Is sales tax paid on evaluation units?

by Dan Davis, CPA, CMI, CFE 

We provide potential customers with evaluation units of our product. Whenever we do this, we generate a zero invoice. Are we obligated to pay sales taxes on these evaluation units?

Evaluation units are products that vendors give to potential customers for the customers to try out in their business operations. The vendors do this in the hope that the customers will like the units enough to buy them, preferably in large quantities. Many vendors track these items by creating ìno-chargeî (zero) sales invoices in the names of the evaluating customers. (The creation of such invoices has no tax effect in itself.)

In most cases, the Board of Equalizationís Regulation 1669, ìDemonstration, Display and Use of Property Held for Resale ñ Generalî determines the tax status of evaluation units. The regulation holds that property may be demonstrated and displayed without creating a sales or use tax liability if three criteria are met:

1. The property is held for resale at all times;
2. No other use of the property is made; and
3. The property subsequently is either resold or returned to resale inventory.

Whether or not tax applies to an evaluation unit generally depends on what happens to it after the customer evaluation. Letís look at three common scenarios.

1. The customer likes the unit, keeps it, and orders several more. The vendor charges sales tax on the sale of the additional units. Although no specific charge was ever made for the original unit, its transfer to the customer is considered part of the sale of the additional items, and no further tax is due. (Reason: the customerís evaluation was considered demonstration and display; the product was for sale at all times; and the unit was resold without any further use.)
2. The customer returns the unit to the vendor after using the item long enough to evaluate it. The vendor polishes up the unit and puts it back into resale inventory. No sales or use tax is due because the unit was used solely for demonstration and display, was held for resale at all times and was returned to resale inventory after the customer evaluated it.
3. A vendor allows customers to keep their evaluation units even if the customers donít buy anything. Here the vendor is simply giving away free samples, which is a taxable use measured by the costs of the samples to the vendor. (Note that tax is not due on the vendorís selling prices for the items. Further, if the vendor manufactures the units, use tax is due only on the costs of the materials that have gone into the items, plus the cost of any outside fabrication labor. The vendorís own manufacturing labor and overhead are not subject to the tax.)

Finally, vendors who provide evaluation units may have trouble on audit even when they meet the criteria for exemption if they do not keep records showing that each item was sold or returned to inventory after being evaluated. Many a valid exemption has been lost simply because the auditor couldnít verify the facts. You might want to consult with a CPA to determine when and if you are liable for sale taxes on evaluation units.

Dan Davis is a senior sales and use tax consultant with Arthur Consulting Group, Inc. He may be reached at (916) 686-4154..

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