The scope of the sales tax exemption for machinery or equipment used in production has been a vexing issue, including the question of when the production process ends and the distribution process begins. A recent New York State Administrative Law Judge decision helps provide some clarity in the case of electricity producers and raises questions about the Department’s policy as expressed in at least one Advisory Opinion. The decision holds that the owners and operators of nuclear power plants that produce electricity were entitled to the production exemption from sales tax on their purchases of step-up transformers and related costs because the transformers were used directly and predominantly to produce electricity for sale. Matter of Entergy Nuclear Operations, Inc. et al., DTA No. 826017 et al. (N.Y.S. Div. of Tax App., Jan. 28, 2016). 

Facts. The case involves several subsidiaries of Entergy Corporation that own and operate three nuclear power plants in New York, two of which are at Indian Point. The plants produce electricity for sale solely to electricity wholesalers and utilities. At issue was whether the operators’ purchase and installation of “step-up transformers,” as well as costs for maintenance and/or repair services for the transformers, were subject to sales tax. The underlying question was whether the production of electricity for sale ended when the electricity exited the generators (in which case the transformer is solely for distribution and therefore taxable) or whether production includes the process of stepping-up the electricity so that it can be sold to the purchasers through the electricity transmission system. The ALJ reached the latter conclusion and held that the transformers were exempt from sales tax.

The decision discusses the restructuring of the electricity industry in New York State beginning in the 1990s. In 1998, the New York Independent Service Operator (“NYISO”), a not-for-profit corporation, was formed to manage New York’s wholesale electricity market and to oversee the State’s electricity transmission system. The transmission system is a series of high-voltage lines and interconnections owned by various transmission companies, including the New York Power Authority and Con Edison.

The decision goes into considerable detail concerning how electricity is produced at a nuclear power plant. Electricity produced for sale at the power plants issue must be input into the transmission system. The transmission system operates at a voltage of 345 kV, as determined by the NYISO and the owners of the transmission system. This means that the electricity produced at the power plants must achieve that voltage in order to be input into the transmission system. The step-up transformers are used to step up electricity solely for that purpose. 

No “energy creation” takes place after the electricity leaves the electric generator at the power plant. The step-up transformer does not create electricity, but instead induces voltage that allows the electricity to travel. Electricity enters a step-up transformer at relatively low voltage and high amperage and exits the transformer at relatively high voltage and low amperage. The power plant operators did not own any portion of the transmission system, nor did they own any of the electricity being transmitted on that system. 

Parties’ Positions. The operators took the position that their purchases and installation of the step-up transformers, as well as repair and maintenance services for the transformers, were exempt from sales tax because the transformers qualified as “[m]achinery or equipment for use or consumption directly or predominantly in the production of . . . electricity . . . for sale . . . by manufacturing, processing, generating, assembling, refining, mining or extracting . . . .” Tax Law § 1115(a)(12). The term “production” generally includes “continuing through the last step of production where the product is finished and packaged for sale.” 20 NYCRR 528.13(b)(1)(ii). The sales tax regulations provide that product “distribution” does not qualify for the exemption. 20 NYCRR 528.13(b)(2).

The Department took the position that the production process ended at the power plant generators, and that the transformers were used only for distribution of the electricity, which would mean that they did not qualify for the exemption. The taxpayers maintained that since the product being sold was not merely electricity, but rather electricity delivered at a prescribed voltage level, the exemption should apply.

The Decision. The ALJ agreed with the taxpayers, concluding that since the electricity could only be sold to customers at specific voltage levels, the voltage level was an integral part of the product sold, which the step-up transformers were directly and predominantly used to create. Quoting 20 NYCRR 528.13(b)(1)(ii), the ALJ concluded that “Petitioners’ product is not ‘finished and packaged for sale’… until such time as it reaches the required voltage levels.”

Addressing the Department’s claim that the courts have already held, in Matter of Niagara Mohawk Power v. Wanamaker, 286 A.D. 446, aff’d, 2 N.Y.2d 764 (1956), that “production stops at the generator,” the ALJ found that Niagara Mohawk was distinguishable since the vast majority of Niagara Mohawk’s customers purchased the electricity at the voltages put out by the transformers. In contrast, the ALJ found that the voltage level was an essential component of the final product being sold.

Once it was concluded that the step-up transformers were exempt, the installation, maintenance, and repair services relating to that equipment was also found to be exempt under Tax Law § 1105-B(b). 

Additional Insights

The ALJ’s decision seems entirely reasonable given that the electricity was not saleable without having the transformer step up the voltage to the necessary level. The Department’s position in this case was consistent with its position in an Advisory Opinion, ABB Power Transmission, Inc., TSB-A-90(34)S (N.Y.S. Dep’t of Taxation & Fin., July 17, 1990), and with its position in Matter of Zapco Energy Tactics Corp., DTA No. 815824 (N.Y.S. Div. of Tax App., Dec. 10, 1998), a case in which an ALJ concluded that step-up transformers were integral parts of the production process but that was not appealed to the Tax Appeals Tribunal, leaving that decision as non-precedential. Whether or not the Department appeals the Entergy decision, the ALJ’s reasoning calls into question the continued viability of the Department’s policy regarding the production exemption for electricity producers and perhaps for others.