Sales tax: missed manufacturing exemptions.

• Author: Nelson, Bruce

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...