When a company builds and tests a custom piece of equipment in Colorado that it intends to sell, are the components subject to Colorado use tax during the design, build, and test process — and what happens if the company ultimately keeps the equipment to use itself?

Plain-English summary

A company designs custom, fit-for-purpose equipment (a "[system]") for oil, gas, geothermal, and mining formations. It's in a research-and-development phase: it buys components, then designs, builds, surface-tests, and field-tests each custom system in Colorado before deploying it — but the actual service delivery (and likely the system's end use) happens outside Colorado. The company hasn't settled on a business model: it might sell the system to a third party, sell it to an out-of-state subsidiary, or keep it and deliver the service itself. It asked whether buying and building/testing those components in Colorado triggers sales or use tax. The core question: is property being built into a custom machine being "used" in Colorado so as to attract use tax (imposed on storing/using/consuming tangible personal property purchased at retail, § 39-26-202(1))?

The answer: no use tax during the build-and-test phase, as long as the system is sold. The Department placed the facts between two poles. Building and testing a traditional prototype would generate use tax on the components; but testing a product as part of a manufacturing "line" is part of manufacturing and triggers no use tax. This custom system looks prototype-like (it's tested to prove it meets customer needs) yet is built to be sold to an already-identified customer, not merely to be tested — which looks like classic manufacturing. (The Department was careful to say this is not traditional prototype development; each system is built to a specific customer/formation and undergoes its own testing as an integral part of manufacturing, so the holding does not extend to true prototypes.)

The Department leaned on two settled points and a prior ruling:

• Inventory isn't "used." Inventory storage gives rise to no use tax because the goods aren't "purchased at retail" and are statutorily exempt (§ 39-26-713(2)(b)(I)).
• Testing before resale isn't a taxable use (PLR 10-006, which the Department found dispositive): components incorporated into a manufactured article and tested in Colorado before sale are not subject to use tax when the only Colorado "use" is testing — the primary purpose of that use (testing) isn't the primary purpose of the good itself, and testing is integral to manufacturing/resale.
• The use here is trivial. The principal component is used for less than one percent of its rated life — consistent with testing during manufacture, not consumption. The Department contrasted General Motors v. Denver (990 P.2d 59), where high-altitude car testing was a taxable use because the cars were essentially consumed/destroyed by the testing, making testing their de facto intended use.

So as long as the system is resold, the components are inventory and not subject to use tax, notwithstanding the Colorado testing. Sold outside Colorado, no Colorado tax is due.

Related-party sales aren't disregarded. The company worried a sale to an out-of-state related party might be treated as not a "true" sale (recharacterizing it as the company providing the service itself). The Department confirmed that, on these facts, a sale to a related party that pays consideration is a true sale and won't be disregarded — heavily caveated to these facts (foreign destination signals a non-tax purpose; the company is genuinely in R&D with no finalized, tax-driven model).

Depreciation didn't change the result — here. Normally, depreciating (or expensing) property is a near-definitive indicator of use by the taxpayer and of use-tax liability. But the company depreciates these components only because GAAP allows it during the R&D phase before a commercialization model is finalized; once revenue-producing with a finalized model, it would treat such purchases as inventory. On that specific understanding, the depreciation doesn't establish a taxable use.

If the company ultimately keeps the system to deliver the service itself, the analysis shifts — sales tax is driven by form, not substance. The components can no longer be treated as inventory. Citing IBM v. Charnes (601 P.2d 622 (Colo. 1979)) — where goods manufactured by IBM and later withdrawn from inventory for IBM's own Colorado use were taxed — the Department read the taxable event as the post-inventory use, not the manufacturing. So any tax in that scenario arises and is due only once manufacturing is complete and the company decides to deliver the service directly rather than sell (i.e., on the conversion from inventory to internal use). The timing is not retroactive to purchase: the taxpayer owed no tax at purchase, and the later conversion doesn't generate penalty or interest for the earlier period merely because the measure of tax may relate back to the original cost. (And if development simply fails and the system is never sold, any tax — strictly as to timing — arises when the company concludes development has failed.)

What this means for you

R&D-stage manufacturers and equipment builders

If you buy components, build them into a custom product, and test that product in Colorado before selling it, those components generally aren't subject to Colorado use tax — the testing is part of manufacturing for resale, and the goods are effectively inventory. This is most defensible when (a) the product is genuinely built to be sold to an identified customer, (b) the testing consumes only a trivial fraction of the components' useful life, and (c) you're not building a reusable prototype (the ruling doesn't shelter true prototype development).

Watch depreciation — it usually signals taxable use

Depreciating or expensing the property you're building is normally strong evidence that you're using it (and owe use tax). The company here avoided that only because its depreciation was a temporary R&D-phase accounting posture, with a stated intent to treat the items as inventory once commercialized. If you depreciate equipment you actually deploy in your own operations, expect use tax.

If you might keep the product instead of selling it

Selling vs self-using has real tax consequences even when the economics are similar — form controls. If you convert a built-for-sale system to your own use, use tax can attach, but only prospectively, at the point of conversion (the IBM withdrawal-from-inventory timing), not back to when you bought the parts — so no penalty/interest for the pre-conversion period, even if the tax is measured by the original cost.

Accountants advising R&D and energy-tech clients

The spine of this ruling: use tax reaches post-inventory use, not manufacturing or pre-sale testing (PLR 10-006; IBM v. Charnes). Distinguish consumed-by-testing facts (General Motors v. Denver — taxable) from trivial testing of resale inventory (not taxable). Related-party sales for consideration are respected as true sales on these facts. A PLR binds the Department only for this taxpayer; the home-rule-city caveat applies.

Common questions

Q: Do I owe Colorado use tax on components I build into custom equipment and test before selling?
A: On facts like these, no. When the only Colorado use is testing as part of manufacturing for resale and the components are essentially inventory, there's no taxable use — even though testing is a form of "use."

Q: What if the equipment is sold and shipped outside Colorado?
A: No Colorado tax is due. And a genuine, paid-for sale to an out-of-state related party is respected as a true sale, not disregarded.

Q: I'm depreciating the components. Doesn't that mean I'm "using" them?
A: Usually yes — depreciation is a strong indicator of taxable use. The company here escaped that only because its depreciation was a temporary R&D-phase accounting treatment with an intent to treat the items as inventory once commercialized.

Q: What if I keep the equipment to provide the service myself instead of selling it?
A: Then it's no longer inventory and use tax can apply — but only going forward, arising when manufacturing is complete and you decide to use rather than sell it (the IBM withdrawal-from-inventory rule). It's not retroactive to the purchase, so no penalty or interest for the earlier period, even if the tax is measured by the original cost.

Q: Does this cover building a reusable prototype?
A: No. The Department expressly limited the ruling to a product built and tested for sale, not traditional prototype development, which raises different issues.

Q: Can I rely on this ruling?
A: Not unless you're the taxpayer it was issued to. A private letter ruling binds the Department only as to that taxpayer and facts and can't be relied on by anyone else. It also doesn't cover self-collected home-rule city taxes.

Citations and references

Statutes and rules:
- § 39-26-202(1), C.R.S. (use tax on the privilege of storing, using, or consuming tangible personal property purchased at retail)
- § 39-26-713(2)(b)(I), C.R.S. (inventory exemption)

Case law and related guidance (cited by the Department):
- International Business Machines v. Charnes, 601 P.2d 622 (Colo. 1979) (tax arises on withdrawal from inventory for own use, not on manufacturing)
- General Motors v. City and County of Denver, 990 P.2d 59 (Colo. 1999) (testing that consumes/destroys the goods is a taxable use)
- Colorado PLR 10-006 (components/goods tested before resale not subject to use tax) — treated as dispositive

Source

• Landing page: Colorado Sales & Use Tax Letter Rulings
• Original PDF: PLR-15-002.pdf

Original ruling text

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

PLR-15-002
February 17, 2015
XXXXXXXXXXXX
ATTN: XXXXXXX
XXXXXXXXXXXX
XXXXXXXXXXXX
Re: Research and Development
Dear XXXXXXXXXXX,
You submitted on behalf of XXXXXXXXXXXXX ("Company") a request for a private
letter ruling to the Colorado Department of Revenue ("Department") pursuant to
Department Rule 24-35-103.5. This letter is the Department's private letter ruling.
Issue
Is an item under manufacture by Company subject to sales or use tax during
Company's design, build, and test process?
Conclusion
Under the circumstances presented here, the item under manufacture by
Company is not subject to sales or use tax during Company's design, build, and
test process. If the item is sold outside of Colorado, no Colorado tax is due. If the
item is ultimately used by Company rather than sold, it may retrospectively be
subject to Colorado sales or use tax, but such tax would be due at the time the
item is identified as being subject to use by Company.
Background
Company is in the business of building applications that apply XXXXXXXXXXX to oil,
gas, geothermal, and mining formations....XXXXX .... Company is currently in a
research and development phase in all target business segments, where it is still
developing its products and services for future commercial applications. Company's
services and products will be customized and fit-for-purpose to the customer
specifications within the target business segment including formation type, borehole
size, and desired performance. Company has several possible models for
commercialization of its products/services in all target business segments.

Within its drilling target business segment for example, Company may develop a
[tangible personal property system] and sell the [system] to a third-party. In such a
case, the third-party will then provide the service required at the oil, gas, geothermal,
or mining formation using Company's product. In this instance, Company will not be
involved in the service delivery.
Company may also develop the [system] to sell to a subsidiary operating outside of
Colorado. In this scenario, Company's out-of-state subsidiary will deliver the service to
the ultimate customer outside of Colorado.
Finally, Company represents that it is possible that Company may retain ownership of
the [system] to itself provide the service outside of Colorado.

...XXXXX ....
Subject to a successful field test demonstration, the customer may then procure use
of the [system] as part of a service from Company's subsidiary, a third-party service
provider, or, possibly, Company itself.
Company has not yet finalized the model for commercialization for the target business
segments among the preceding options.
Company makes significant expenditures in responding to customer interest in
procuring specific, fit-for-purpose services of the [system]. For example, Company
may purchase XXXXXXXX, and other equipment that are necessary to design, build,
surface test, and field test the [system] for the [system application]. Upon a successful
field test demonstration, Company would deploy the [system], and other equipment in
a commercial tool and field system to deliver the fit-for-purpose product to the
customer's specification.
Company is considering embarking on the development of a particular [system],
including the XXXXXX, and other equipment. The pre-deployment activities would
take place in Colorado. However, the ultimate service delivery, either by Company or
a third-party service provider that purchases the [system], would take place outside of
Colorado. The pre-deployment activities can consist of several phases (sometimes
anticipated over several years) of manufacturing the [system] and testing, improving,
and verifying the performance of the [system], including components, subsystems,
and full system.
The tangible personal property purchased for the development of the [system] is not
significantly consumed during the design, build, surface test, and field test of the
[system]. For example, while the XXXXXX forming the core of the [system] is rated for
XXXXX hours of use, Company expects to operate the XXXXXX for less than [one
percent of XXXXX] hours within Colorado.
Company discloses that it either expenses or depreciates the components of the
[system] according to US GAAP guidelines in the context that it is still in the research
and development phase for the particular target business segment and the model for
commercialization is not finalized. Although Company is depreciating the tangible
personal property it acquires to be incorporated into the [system], Company confirms
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DR 4010A (06/11/14)

that it intends to successfully develop and sell1 the [system] with no additional use
other than pre-deployment activities prior to selling or placing the [system] in service.
Company asks whether the pre-deployment activities give rise to a sales or use tax
obligation with respect to tangible personal property that is incorporated into the
[system].
Discussion
The central issue presented is whether tangible personal property being built into a
piece of manufactured machinery is being "used" in Colorado so as to attract a sales
or use tax obligation. We begin by noting that use tax is imposed on the "privilege of
storing, using, or consuming in this state any articles of tangible personal property
purchased at retai1"2.
Generally, the construction of a traditional prototype model3, including testing the
prototype, will generate a sales or use tax obligation for the components of the
prototype. By contrast, testing a product as part of a manufacturing "line" operation
will be considered to be part of the manufacturing operation, and not create a sales or
use tax obligation.
We view the question presented as a case between these extremes. Because the
[system] is a custom-built piece of equipment on which testing occurs to establish that
the [system] meets the needs of prospective customers, this appears to be similar to
the development of a traditional prototype. However, the [system] will be sold to an
already identified customer and is being constructed for the purpose of being sold, not
for the purpose of testing. To that extent, this appears to be similar to classic
manufacturing.
The Department has long held that inventory storage does not give rise to a use tax
obligation, because such products are not "purchased at retail" and are clearly
exempted by statute4. Similarly, the Department has recently held that a product is not

1

Though it also represents that it may deliver the service itself, if the direct sale of the [system]
is not the most economically advantageous option.
2
§39-26-202(1} C.R.S.
3
This discussion should not be read to extend to prototype development, which presents
different, though admittedly related, issues. The [system] is itself being developed for sale, and
Company represents that it is not a traditional prototype for future "off-the-rack" products.
Company represents that each application is unique and undergoes its own product testing and
development phase. Thus, the testing and development that we review here is an integral part
of the manufacturing process, not a separate research and development phase leading to the
development of a manufacturing process. As a consequence, our conclusions reached here
cannot be read to reach traditional prototype development. We recognize that Company may
use its experience in developing the [system] to develop and sell further similar systems.
However, because Company represents that the [system] is developed to the specifications of
the particular customer and the particular rock formation type, borehole size and desired
performance, and because each [system] will undergo similar testing and development, we do
not view the [system] as a traditional prototype (which serves as a template for a manufactured
product that is, in all material respects, identical to the prototype}.
4
§39-26-713(2}(b}(I} C.R.S.

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DR 4010A (06/11/14)

subject to use tax when it is purchased for testing and resale,5 even though the testing
constitutes some form of "use". We believe our prior conclusion in PLR 10-006, with
respect to the situation of Company selling the [system] to a third-party service
provider, is dispositive of the issue here, and we see no reason to depart from our
reasoning in PLR 10-006.
In PLR 10-006, the Department was asked whether a company was subject to sales
or use tax when it purchased components for incorporation into a manufactured
article, tested the manufactured article in Colorado, and then sold the manufactured
article to the ultimate customer for whom they were manufacturing the article. The
letter also posed the question whether completed goods purchased for testing were
subject to tax if the company tested the goods on behalf of their ultimate customer
and then sold the goods if they passed testing.
We concluded that neither the completed goods when purchased for testing nor the
component parts incorporated into a manufactured article were subject to sales or use
tax when the only "use" of the goods in Colorado was the testing of the products prior
to sale. We concluded that in both cases, the primary purpose of the specific "use" of
the property (i.e., testing) was not the primary purpose of the good itself, and,
therefore, concluded that no taxable use occurred.6 We also noted that the testing
was an integral part of the process of manufacturing or resale.
In this case, Company represents that the components of the [system] do not undergo
any substantial use beyond what would be expected of testing a product during
manufacture. Specifically, Company represents that the principal component of the
[system], the XXXXXX itself, will be used for less than one percent of its rated useful
life. The Department understands that other components will have similarly
insubstantial amounts of use.
As noted above, we see no reason to depart from the analysis in PLR 10-006 and
conclude that, as long as the [system] is resold, the parts are not subject to sales or
use tax, notwithstanding the testing that is being done in Colorado.
Company also asks whether the sale of the [system] to a related party doing business
outside of Colorado would be disregarded because it is not a "true" sale. Because the
taxability of the [system] may depend on whether Company sells the [system] to a
third-party service provider or whether Company uses the [system] itself in the
delivery of the service7, Company expresses concern that a sale to a related party for
the related party to deliver the service could be disregarded and Company could be
treated as providing the service directly.
5
6

7
4

Department Private Letter Ruling PLR 10-006
In contrast, we noted the case of General Motors v. City and County of Denver, 990 P.2d 59
(Colo. 1999) where GM brought vehicles into Colorado for high altitude testing. The Colorado
Supreme Court concluded that the testing of the vehicles was a taxable use. However, because
the cars were essentially consumed during the testing (their value was appreciably diminished
or they were completely destroyed) the "intended use" of those particular vehicles was, in fact,
the testing that they underwent. We further note that it is not necessary that a product be "used"
for its intended use in order to be subject to use tax. We note here only that it is one factor to
consider in determining whether a taxable use has occurred.
More fully discussed below.
DR 401OA (06/11/14)

In the context of the facts of this ruling6 we confirm that the sale of the [system] to a
related party for the related party to deliver the service using the [system] will not be
disregarded so long as consideration is paid for the [system]. In this situation,
Company will not be treated as directly providing the service. This conclusion,
however, should not be read more broadly than a conclusion related to the specific
facts of this ruling. The Department may in the future, either with respect to other
transactions by other parties or other transactions by Company, review certain sales
and determine that such sales are not true sales. Based on the facts presented here,
however, we conclude that a sale from Company to a related party would be a true
sale.
Company also represents that it is currently depreciating or expensing, or will
depreciate or expense when purchased, the components of the [system]. Generally,
depreciation (or expensing) is a definitive indicator of use by the taxpayer, and would,
almost without exception, be an indicator of use tax liability. However, Company
represents that it is entitled to depreciate the components of the (system] by
appropriate accounting standards because Company is in a research and
development phase for the target business segment and the model for
commercialization has not been finalized. Notwithstanding the fact that the relevant
components are being developed into the (system], which will ultimately be sold as
essentially new,9 appropriate accounting standards apparently allow Company to
depreciate these "assets". In these specific circumstances, the fact that Company is
depreciating the assets that comprise the [system] does not change our conclusion
that Company is not making a taxable use of the components of the [system] and is
not liable for use tax.10
Finally, Company asks that we address the possibility that Company will itself deliver
the service using the [system].
Sales tax is a tax that is driven by form, not generally by substance. As a
consequence, the form of a transaction can have significant tax consequences, even
where the economic substance of a transaction is little changed, and we believe that
may be the case here. Although substantively there is little difference between selling
6

The principal facts that we rely on here are Company's representations that the [system] will be
used in a foreign (i.e., non-U.S.) jurisdiction, and Company's representations that they are still
developing the [system], have made no retail sales of products or services, and that Company
genuinely has not adopted a marketing model either to sell to third-parties, sell to a related
party, or deliver the service itself. The foreign destination of the [system] is strongly indicative of
a non-tax purpose in forming a separate subsidiary. While Company's status in a research and
development phase for the target business segment, together with Company's representation
that its structuring of the future delivery of the service/sale will be entirely driven by market
forces, not by tax considerations, indicate a non-tax business purpose.
9
No significant use of the [system] or its components beyond pre-deployment activities.
10
We note, however, that were Company to be in a revenue producing phase for a target
business segment and thus with a finalized model for commercialization, the Department
understands that Company would be treating all of the purchased components of future
systems as inventory not subject to depreciation. Our conclusion in this regard is dependent on
that understanding: that the sole reason that Company is treating these purchases as assets
and taking depreciation on them is the research and development status of the particular target
business segment of the Company without a model for commercialization being finalized..
5

DR 401OA (06/11/14)

the [system] to a subsidiary and Company delivering the service itself, this difference
in form may have significant tax consequences for Company.
In this case, as noted above, the Department understands that Company's decision to
sell to a third-party, sell to a related party, or deliver the service itself will be entirely
driven by non-tax business purposes. Thus, we have concluded that any ultimate sale
will be treated as a true sale. As a result, we have little trouble concluding that the
components of the [system] should be treated as inventory and not subject to use tax.
However, should Company ultimately decide to deliver the service itself, the
components of the [system] can no longer be treated as inventory, and the nature of
the potential taxable transaction (i.e., the use of the product) changes.
We have carefully reviewed the cases noted above in this ruling and in PLR 10-006,
as well as a number of other cases relating to timing and incidence of taxation.
Colorado's most significant case with respect to this issue is International Business
Machines v. Chames, 601 P.2d 622 (Colo. 1979). In that case, the Colorado Supreme
Court reviewed the taxability of IBM computers and typewriters being manufactured
by IBM and subsequently withdrawn from inventory for use by IBM in Colorado. The
case is focused on the measure of tax, rather than the timing or the incidence of tax,
but we read the case as indicating that it is the post-inventory use of the computers or
typewriters that gives rise to the tax, not the manufacturing process itself.11
Although the case does speak of a "retroactive recognition" of tax12, we read that
reference as limited to the valuation question that was directly in issue. It appears to
us that the Court recognized implicitly that the timing of the liability for the tax and the
taxable event itself was not retroactive and did not arise until the item was withdrawn
from inventory. (I.e., although not in issue, we read IBM to suggest that the tax that is
due is properly due at the time the item is withdrawn from inventory. The taxpayer did
not owe tax at the time of purchase, and the subsequent taxable event did not give
rise to potential penalty or interest for late payment simply because the measure of
tax related back to the original purchase.)13
Your question raises a difficult issue: if Company uses the product itself to deliver the
service outside of Colorado, whether a subsequent non-inventory use of the [system]
gives rise to a Colorado sales or use tax obligation as a consequence of Company's
using and developing it in Colorado without subsequent resale. In further discussions
with you, you have agreed that this issue can be put aside and we can limit our
discussion to the question of timing of tax, should any tax be due.
On the basis of our reading of the IBM case, we have little trouble concluding that if
tax is due in the above circumstance, it arises and is due only once manufacturing of

11

This conclusion is, of course, consistent with our conclusion in PLR 10-006 and herein above.
/BM, at 625
13
We also do not offer any opinion regarding a situation in which goods are purchased with
knowledge that the goods will be used directly by the taxpayer. Our discussion is limited to facts
similar to IBM: items purchased for resale but subsequently converted to internal use.
12

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DR 4010A (06/11/14)

the product is complete and the decision is made to deliver the service directly rather
than sell the product.1415
Miscellaneous
This ruling applies only to sales and use taxes administered by the Department.
Please note that the Department administers state and state-collected city and
county sales taxes and special district sales and use taxes, but does not
administer sales and use taxes for self-collected home rule cities and counties.
You may wish to consult with local governments which administer their own sales
or use taxes about the applicability of those taxes. Visit our web site at
www.colorado.gov/revenue/tax for more information about state and local sales
taxes.
This ruling is premised on the assumption that Company has completely and
accurately disclosed all material facts. The Department reserves the right, among
others, to independently evaluate 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

14

"[T]he wholesale transactions were transformed into retail ones upon the company's ultimate
election to dispose of the items purchased by using or consuming them in its own business
operations rather than reselling them. The state's concern that a purchaser might evade both
sales and use taxes by purchasing at wholesale and then converting the items to its own use is
groundless, for the transaction must be re-examined at the time of such a conversion." Id.
15
This conclusion also should not be read to address the question of taxability in the event that
product development fails and the [system] is not sold as a complete and functional unit by
Company. It is an equally difficult issue to determine whether the failure of a development
process for a product intended for sale gives rise to a sales or use tax obligation, and Company
has not asked us to definitively rule on that issue. However, we do conclude that, strictly in
terms of timing, any tax due arises at the time Company reaches the conclusion that
development has failed, regardless of the ultimate disposition of the [system] or its components.

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DR 4010A (Of.ii 1/14)