Laws, Regulations & Annotations

Business Taxes Law Guide – Revision 2018

Sales and Use Tax Annotations

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Annotation 477.1000

477.1000 Design and Develop Contract. A taxpayer entered into a contract with a customer to design and develop a custom test instrument for installation of fiber optic equipment. The contract called for initial delivery by the taxpayer of three prototypes to be used for primary evaluation of design and mechanical flaws. At later dates, eleven units were to be delivered consisting of changes and improvements as a result of the evaluation of the prototypes. This "final unit" delivery was to "include all documentation to manufacture and/or repair the units." The customer would exclusively own all intellectual property conceived or reduced to practice which related to the prototype test instruments. All other intellectual property conceived or reduced to practice and developed under the agreement by the taxpayer would be jointly owned by the taxpayer and the customer. All tangible materials including but not limited to records, drawings, models, apertures, samples and the like conceived or produced in the design and development of the test instruments by the taxpayer, including all documents required to manufacture and/or repair the test instruments, were to be delivered to the customer no later than upon delivery of the "final units."

In analyzing the contract between the taxpayer and the customer, a distinction must be made between the contract to manufacture a custom-made item (a sale) and the contract to provide research and development (a service). From the language of the contract, it is apparent that the customer wanted the test instruments designed and developed so that the customer would have the option to manufacture and sell the instruments. In other words, the customer was not merely interested in the production of custom made items for its own consumption or resale, but wanted to obtain all information necessary to both manufacture and repair the test instruments. The delivery of the first three units (prototypes) were for primary evaluation which consisted of testing for verification of a design to specifications and also testing to determine if alternative design features are necessary. As such, charges related to the research and development of the first units and to their delivery to the customer for "primary evaluation" are not subject to sales tax under Regulation 1501.1.

It is not clear whether the "final units" delivered by the taxpayer are also prototypes transferred for informational and testing purposes. (Regulation 1501.1(a)(7).) However, it is possible the "final units" are sales of additional prototypes transferred in a qualified research and development contract for purposes other than informational testing and use. When a functional use occurs such as actual functional use by the customer of the "final units" to try out its installation of fiber optic equipment (i.e., the use for which the test instrument was designed) the sale of such units is subject to tax. (Regulation 1501.1(b)(2).) In other words, if the customer's objective in receiving the "final units" is for functional use (use for which the property was designed) which occurs after completion of the research and development, the transfer of the "final units" is a sale subject to sales tax. Since the contract does not state a value for the "final units," the measure of tax is the computed fair market value as determined by applying a factor of three to the cost of the direct materials used in the production of the "final units." 1/3/96.