Sales tax: missed manufacturing exemptions

If a company is engaged in manufacturing, it may very well be paying too much in sales taxes. Experience shows that many manufacturers fail to capitalize on the sales tax exemptions available to them and, consequently, that they overpay their taxes. This failure is attributable both to the extremely varied nature and complexity of the exemptions and to the process that companies use in applying the law; specifically, in many companies, exemption determinations are made at low levels by people unfamiliar with the tax laws, e.g., accounts payable clerks. In other words, the people making the evaluation whether to tax or exempt particular transactions often do not have the requisite knowledge.

In their efforts to promote economic development, many states offer a variety of sales tax exemptions to companies engaged in manufacturing. The exemptions can be classified under four general headings:

* Resale/wholesale exemptions

* Packaging/container exemptions

* Energy exemptions

* Machinery exemptions

Because all the exemptions are tied to manufacturing, they often overlap, causing confusion for the company tax manager. In fact, the major obstacle to compliance is the mind-numbing definitional variations from state to state. Proper tax planning with manufacturing exemptions must begin and end with definitions. Good recommendations and strategies can only be made in light of each state's specific definitions. There are no shortcuts.

The first definitional hurdle to overcome is to determine just who is a "manufacturer." Although definitions vary from jurisdiction to jurisdiction, most states impose some requirement to change raw material into a new product. For example, the statute in Illinois simply defines manufacturing as "the production of an article of tangible personal property ... by a procedure commonly regarded as manufacturing, processing, fabricating, or refining that changes some existing material ... into a material with a different form, use, or name."(1) Colorado defines manufacturing as "manufacturing, producing, fabricating or processing is usually deemed to have occurred when tangible personal property is created, transformed or reduced to a different state, quality, form, property or thing. Transformation may occur by hand, machine, art, chemical action, or natural means."(2) The Supreme Court of the United States has said that "manufacturing implies a change ... there must be a transformation; a new and different article must emerge, having a distinctive name, character or use."(3)

Such broad definitions are only partly helpful. Take, for example, a dairy. Does it qualify as a manufacturer? After all, it starts out with milk and ends up with milk--so it may not be a manufacturer, but a processor. One-percent milk, however, is arguably a different article than raw milk straight from the cow--so perhaps the dairy is a manufacturer. Or is the dairy a manufacturer only when making cheese or yogurt, but not when processing milk? State courts are divided on such issues. A Pennsylvania court has ruled that changing honey from its raw form into a marketbale product meeting federal standards is not manufacturing because the end product is not substantially different from the beginning.(4) Some meat processors have been deemed manufacturers, while others have not.(5) Rebuilding machine tools has been ruled to constitute manufacturing, but rebuilding engines has not.(6)

In the many controversies over the definition of manufacturing, the key terms are processing, refining, assembly, construction, and fabrication. It is often unclear whether a given state's definition of manufacturing extends to, say, gas exploration, meat processing, oil refining, general building construction, or specific product fabrication--not to mention software development.

In states that require manufacturing to result in a new product different from the raw material, activities such as assembly, processing, and refining often fail to qualify for the exemption. In Colorado, manufacturing status has been denied to a company in the business of retreading and recapping tires. The company argued that it should not have to pay sales tax on its purchases of camel back, cushion gum, rubber cement, and cord used in retreading tires because such items are used in manufacturing tires for resale. The court disagreed, however, stating that to be a manufacturer must produce a new article:

In order that one may be a maker, it is essential

that he be the efficient cause of the coming into

existence of something that did not before exist.

Manufacture implies change, but every change is

not manufacture. There must be transformation: A

new and different article must emerge having a

distinctive name, character, or use.(7) Some states specifically address these questions in their implementing regulations; many do not.

Faced with this variety, how should tax managers proceed? First, they should focus on a state's specific statutory definition of manufacturing and other related terms. What is included or excluded? Second, they must consider whether an activity is deemed to constitute manufacturing for some exemptions, but not others. Finally, they should review the case law for the specific state. Courts often provide helpful guidance where statutes and regulations are insufficient.

Resale/Wholesale Exemption. The first and most obvious exemption for manufacturers is the resale--or wholesale--exemption. Most states provide that purchases of tangible personal property by a business engaged in manufacturing is exempt from sales tax if the item becomes an ingredient or component part of the product being manufactured. As one judge stated, "A sale of raw material which is to become an integral part of a manufactured article that is to be later sold at retail is not subject to the sales or use tax."(8) In essence, the purchase is considered to be a wholesale, not a retail, transaction and thus exempt from taxation. Instead, a sales tax will be charged on the retail sale of the finished product.

In most states, exempt property must become an integral, physical part of the article being produced for resale. An easy example is wood used by cabinetmakers. Cabinetmakers buy the wood tax-free because it is used to make cabinets that, when finished, will be sold at retail (and that subsequent sale will presumably be taxed). If the tangible personal property is used as an aid in the manufacturing process and does not become a physical part of the product, however, the sales tax may be imposed. Returning to the cabinetmaker example, the sandpaper, saws, and cutting tools would generally not be exempt; cabinetmakers must pay salas tax on these items. Unfortunately, real life is rarely this simple.

The debate between taxpayers and tax administrators on the resale/wholesale exemption usually focuses on what it means for a raw material to become an ingredient--or an integral, component part--of the manufactured product. Generally speaking, the states fall into two groups. Most states follow a "dominant" or "primary purpose" rule in deciding which raw materials to exempt. If the primary purpose of the purchased material is to become part of the product for resale, then the state will exempt the entire purchase is exempt from sales tax. Where a purchase serves two purposes--one exempt, the other not--apportionment of the tax may be an option. Fewer states emphasize the "necessary" or "essential" rule, thereby exempting items that, while not becoming part of the finished product, are necessary or essential to production (e.g., lubricating oils and chemical catalysts).

For example, in Colorado, chemicals that become a part of the product are exempt from sales tax; chemicals that act only as catalysts are not. It is unclear how chemicals that act as both a catalyst and ingredient are treated, though proration seems to be acceptable.

Sometimes, state regulations are quite specific. Colorado regulations explain that paint thinner used by auto body paint shops is taxable because, though mixed with the paint, it does not adhere to the car; it evaporates during and after application.(9) So, too, in Arkansas, where chlorine used as an oxidizing agent to change bromide into bromine is deemed taxable.(10) In contrast, a Missouri court has held that diesel oil used in manufacturing clay pots is exempt even though it dissipates during baking because the oil is initially a "component part or ingredient" and necessary for production.(11) Alabama exempts chemicals and materials that unintentionally "enter into and become an ingredient or component part of the tangible personal property."(12) New Jersey exempts chemicals and catalysts even where they do not become a component part of the finished product.(13) Unfortunately, there are no hard and fast rules; variety abounds.

In practice, the "primary purpose" test means that some products can be subject to or exempt from sales tax depending on not only how businesses actually use them, but on the manufacturer's intent. Thus, in Louisiana, graphite used in the manufacturing process is taxable even though a residue of the graphite is present in the final product. The court determined that the graphite is a manufacturing aid and not intended to become a part of the final product.(14)

Another example is carbon dioxide gas ([CO.sup.2]). Used in the sale of draft beer, it is often taxable. The gas is used to force the beer to the tap and is not intended to become an integral or constituent part of the beer. On the other hand, [CO.sup.2] used to produce soda water and other carbonated beverages is exempt. So, too, with flux: When used to clean or prevent oxidation of metals, it is taxable; if used for transmitting desirable alloys to metal, it may be exempt. If the flux is used for both an exempt and nonexempt purpose--e.g., 40 percent of it becomes part of the product with the remainder acting as a catalyst--it may be possible to prorate the tax.

A humorous illustration of the lack of uniformity on this issue involves hotdogs. In Nebraska, the court has held that frankfurter casings, though absolutely essential to manufacturing wieners, are nothing more than a mold and, hence, taxable. That some of the glycerine in the casing actually becomes part of the meat is deemed "incidental."(15) Compare that result to Colorado's statute that exempts skin casings even if "the item is used only for the purpose of placing a food product in a more marketable condition ...."(16) Apparently Colorado likes its new baseball team so much that even hot dogs receive preferential tax treatment.

Is there any doubt why taxpayers are confused? It is easy to understand why smaller manufacturers and accounts payable clerks in larger manufacturing establishments need guidance in this area. What can tax executives do? They must focus on the crucial terms and phrases for their particular state. Start with this key question: What does it mean for an item to become part of the product being sold. Must it be an integral or physical part of the product? Must the item be essential or necessary to production, or can it play only a primary or dominant purpose? Finally, can a manufacturing aid (such as lubricating oil or catalysts) fall within the exemption? Unfortunately, there are no comprehensive rules. Nevertheless, paying attention to these questions will clarify the key distinctions needed to claim refunds in this confusing area.

Packaging/Container Exemption. Closely related to the resale/wholesale exemption is the exemption for packaging materials and containers. The theory behind both exemptions is the same--items purchased for later sale at retail should be exempt. Nevertheless, most states specifically exempt purchases of shipping and packaging materials when included with the article being sold. The California definition of containers is typical:

Articles in or on which tangible personal property

is placed for shipment or delivery, such as wrap-

ping materials, bags, cans, twine, gummed tapes,

barrels, boxes, bottles, drums, carboys, cartons,

sacks, pallets and materials from which such con-

tainers are manufactured.(17)

The packaging exemption often applies not just to manufacturers, but to all businesses. For example, many states exempt plastic and paper products used by fast-food restaurants, including sandwich wrappers, cups and lids, napkins, soda straws, and even plastic knives, spoons, and forks.

Usually the key to the packaging exemption is that the container, carton, paper, or whatever must go with and belong to the customer who buys the item at retail. The theory driving this exemption is that the packaging is an inseparable part of the product being purchased. A customer does not separately purchase the paper cup from the soda, the wrapper from the candy, and the instruction manual from the copier.

Some states distinguish containers and packaging used in handling, storage, and transportation from packaging that is part of the product sold at retail. In Ohio, for example, the sale of racks and display cases have been held to be taxable because "the predominant economic purpose of these articles ... [is] to facilitate the marketing of its products, rather than ... packag[ing] ...."(18)

In addition to being specifically exempted, a packaging exemption might be indirectly allowed under a broader manufacturing exemption. In an old Michigan case, a dairy argued successfully that its milk cans used for storage and transportation within its facility are exempt, not as containers per se, but as material used in industrial processing.(19) An Indiana dairy has been equally successful on its in-plant containers, but lost its argument that cases used by delivery employees are also exempt.(20) Illinois law makes the same distinction in a regulation that provides for exemption where the packaging is part of the finished product in the hands of the consumer. If the packaging serves the manufacturer's purpose of transportation or conveyance, however, it is taxable.(21)

The two primary problems to review under this exemption are the precise scope of a state's packaging exemption and the treatment of specific subjects such as returnable containers (i.e., bottles,kegs, drums, or pallets). Taxpayers should remember that packaging or containers may be exempt in one of two ways--by specific statute or regulation, or under the state's general manufacturing exemption. Since packaging is often not specifically mentioned under the latter exemption, companies often overlook it, and unnecessarily pay tax on internal packaging such as packing "popcorn," labels attached to the product or package, and brochures sent with the product detailing assembly instructions or warranty coverage. One Colorado company, for example, recently received a substantial refund for mistakenly paying sales tax on instruction labels affixed to its products.

Energy Exemption. Many states exempt manufacturing uses of electricity, coal, gas, fuel oil, or nuclear fuel from sales tax. Aside from political considerations, the argument behind this exemption is that it avoids "pyramiding" the sales tax. As in the manufacturing or packaging exemptions, energy becomes an ingredient part of the product manufactured. (Colorado, for example, even exempts a portion of the gas and electricity used in restaurants in the preparation of food.(22)) Unlike the case with the manufacturing exemption, some states exempt energy use not just for manufacturing but also for processing, refining, irrigation, construction, telegraph, telephone and radio communication, and street and railroad transportation services.

In New York, the energy exemption provides that "fuel, gas, electricity, refrigeration and steam and gas, electric, refrigeration and steam service of whatever nature is exempt from the sales and compensating use tax when used directly and exclusively in the production, for sale, of tangible personal property, gas, electricity, refrigeration or steam by one of the following endeavors: (i) manufacturing, (ii) processing, (iii) assembling, (iv) generating, (v) refining, (vi) mining, (vii) extracting, (viii) farming, (ix) agriculture, (x) horticulture, or (xi) floriculture."(23) At first blush, the energy exemption appears to exempt every business activity short of retail sales and professional services. Nevertheless, most states draw a distinction between energy use for industrial production and nonproductive, non-manufacturing usage.

For example, the New York regulations provide that energy used to run turbines is exempt, but energy used to heat the building housing them is not; that energy used in manufacturing to run machines is exempt, but energy used to light the manufacturing plant is not; and that refrigeration to freeze TV dinners is exempt, but refrigeration for storing the dinners is not.(24) These distinctions are fairly common.

In Pennsylvania, the law provides that gas used in the actual production process is exempt but gas used in heating a manufacturing building is not.(25) Since the energy consumption must often be prorated between exempt and taxable use, getting professional help in the proper allocation is important. In fact, refunds are so common that a cottage industry has emerged offering to "perform an analysis" of a company's energy usage in exchange for a percentage of the refund. The bulk of these refunds are paid to manufacturers that had been unaware of how broad their state's energy/fuel exemption can be.

The key question to ask here is whether the fuel exemption is limited to manufacturing or whether it includes other activities such as processing, refining, construction, fabrication, or all industrial production. Fortunately, many city-owned utilities are willing to help. One Colorado company received a sizable refund after working out an apportionment formula with its local city engineer. Every manufacturers should check its utility bills and review its operations accordingly.

Machinery Exemption. This last exemption provides that purchases of machinery, machine tools, and sometimes even machine parts used to manufacture tangible personal property for sale or profit are exempt from sales tax. For example, cabinetmakers are eligible for a tax exemption in several states on their purchases of saws, lathes, and perhaps blades.

The machinery exemption varies and is often missed. Some states allow a broad "integrated plant" interpretation of this exemption. In other words, any purchase of machinery that is "necessary" or an "integral" part of the production process may be purchased free from sales tax. As a consequence, the "integrated plant" approach blurs the distinction between a machinery exemption and a manufacturing exemption. Thus, packaging equipment may be exempt under three different scenarios: (i) it may be specifically exempted from tax by statute; (ii) it may be exempt under a general machinery exemption; or (iii) it may be exempt under the broader manufacturing exempion. Ohio has traditionally embraced a broad interpretation of the machinery exemption, allowing exemptions, for example, for conveyor systems.(26)

In contrast to the "integrated plant" approach, many states exempt only machinery that "directly and exclusively" acts on the product and changes it in some fashion. Colorado has traditionally taken a very narrow approach to the machinery exemption. Its statute provides for "purchases of machinery, machine tools or parts thereof, in excess of five hundred dollars ... to be used in Colorado directly and exclusively ... in manufacturing...."(27) As defined in the regulations, direct and exclusive use does not include machinery used in transporting raw material to the beginning point of manufacture, machinery used in repair or maintenance, research and development, testing, or in quality control.

In Connecticut, design computers do not qualify for the machinery exemption because they do not act directly upon the product.(28) A Georgia court succinctly put the direct and exclusive test this way: "The test is not whether the property is essential to the operation of the plant, but whether it is an actual part of the process of manufacture."(29)

Taxpayers should not only examine the state's statutes and regulations on the machinery exemption, but also its judicial decisions. A Pennsylvania court has applied the machinery exemption to snowmaking equipment used by ski resorts, but a New York court has denied such an exemption.(30) Not only do state regulations vary, but just slight changes in phraseology can signal a much different approach. New York's law, for example, does not appear to read much differently from Colorado's. It states that machinery and equipment are exempt from sales and use tax if they are used "directly and predominantly" in manufacturing. Nonetheless, the regulations exempt machines used "in the handling, storage, or conveyance of materials or the product to be sold."(31) This is in stark contrast to Colorado where, to be exempt, the "equipment must act upon and have a positive effect on the manufactured article."(32) Changing a phrase from "direct and exclusive" to "directly and predominantly" may easily indicate an "integrated approach" to the machinery exemption, rather than a narrow focus. As one New York court has written in support of the integrated plant approach: "It is not practical to divide a generating plant into 'distinct' stages. It was not built this way, and it does not operate that way. The words 'directly and exclusively' should not be construed to require the division into theoretically distinct stages of what is in fact continuous and indivisible."(33)

Between the two extremes lies much variety. Some states, such as Alabama, do not exempt machinery outright, but do impose tax at a lower rate.(34) Other states, such as Utah, grant partical exemptions tied to new acquisitions or plant expansions.(35) New York not only exempts manufacturing equipment, but also exempts the parts, tools, supplies, and services to repair or maintain them.(36) Just next door, New Jersey does not.(37) Additional exemptions or tax credits may be available in states with enterprise zones. Finally, the machinery exemption is not permitted for businesses rendering services unless, like utilities, the service is taxable. In 1980, Burger King was denied a machinery exemption for its milkshake machines, fryers, etc., because the court imaginatively decided the processing and delivery of restaurant food is not a sale of tangible, personal property, but a sale of a service.(38) McDonald's Corporation has also been unsuccessful in arguing that its drink dispensers qualify for the machinery exemption.(39)

Careful planning is required for the machinery exemption, but the rewards can be significant. One Colorado company received a refund in excess of $50,000 after learning of the exemption. As with the other exemptions, some key questions will guide the tax executive through the traps of the machinery exemption. First, does the state require direct use of the machine in manufacturing, or is it sufficient that the machinery be necessary for production? Second, will predominate use of the machine qualify for exemption or is exclusive use required? Finally, does the exemption extend beyond the machine to tools or repair parts?

Given the overlapping character of the exemptions, the varied statutory wording, and the sometimes conflicting case law of the more than 40 states that offer one or more of these four sales tax exemptions, it is not surprising that these exemptions are frequently missed or misunderstood. Accounts payable clerks often do not have either the training or experience to know when to claim the exemptions, and smaller manufacturers are many times simply unaware of them. Tax planning with these exemptions requires careful attention to the definitional differences among the states. Manufacturing includes so many different activities, using so many different processes, under so many different conditions, that there is no shortcut to discovering these exemptions. Each state must be specifically examined. Nevertheless, the key questions offered under the exemptions will offer the conscientious tax executive opportunities to reduce local tax burdens, stay ahead of less-informed competitors, and increase that bottom line.

Notes

(1)I.L.C.S. [sections] 120/2-45(1).

(2)Colo. Rev. Stat. Reg. [sections] 26-102.12.

(3)East Texas Motor Freight Lines, Inc. v. Frozen Foods Express, 351 U.S. 49 (1956).

(4)Stewart Honeybee Products, Inc. v. Commonwealth, 562 A.2d 1015 (Pa. 1989).

(5)Wilson & Co., Inc. v. Department of Revenue, 531 S.W.2d 752 (Mo. 1976); Stone v. Tax Commissioner, 227 A.2d 76 (Conn. 1967).

(6)Eastern Machinery Co. v. Peck, 114 N.E.2d 55 (Ohio 1953); Beasley Industries Inc. v. Commonwealth, No. 1198, C.D. 1976 (Pa. June 2, 1988).

(7)Zook v. Perkins, 195 P.2d 962 (Colo. 1948).

(8)McNamara v. UOP, Inc., 389 So.2d 741 (La. 1980).

(9)Colo. Rev. Stat. Reg. [sections] 26-102(20)(9).

(10)Great Lakes Chemical Corp. v. Wooten, 587 S.W.2d 220 (Ark. 1979).

(11)Ceramo Co., Inc. v. Goldberg, 650 S.W.2d 303 (Mo. 1983).

(12)Ala. Code [sections] 40-23-1(9)(b). See also Rule 810-6-1-.137.

(13)N.J. Rev. Stat. [sections] 54:32B-8.20.

(14)Traigle v. PPG Industries, Inc., 332 So.2d 777 (La. 1976).

(15)American Stores Packing Co. v. Peters, 277 N.W.2d 544 (Neb. 1979).

(16)Colo. Rev. State. [sections] 39-26-102(20)(b) (emphasis added).

(17)18 Cal. Code Reg. [sections] 1589(a).

(18)Cole National Corp. v. Collins, 348 N.E.2d 708 (Ohio 1976).

(19)Michigan Allied Dairy Ass'n v. Auditor General, 5 N.W.2d 516 (Mich. 1942).

(20)Indiana Dept. of State Revenue v. American Dairy, 338 N.E.2d 698 (Ind. 1976).

(21)86 Ill. Admin. Code [sections] 130.2070.

(22)Colo. Rev. Stat. Special Regulation: Gas and Electric Services.

(23)20 N.Y. Comp. Codes Rules & Regs. [sections] 528.22(a)(1).

(24)20 N.Y. Comp. Codes Rules & Regs. [sections] [sections] 528.22(c)(3)(v).

(25)61 Pa. Const. Stat. [sections] 41.4.

(26)See Hawthorn Mellody, Inc. v. Lindley, 417 N.E.2d 1257 (Ohio 1981); Kroger Co. v. Limbach, 560 N.E.2d 192 (Ohio 1990).

(27)Colo. Rev. Stat. [sections] 39-26-114(11)(a).

(28)Plastic Tooling Aids Lab, Inc., v. Commissioner, 567 A.2d 1218 (Conn. 1990).

(29)Blackmon v. Screven County Indus. Dev. Auth., 205 S.E.2d 497 (Ga. 1974).

(30)Ski Roundtop v. Commonwealth, 553 A.2d 934 (Pa. 1989); Shanty Hollow Corp. v. New York, 111 A.D.2d 68, leave to appeal denied, 489 N.E.2d 256 (N.Y. 1985).

(31)20 N.Y. Comp. Codes Rules & Regs. [sections] 528.13(c)(1)(iii).

(32)Colo. Rev. Stat. Reg. [sections] 26.114(11).

(33)Niagara Mohawk Power Corp. v. Wanamaker, 157 N.E.2d 972 (N.Y. 1959).

(34)Ala. Code [sections] 40-23-2(3).

(35)Utah Code Ann. [sections] 59-12-104(15).

(36)20 N.Y. Comp. Codes Rules & Regs. [sections] 528.13(e)(1).

(37)N.J. Rev. Stat. [sections] 54:32B-8.13(d).

(38)Burger King, Inc. v. New York, 416 N.E.2d 1024 (N.Y. 1980).

(39)McDonald's v. Oklahoma, 563 P.2d 635 (Okla. 1977).

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