California Taxpayer Liable for Use Tax on Repair Parts Used for Out-of-State Customers

The California Office of Tax Appeals (OTA) held that a taxpayer is liable for use tax on parts used to repair equipment in California for out-of-state customers. The taxpayer is a distributor, retailer and repairer of endoscopes and other medical devices. The taxpayer offered optional lump-sum maintenance contracts with the sale of its products and provided the materials, parts and labor for warranty repairs free of charge.

The taxpayer purchased repair parts without payment of California sales tax to the manufacturer, which is a related company. The taxpayer stored the repair parts in its California facility until it withdrew the parts from resale inventory to perform repairs. The taxpayer’s customers would ship equipment needing repair to the taxpayer’s California facility. After performing the repairs, the taxpayer would ship the equipment back to customers via common carrier.

At no time prior to the end of the most recent audit period did the taxpayer report use tax due to the California Department of Tax and Fee Administration (CDTFA), measured by its cost of the repair parts consumed during the course of warranty repairs. The taxpayer argued that it was not the consumer of the repair parts and that the parts were consumed by the customer when the repaired equipment was used for its intended purpose. The CDTFA audited the taxpayer for use tax due on the repair parts for multiple periods.

The OTA relied on two state regulations to determine that the taxpayer was liable for use tax on the repair parts. Regulation 1655(c)(3) provides that the person obligated under an optional warranty contract to furnish parts, materials and labor is the consumer of the materials and parts furnished and tax applies to the sale of such items to that person. Regulation 1546(b)(3)(C) states that if repair work is performed under an optional lump-sum maintenance contract or optional warranty providing the furnishing of parts, materials and labor, the repairer is regarded as the consumer of the parts and materials furnished. As such, sales or use tax applies to the sales to the repairer. The OTA found that the property was not used solely outside the state since the repairs, which are taxable use, occurred in California.

The CDTFA had imposed a negligence penalty on the taxpayer based on its determination that the taxpayer made errors in the current audit similar to those made in previous audits. The taxpayer’s repeated failure to correct its errors from prior audits was evidence of negligence. As such, the taxpayer was liable for the negligence penalty in addition to the tax due.

(In the Matter of the Appeal of Olympus Am. Inc., 2023-OTA-087 (Cal. OTA Dec. 20, 2022)

Posted on March 13, 2023