Did pilot-line equipment qualify for Virginia's R&D sales-tax exemption when it was also used for quality control and customer-specific work?

Subject

Technical center in Virginia that conducts research, development, analysis and testing of film products and ingredients manufactured by a related non-Virginia entity and others.

Plain-English summary

Virginia denied the research-and-development exemption for the contested pilot-line equipment. The technical center did conduct qualifying work, such as developing new film products and new uses. But the same equipment also handled activities outside the exemption.

Those taxable activities included testing defective products for quality control, adjusting products or processes to customer specifications, reducing costs, and analyzing competitors' products. The Department found that this mixed use was not de minimis.

Virginia's exemption required tangible personal property to be used directly and exclusively in actual experimental or laboratory research. Equipment was not exempt merely because it was important or necessary to research, and quality-control testing was expressly outside the definition. With no proof that all customer modifications were experimental work aimed at general product improvement or a new use, the paid assessments were upheld.

What this means for you

• A facility can perform real R&D while particular equipment still fails the exemption.
• Track each machine's qualifying and nonqualifying uses rather than relying on the facility's overall mission.
• Quality control, routine customer customization, cost reduction, and competitor analysis can break exclusive use.
• Preserve project protocols, machine logs, experimental objectives, prototypes, and records distinguishing research from production support.

Common questions

Q: Did Virginia agree that some qualifying R&D occurred?

A: Yes. The denial resulted from nonexempt use of the same equipment, not from a finding that the center performed no R&D.

Q: Why did customer-specific work matter?

A: Modification merely to meet customer specifications was outside the definition unless performed experimentally to improve the product generally or develop a new use.

Q: What happened to the paid assessments?

A: They were upheld as correct, and no further action was required.

Citations and references

• Va. Code § 58.1-609.3(5).
• 23 VAC 10-210-3070(A)-(B) and 23 VAC 10-210-3071(A), (C).

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 15-82

Original ruling text

April 22, 2015

Re: § 58.1-1821 Application: Retail Sales and Use Tax

Dear *:

This is in response to your letter in which you request correction of the retail sales and use tax assessments issued to * (the "Taxpayer") as a result of an audit for the period August 2010 through June 2013. The two assessments issued in this matter are paid in full.

FACTS

The Taxpayer operates a technical center in Virginia that conducts research, development, analysis and testing of film products and ingredients manufactured by a related non-Virginia entity and others. An audit resulted in the assessment of consumer use tax on untaxed purchases of tangible personal property used in the Taxpayer's operations.

The Taxpayer contests the audit findings and contends that some of the contested purchases qualify for the research and development exemption set out in Va. Code § 58.1-­609.3 5 and as further interpreted by Title 23 of the Virginia Administrative Code (VAC) 10­-210-3071. Specifically, the Taxpayer maintains that its production equipment is used directly and exclusively to produce newly designed products or processes and should, therefore, be removed from the Department's audit.

DETERMINATION

Virginia Code § 58.1-609.3 5 provides an exemption from the Virginia retail sales and use tax for "[t]angible personal property purchased for use or consumption directly and exclusively in basic research or research and development in the experimental or laboratory sense."

Title 23 VAC 10-210-3071 A explains the scope of the research and development exemption as follows:

The exemption is limited in scope to tangible personal property used directly and exclusively in an actual research process, starting with the handling and storage of raw materials and supplies at the research facility and ending after the last step of the research process when the products of the research process are stored at the research facility. Items of tangible personal property used directly and exclusively in research include chemicals, drugs and other materials, equipment, machinery, tools, supplies, energy, fuel, and power used in these processes. An item is not considered used directly and exclusively merely because it is essential to research activities or because its use is required by law. [Emphasis added.]

Title 23 VAC 10-210-3070 A defines the phrase "research and development as follows:

"Research and development" means a systematic study or search directed toward new knowledge or new understanding of a particular scientific or technical subject and the gradual transformation of this new knowledge or new understanding into a usable product or process. Research and development must have as its ultimate goal: (i) the development of new products; (ii) the improvement of existing products; or (iii) the development of new uses for existing products. Research and development does not include the modification of a product merely to meet customer specifications unless the modification is carried out under experimental or laboratory conditions in order to improve the product generally or develop a new use for the product . [Emphasis added.]

Title 23 VAC 10-210-3070 A also defines the phrase "exclusive use" to mean "items are used solely in basic research or research and development activities." [Emphasis added.] Title 23 VAC 10-210-3070 B provides that "[r]esearch does not include testing or inspection of materials or products for quality control."

I understand that the Department's audit staff took a tour of the Taxpayer's facility and learned that the facility is divided into three sections: the processing section, the laboratory, and materials storage. According to the Taxpayer's appeal, only the equipment used in the processing section is at issue.

As indicated by the audit staff, the processing section consists of mini or pilot processing lines set up to test various methods of manufacturing film products. Activities may involve experimenting with developing a new type of film product or adjusting existing processes to meet customer requests. I understand that experiments are also done to learn how to more efficiently produce a film product.

I also understand that products coming off of the line are analyzed by the laboratory, and a prototype of the product may be sent to the customer for further analysis. The audit staff indicates that most of the products fabricated on the pilot processing line are sent to customers for testing the film product prototypes on their production equipment to ensure compatibility with such equipment and other materials used in the customer's manufacturing process.

While I recognize that the Taxpayer does perform research and development ( e.g. , developing new products and new uses for the Taxpayer's products) that falls within the scope of the research and development exemption, I must also recognize that the Taxpayer performs taxable activities ( e.g. , testing of defective products from a related entity for quality control purposes, adjusting and modifying the product or process to meet customer specifications or to reduce costs, and the analysis of competitor products) that fall outside the scope of the research and development exemption. As I understand that some of the taxable activities were performed with the production equipment used in the mini or pilot processing lines, such taxable use would not be de minimis usage. See Title 23 VAC 10-210-3071 C. Accordingly, I must conclude that the contested property was not used exclusively in exempt research and development activities as required by Va. Code § 58.1-609.3 5. Furthermore, no evidence was provided to establish that all modifications of products (performed on mini processing lines during the audit period) to meet customer specifications were carried out under experimental or laboratory conditions in order to improve the product generally or develop a new use for the product. For these reasons, the research and development exemption is denied.

CONCLUSION

Based on this determination, the paid assessments are correct. Because the assessment has been paid in full, no further action is required.

The Code of Virginia section and regulations cited are available on-line at www.tax.virginia.gov in the Laws, Rules and Decisions section of the Department's web site. If you have any questions about this determination, please contact * in the Department's Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns
Tax Commissioner

AR/1-5927958583.R