I bought prototypes of a medical device along with the software and intellectual property needed to run it, structured as an 'Intellectual Property Purchase Agreement' -- can I argue the tangible prototypes were just an inconsequential part of an intangible IP purchase, so the deal isn't fully taxable?

Plain-English summary

A Virginia information technology company entered into a contract titled "Intellectual Property Purchase Agreement" to purchase assets related to an "Exam Room Consultation Device" (ERCD) -- four prototypes of the device, the associated intellectual property rights, the software programmed to run the equipment, and goodwill. The company didn't remit or accrue Virginia sales or use tax on the deal. On a second-generation audit, the Department assessed sales and use tax on the entire purchase price. The company appealed, arguing the transaction wasn't taxable because any tangible personal property transferred was an "inconsequential" element of what was really an intangible rights purchase, under the true object test.

The true object test. Virginia exempts professional or personal service transactions where a sale of tangible personal property is only an "inconsequential element" with no separate charge (Va. Code § 58.1-609.5 1). Under 23 VAC 10-210-4040 A and D, a transaction mixing services (or intangibles) with tangible personal property is generally either FULLY taxable or FULLY exempt on the whole charge -- there's no splitting a bundled deal into taxable and exempt pieces based on how it's itemized. The test is the "true object" of the deal: if the customer is really after a service (or intangible right) and the tangible property transferred isn't critical to that, the whole thing can be exempt; but if the customer is really after the PROPERTY, the entire charge -- services and all -- is taxable.

Why bundled royalties are instructive here, even though this deal wasn't a royalty arrangement. The Department has previously held that royalties paid purely for an intangible right, with no transfer of tangible personal property, aren't taxable -- but once royalties are paid for both intellectual property AND tangible personal property together, the whole transaction becomes taxable (P.D. 00-76, P.D. 03-37, P.D. 03-74). While this deal wasn't structured as royalties, the same underlying concept applied: medical equipment that requires intellectual property and software just to function is inextricably linked to that equipment, making the whole package taxable.

Why the company's cited precedents didn't help. The company pointed to P.D. 04-199 and P.D. 13-23, where marketing consulting services and document management services (respectively) were found nontaxable. The Department distinguished those cases: the SERVICES in those rulings were independent of whatever tangible personal property happened to be included -- the property wasn't critical to the service being provided. Here, by contrast, the device prototypes, the software, and the IP rights were all inseparably bound up in a single working device.

Outcome. The Department found the true object of this contract was acquiring the ERCDs themselves -- with the tangible property, software, and intangible rights all inextricably connected -- so the tangible property could not be treated as inconsequential. The full purchase price was taxable, and the assessment was upheld.

What this means for you

Businesses structuring a purchase of a physical device bundled with its software and IP rights

Labeling the deal an "intellectual property purchase agreement" doesn't control the tax result -- if the device, software, and IP are functionally inseparable (the software/IP exist to operate the physical product), expect the WHOLE purchase price to be taxable, not just an allocated tangible-property portion.

Anyone citing a services precedent (consulting, document management) to argue a bundled transaction is exempt

Those precedents only help where the service itself is genuinely independent of any tangible property involved -- if the property is central to what's being acquired (as with equipment requiring its own dedicated software to function), the true object test cuts the other way.

Common questions

Q: I bought device prototypes along with software and IP rights needed to run them, under an agreement labeled as an "intellectual property purchase" -- is that exempt from sales tax as an intangible transaction?
A: Not based on this ruling. If the device, software, and IP are inextricably linked to a single functioning product, the true object is the equipment itself, and the entire purchase price is taxable.

Q: Does it matter that the contract's title emphasized "intellectual property" rather than the physical device?
A: No. The Department looks at the true object of the transaction based on substance, not the contract's title or how the price is characterized.

Citations and references

Statutes and regulations:

• Va. Code § 58.1-609.5 1 -- exemption for professional/personal service transactions where tangible personal property is an inconsequential element
• 23 VAC 10-210-4040 A and D -- the true object test for transactions mixing services/intangibles with tangible personal property

Prior rulings the Department relied on (described here, not linked): P.D. 00-76 (5/15/2000), P.D. 03-37 (4/15/2003), and P.D. 03-74 (10/27/2003) -- royalties paid for intellectual property alongside tangible personal property are taxable, unlike royalties for a purely intangible right; P.D. 04-199 (11/3/2004) and P.D. 13-23 (2/20/2013) -- distinguished, because those service transactions (marketing consulting, document management) were independent of any tangible property involved.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 24-40

Original ruling text

March 27, 2024

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

Dear *:

This will respond to your letter in which you seek correction of the retail sales and use tax assessment issued to * (the “Taxpayer”) for the taxable period August 2013 through July 2016. I apologize for the delay in responding to your request.

FACTS

The Taxpayer, an information technology company in Virginia, entered into a contract titled “Intellectual Property Purchase Agreement,” whereby it agreed to purchase various assets related to an “Exam Room Consultation Device (ERCD).” The purchased assets included four prototypes of the ERCD, as well as any associated intellectual property rights, software programmed to operate the equipment, and goodwill. The Taxpayer did not remit or accrue Virginia retail sales or use tax on the transaction.

Under second generation audit, the Department issued an assessment of retail sales and use tax on the total purchase price for the transaction. The Taxpayer timely filed an application for correction, contending that the transaction is not taxable because any tangible personal property transferred was inconsequential pursuant to the true object test.

DETERMINATION

Virginia Code § 58.1-609.5 1 provides, in pertinent part, that the retail sales and use tax does not apply to “professional, insurance, or personal service transactions which involve sales as inconsequential elements for which no separate charges are made….” Under Title 23 of the Virginia Administrative Code (VAC) 10-210-4040 A:

Charges for services generally are exempt from the retail sales and use tax. However, services provided in connection with sales of tangible personal property are taxable.

Transactions involving both the sale of tangible personal property and the provision of services, generally are either taxable or exempt on the full amount charged, regardless of whether the charges for the service and property components are separately stated. As explained in subsection D of this section, the "true object" test is used to determine the taxability of these transactions.

Further, Title 23 VAC 10-210-4040 D provides:

In order to determine whether a particular transaction which involves both the rendering of a service and the provision of tangible personal property constitutes an exempt service or a taxable retail sale, the "true object" of the transaction must be examined. If the object of the transaction is to secure a service and the tangible personal property which is transferred to the customer is not critical to the transaction, then the transaction may constitute an exempt service. However, if the object of the transaction is to secure the property which it produces, then the entire charge, including the charge for any services provided, is taxable.

The Department has held that royalties paid only for an intangible right without any transfer of tangible personal property are not subject to retail sales and use tax. However, when royalties are paid for intellectual property rights and tangible personal property, the transaction becomes taxable. See Public Document (P.D.) 00-76 (5/15/2000), P.D. 03-37 (4/15/2003), and P.D. 03-74 (10/27/2003). While the Taxpayer’s transaction does not involve royalties, the concept that a transaction for medical equipment requiring intellectual property, software, and tangible personal property in order to operate is inextricably linked and, thus, taxable remains applicable.

The Taxpayer cites P.D. 04-199 (11/3/2004) and P.D. 13-23 (2/20/2013) in support of its position that transactions are not taxable. However, the services in those cases, marketing consulting services and document management services respectively, were independent of the tangible personal property included in the transactions. The transactions were not taxable because the tangible personal property was not critical to the service transactions.

After reviewing the terms of the Taxpayer’s contract, I find that the true object of the transaction was the acquisition of the ERCDs. Because the tangible personal property, intangible rights, and software are all inextricably connected to the ERCD, the tangible personal property cannot be considered inconsequential.

Accordingly, the transaction is taxable and the assessment must be upheld. An updated bill with accrued interest to date will be issued shortly. The Taxpayer should pay the amount due within 30 days of the date on the bill to avoid the accrual of additional interest or possible collection action.

The Code of Virginia sections, regulation, and public documents cited are available online at www.tax.virginia.gov in the Laws, Rules, & Decisions section of the Department’s website. If you have any questions regarding this determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at , or via email at **.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/2083-C

Related Documents

00-76

03-37

03-74

04-199

13-23