The Michigan Supreme Court held that an electric utility’s transmission and distribution equipment used for both taxable and exempt purposes qualifies for a partial sales and use tax exemption. See Detroit Edison Co. v. Dept. of Treasury, No. 148753 (Mich. July 22, 2015). This marks the latest in a line of cases addressing whether transmission and distribution equipment is used in processing or manufacturing-like activities.

Background

Detroit Edison Company (Detroit Edison) sells electricity to residential, commercial and industrial customers. The electricity is delivered from the company’s generation plants to customers through its transmission and distribution system (T&D system) – a network of machinery and equipment including transformers, fuses, circuit breakers and poles. To transmit the electricity and deliver it to the consumer in a usable form, the T&D system increases and decreases the electricity’s voltage and current.

Michigan exempts from sales and use tax tangible personal property used in an “industrial processing activity.” Mich. Comp. Laws § 205.94o(1). Electricity is included in the definition of “tangible personal property.” Id. § 205.92(k). “Industrial processing” is defined as:

[T]he activity of converting or conditioning tangible personal property by changing the form, composition, quality, combination, or character of the property for ultimate sale at retail. … Industrial processing begins when tangible personal property begins movement from raw materials storage to begin industrial processing and ends when finished goods first come to rest in finished goods inventory storage. Id. § 205.94o(7)(a).

Industrial processing does not include distribution activities. Id. § 205.94o(6)(b). If tangible personal property is simultaneously used for both exempt and non-exempt activities, the industrial processing exemption is limited by the “percentage of exempt use to total use.” Id. § 205.94o(2).

Detroit Edison claimed that all of its T&D system equipment qualified for the industrial processing exemption. The Department of Treasury disallowed the exemption in full and issued an assessment against Detroit Edison.

The Court of Claims and the Court of Appeals Decisions

Detroit Edison appealed the Department’s assessment to the Michigan Court of Claims. In an unpublished order, the Court of Claims held “that electricity is continuing to be processed up until the point at which it reaches the customer’s meter, because the voltage and current levels are drastically changed multiple times at set points, the last being at or near the customer’s meter.” As a result, the court held that Detroit Edison’s T&D system was fully exempt from use tax.

The Department of Treasury appealed, and the Michigan Court of Appeals affirmed the lower court’s holding. The Court of Appeals held that the “machinery and equipment are concurrently used in a unified system for purposes of both distributing and industrial processing. In such a situation, the ‘industrial processing’ exemption applies to the machinery and equipment in full.” Detroit Edison v. Dep’t of Treasury, 303 Mich. App. 612, 630 (2014) (emphasis in original).

Majority Holding

The Michigan Supreme Court upheld the Court of Appeals decision that industrial processing of electricity – i.e., voltage and current changes as electricity flows through the T&D system – occurs throughout Detroit Edison’s T&D system, and the system therefore qualifies for the industrial processing exemption. However, the court held that because the T&D system was simultaneously used for a non-exempt purpose, i.e., the distribution and delivery of electricity to the final consumer, Detroit Edison could not claim the exemption for the entire T&D system. Rather, it was necessary to determine the percentage of exempt use to total use based on a “reasonable formula or method approved by the department.” For that reason, the court remanded the case to the Court of Claims for the Department to approve such “reasonable formula or method.”

Sutherland Observation

Other states permit the use of a reasonable formula or method in calculating the percentage of exempt use. For instance, Pennsylvania applies a 50% predominant-use test in determining the applicability of its manufacturing/processing exemption. See, e.g., 61 Pa. Code § 32.32(a)(1); seealso MetroPCS Pennsylvania LLC v. Commonwealth of Pennsylvania, No. 88 F.R. 2012 (resolved 2013). Alternatively, Virginia prorates its sales and use tax exemption when equipment is used in both exempt and non-exempt activities based on the amount of time equipment is used in exempt versus non-exempt activities. See, e.g., Va. Tax Comm’r Rul., No. 13-139 (July 28, 2013).

Decisions of Other States

Other state courts are split over whether T&D systems qualify for sales and use tax exemptions similar to Michigan’s industry processing exemption. Some states take a narrow view on what activities constitute “manufacturing” or “processing.” For example, the Georgia Tax Tribunal recently held that an electric utility company’s T&D system was not “necessary and integral to the manufacture of tangible personal property,” and therefore did not qualify for an exemption from Georgia sales and use tax. Georgia Power Co. v. MacGinnitie, No. Tax-S&UT-1403540 (Ga. Tax. Tribunal, Jan. 5, 2015). Unlike the Detroit Edison court, the Georgia Tax Tribunal reasoned that the electricity manufacturing process was completed at the generation plants, and the utility’s T&D system was used only to distribute the product. The Tribunal rejected the utility’s argument that it was “manufacturing” in the transmission system when it sold electricity at different voltages to different customers: “[D]ifferences in voltages do not represent a difference in the kind of energy delivered, the amount of work a [kilowatt-hour] of that energy will perform, or how that work is performed. A rose is a rose, and a kilowatt-hour is a kilowatt-hour.”

The Maryland Tax Court recently held that the transmission and distribution of electricity did not constitute exempt “production activity” because that term was limited to “generating electricity for sale or for use in another production activity.”Potomac Edison Co. v. Comptroller of the Treasury, Nos. 12-SU-OO-0644 & 12-SU-OO-0645 (M.D. Tax Ct. Jan. 22, 2015). This case is on appeal to the Circuit Court for Baltimore City.

Sutherland Observation

Qualifying for a state’s processing/manufacturing exemption can turn on exceedingly fine distinctions. For instance, in some states, tangible personal property must be “directly” and/or “predominantly” used in a manufacturing process to qualify for the state’s exemption. See, e.g., Utilicorp United, Inc. v. Dir. of Revenue, 75 S.W.3d 725 (Mo. 2001) (holding that the T&D system was not “used directly” in a manufacturing process); Peoples Gas & Electric Co. v. State Tax Comm’n, 28 N.W.2d 799 (Iowa 1947) (holding that the T&D system was not “directly used in the actual” manufacturing process); Niagara Mohawk Power Corp. v. Wanamaker, 144 N.Y.S.2d 458 (N.Y. App. Div. 1955) (holding that the T&D system was not used “directly and exclusively” in a manufacturing process); and 61 Pa. Code § 32.32(a)(1) (requiring a predominant use). Other states only require that the exempt property is “used or consumed” in industrial processing or manufacturing. See, e.g., Mich. Comp. Laws § 205.94o.