Good intentions, but unintended consequences: expanding Virginia's manufacturing tax exemption.

• Author: Wilson, Stacey L.
• Position: Case Note

The Virginia Supreme Court recently opened the door to challenges by Virginia manufacturers requesting exemptions or refunds of local property taxes with its decision in City of Winchester v. American Woodmark Corp.(1) American Woodmark, a nationwide furniture manufacturer headquartered in Winchester, Virginia, filed suit against the City of Winchester in 1995 requesting a property tax refund of approximately half a million dollars.(2) Although American Woodmark did not perform any manufacturing functions within the Winchester city limits, the company argued that the computers and office equipment in its corporate headquarters were exempt from the local personal property tax because this equipment was "used in manufacturing" under [sections] 58.1-1101(A)(2) of the Virginia Code.(3) Counterintuitively, the Virginia Supreme Court agreed.

As a result of this decision, cities and counties in Virginia now face requests for tax refunds on a variety of property that businesses claim is "used in manufacturing."(4) Prominent examples include Coca-Cola, which claims that its vending machines are "part of the manufacturing" of Coke,(5) and Sherwin Williams, which claims that equipment at its retail stores is "used in manufacturing" paint.(6) Local governments stand to lose millions of dollars in tax revenues if these challenges succeed.(7)

This Note analyzes the impact of American Woodmark on Virginia's personal property tax exemption for manufacturers, comparing the recent consequences of the court's holding with legislative and judicial intent. The first section describes the constitutional and statutory background against which the American Woodmark decision took place. The second section presents an overview of American Woodmark and places the court's holding in the context of previous decisions granting tax exemptions to Virginia manufacturers. The third section compares Virginia's personal property tax exemption for manufacturers with similar tax exemptions offered by other states.

Next, the fourth section discusses the repercussions of the decision and argues that although Virginia's expansive exemption is consistent with the tax breaks offered in other states, the court's convoluted interpretation of the Virginia Code may have unintended consequences for both consumers and Virginia cities and counties. This Note concludes with suggestions for ways in which local governments can defend against upcoming challenges by manufacturers.

CONSTITUTIONAL AND STATUTORY BACKGROUND OF THE AMERICAN WOODMARK DECISION

Unlike the manufacturing exemptions offered by most states, Virginia's exemption is fairly convoluted(8) because it classifies tangible property as intangible property for tax purposes.(9) In general, personal property is usually divided into two categories: tangible and intangible.(10) Tangible personal property is "property which is touchable and has real [physical] existence."(11) Examples include motor vehicles, jewelry, books, or computer equipment.(12) Intangible property, on the other hand, is "property which cannot be touched because it has no physical existence."(13) Intangible property also includes property that has only representational value;(14) examples include corporate stock, bonds, goodwill, or franchises.(15)

Unlike most states, Virginia classifies a number of items of a manufacturer's tangible personal property as intangible for property tax purposes.(16) According to the Virginia Constitution,(17) the General Assembly has the power to determine whether property should be taxed at the state or local level.(18) In 1942, the Virginia Supreme Court in City of Roanoke v. James W. Michael's Bakery Corp.,(19) extended this power to include the ability to classify tangible personal property as intangible property.(20) This extension essentially gave the General Assembly the authority to merge the intangible and tangible categories together.

Virginia has five statutes concerning the local government taxation of intangible personal property.(21) As a result of Michael's Bakery and the language of these five statutes, "a taxpayer easily could owe tax on a number of tangible personal property items used in a manufacturing business which are now treated as if they were intangible personal property assets."(22) This change in classification is important because under [sections] 58.1-1100 of the Virginia Code, intangible personal property is segregated for state taxation only.(23) In 1994, however, Virginia discontinued its state tax on intangible personal property.(24) As a result, property now classified as intangible personal property is not taxed by either the state or local government.

The court's decision in Michael's Bakery also made it difficult for cities and counties to challenge directly the constitutionality of Virginia's intangible personal property tax scheme.(25) As a result, recent challenges by local tax authorities focused on "carving out" items of tangible personal property, which would be subject to local tax, by narrowly interpreting the definition of intangible personal property.(26) American Woodmark, however, indicates that the Virginia Supreme Court is not receptive to these challenges.(27)

AN OVERVIEW OF THE AMERICAN WOODMARK DECISION

In 1994, American Woodmark filed suit against the City of Winchester alleging that the company used its personal property in its manufacturing business, and therefore, the property was exempt from local taxation.(28) American Woodmark manufactures and sells wooden kitchen and bathroom cabinets nationwide.(29) The company's corporate headquarters, located in the City of Winchester,(30) established and monitored the overall corporate strategy, maintained the company's computer system, and engaged in the sales and marketing of cabinets and vanities produced by manufacturing facilities located outside of Virginia.(31)

The primary issue in American Woodmark was whether the law should treat a taxpayer's furniture, computers, and office equipment, located in its corporate headquarters, as intangible personal property under the Virginia Code.(32) At the time, the Code defined intangible personal property as:

Capital which is personal property, tangible in fact, used in manufacturing.... Machinery and tools, motor vehicles and delivery equipment of such businesses shall not be defined as intangible personal property for purposes of this chapter and shall be taxed locally as tangible personal property according to the applicable provisions of law relative to such property.(33) Affirming the circuit court's decision, the Virginia Supreme Court stated that "we decline the City's invitation to construe Code [sections] 58.1-1101(A)(2) as requiring that a manufacturer maintain a manufacturing facility within the City's geographical boundaries or that the manufacturer's capital, which is personal property, tangible in fact, be used `directly' in the manufacturing process."(34) The court placed the burden on the City of Winchester to prove that American Woodmark's corporate headquarters was not engaged in a manufacturing business, and it found that the evidence "fell short of carrying that burden."(35) In short, despite the fact that no actual manufacturing activity occurred at American Woodmark's corporate headquarters, the court held that the furniture, office equipment, and computers located at the site were "used in manufacturing," and therefore not subject to tax by the City of Winchester.(36)

The Virginia legislature acted swiftly to codify the court's holding in American Woodmark by amending Virginia Code [sections] 58.1-1101(A)(2).(37) The amendment added parenthetically the following language to the section: "[P]ersonal property, tangible in fact, used in manufacturing (including, but not limited to, furniture, fixtures, office equipment and computer equipment used in corporate headquarters)."(38) Unanimous votes of both the Virginia House and Senate approved the change, which became effective July 1, 1996.(39)

The American Woodmark court adopted a very broad interpretation of tangible personal property under [sections] 58.1-1101(A)(2). As a result of the court's decision and the subsequent statutory change by the General Assembly, tangible personal property for Virginia manufacturers is now defined as any property that is owned by a manufacturer, but such property need not be used directly in the manufacturing process.(40) Enlarging the exemption even further, the Virginia Supreme Court has narrowly defined what constitutes "machinery and tools" for purposes of manufacturing.(41) As a result, Virginia businesses are exempt from an increasing number of local taxes. In short, after American Woodmark, any retailer who performs a small amount of manufacturing somewhere in its operation may claim an exemption from its personal property tax obligations.(42)

There are three important parts of the American Woodmark holding: (1) further defining "manufacturing" under [sections] 58.1-1101; (2) augmenting the definition of machinery and tools; and (3) the finding that the locality, not the taxpayer, bears the burden of refuting the tax exclusion.

Defining Manufacturing

The Virginia Code did not define "manufacturing" under [sections] 58.1-1101,(43) but over the years Virginia case law established the essential elements of what constitutes "manufacturing."(44) Businesses included as manufacturers under Virginia law are those (1) transforming livestock into different meat products;(45) (2) curing hams and bacon and making sausage;(46) and (3) producing and selling personal computers, file servers, and computer parts.(47) Businesses not qualifying as manufacturers include those (1) pasteurizing milk and producing buttermilk;(48) (2) killing and plucking chickens;(49) and (3) blending rock and gravel.(50) As the Virginia Code indicates, classification as a manufacturer is important not just for intangible personal property tax exemptions,(51) but also for...