New Tax Guidance for Software Used in Research and Development

Submitted on Wed, 10/28/2020 - 4:00 pm

Financial Services would like to share tax savings news for University departments that qualify to make tax exempt purchases of machinery or equipment used in research and development (R&D) as that term is defined by the State. The statutes (A.R.S. § 42-5061(B)(14) and A.R.S. § 42-5159(B)(14)) read as follows:

Machinery or equipment used in research and development: For the purposes of this paragraph, "research and development" means basic and applied research in the sciences and engineering, and designing, developing or testing prototypes, processes or new products, including research and development of computer software that is embedded in or an integral part of the prototype or new product or that is required for machinery or equipment otherwise exempt under this section to function effectively. Research and development do not include manufacturing quality control, routine consumer product testing, market research, sales promotion, sales service, research in social sciences or psychology, computer software research that is not included in the definition of research and development, or other nontechnological activities or technical services.

To qualify for tax exemption, a purchase must be machinery or equipment and its use must be a match for the first sentence of the definition. Uses listed in the second sentence do not qualify as R&D for this purpose, and R&D in the social sciences does not qualify for this exemption.

Tax Services requested and received a mostly favorable Statement of General Guidance from the Arizona Department of Revenue (ADOR) regarding the qualification of software as machinery or equipment for the purposes of an R&D tax exemption. Not all software used in the R&D process qualifies as tax exempt machinery or equipment. Please review our new Sales and Use Tax Exemptions for Research and Development web page for the details prior to claiming a tax-exempt R&D software purchase.

With this news, we understand departments may wish to make corrections to sales or use tax previously paid for software qualifying as R&D machinery or equipment. If sales tax was paid, a department must work with their vendor directly. It is up to the vendor if they will accept an exemption certificate the fact and provide a refund of sales tax. If reversing use tax on a Procurement Card Transaction (PCDO), a General Error Correction (GEC) can be used for the current fiscal year and a Distribution of Income and Expense (DI) may be used for the prior 3 fiscal years (FY18 – FY20). Exemption certificates, instructions, and guidance for correcting use tax on a PCDO are available on the Arizona Sales and Use Tax web page. If reversing use tax on a Purchase Order (PO), please reach out to Tax Services with the details of the purchase for review.

As always, Tax Services is your primary resource should you have questions regarding R&D exemptions, the taxation of software, or any other purchase for the University. If additional assistance is needed, please do not hesitate to contact us at taxservices@fso.arizona.edu or 520-621-1957.