The Michigan Court of Appeals recently shocked the Michigan Department of Treasury when it held that machinery and equipment used to transmit and distribute electricity was entitled to a use tax exemption available for industrial processing. In Detroit Edison Co. v. Department of Treasury, the Court found that the electricity was not a finished good ready for sale when it left the generating facility, but instead needed further processing to be usable by the taxpayer’s customers – processing performed by the distribution equipment. In so finding, the Court specifically invalidated the Michigan regulation that declared taxable the sale of property consumed or used in the transmission or distribution of electricity.
The taxpayer’s charge and the Department’s resistance
Detroit Edison (DTE) is an electric utility that provides electricity to a variety of residential, commercial, and industrial customers. DTE produces electricity in its generation plants and distributes that power to its customers via a network of substations, transformers, high-voltage towers, and cables. DTE’s voltage levels at its generation plant range from 15,000 to 25,000 volts, a voltage that is actually stepped-up to as much as 500,000 volts. The usable voltage for most customers is 120/240 volts. The voltage must be stepped-down to be usable by customers, but must be stepped-up to an extreme level so that it can reach the customer. DTE’s expert testified that it would “not [be] practical under the laws of physics” for generation plants to produce electricity at the 120/240 volt level.
There was no dispute that equipment used in the production of electricity in DTE’s plant qualified for a sales tax exemption under the Michigan statutes. The Department determined that the exemption ended at the wall of the generating plant; as soon as the electricity was released into the grid, it was ready for consumption by the consumer. The Department relied on its own Rule 205.115, which declared “the sale of tangible personal property consumed or used in the transmission or distribution of electricity” taxable. The Department’s expert testified that though the voltage was stepped-up and stepped-down, “the nature, composition, and character of the electricity” was not altered.
An ample review of the evidence conducted by the Court
In Michigan, “industrial processing” is an activity entitled to sales tax exemption. Industrial processing – i.e. the activity of converting or conditioning tangible personal property by changing its form, composition, quality, combination, or character – begins when the property begins movement from raw materials storage into production and ends when the finished goods come to rest in inventory. Virtually all states imposing sales tax provide a similar exemption for property used in manufacturing or processing activities.
The Court noted that the legislature “seemingly envisioned a simple manufacturing situation in which a company engages in industrial processing at its plant to produce a product, the product is in the form of a finished good and ready for retail sale while awaiting transport at the company’s plant, and then the company ships or distributes the product to a customer.” But when is electricity a finished good? The Court found it “indisputable” that electricity is not a finished good ready for sale until it reached the meters of DTE’s customers.
The Court favorably cited the “extremely detailed scientific views espoused by DTE’s experts.” DTE’s experts provided opinions on and explanations of the nature of electricity, the physics inherent in the transmission of electricity, and the ways that the electricity was continually processed as it passed through the distribution grid. In contrast, the Department’s expert testified in conclusory fashion that the electricity did not change during transmission and distribution. The Court noted that the Department’s expert struggled at times to toe the Department’s line – for example, by noting that the “change [in] phase angle” could qualify as conditioning and stating that electricity was unusable “until it’s transformed.”
The Department argued that the industrial processing exemption does not extend to distribution activities, so any processing performed by the equipment was secondary to its taxable distribution purpose. The Court reiterated that a concurrent taxable use with an exempt use does not remove the protection of an exemption. The equipment was part of a unified system concurrently used for both distribution and processing, and was accordingly exempt.
Science provides the spark
The case is a helpful reminder that science can be a helpful ally, even in state tax cases. Many sales tax exemptions turn on when a certain process begins and ends, and whether a change is occurring in the product. Consider, for example, a recent administrative decision in Indiana (LOF 04-20110458) where the taxpayer prevailed by showing the molecular and pH changes in slag, or Southwest Royalties, Inc. v. Combs, where the 353rd District Court in Texas evaluated the physical changes in petroleum. As Detroit Edison and other cases show, science can positively charge a taxpayer’s position.