
items to non-taxable items. We also recognize, however, that a retailer may offer a “loss leader” to
consumers on the assumption that the forgone profit the retailer would otherwise realize on a
separate sale of item will be offset by a greater gain from the sale of goods or services tied-in to the
sale of the loss-leader. Valuing the loss-leader at its fair market value may not reflect the economic
realities in such circumstances.
1 We do not imply here that the sales tax must be the same as the use tax if the Company gave away the equipment.

Sales
tax must be paid on any portion of the price of the taxable item reflected in the price of the non-taxable item. We have
concluded here that, in the absence of evidence to the contrary (such as a market for the equipment independent of the
[service]), the Company’s cost is the best measure of the price for the equipment.
2 Some states take the position that sales tax is computed only on the discount price paid by the consumer even if the item
is bundled with non-taxable services.
3 Mass. Regs. Code 64H.1.4(1)(example 5).
4 Mercury Cellular Telephone Company v. Calcasieu Parish of Louisiana, et al., 773 So 2d 914 (La. 2000) (retailer liable for
use tax for cell phones offered for free, nominal price, or at a price substantially below the retailer’s costs, as a marketing
tool to induce consumers to purchase wireless telecommunications services).
5 Texas Comptroller's Decision No. 47,362, 10/13/2006
6 See, e.g., Nebraska Revenue Ruling 1-98-1, 09/14/1998
7 North Carolina Sales and Use Technical Bulletins No. 21-3,04/01/2007

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We believe the better analysis in this particular case is that the sales tax is computed based on the
price the Company purchases the equipment from its supplier. Important to our determination is the
assumption that the equipment has no market value other than as equipment necessary for the
provisioning of the Company’s [service]. If there were evidence that the equipment could be
separately sold without also acquiring the Company’s [service], we might well come to a different
conclusion. However, the facts presented in your letter do not disclose that this is the case.
The approach we outline here addresses the circumstance of a single transaction in which the
taxable and non-taxable items are sold together. Cell phones and wireless services are often sold in
a similar manner. Scenario A, however, is slightly different in that it encompasses two situations. In
one case, the Company sells both the [service] and the equipment to the consumer. In the second
case, there appears to be two sellers: the Dealer (who purchased the equipment from the Company)
sells the equipment to the consumer and the Company sells the [service] to the consumer. Some
states have concluded that when there are two separate sales transactions (e.g., a retailer sells
equipment as one transaction and sells the tied-in service in another transaction), the retailer of
equipment incurs use tax liability for the discounted or donated item. It appears from the facts
presented in your letter that this is a bundled transaction in which the purchase of the equipment
would not occur but for the purchase of [service].8 We conclude that treating these two transactions
as one is appropriate because it reflects the economic realities and simplifies the tax treatment by
treating both as sales transactions.
The determination we make here is limited to the case where the discount for the taxable item is
expressly contingent on the consumer’s purchase of the non-taxable service. Thus, for example, this
approach is not appropriate, for reasons discussed above, where the retailer has tied-in two taxable
items, such as a “buy-one, get one” free sale, or offers for sale a taxable item at a price below its
costs and not conditioning the discount on the consumer’s agreement to purchase another good or
service.
We turn now to the question of how the tax is collected. The most straight-forward case is when the
Company sells both the equipment and the [service]. In both cases, the Company is the retailer and
must collect the tax from the consumer. The issue is more complicated when the Dealer sells the
equipment and the Company9 is the seller of the [service]. The Dealer may or may not be aware of
the Company’s cost of acquisition for the equipment and, therefore, may not be in a position to
calculate the correct sales tax, which includes the difference between the Company’s cost of
acquisition and the sale price to the Dealer. The better approach is to have the Dealer collect sales
tax from the consumer based on the sale price charged by the Dealer to the consumer, and the
Company will collect from the consumer sales tax calculated on the difference between the
Company’s cost and the price charged by the Dealer. This is appropriate because the Company is
selling a portion of the equipment as part of its sale of the [service]. The Company is also aware of
the price difference between the price it acquires the property and the price at which the Dealer sells
the equipment to the consumer. The Company may collect the sales tax from the consumer as a one
time charge, or treat the sale as a credit sale and collect a prorated portion of the tax on the
installment payments.
8 Even if we viewed these as two separate, independent transactions, we would likely conclude that tax is due on the
difference between the price at which the Company acquired the equipment from its supplier and the price at which the
Company sold the equipment to the consumer or Dealer. As noted above, a retailer incurs use tax liability when it uses
goods in inventory for its own purposes, such as transferring the property to a consumer without charge as an inducement
to the consumer to purchase other goods of the retailer. A retailer that sells a taxable item below its costs as an inducement
for the consumer to enter into a separate transaction for a non-taxable good or service, the retailer has converted a
significant portion of the taxable item for its own purposes. Use tax would appear to apply on the difference between the
price incurred by the retailer to acquire the taxable item and the price it sells the item.
9 In the second circumstance, the Dealer is acting as the agent of the Company for the sale of [the service].

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We mentioned earlier that our ruling would be different if the Company gave Dealers a manufacturer’s
rebate. A manufacturer rebate is a payment from a manufacturer to a retailer who sells the
manufacturer’s goods at a discount. In general, the price upon which sales tax is computed must
include a manufacturer’s rebate. Our caution is based on your statement that Dealers receive a
commission from the Company. It is unclear from the facts you provide whether the commission a
Dealer receives from the Company is a manufacturer’s rebate or a non-taxable commission for
signing a consumer to the [service]. In determining whether the commission is a taxable rebate or a
non-taxable commission, the Department will look to the substance of the transaction and is not
bound by the terminology adopted by the Company in its contracts with Dealers. The department will
consider a number of factors, including whether the equipment can be purchased separately and has
a price greater than the price at which the equipment is sold to the Dealer, and whether the Company
pays the commission regardless of whether the consumer purchases the equipment.
Scenario B
Scenario B involves three separate transactions. It appears that the Company initially sells the
equipment to a Dealer. This is a sale for resale transaction and, therefore, is exempt from sales and
use tax. The Company then sells the equipment to a consumer. This is a retail sale and the
consumer is liable for sales tax. The Company’s credit memo appears to be a repurchase of the
equipment it sold to the Dealer. Again, this is a sale for resale from the Dealer to the Company and,
therefore, is exempt from sales and use tax. The sales tax treatment described in Scenario A applies
to this scenario.
Scenario C
This scenario involves the sale and delivery of goods by a retailer to a consumer who is located
outside of Colorado. Colorado does not impose sales tax on goods that are delivered by the retailer
to a destination outside of Colorado. Similarly, Colorado does not impose a use tax on the consumer
who, as in this case, uses the goods outside of Colorado.
Scenario D
As discussed in our responses to Scenarios B and C, Colorado does not impose a sales tax on
goods sold and delivered by a retailer to a consumer who is located outside of Colorado. Similarly,
the Company’s sale of equipment to the Dealer and the Company’s subsequent repurchase of the
equipment from the Dealer are both sales for resale and, therefore, exempt from sales and use tax.
Miscellaneous Matters
Please note that the department does not collect sales and use taxes for “home-rule” cities and
counties. You can find a list of these jurisdictions by visiting our web site at:
www.revenue.state.co.us (go to Taxation > Forms > Businesses > Sales and Use > DRP 1002)
Contact those governments for information about their taxes.
This ruling is premised on the assumption that the Company has completely and accurately disclosed
all material facts, and is subject to the limitation and qualifications set forth in the ruling. The
department reserves the right, among others, to independently evaluate the Company’s
representations. This ruling is null and void if any such representation is incorrect and has a material
bearing on the conclusions reached in this ruling. Enclosed is a redacted version of this ruling which
the department will publish on its website.
Respectfully,
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Office of Tax Policy
Colorado Department of Revenue

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