"True Object of Taxpayer's Work" test applied to establish tax liability for assets and supplies purchased by taxpayer to operate and maintain public vessels under a federal government contract.  
Using the "true object of taxpayer's work" test, the Virginia Department of Taxation recently ruled that assets and supplies purchased to operate and maintain public vessels under the taxpayer's contract with the federal government were not eligible for the exemption for property sold to the government because the true object of the federal contract was the taxpayer's provision of services, not the purchase of supplies.  In this three part ruling, the Virginia Department of Taxation found no exemption applied where 1) the object of the overall contract - provide ship operation and management services - was sufficiently clear, 2) the contract did not designate the taxpayer as the "purchasing agent" of the federal government, and 3) the credit of the taxpayer and not the government was bound to the purchases.  The Virginia Department of Taxation did find that where purchases of tangible property were delivered directly from the vendor to the vessel or were warehoused only briefly pending arrival of the qualifying vessel, they were not subject to the tax audit.


Taxpayer was a federal government contractor with a contract to operate and maintain specified public vessels.   The contract provided that taxpayer would retain ultimate authority to control the movements and navigate the vessels in support of government operations.  Specifically, the taxpayer would provide the crew and Master for each vessel and perform operational, managerial and maintenance tasks for the vessels.  The Statement of Work specifically provided that the taxpayer would provide "personnel, operational and technical support (ashore and afloat), equipment, tools, provisions, and supplies to operate and maintain" these vessels.   It also provided that taxpayer would provide managerial control in overhaul of the vessels, maintain and repair the vessels and accomplish all alterations to the vessels.  

Taxpayer claimed to be agent of the United States and sought tax exemption under Va. Code §58.1-609.14 for purchases made in performance of the contracted operation and maintenance services.  


The Virginia Department of Taxation found that Taxpayer was not an agent of the United States for all purposes and therefore its purchases were not exempt from taxation by law.   Specifically, the taxpayer was not an agent of the United States exempt from taxation of purchases because the taxpayer's government contract did not expressly designate the taxpayer as a purchasing agent.  "Only in instances where the credit of a governmental entity is bound directly and the contractor has been officially designated as the purchasing agent for such government entity will such purchases be deemed exempt from the tax."  Title 23 VAC 10-210-410(J).   For Virginia retail sales and use tax purposes, "the user and consumer of all tangible personal property used in performing its services" is taxable "even though title to the property provided may pass to the government or the contractor may be fully reimbursed by the government, or both."  Title 23 VAC 10-210-693.  The lynchpin of the Department of Taxation's position was that it found the government contract to be a "services" contract.  

From the decision by the Department of Taxation, it appears that the form of the contract controls the result.  In this case, the taxpayer was put in charge of overall control, operation and maintenance of the vessels.  Any thing bought for inclusion or use in the running of the vessel was viewed by the Department of Taxation as merely incidental to the services being performed by the taxpayer except for those supplies that were directly delivered to the vessel or warehoused only briefly until the vessel's arrival at port.  

From the little we see in the opinion, it appears that if the contract had been crafted differently, the Department of Taxation might have reached a different conclusion.  For example, if the contract had been broken out into separate contract line items for performance of services and acquisition of specified supplies, the Department of Taxation might have found that the overall purpose of the contract was not clear or not limited to the performance of services.  It might have had to enquire into the taxable nature of the specific purchases on a contract line item or task order basis.  Indeed, the Department of Taxation might well have found that the presence of a separate line item for the purchase of supplies would have been sufficient to establish the purchasing agency of the taxpayer for tax exemption purposes.   If the contract had been crafted to provide that the supplies procured would become government furnished equipment ("GFE") to be used to perform the overhaul or other services, then that too might have sufficed to establish the agency requirement for exemption purposes.

The Department of Taxation points to the fact that the vendor purchases were billed directly to the taxpayer, showed that the taxpayer was the entity for billing purposes, and did not otherwise indicate that the government was the party liable for payment in support of its position on the non-exempt nature of the purchases.  In short, it appears that the Department of Taxation's reasoning is that if the purchase appears to be for the taxpayer, then it is not a purchase done for the government.  Had the taxpayer entered into (and identified to the Department of Taxation) subcontracts or vendor agreements stating that the items were being procured for the specific government contract, for delivery to the specific government vessel, and/or that the terms of the purchase included mandatory federal acquisition provisions that had to be flowed down to the subcontractor or vendor, these indicia of government "control" might have made a difference.

Taxpayers should be mindful in crafting their prime and subcontracts to ensure that they clearly identify their authority to purchase and the tax exempt nature of such purchases.  So too taxpayers should try to establish a clear position on the tax exempt nature of their purchases by ensuring that they flow down clauses from the prime government contract to their subcontract and vendor purchase agreements, that the items they purchase for government contracts are clearly identified as such, and that, where possible, delivery of such items is made directly to the vessel or government site.