TX: Software used to produce semiconductor chips was not used in manufacturing

A Texas appeals court ruled that a taxpayer’s software purchases were not exempt from sales tax under the state’s manufacturing exemption.

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Recently, the Texas Court of Appeals, Third District, ruled that a taxpayer’s software purchases were not exempt under the state’s manufacturing sales and use tax exemption. The taxpayer, a producer of semiconductor chips, purchased Electronic Design Automation (EDA) software tools to design and develop semiconductor chips in a virtual environment. The taxpayer did not produce the chips itself, but contracted with a third-party foundry, based in Taiwan, to manufacture and fabricate the semiconductor chips. The software, in essence, enabled the taxpayer to replicate the foundry’s specific manufacturing tolerances in the virtual environment in which it designed the chips. After the design phase was complete, the taxpayer created and transmitted a graphic design system file to the third party, which was used to fabricate the semiconductor chips. The third-party did not use the taxpayer’s EDA software tools in the manufacturing process. Under the applicable section of the manufacturing exemption, sales and use tax does not apply to property that causes a direct “chemical or physical change” and “is necessary or essential” to the manufacturing operation. The tangible personal property—here, the EDA software tools—must be “directly used . . . in or during the actual manufacturing . . . of tangible personal property for ultimate sale.”  After the Comptroller concluded that the taxpayer did not qualify for the exemption, a trial court affirmed.

On appeal, the taxpayer argued that the trial court erred when it ruled that its EDA software purchases were not exempt. The appeals court, however, upheld the assessment. In the court’s view, the software, which was used during the creation of the graphic design system file, was used in an activity performed in preparation for manufacturing and not during the actual manufacturing process. Under Texas law, the taxpayer bore the burden of establishing that the EDA software tools were “directly used” in the actual manufacturing of the semiconductor chips and not in preparation for the first stage of the production of the chips. The taxpayer failed to do so. The appeals court also addressed an ancillary argument that the EDA software tools were exempt as semiconductor fabrication equipment. The Texas manufacturing exemption includes “semiconductor fabrication cleanrooms and equipment.” This section of the exemption captures tangible personal property used in connection with manufacturing a semiconductor product in a cleanroom environment. The court concluded that the taxpayer failed to show that the software tools “had a reasonable nexus” with the third-party’s cleanroom environment used for fabricating the semiconductor chips. Notably, the non-exclusive examples of exempt cleanroom property in the statute focused on property actually used in the cleanroom. The court next dismissed the taxpayer’s remaining arguments. Please contact Chad Woodfork at 713-319-3846 with questions on Silicon Laboratories, Inc. v. Hegar.

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