Document Number
08-85
Tax Type
Machinery Tools Tax
Description
The Taxpayer and the County must reach a mutually agreed upon decision as to what computer equipment is used directly in the manufacturing process and what is intangible
Topic
Local Power to Tax
Tangible Personal Property
Date Issued
06-06-2008



June 6, 2008




Re: Appeal of Final Local Determination
Taxpayer: *****
Locality: *****
Machinery and Tools tax

Dear *****:

This final state determination is issued upon the application for correction filed by you on behalf of ***** (the "Taxpayer") with the Department of Taxation.

You appeal an assessment of Machinery and Tools (M&T) taxes made on the Taxpayer by the ***** (the "County") for tax years 2002 through 2006.

The M&T tax is imposed and administered by local officials. Virginia Code § 58.1-3983.1 authorizes the Department to issue determinations on taxpayer appeals of M&T tax assessments. On appeal, a M&T tax assessment is deemed prima facie correct. That is, the local assessment will stand unless the taxpayer proves that it is incorrect.

The following determination is based on the facts presented to the Department summarized below. The Code of Virginia sections cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site.

FACTS


The Taxpayer is a manufacturer of pressure-sensitive carton sealing tape and pallet stretch wrap. In its original appeal to the County, the Taxpayer asserted that it had erroneously over-reported certain assets by including start up costs, repair costs, capitalized interest, computer hardware and software, non-manufacturing equipment and real estate construction costs on its M&T tax returns. The Taxpayer filed an amended return that included adjustments for all of these costs and reflected a refund due to the Taxpayer. In response to the Taxpayer's refund request, the County employed an outside accounting firm to audit the Taxpayer. The firm found that the Taxpayer was correct in its requests for the elimination of the non-manufacturing equipment, capitalized interest and the cost of the real estate construction from the basis of the M&T assessment.

The audit also found that the computer and software assets were used directly in the manufacturing process and, therefore, were subject to the M&T tax. Finally, upon reconciling the Taxpayer's federal tax returns with its M&T returns, the audit found that the "value originally reported is consistent with the amounts shown on the federal depreciation schedule to Form 1120, which is the proper basis for assessment." The County issued a second assessment that did not reflect the Taxpayer's adjustments for inventory associated with start-up costs, cost of repairs or the computer equipment.

The Taxpayer appeals the final local determination and requests relief to reflect the adjustments made by the Taxpayer to the original assessment.

ANALYSIS


Valuation for Purposes of Property Taxation

Virginia has created a separate classification of tangible personal property for machinery and tools used in manufacturing. In so doing, it has also prescribed the valuation method localities may elect to use in assessing such property for taxation. The method of valuation used to ascertain the fair market value of machinery and tools is established in Va. Code § 58.1-3507 B:
    • Machinery and tools segregated for local taxation pursuant to subsection A, other than energy conservation equipment of manufacturers, shall be valued by means of depreciated cost or a percentage or percentages of original total capitalized cost excluding capitalized interest.

The County uses an assessment ratio of a straight 10% of original capitalized cost to determine the value of property for purposes of the M&T tax. In other words, machinery purchased in 1980 is assessed at 10 percent of its original cost in 1980 and in all subsequent years.

Original Capitalized Cost

The original capitalized cost of business tangible property generally refers to the cost of property, including all costs associated with putting the property in use. This includes: sales tax, installation, delivery and freight charges, labor etc. The Taxpayer contends that certain costs associated with the installation and start-up of various manufacturing lines were applied to the original cost of such lines and asks that these be excluded from the original cost used as the basis for the M&T tax assessment. I disagree. In S. & L. Straus Beverage Corporation v. Commonwealth of Virginia, 185 Va. 1055, 41 S.E.2d 76 (1947), the Virginia Supreme Court found:
    • Taxes of all kinds, property taxes, privilege taxes, tax on capital, income tax and others are usually elements that are combined with cost of material, labor, insurance, rent and many other items to arrive at the selling price of the article produced, and when the article is bought, the amount of purchase is the total sum of money the buyer parts with to get the article, regardless of what proportion of that amount is taxes and what proportion is labor or material or other cost.

Scrap Material Inventory

The Taxpayer states that it incorrectly included the capitalized cost of scrap manufacturing inventory used in test runs of the machinery in its reporting of original capitalized costs, Inventory is not subject to M&T tax. The Taxpayer states that these materials were "improperly reported as capital asset additions on the tangible personal property reports." The Taxpayer listed these materials as assets and they were included as machinery on the Taxpayer's federal Form 1120. The County states that because these items were included on the Taxpayer's federal tax returns as capitalized costs, and there was no documentation showing these materials were inventory, it had to rely on the Taxpayer's reporting on its federal income tax return.

In most cases materials moved from inventory to a manufacturing line will not be evidenced by an invoice or a receipt. Manufacturers generally track the movement of inventory through internal reporting mechanisms. The Taxpayer did provide the County with a detailed listing of such costs. The County may, however, require supporting documentation in the form of journal entries or workpapers to show how the costs were computed and attributed to the assets.

As noted above, capitalized cost of machinery includes all costs associated with putting the property in use. In this case, the test runs were necessary to get the machinery in proper working condition for producing marketable products. The raw materials inventory used in the test runs did not become part of the finished products inventory. Rather, it was discarded after testing was complete. It follows that the costs associated with these test runs, including raw materials inventory, were properly included in the basis of the machinery asset's capitalized cost. As a capitalized cost, the County properly included these costs in the value of the machinery for purposes of determining M&T tax.

While the Taxpayer is correct that inventory is not subject to M&T tax, the raw materials used in the test runs ceased to be inventory and became part of the time, labor and materials necessary to put the machinery into use. The costs associated with this inventory added value to the machinery by helping to get it ready for production. In contrast, raw materials inventory used to manufacture finished products would be properly accounted for as part of the cost of those finished goods inventory and not subject to M&T tax.

Cost of Repairs to Machinery

The Taxpayer asserts that certain capitalized costs should be classified as repairs for purposes of M&T tax and not included in the cost of the machinery. The Taxpayer asserts that these repairs did not extend the life of the original equipment and were not upgrades to the machinery.

In most cases, ordinary repairs and maintenance to manufacturing machinery and equipment are charged to an expense account in the period in which they occur. Such repairs might include minor parts, lubricating and adjusting equipment, repainting, and cleaning. Major repairs or modifications may become an addition, improvement, or replacement cost added to the value of an asset because such costs are considered to effect more than one accounting period.

In this case, the repair costs at issue were costs that the Taxpayer added to the value of it machinery. Therefore, the presumption would be that these costs were considered to be major repairs and modifications and properly included in the basis for determining the M&T tax. The evidence provided does not clearly indicate when the repairs occurred, or whether they increased the value of the machinery. The burden to show that these costs should not be included in the taxable basis rests with the Taxpayer.

Under the provisions of Va. Code § 58.1-3109 6, the local commissioner of the revenue is empowered with the authority to require records and other information necessary to make an accurate assessment of a person's tangible personal property. In the present instance, because the Taxpayer failed to produce sufficient documentation to verify its claims, the County relied upon the Taxpayer's itemizing of its tangible personal property as reported on its federal income tax returns. Absent more concrete evidence, this is a method generally utilized to extrapolate original capitalized cost and depreciation for purposes of the M&T tax. It is incumbent upon the Taxpayer to prove to the satisfaction of the local commissioner of the revenue that the repairs should not be included. See Va. Code § 58.1-3983.1 B 4.

Computer Hardware and Software

The Taxpayer claims that its computer hardware and software are exempt from the M&T tax under Va. Code § 58.1-1101, which classifies certain property as intangible personal property. Included in the category of intangible personal property, which is subject to state taxation only, is "Capital which is personal property, tangible in fact, used in manufacturing (including, but not limited to, furniture, fixtures, office equipment and computer equipment used in corporate headquarters)." See Va. Code § 58.1-1101 A 2. This same section provides that the machinery and tools, motor vehicles and delivery equipment of a manufacturing business are not defined as intangible personal property. Such property is to be taxed locally as tangible personal property.

Virginia has established a separate classification of tangible personal property for machinery and tools used in manufacturing. Virginia Code § 58.1-3507 A states:
    • Machinery and tools, except machinery and equipment used by farm wineries as defined in § 4.1-100, used in a manufacturing . . . business shall be listed and are hereby segregated as a class of tangible personal property separate from all other classes of property and shall be subject to local taxation only.

Virginia Code § 58.1-1101 applies only to computer hardware and software that are not directly used in the manufacturing process. Computer hardware that is used directly in the manufacturing process and computer software used to drive that hardware are classified as machinery and tools and are subject to the M&T tax. Upon audit, it was found that the computer hardware and software assets were directly used in the manufacturing process, and therefore were properly classified as machinery and tools. The evidence furnished by the Taxpayer is not sufficient to prove this classification is erroneous.

DETERMINATION


The Taxpayer's appeal rests on three specific issues: the inclusion of the cost of assets it maintains were inventory, the costs of repairs to its capitalized assets, and computer and software assets.

The raw materials inventory used for the test runs was properly included in original capitalized costs.

The evidence provided is not sufficient to show that the cost for repairs to machinery should be excluded from original cost. It is incumbent upon the Taxpayer to demonstrate that these costs represent mere repairs.

Finally, if the computer hardware and software in question are used directly in the manufacturing process, they are subject to the M&T tax. All computer hardware and software not used directly in the manufacturing process are intangible under the provisions of Va. Code 58.1-1101, and exempt from local taxation. This determination must be made by the County

I am remanding this matter to the County with the instructions to the Taxpayer to furnish the County with the requested material to substantiate its claims concerning the inventory and repairs within 45 days. In addition, the information provided does not clearly indicate what computer equipment was considered in the assessment. The Taxpayer and the County must reach a mutually agreed upon decision as to what computer equipment is used directly in the manufacturing process and what is intangible under the provisions of Va. Code § 58.1-1101 A.

If you have any questions regarding this determination, you may call the Office of Tax Policy, Appeals and Rulings, at *****.
                • Sincerely,

                • Janie E. Bowen
                  Tax Commissioner



AR/1-1363399312H


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46