State Tax Ruling

Plain-English summary

This ruling is an appeal by a marine engine manufacturer of a Virginia retail sales and use tax audit assessment covering August 2011 through August 2015. The Department's auditor had assessed use tax on four prototype marine engines that the taxpayer built at its Virginia research and development facility, treating them as taxable withdrawals from inventory for marketing purposes, and had also assessed sales tax on the taxpayer's sale of two boats used to test the engines.

On the engines, the Tax Commissioner agreed with the taxpayer. Virginia Code § 58.1-609.3 5 exempts tangible personal property used directly and exclusively in research and development. Under 23 VAC 10-210-3071 C, property otherwise used exclusively in exempt research keeps its exemption even if it has some taxable use, as long as that taxable use is "de minimis" — not continuous or ongoing, not following a regular pattern, occurring no more than three times, and totaling no more than three days. Here, the prototype engines were installed in test boats and demonstrated just once, as a pre-production event, before the engines went into production months later. The Commissioner found this one-time demonstration fit squarely within the de minimis standard, so the engines kept their R&D exemption and the assessment on them was removed.

On the boats, the Commissioner agreed the retail sales and use tax assessment was wrong, but for a different reason: watercraft in Virginia is not taxed under the general retail sales and use tax at all. Va. Code § 58.1-609.1 9 exempts "watercraft" (as defined in Va. Code § 58.1-1401) from the retail sales and use tax, because watercraft instead falls under Virginia's separate 2.0% Watercraft Sales and Use Tax Act. Under 23 VAC 10-230-90, that watercraft tax is owed by the purchaser or user, collected by the Tax Commissioner (or by a dealer who has signed a collection agreement) when the owner titles the boat — and if no title is required, the watercraft tax isn't levied at all unless the owner chooses to title it. Since the taxpayer here was not shown to have registered as a collecting dealer, it was not liable for the watercraft tax on the two boat sales either.

The bottom line: both contested line items were removed from the audit, the assessment was ordered revised, and because the taxpayer had already paid the original (incorrect) assessment in full, the Department ordered a refund of the overpayment plus interest.

What this means for you

Manufacturers doing R&D with prototypes

If you build prototypes under Virginia's R&D exemption, a single, non-recurring demonstration or test use of the item generally will not blow the exemption, so long as it truly is a one-off (no more than three occurrences, no more than three days total, no recurring schedule). But note 23 VAC 10-210-3071 B: if a single item is used in both exempt and taxable ways beyond the de minimis threshold, the whole item becomes taxable — there is no proration based on percentage of exempt versus taxable use.

Businesses that manufacture or sell boats in Virginia

Don't assume a sale of watercraft is subject to Virginia's general retail sales and use tax — it isn't. Watercraft as defined in Va. Code § 58.1-1401 is instead covered by the separate 2.0% Watercraft Sales and Use Tax, which is generally the purchaser's/user's obligation and gets collected at titling (through the Department of Game and Inland Fisheries process referenced in the ruling), unless the seller has specifically signed on as a collecting dealer.

Accountants and tax professionals

This ruling illustrates two doctrinally distinct but related outcomes for a manufacturer: (1) the R&D exemption's de minimis carve-out under 23 VAC 10-210-3071 C for otherwise-exempt research property, and (2) the jurisdictional line between the general retail sales/use tax and the standalone Watercraft Sales and Use Tax Act, which changes who owes the tax and how it's collected. When advising audit clients on cross-cutting sales involving R&D property or watercraft, check whether the item falls under a wholly separate tax regime before assuming the general sales/use tax audit assessment is correct.

Common questions

Q: Does demonstrating a prototype product disqualify it from the R&D exemption?
A: Not automatically. Under 23 VAC 10-210-3071 C, a taxable use of otherwise-exempt research property stays de minimis (and the exemption survives) if the taxable use isn't continuous/ongoing, doesn't follow a regular pattern, happens no more than three times, and totals no more than three days. A single pre-production demonstration event, as in this ruling, met that standard.

Q: Why wasn't the taxpayer required to pay retail sales tax on the boats it sold?
A: Because boats meeting Virginia's statutory definition of "watercraft" (Va. Code § 58.1-1401) are exempted from the general retail sales and use tax by Va. Code § 58.1-609.1 9. They're taxed instead under the separate Watercraft Sales and Use Tax Act at a 2.0% rate.

Q: Who actually owes the 2.0% watercraft tax, and was the taxpayer liable for it?
A: Per 23 VAC 10-230-90, the watercraft tax is paid by the purchaser/user and collected at titling, unless a registered dealer has an agreement with the Tax Commissioner to collect it directly from customers. The ruling found nothing showing the taxpayer had such an agreement, so it was not liable for the tax on the two boat sales.

Q: What happened to the original audit assessment?
A: Both the prototype-engine line item and the boat-sales line item were ordered removed, the audit was to be revised accordingly, and — because the taxpayer had already paid the full original assessment — the Department ordered a refund of the overpayment with applicable interest.

Citations and references

Statutes and regulations:

• Va. Code § 58.1-609.3 5 (R&D sales and use tax exemption)
• Va. Code § 58.1-609.1 9 (retail sales and use tax exemption for watercraft)
• Va. Code § 58.1-1401 (definition of "watercraft," Watercraft Sales and Use Tax Act)
• 23 VAC 10-210-3070 (definition of basic research and R&D)
• 23 VAC 10-210-3071 A-C (direct/exclusive use requirement; no proration; de minimis taxable-use standard)
• 23 VAC 10-230-40 A (2.0% Watercraft Sales and Use Tax imposition)
• 23 VAC 10-230-90 A-C (payment and collection of the watercraft tax)
• Va. Code § 58.1-1821 (procedure for correction of an erroneous assessment)

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 20-171

Original ruling text

September 22, 2020

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

Dear *:

This is in response to your letter submitted on behalf of * (the “Taxpayer”), in which you seek correction of the retail sales and use tax assessment issued as a result of the Department’s audit for the period August 2011 through August 2015. I note that the assessment has been paid in full. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayer is a manufacturer engaged in developing, building and selling marine engines and related parts. The Taxpayer’s manufacturing facility is located outside of Virginia; however, the Taxpayer maintains Virginia locations that serve as administrative headquarters, engineering, testing and research facilities. During the audit period, the Taxpayer built four new prototype marine engines in its research and development facility that were installed into test boats and demonstrated at the Taxpayer’s test center. The auditor assessed use tax on the four prototype engines as taxable withdrawals from inventory for marketing purposes. In addition, the auditor assessed the sales tax on the untaxed sales of two boats.

The Taxpayer contests the tax assessed on the prototype engines and contends that the demonstration of the engines qualifies as de minimis usage pursuant to Title 23 of the Virginia Administrative Code (VAC) 10-210-3071 C. The Taxpayer contends that the use of the prototype engines for demonstration purposes was a one-time event marking the pre-production introduction of the marine engines. Further, because the prototype engines did not go into production until several months after the demonstration, they were not withdrawn from a resale inventory. The Taxpayer claims that the tax is incorrectly imposed on the prototype engines.

The Taxpayer also claims that the auditor erroneously assessed the tax on the sales of two boats that were used to test marine engines. The Taxpayer contends that the purchasers were responsible for transporting the boats to the purchasers’ locations outside Virginia. Further, the Taxpayer claims the two boats were not required to be registered in Virginia and are not subject to Virginia tax. The Taxpayer provides additional documentation in support of its claim that the boats are exempt of the tax.

DETERMINATION

Research and Development

Virginia Code § 58.1-609.3 5 provides an exemption from the 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 10-210-3070 interprets the exemption statute. Subsection A defines “basic research” as:

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.

Title 23 VAC 10-210-3071 A discusses the direct and exclusive use requirements of the exemption and states:

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.

Title 23 VAC 10-210-3071 B states, “When a single item is used both in exempt and nonexempt activities, it is not used exclusively in research activities and is taxable. Therefore, a prorated research exemption of the single item based upon percentages of exempt and nonexempt usage or an exemption based upon the preponderance of an item's use in exempt activities is not permitted.”

Title 23 VAC 10-210-3071 C provides that “[w]hen research property is used in a taxable manner, it will continue to be exempt from the tax if the taxable use is de minimis in nature. Taxable use of the property is considered de minimis if the taxable usage of the property (i) does not involve a continuous or ongoing operation; (ii) does not follow a consistent pattern, i.e. , weekly, monthly, quarterly, etc.; (iii) is occasional in nature occurring no more than three times; and (iv) in total, accounts for no more than three days.”

The Department agrees that the Taxpayer’s design of prototype engines qualifies as exempt research and development in accordance with Virginia Code § 58.1-609.3 5. Based on the information provided and the above authorities, I agree that the taxable use of the prototype engines is within the specific requirements set out in the regulation to be considered de minimis in nature. As such, the prototype engines used in the one-time demonstration maintain their exempt status. Accordingly, the audit assessment will be revised to reflect the removal of the line item for estimated cost of the prototype marine engines.

Watercraft

Virginia Code § 58.1-609.1 9 exempts from the retail sales and use tax “watercraft” as defined in § 58.1-1401 of the Watercraft Sales and Use Tax Act. Virginia Code § 58.1-1401 defines “watercraft” to mean:

any vessel propelled by machinery whether or not the machinery is the principal source of propulsion. The term shall also include any sail-powered vessel which is in excess of eighteen feet in length measured along the centerline. The term shall not include a seaplane on the water or a watercraft which has a valid marine titling document issued by the United States Coast Guard.

Based on the above authorities, the contested boats meet the definition of watercraft for purposes of the application of the tax. Therefore, the retail sales and use tax assessed on the two boats is incorrect. The question is whether the Taxpayer is liable for the watercraft sales and use tax on the sale of the two boats.

Watercraft Tax

Title 23 VAC 10-230-40 A provides that “[t]he Watercraft Sales and Use Tax is imposed at the rate of 2.0% upon the sale of every watercraft sold in Virginia that is required to be titled with the Department of Game and Inland Fisheries and upon the use in Virginia of any watercraft that is required to be titled with the Department of Game and Inland Fisheries.” [Emphasis added].

Title 23 VAC10-230-90 A states that “[t]he watercraft sales and use tax is to be paid by the purchaser or user of watercraft and is to be collected by the Tax Commissioner at the time the owner is required to apply for a title for the watercraft.” Subsection 2 of this regulation further provides that “[i]f no title is required on a watercraft, then the watercraft sales and use tax will not be levied on the watercraft unless the owner chooses to apply for a title with the Department of Game and Inland Fisheries.”

Title 23 VAC 10-230-90 C addresses the collection of the watercraft tax by dealers and states, “The Tax Commissioner may also enter into agreements with registered dealers allowing them to collect the tax from their customers. If a registered dealer desires to collect the 2.0% Watercraft Sales and Use Tax on all his taxable transfers of watercraft, he may do so by signing an agreement with the Tax Commissioner.” [Emphasis added].

According to the cited authorities, the Taxpayer is not required to register with the Department to collect the 2.0% watercraft sales and use tax. The purchaser is responsible to pay the 2.0% watercraft tax to the Department of Game and Inland Fisheries if the watercraft are required to be titled in Virginia. Accordingly, the Taxpayer is not liable for the tax assessed on the sales of the two boats. The line item for the boat sales will be removed from the audit assessment.

The audit will be revised by the appropriate field audit staff in accordance with this determination, and the Taxpayer will be provided a revised audit report. Because the audit assessment has been paid, a refund of the bill overpayment, with applicable interest, will be issued to the Taxpayer as soon as practicable.

The Code of Virginia sections 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 concerning this determination, please contact * in the Department's Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1363.T