An area of tax law that has been undergoing changes lately is the area of research and development (R&D) contracts. The issue centers around the true object of the contract.

Background

In a R&D contract, the true object is the development of information and not the sale of tangible personal property. Since the true object is information, the physical transfer of that information such as plans and designs, is ordinarily transferred on paper. This paper transfer is incidental to the information contracted for and as such is not subject to tax. If the information cannot be transferred without the production of a prototype, the transfer of a prototype is also incidental to the R&D contract.

If, however, a prototype is transferred even though the results of the research could be conveyed in some other form, the transfer of the prototype has been held as a sale subject to tax. The measure of tax has not been the full contract price since the primary purpose of the contract was for the service of developing information.

New development

In a recent case in Silicon Valley, the State Board of Equalization ruled 3 to 1 that Sierra Semiconductor was not liable for sales tax on R&D contracts involving sales of prototypes. The new Board, led by Johan Klehs, voted that even though a few prototypes changed hands, they were not subject to tax since they were pursuant to an R&D contract.

The staff of the State Board of Equalization, being unhappy with the decision, has issued a draft interpretation that would limit the scope to the Semiconductor industry. Undoubtedly the staff is trying to cap the potential revenue loss by narrowly applying this outcome.

A R&D contract is still distinguishable from a contract for the manufacture of a custom made item. If the emphasis in the contract is the tangible personal property, it is taxable notwithstanding the fact that a certain amount of research and design is required. Also, as in the case of Navistar, if no new research is involved, the sale of certain drawings and specifications will be taxable.

As usual, the battle between the State Board of Equalization staff and the taxpayers continues.