The Austin Court of Appeals recently ruled that the manufacturing process does not include packaging of finished items received from another manufacturer when the physical properties of those items are not changed in some way, even if the purchase is by a manufacturer. The court held that the manufacturing exemption does not apply to the purchase of materials used to package items that the taxpayer does not fabricate, process, alter, or assemble. In essence, the court held that the manufacturing process ended when Home & Garden Party, Ltd. (HGP), purchased the items from the initial manufacturer and that it was not revived or continued by the activities of HGP. The decision illustrates how the courts sometimes resolve tension between the statutes and the Comptroller rules where the statute favors the taxpayer but the rule may not. The case also provides a good opportunity to reiterate some important tips and traps associated with the Texas manufacturing exemption.
Home & Garden Case
In addition to manufacturing some items itself, HGP purchased bulk-packaged items that it then repackaged prior to shipping but did not alter or assemble in any way. HGP claimed this packaging operation was integrated with the packaging of the items manufactured internally and asserted that the packaging materials were exempt property used in manufacturing.
The Comptroller argued that HGP merely repackages the majority of the items it sells, an activity that does not qualify for the manufacturing exemption because it does not make or cause a physical change in the items themselves. Acknowledging that manufacturing in some cases includes packaging, the Comptroller suggested that once an item has the physical properties, including packaging, it possesses when transferred from the manufacturer to another, the manufacturing process has ended and subsequent repackaging by another does not qualify for the manufacturing exemption. The court agreed that a distinction exists between manufacturers that package items for transfer and wholesalers that repackage them for sale, ruling that materials used by the latter in repackaging are taxable, even if the wholesaler engages in manufacturing other items.
Tension Between Statute and Comptroller Rules
The HGP case illustrates just one example of the tension that exists between items qualifying for the manufacturing exemption under the statute and those allowed by the Comptroller's administrative rules. The statute exempts tangible personal property used or consumed in the manufacturing of tangible personal property when sold, leased, rented to, stored, or used by a manufacturer. Under the statute, the manufacturing process ends "with the completion of tangible personal property having the physical properties (including packaging, if any) that it has when transferred by the manufacturer to another." While the exemption statute itself does not define "manufacturer," the attendant rule defines "manufacturer" as "a person who is engaged in manufacturing." Under the statute, there was no doubt that HGP was a manufacturer and that the items being sold by HGP to its customers were not complete until the packaging materials at issue were used.
Under the Comptroller's rules, however, a business may purchase all of its packaging supplies tax-free only if it primarily manufactures tangible personal property for sale. The rules have an added requirement – that the business be primarily engaged in manufacturing. To complicate matters for unfamiliar taxpayers, this requirement is not found in the rule attendant to the manufacturing exemption, but in the rule dealing with wrapping, packing, and packaging supplies. There exist numerous other examples of discrepancy between the manufacturing-exemption statute and the applicable rules, as well as traps for taxpayers not well versed in Texas sales and use tax law. A pretty good gauge for the chance of succeeding in an exemption claim is whether both the statute unequivocally supports the taxpayer and the Comptroller's rule either supports the taxpayer or at least does not directly contradict the taxpayer's position.
Planning Tips Related to the Manufacturing Exemption
Planning can sidestep a number of these issues and take fuller advantage of the manufacturing exemption. Here are some examples to keep in mind.
New Construction of Manufacturing Plant – Use Separated Contract
Perhaps the biggest risk of loss of the manufacturing exemption lies in new construction. The manufacturing exemption does not apply to the purchase of otherwise exempt manufacturing equipment if the contractor and the manufacturer/customer use a lump-sum contract. Under a lump-sum contract, the contractor is treated as the consumer and end user of all goods used in construction, and because the manufacturing exemption applies only to purchases by the manufacturer, neither the contractor nor the manufacturer can claim the manufacturing exemption on otherwise qualifying manufacturing equipment. Under a separated contract, the contractor is treated as a reseller of materials physically incorporated into the realty, in which case the contractor's purchase of manufacturing equipment qualifies for the resale exemption, while the subsequent sale to the manufacturer qualifies for the manufacturing exemption. The contract must state separate amounts for qualifying and nonqualifying materials. A manufacturer hiring a contractor to build a manufacturing plant and purchase and install the equipment should use a separately stated contract with the contractor.
Labor and Service Charges
Generally, the repair, remodeling, maintenance, or restoration of tangible personal property is a taxable service. However, services performed on tangible personal property that would be exempt from sales tax if sold at the time the service is performed are exempt. Accordingly, installation charges for exempt manufacturing equipment are not taxable. Likewise, repairs, remodeling, maintenance, and restoration charges relating to exempt manufacturing equipment are exempt, so long as the equipment has not been incorporated into realty such that it has lost its characterization as tangible personal property at the time the service is performed. Repair or remodeling of real property is a taxable service. The manufacturing exemption does not apply to repairs of real property.
Even when manufacturing machinery and equipment have lost their characterization as tangible personal property, making repairs or remodeling services taxable, opportunities for tax savings still exist. The Comptroller's rules provide that maintenance on real property is not taxable. To qualify as maintenance, the services must be scheduled and periodic. That is, services cannot be requested and performed on an as-needed basis. Certain types of repairs, replacements, and modifications become nontaxable when performed as part of scheduled maintenance. Further, the scheduled shutdown or turnaround of a manufacturing or processing plant is considered to be maintenance. Manufacturers and processors can realize significant tax savings by performing certain repair, remodeling, and restoration activities during scheduled shutdowns, turnarounds, or outages.
Gas and Electricity Used in Manufacturing
Gas and electricity used to power exempt manufacturing equipment or used to light, cool, and heat the actual manufacturing area during the manufacturing process is exempt. Gas and electricity used to power exempt manufacturing equipment is exempt even if the equipment has been incorporated into realty. When gas or electricity is used for both exempt and taxable purposes, the Comptroller applies a predominant-use test. Under the predominant-use test, gas and electricity billed under a single meter is totally exempt or taxable based on the predominant use as measured by that meter. Taxpayers claiming the predominant-use exemption must perform a utility study to establish predominately exempt use for 12 consecutive months.
Taxpayers who use gas and electricity in manufacturing can realize tax savings by performing a predominant-use study to determine whether the use of gas and electricity is predominately exempt. Taxpayers who cannot establish predominately exempt use can nonetheless realize tax savings by having an additional meter installed, directing all exempt use of gas and electricity through the second meter. As the predominant-use test is performed on a meter-by-meter basis, all gas and electricity billed under a single meter will be exempt so long as 51 percent of the gas or electricity billed under the meter is exempt. Thus, taxpayers should also maximize taxable use of electricity through the second meter, so long as use under the meter remains predominately exempt.
Use of Equipment During Manufacturing
Taxpayers should take steps to ensure that equipment is used during the manufacturing process. Under the statute, the manufacturing process begins with the first stage in production. The Comptroller's rule limits this to the first stage of actual production, excluding acts in preparation for production. The statute provides that the manufacturing process ends with the completion of all physical properties the item has when transferred by the manufacturer to another. Items that would otherwise be exempt will not qualify if used before or after the manufacturing process. For example, quality-control machinery is eligible for the manufacturing exemption but must be used during the manufacturing process. Taxpayers can realize tax savings by performing quality-control tests prior to products having all complete physical properties (including packaging) whenever possible.
Direct Use in Manufacturing
In addition to being used during the manufacturing process, to qualify for the exemption, an item must either: (i) become an ingredient or component part of the manufactured item, or (ii) directly make or cause a chemical or physical change to the product being manufactured or to an intermediate or preliminary product that will become an ingredient or component part of the product being manufactured. Items that are "one step removed" from the manufacturing process may not qualify, as they do not directly make or cause a physical change to the product being manufactured. For example, suppose a taxpayer manufactures cast-iron pipes using molds made from specially treated sand. The mold itself would be exempt because it directly forms steel into the proper shape for the product being manufactured – the pipes. However, items used to make the mold would not be exempt. The product ultimately being manufactured is the pipe, and the items used to make the mold do not become component parts of the pipe, nor do they directly make or cause a physical change to the pipe.
Taxpayers can avoid loss of the exemption on "one step removed" items through the use of multiple entities. In the example above, the taxpayer would create a drop-down subsidiary to manufacture the molds. As the molds are the product manufactured by the subsidiary, any items becoming ingredients or component parts of the molds, or causing a direct change to the molds, would be exempt. The sale of the molds to the parent would be exempt, as the molds directly make a physical change to the pipes, the product manufactured by the parent. By placing the production of items used in manufacturing, but not ultimately sold, in a separate entity, taxpayers can avoid the "one step removed" issue, maximizing tax savings.
There are numerous other nuances of the manufacturing exemption of which taxpayers should be aware, including general qualifications, lease and rental provisions, and the divergent-use exception. As noted above, to qualify for the exemption, an item must become an ingredient or component part of the manufactured item, or be "necessary or essential" to the manufacturing process and directly make or cause a physical change. Neither the statute nor the Comptroller's rule defines the terms "necessary" or "essential," and much litigation focuses on these terms. Knowledge of the Comptroller's positions and case law can be helpful in determining whether an item is likely to qualify for the exemption.
Leases and rentals of qualifying manufacturing equipment may also be exempted.However, the leases or rentals must be for a period of one year or greater. The Comptroller's Office looks only to the actual term of the lease or rental to determine whether an item qualifies. Thus, an item rented on a month-to-month basis will not be exempt even if the lease is renewed for 12 consecutive months or more. Manufacturers renting their manufacturing equipment should ensure that the term of the lease is for a year or more. An item rented or leased for a full year that is removed from manufacturing prior to the completion of the contract is not taxable, unless it is moved or put to a nonmanufacturing use, in which case the divergent-use exception applies.
The divergent-use exception applies when property that qualified for the manufacturing exemption is put to a nonqualifying use within four years of purchase. When applicable, a fraction of the tax that would have been due at the time of purchase is imposed based upon the percentage of divergent use during that month. No tax is due if the divergent use during a single month does not exceed 5 percent.
Alternative Tax-Saving Possibilities
Taxpayers whose activities meet the intent of the manufacturing exemption, if not the explicit requirements, may want to take proactive steps in an attempt to have the exemption broadened.
The exemption has been amended roughly every three years since inception and has been expanded to include items such as semiconductor fabrication cleanrooms and equipment, photographic props used in printing, and pharmaceutical biotechnology cleanrooms and equipment. We have assisted industry groups who were successful in obtaining some of these provisions.
Rulings and Other Options
There are other ways for taxpayers to confirm that the manufacturing exemption applies to their activities. For example, taxpayers can request rulings from the Comptroller confirming the applicability of the exemption, such as our August 26, 2003, ruling that the exemption covers production and testing machinery used during the early or initial stages of manufacturing before optimum production is achieved (i.e., in implementing a new manufacturing process). Taxpayers are sometimes forced to litigate whether their equipment qualifies for the exemption. Taking up the fight can pay off. We have successfully argued at the administrative hearing level that equipment used during the manufacturing process to move, store, and sequence the manufactured product qualified for the exemption, including the outer walls, ceiling, and frame.
The above examples show only some of the tax-saving tips relating to the Texas manufacturing exemption. Requirements to qualify for the exemption are nuanced and complex, and taxpayers will benefit from advice and counsel from those well versed in Texas sales and use tax law.