Does a contractor owe Colorado use tax on goods it tests in Colorado before reselling them, and on materials it builds into products it manufactures partly in Colorado and finishes out of state?

Plain-English summary

A federal-government contractor asked the Department about two operations:

• Service Offering No. 1 (buy-test-resell). It buys customized security/communications computers from suppliers, tests them in Colorado to confirm they meet its contract's performance criteria, then resells them (with a nominal markup) and delivers them to the Customer's facilities inside and outside Colorado. A passing computer is invoiced to the Customer; a failing one is returned to the supplier. Computers are typically in Colorado less than 90 days, and the contractor never uses them for security or communications itself.
• Service Offering No. 2 (manufacture partly in Colorado). It manufactures computers, testing components at its Colorado lab, doing the initial manufacturing at another Colorado facility, then shipping partially finished computers outside the U.S. for final assembly.

The Department ruled the contractor owes no use tax in either case.

Offering No. 1 — testing before resale is an exempt use. The contractor raised two possible exemptions:

• Testing exemption (§ 39-26-713(2)(j)) — does NOT apply. That exemption covers testing/inspection of property acquired for ultimate use outside Colorado in manufacturing (if testing is ≤90 days). Here the computers are already fully manufactured and are used for security/communications (a service), not in manufacturing — and some are even delivered for use in Colorado. So this exemption doesn't fit.
• Resale exemption (§ 39-26-713(2)(b)(I)) — DOES apply. The Department worked through Colorado's "use before resale" cases — Regional Transportation District and A.B. Hirschfeld Press (the "primary purpose" test: was the property acquired primarily for resale unaltered and basically unused?) and General Motors (a manufacturer that pulled cars from inventory, ran emissions testing, and consumed them was taxable). It distinguished all of them: here the contractor neither consumes the computers nor uses them for their intended purpose. Its compliance/acceptance testing is an integral part of the resale process — a buyer's ordinary right to inspect goods before acceptance (UCC § 4-2-513). Had the ultimate buyer or the supplier done the same testing, it plainly wouldn't be a separate taxable use. Because the primary purpose of the testing is resale, the use is exempt. (On top of that, the sales to the federal government are exempt under § 39-26-704(1), and the customized — non-standardized — software likely isn't taxable at all under § 39-26-102(13.5).)

Offering No. 2 — component-part exemption survives out-of-state finishing. Colorado exempts tangible personal property a manufacturer buys that becomes an ingredient or component part of a product manufactured for sale (§ 39-26-713(2)(e)(I)). The Department confirmed this applies regardless of whether the finished goods are sold (or finished) in Colorado, another state, or another country. So the contractor's purchases of materials that become component parts of the manufactured computers are exempt, even though final assembly happens overseas.

Because this is a private letter ruling, it is binding on the Department only for this taxpayer and these facts and cannot be relied on by anyone else.

What this means for you

Resellers and value-added resellers

Routine acceptance/compliance testing of goods you buy to resell — confirming they meet spec before you accept and pass them on — is generally an exempt use incident to resale, not a separate taxable use, as long as you don't consume the goods or use them for their intended end purpose. The line the cases draw is consumption/end-use (taxable) vs. testing-as-part-of-the-sale (exempt). Keep markups and resale intent documented.

Manufacturers with multi-state or international supply chains

Materials that become an ingredient or component part of your finished product are exempt under § 39-26-713(2)(e)(I) even if the manufacturing finishes out of state or out of the country. Where the product is ultimately sold or assembled doesn't defeat the component-part exemption.

Government contractors and accountants

Watch the difference between the testing exemption (§ 713(2)(j): for property bound for out-of-state manufacturing use, ≤90 days) and the resale exemption (§ 713(2)(b)(I)). Fully-manufactured goods used in a service won't fit the testing exemption, but pre-resale acceptance testing can still ride the resale exemption. And remember sales to the federal government are exempt (§ 39-26-704(1)).

Common questions

Q: We test goods in Colorado before reselling them. Do we owe use tax on that testing?
A: Generally no. If the testing is acceptance/compliance testing that's part of the resale — and you don't consume the goods or use them for their end purpose — it's an exempt use under the resale exemption.

Q: Our manufacturing starts in Colorado but finishes overseas. Are our component-material purchases taxable?
A: No. The component-part exemption (§ 39-26-713(2)(e)(I)) applies regardless of where the finished product is sold or assembled.

Q: Doesn't the 90-day testing exemption cover our testing?
A: Only if the property is headed for out-of-state manufacturing use. Fully-built goods you test and resell for a service don't qualify under that exemption — but the resale exemption can still apply.

Q: We sell the finished goods to the federal government. Is that sale taxable?
A: No. Sales to the federal government are exempt under § 39-26-704(1).

Citations and references

Statutes, rules, and cases:
- § 39-26-202(1)(a), C.R.S. (use tax)
- § 39-26-713(2)(b)(I), C.R.S. (resale exemption); § 39-26-713(2)(j), C.R.S. (testing exemption); § 39-26-713(2)(e)(I), C.R.S. (component-part exemption)
- § 39-26-704(1), C.R.S. (federal-government sales exempt); § 39-26-102(13.5), C.R.S. (only standardized software taxable); § 4-2-513, C.R.S. (UCC inspection right)
- Regional Transportation District v. Dep't of Revenue, 805 P.2d 1102 (Colo. 1991); A.B. Hirschfeld Press v. City & County of Denver, 806 P.2d 912 (Colo. 1991) (primary-purpose test); General Motors v. City & County of Denver, 990 P.2d 59 (Colo. 1999); United States v. Boyd, 378 U.S. 39 (1964)

Related rulings

• [[gil-09-002-colorado-sales-and-use-tax]] — component-part exemption; manufacturer-contractor pays use tax on materials, not labor
• [[gil-12-010-tangible-personal-property-assembled-in-colorado]] — manufacturing/assembly situs and the component exemption
• [[gil-15-004-contract-manufacturing]] — who is the manufacturer and how the exemption flows
• [[plr-11-010-private-letter-ruling]] — component/ingredient portion exempt; dual-use apportionment

Source

• Landing page: https://tax.colorado.gov/sales-use-tax-letter-rulings
• Original PDF: https://tax.colorado.gov/sites/tax/files/documents/PLR-10-006.pdf

Original ruling text

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

PLR-10-006
September 19, 2010

xxxxxxxxxxxxxx
Attn: XXXXXXXXXX
xxxxxxxxxxxxxx
xxxxxxxxxxxxxx

Re: Private Letter Ruling
Dear XXXXXXXXXXX,
Your firm submitted a request for a private letter ruling on behalf of XXXXXXXXXX
("Company") to the Colorado Department of Revenue ("Department") pursuant to
Regulation 24-35-103.5. This letter is the Department's private letter ruling.

Issue
1. Is Company subject to use tax when, pursuant to a contract with a client, it
conducts in Colorado compliance testing on property it purchases for resale
and delivery to various customer's facilities located inside and outside
Colorado?
2. Is Company subject to sales or use tax for purchases of materials for
integration into manufacturing activities that begin in Colorado and conclude
outside Colorado despite the testing function that are performed in Colorado?
Conclusion
1. Company is not liable of use tax on property tested in Colorado prior to resale
and delivery to a client located outside Colorado.
2. Company is not liable for sales or use tax for purchases of materials integrated
into a manufactured product where the manufacturing process (including
testing of such product) begins in Colorado and concludes outside Colorado.

Background
Service Offering No. 1
Company has entered into a contract with the federal government ("Customer") to
provide testing of software and computer hardware. The overall terms of its contract
with the Customer provide that Company will construct turnkey facilities for the
Customer, including real property construction and installation of numerous items of
tangible personal property. The first service offering (Service Offering No. 1) requires
Company to purchase customized security and communications hardware and
software (collectively referred to here as "computers") from suppliers and test the
computers to ensure that they satisfy performance criteria required by its contract
with the Customer. Testing is performed by Company at locations within Colorado.
Once testing begins on a computer, it typically takes a day or less to complete and
the computer is not appreciably consumed in the testing process. If the computer
passes the testing, Company issues to Customer an invoice for the computer and the
price includes a "nominal" mark-up. The computers are delivered to the Customer at
Customer's various facilities inside and outside Colorado. If the computer does not
pass testing, then Company returns it to the supplier. Computers are in Colorado for
testing typically for less than 90 days. Company does not, itself, use the computers
for security or communications purposes.
Service Offering No. 2
Company manufactures the computers and delivers them to various Customer
locations outside the United States. The process begins with Company employees
testing various components of the computers at Company's Colorado laboratory
facility to determine whether the components meet certain quality standards. If the
components pass inspection, they are moved to another Company facility, also
located in Colorado, where the initial manufacturing begins. Partially finished
computers are then shipped to Customer's facilities located outside the United States
where final assembly of the components occurs.
Discussion
1. Company is not subject to use tax when, pursuant to a contract with a client, it
performs in Colorado compliance testing on property it purchases for resale
and delivery to various customer's facilities located inside and outside
Colorado.
Colorado imposes use tax on the use, storage, and consumption of tangible personal
property in Colorado. §39-26-202(1 )(a), C.R.S. There are several exemptions to this
tax. You ask us to consider two: whether the testing of the goods is exempt under the
"testing" exemption of §39-26-713(1)0), C.R.S. or exempt under the "resale"
exemption of §39-26-713(2)(b)(I), C.R.S.
Before addressing these exemptions, we note that the computer software at issue
may be exempt from sales or use tax even if it does not qualify under either of these
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exemptions. Colorado does not levy sales or use tax on software that is not
standardized software.1 You have stated that the software at issue is "customized."
Company does not alter or modify these goods prior to resale to the federal
government. Obviously, if the computer software is exempt, it does not matter
whether the testing of the software is also exempt under the provisions we discuss
below. In order to address the specific statutory exemptions you raise, we assume
the software is taxable tangible personal property.

a. Testing Exemption
Colorado exempts from use tax the,
testing, modification, inspection, or similar type activities of tangible
personal property acquired for ultimate use outside of this state in
manufacturing or similar type of activities if the test, modification, or
inspection period does not exceed ninety days.2
In order to qualify for this exemption, the taxpayer must demonstrate that, among
other things, (1) the property will ultimately be used outside Colorado and (2) the
property will be used in manufacturing or similar type activities.
The testing performed under Service Offering No. 1 is not exempt under this
provision. The computers are fully manufactured when they are shipped to Colorado
and they are not used in manufacturing but, rather, for security and communications.
These activities are more appropriately characterized as the provision of services.3
Nor do these activities fall under "similar type activities." Activities of a type similar to
manufacturing might include processing, refining, compounding, and other processes
that result in production or alteration of tangible personal property.4 In contrast, the
true object of a service is the performance of a task or activity.
Even if the testing of goods is considered an activity similar to manufacturing, you
state that in some instances the goods are used in Colorado. Goods delivered to the
Customer in Colorado for use in Colorado are not entitled to an exemption under this
provision.

b. Resale Exemption
The resale exemption raises the interesting and novel question of whether the
compliance testing constitutes a taxable use of the computers performed on behalf of
the Customer or, on the other hand, an exempt use under the resale exemption. We
1 See, 39-26-102(13.5), C.R.S.
2 §39-26-713(2)(j), C.R.S.

3 See, e.g., §39-26-104(1)(c), C.R.S. (telephone "services• are taxable); §39-26-102(21), C.R.S.

(manufacturing listed as an activity separate from radio and telephone communications); §39-26709(1)(c)(lll), C.R.S. ("'Manufacturing' means the operation of producing a new product, article,
substance, or commodity different from and having a distinctive name, character, or use from raw or
prepared materials.")
4 See, e.g., §39-26-102(20), C.R.S.
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begin with a discussion of two Colorado cases in which the court affirmed the
application of use tax on an entity that used equipment to perform a service on behalf
of another.
In Regional Transporlation District v. Department of Revenue, 805 P.2d 1102 (Colo.
1991), the court considered whether use tax applied to testing equipment used by a
contractor hired by the federal government to produce and deliver goods to federal
agencies. The decision is important for two reasons. First, the court rejected, as an
"unduly narrow" interpretation of the resale exemption, the notion that use of goods
"in any fashion" by a seller prior to resale is a taxable use. Although the court does
not explain5 what uses do not trigger the use tax, it is likely for reasons discussed
below that some acceptance testing of goods prior to resale will not be a separate
taxable use.
Second, and citing A.B. Hirschfeld Press, Inc. v. City and County of Denver, 806 P.2d
912 (Colo. 1991), the court held that an activity is an exempt use under the resale
exemption if the "primary purpose" of the transaction is,
"(the acquisition of the item} primarily for resale in an unaltered condition
and basically unused by the purchaser. ... The use to which the
purchaser puts the property will often define the true nature of a particular
transaction. [citations omitted] This test does not emphasize the
purchaser's intent, but rather focuses on the conduct of the purchaser."
The taxpayer argued that the use of the testing equipment was exempt because the
federal government was the owner and user of the testing equipment (the taxpayer
presumably argued that it acted merely as an agent of, and on behalf of, the federal
government). The court rejected these arguments, finding that the contractor's use of
the testing equipment in performance of its contract was the controlling factor in
determining the primary purpose of the contractor's purchase of the testing
equipment. See, also, United States v. Boyd, 378 U.S. 39 (1964) (contractor hired by
federal government was liable for use tax on equipment owned by federal
government and used by contractor to perform services for federal government) cited
in United States v State of Colorado, et. al., 627 F.2d 217 (10th Cir. 1980).
A.B. Hirshfeld Press, supra, also involved a company using property owned by the
ultimate purchaser to perform a service. As in Regional Transportation District, the
business argued that it was not liable for use tax because it resold the property to the
ultimate purchaser, the property was owned by the ultimate purchaser at the time the
company used the property, and the company was merely providing a non-taxable
service. The court disagreed, finding that the primary purpose of the company's use
of the property was not for resale but for the purpose intended for such property.

5 The court does not disclosed in the opinion whether the testing equipment was used as part of the
manufacturing process or only to ensure that the manufactured goods complied with the terms of the
federal contract.

4

These "primary purpose" cases present significant conceptual problems for this
ruling. In some respects, the Regional Transportation District, Boyd, and AB
Hirschfeld are similar to the present case: a third-party is using property to perform a
service and the service inures to the benefit of either the federal government or the
ultimate purchaser of the property.
The difficulty arises when these cases are juxtaposed with value-added reseller
cases. A value-added reseller typically purchases goods exempt of sales and use tax
and, either through additional manufacturing or other activities, enhances the value of
the goods. For example, value-added software developers purchase exempt from
tax what is otherwise taxable software and add functionality to increase the software's
value to the ultimate consumer. The developer does not incur use tax liability for its
use of the software because software is held by the developer for resale. However,
applying the "primary purpose" test set forth in AB. Hirschfeld (which requires the
reseller to resell the goods in an "unaltered condition and basically unused by the
purchaser") would mean that the value-added developer is subject to use tax. This
primary purpose test casts a net too broadly: it appropriately identifies a retailer or
consumer who uses property for their own purposes (e.g., pulls software from its
inventory to use for word processing on the retailer's computer), but inappropriately
includes resellers who alter or in some fashion use the goods for the purpose of
resale (reseller modifying software to enhance its functionality).
The second Colorado case is General Motors v. City and County of Denver, 990 P.2d
59 (Colo.1999), in which the Colorado supreme court upheld a use tax assessment
on a car manufacturer which performed extensive emissions testing on its vehicles
and then later resold them as used or junk. The court found that use tax applied
because the manufacturer was the user and consumer of the vehicles. Vehicles were
pulled from inventory and substantially consumed by the manufacturer, much in the
same way that a manufacturer incurs use tax when it consumes tools in the
manufacturing process or consumes tangible personal property in research and
product development.
At first blush, both the "primary purpose" cases and General Motors suggest that use
tax applies in the present case. There are, however, certain differences in the
present circumstances from those in General Motors, Regional Transportation
District, A. B. Hirschfeld, and reseller cases, and we think these are important. In the
those cases, the taxpayers either consumed the goods or used the property for the
ultimate purposes intended for such property - e.g., consumed motor vehicles for
research and product development and then reselling them as used or junk, or using
testing equipment as testing equipment in the manufacturing process.. And, as the
court held in AB. Hirschfeld Press (quoted above), the use to which the property is
put is often the crucial factor in determining whether the use is a taxable use or a
non-taxable use that is part of a resale transaction. The only reason an issue arises
in cases such as Regional Transportation District and Boyd is because the titled
owner of the property (federal government) is an exempt entity. Had the owner in
those cases not been an exempt entity, there would have been no question but that
the use of the item had been a taxable use. Thus, the question there is whether a
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third-party contractor, who uses the federal government's property to perform
services for the government, is the user of such property.
In the present case, the Company neither consumes the computers nor uses them for
their intended purposes - i.e., to perform security or communications services.
Rather, we view the compliance testing to be an integral part of the resale process. A
buyer will typically examine goods at the time of delivery and prior to acceptance to
determine whether the goods comply with the terms of the sale.6 This is a common
and commercially reasonable practice and is codified in Colorado's Uniform
Commercial Code.7 This "acceptance" testing may be as simple as a plugging in a
device to determine whether it operates. And although this testing by the buyer is a
"use" of the goods, we believe that at least some level of testing is not a taxable use
that is separate from the sale of the goods.8
Indeed, had the ultimate purchaser, rather than the Company, engaged in this
acceptance testing, we would conclude that the testing is part of the sales transaction
itself.9 Similarly, had the component supplier performed the testing before delivering
the computers to the Company, such use would have been exempt because the
supplier was holding the goods for resale.10 Thus, unlike Regional Transportation
District, A.B Hirschfeld, and Boyd, where the use would have been taxable had the
consumer, rather than the contractor, used the goods, and unlike General Motors,
where the goods were pulled from inventory for the manufacturer's own use, the use
here does not significantly consume the goods and the use is primarily for the
purpose of reselling the goods.
For these reasons, we conclude that the "primary purpose" of the Company's testing
activities is for the purpose of resale and is exempt under the resale exemption.
Moreover, the sales of the goods to the federal government are exempt from sales
tax. §39-26-704(1), C.R.S. (sales to federal government exempt).
2. Company is not liable for sales or use tax for purchases of materials for
integration into manufacturing activities that begin in Colorado and conclude
outside Colorado, despite the testing function that are performed in Colorado.

Buyer has right to inspect goods prior to acceptance. §4-2-513, C.R.S. (Colorado Uniform
Commercial Code).
7
Colorado's Uniform commercial code also recognizes that goods may, prior to acceptance, be stored
for a short duration pending this inspection. Ibid.
8
We agree in a broad sense with the Virginia Tax Commissioner's decision in Virginia Public
Document 88-159 holding that acceptance testing that is integral to the sale transaction does not
constitute a separate taxable activity. We do not attempt here to define all parameters under which
such testing is exempt.
9
Use tax would not apply for two reasons. First, the "primary purpose" test indicates that the use is
consistent with the resale exemption. Second, use tax applies only if there is a retail sale and there is
no retail sale because the buyer has rejected the goods for failing to meet contractual performance
criteria. See, §§39-26-104(1 }(a) and 202(1}(a), C.R.S.
10
§39-26-713(2)(e)(I), C.R.S. (storage, use, or consumption of tangible personal property which
becomes a component part of manufactured goods for resale is exempt), discussed infra.
6

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Colorado exempts from sales and use tax tangible personal property purchased by a
manufacturer who integrates the property into a finished manufactured or processed
product and holds the same for resale.
[The following are exempt from use tax:] (e)(I) The storage, use, or
consumption of tangible personal property by a person engaged in the
business of manufacturing or compounding for sale, profit, or use any
article, substance, or commodity, which tangible personal property enters
into the processing of or becomes an ingredient or component part of the
product or service that is manufactured, compounded, or furnished, ...
§39-26-713(2)(e)(I), C.R.S. This exemption applies regardless of whether the
finished goods are sold outside Colorado. The Company represents that the
materials at issue here become a component part of a manufactured good and these
manufactured goods are resold. Therefore, the purchase of such materials and their
use as component parts of finished manufactured goods are exempt, regardless of
whether the manufactured good is sold in this state, in another state, or in another
country.

Miscellaneous
This ruling is premised on the assumption that the Company has completely and
accurately disclosed all material facts. 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. This ruling is subject to modification or revocation
in accordance to Department Regulation 24-35-103.5
Enclosed is a redacted version of this ruling. Pursuant to statute and regulation, this
redacted version of the ruling will be made public within 60 days of the date of this
letter. Please let me know in writing within that 60 day period whether you have any
suggestions or concerns about this redacted version of the ruling.

Sincerely,

Office of Tax Policy
Colorado Department of Revenue

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