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State & Local Tax Bulletin
(Volume 1, Number 4, September 1995)

The California Use Tax Will Not Lie
Where a Taxpayer's Use of Property
in the State Is De Minimis




By Richard Nielsen, of counsel in the San Francisco office of Pillsbury Winthrop Shaw Pittman LLP.

This information is only of a general nature, intended simply as background material, omits many details and special rules and cannot be regarded as legal or tax advice.


Recently, following a four-year odyssey through the California sales and use tax administrative process, the buyer and seller in a transaction which occurred in California were successful in abating separate assessments in two extremely unusual cases. The cases, which were handled by the firm, revolved around whether a 1986 sale in California of a mobile magnetic resonance imaging unit by Diasonics, Inc. (Diasonics) to Mobile M.R. Inc. (Mobile) was subject to either the sales or the use tax. The taxpayers' long and successful journey through the administrative process took several unexpected twists and turns due to the applicability of seldom-encountered sales and use tax statutes involving sales of vehicles, statutes of limitations, and exclusions for storage, use and testing.

Background

Diasonics was a manufacturer of medical electronic diagnostic equipment. Mobile provided the use of mobile magnetic resonance imagers ("MRI") to doctors and hospitals. An MRI produces a three-dimensional picture of a patient's internal organs and structures similar to a CAT-scan. The MRI was installed in the trailer section of a tractor/trailer and was towed from hospital to hospital as needed. As was later determined, Diasonics was neither licensed nor certificated as a dealer under the Health and Safety Code or the Vehicle Code.

On June 17, 1985, Diasonics entered into an MRI Purchase Agreement with Mobile to sell seven mobile MRIs. The sale of the second mobile MRI to Mobile by Diasonics was the subject of the instant cases. The total price for the second mobile MRI and van was $2,100,000. The purchase agreement provided that Diasonics would provide certain training to physicians and technicians selected by Mobile within 10 days after the purchaser executed a certificate of completion.

The use of mobile MRIs was in the development stage at this time and various technical problems arose in the first unit sold to Mobile. Proper installation was critical to the unit's performance, especially to ensure that passing vehicles and movement of the unit between locations would not disrupt the unit's magnetic field. Accordingly, the purchase agreement was amended to provide that, before making final payment, Mobile was entitled to a period of up to 60 days following delivery of the second unit to verify that the system was performing to specifications.

Diasonics manufactured the second MRI and then shipped it to a van manufacturer in Illinois. The van manufacturer built a trailer van to house the MRI and returned the unit to Diasonics in California. Diasonics delivered the second mobile MRI unit to Mobile on May 19, 1986 at the Scripps Clinic in Rancho Bernardo, California. Mobile had a preexisting contract to perform imaging services for doctors in Oklahoma and acquired the second unit for use there. Because of the problems experienced with the first unit, Mobile decided to subject the second unit to rigorous testing before sending it to Oklahoma. The tests had to be done in California because adequate facilities were not available in Oklahoma to correct any defects.

Mobile had been using the first unit to perform imaging services for various doctors and hospitals in California. After the second unit was delivered, Mobile would on occasion substitute the second unit for the first to see if the second unit was functioning properly. The unit did not produce satisfactory images and had to be returned to Diasonics on several occasions to correct such problems. This went on for a period of about five months. Supplier invoices indicate that during this period of time, Mobile made monthly purchases of cryogen, which is used to cool MRI units. Finally, in about October 1986 following a last attempt to correct outstanding problems, Mobile decided to transport the unit to Oklahoma. Apparently, Mobile concluded that even though the unit never performed well enough under California medical standards, the unit would be satisfactory under the less stringent standards of Oklahoma.

Diasonics reported the sale to Mobile on its fourth quarter 1986 Oklahoma sales and use tax return. However, it was later determined that such mobile units should not be so reported as they were subject to a motor vehicle excise tax. Diasonics requested and obtained a refund and subsequently on February 23, 1987, about nine months after accepting delivery in California, Mobile registered the unit in Oklahoma. It paid $64 in registration fees and an excise tax of $64,375 to Oklahoma for the unit. Diasonics did not report the sale of the second unit to Mobile as a taxable sale in California, and Mobile had never registered the unit in California.

The California State Board of Equalization ("Board") originally determined that Diasonics was liable for $126,814 in sales tax plus interest on the sale of the second unit to Mobile. Diasonics paid the amount, and both Diasonics and Mobile petitioned for redetermination.[fn. 1] Following a preliminary hearing and two Decisions and Recommendations, the Board's staff recommended a redetermination (as explained more fully below) in favor of Diasonics and a refund of sales tax and interest. However, the staff then recommended that a use tax of $126,814 plus interest be assessed against Mobile, which was petitioned by the taxpayer. While Mobile's petition was working its way through the administrative process, the Board's staff held its recommendation regarding Diasonics' refund in abeyance pending resolution of the Mobile matter.

Diasonics' Petition for Redetermination

At the September 26, 1991 preliminary hearing conducted before a hearing officer of the Board, various arguments were presented on behalf of both Diasonics and Mobile regarding their respective positions concerning the taxability of the unit in question. A declaration was submitted from the out-of-state manufacturer of the trailer van that said units are customarily registered in California with the Department of Motor Vehicles. The Board's hearing officer, in her Decision and Recommendation issued on April 3, 1992, initially rejected all such contentions, finding that Diasonics was a retailer and was required to collect the sales tax. The hearing officer also concluded that Mobile had made a taxable use of the unit in California notwithstanding that Mobile subsequently shipped the unit to Oklahoma and paid tax on it there.

Diasonics and Mobile requested an oral hearing before the full Board. Prior to that hearing, scheduled for October 5, 1992, the taxpayers were notified that the matter was being further reviewed by the Board's Appeals Review Section. On October 9, 1992, a Supplemental Decision and Recommendation was issued wherein the Board's staff concluded that under RTC § 6282 Diasonics was not required to pay sales tax.

RTC § 6282 provides:

There are exempted from the computation of the amount of the sales tax the gross receipts from sales of mobilehomes or commercial coaches required to be annually registered under the Health and Safety Code or vehicles required to be registered under the Vehicle Code when the retailer is other than a person licensed or certificated pursuant ....

The Board's staff concluded that Diasonics was not a licensed dealer and therefore it had no responsibility to pay a sales tax or to collect the use tax. However, pursuant to RTC § 6292, the Board's staff recommended a use tax be determined against Mobile because it was the purchaser of a vehicle which was required to be registered. This is analogous to an individual buying a used car from a private party (non-dealer) and paying use tax when he or she registers it with the DMV. The staff did not reconsider the part of its ruling that Mobile had made a taxable use of the unit in California. The staff's recommendation regarding Diasonics was held in abeyance pending resolution of the Mobile determination.

Open-Ended Statute of Limitations

On December 29, 1992, two months after the Supplemental Decision and Recommendation was issued in the Diasonics matter, the Board issued a Notice of Determination against Mobile regarding its purchase of the second unit in the total amount of $248,555 ($126,814 tax, $109,060 interest and $12,681 penalty). The transaction under review occurred in May 1986 and the Board was now issuing a determination for the first time against Mobile in December 1992, some six years after the transaction.

The Board relied upon the little noticed and used subsection (c) of RTC § 6487 which provides that if a notice of deficiency determination has been issued for the sale of property, the statute of limitations will not bar a later proposed determination of use tax on the same transaction. The section essentially overrides the otherwise three-year statute of limitation (in cases other than fraud and failure to file a return) for the issuance of deficiency determinations provided in subsections (a) and (b) of RTC § 6487.

Mobile's Petition for Redetermination

Following receipt of its Notice of Determination, Mobile petitioned for redetermination and primarily argued that any use it made constituted nontaxable testing, and relied upon the Board's Sales and Use Tax Annotation 570.1180 which provides that

The testing of equipment in this state which is not used in production here and is subsequently used solely outside this state meets the requirements of Section 6009.1 for exemption from use tax.

RTC § 6009.1 limits the broad definition of taxable use found in RTC § 6009 and provides that

"Storage" and "use" do not include the keeping, retaining or exercising any right or power over tangible personal property for the purpose of subsequently transporting it outside the state for use thereafter solely outside the state . . . .

The Board generally has applied the section 6009.1 exclusion from storage and use in situations where the purchaser of property attempts to avoid application of the use tax (e.g., property purchased from outside of California). When property is sold in California, generally the applicable tax is a sales tax against the seller and RTC § 6009.1 would not be relevant in the Board's viewpoint. Accordingly, in order for Mobile to contend that its use—testing—was an excepted or nontaxable use, it was necessary that its transaction with Diasonics be examined in the use tax rather than the sales tax context. As explained above, due to the unusual procedural posture of this case, Mobile was able to rely upon RTC § 6009.1, whereas Diasonics would not have been able to do so.

At a preliminary hearing held on December 16, 1993, Mobile presented its arguments, supported by documentary evidence and three witnesses. One month later, the Board's hearing officer issued an adverse Decision and Recommendation and held that the testing conducted by Mobile constituted a taxable use of the property in question.

The hearing officer concluded that Mobile used the unit for its intended purpose, that is, to make images for customers as part of the regular business operations, just as it would use any other capital asset. This conclusion was premised on the fact that Mobile allegedly earned revenue from the testing of the unit due to its occasional substitution for the first unit on Mobile's hospital route during the time it was in California. The hearing officer also stated that even if the unit earned no revenue, the fact that it was used on jobs meant to earn revenue would constitute a taxable use. Mobile argued that the alleged earning of revenue should not defeat the exempt nature of testing and cited the Board's Annotation 210.0060 which provides that assessing a charge in connection with demonstrating an item held for sale does not defeat the exemption or nontaxable nature of demonstration.[fn. 2]

Mobile requested an oral hearing before the full Board and on November 16, 1994, Mobile presented its evidence both documentary and oral (three witnesses plus a declaration) to the Board. There was much discussion and questioning by the Board regarding the nature, length and method of testing undertaken by Mobile during the time the unit was in California. The Board was concerned about how a finding of taxability in this context would affect California industries that are developing new technologies and may need to engage in forms of testing not normally encountered by the Board's staff.

On February 1, 1995, the Board issued a Redetermination to Mobile abating the entire amount of tax, interest and penalty. The Board ruled that "any use of the mobile imagers in California was de minimis." Five months later, the Board issued a Redetermination to Diasonics deleting the tax on the unit in question and refunding the tax and interest previously paid.

Conclusion

There were many factors in this matter which influenced the final decision rendered by the Board, including the fact that new technology was involved; tax was paid to another state; the credibility of the witnesses; and the staff's overly strict interpretation regarding what constitutes a taxable use within the context of testing. While this decision is not precedential because it was not published, it should provide taxpayers with hope that the long and winding road of the administrative process can lead to victory—albeit sometimes at the last turn in the road.


Notes

  1. Mobile petitioned as an interested party under RTC § 6561 because it was contractually liable for any tax. [return to text]

  2. RTC § 6094(a) provides that use tax applies to property purchased under a resale certificate which is used for purposes other than retention, demonstration and display while holding it for sale in the regular course of business. [return to text]


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