11-11 | Virginia Tax

Tax Type

Retail Sales and Use Tax

Description

Taxpayer is a food products manufacturer and processor.

Topic

Appropriateness of Audit Methodology

Manufacturing Exemption

Tangible Personal Property

Date Issued

01-21-2011

January 21, 2011

Re: § 58.1-1821 Application: Retail Sales and Use Tax

Dear *****:

This will reply to your letter in which you seek correction of a retail sales and use tax assessment issued to ***** (the "Taxpayer") for the period July 2005 through March 2008. I apologize for the delay in the Department's response.

FACTS

The Taxpayer is a food products manufacturer and processor. An audit by the Department resulted in an assessment of use tax on certain expense and fixed asset purchases made during the audit period. The Department's auditor revised the audit to remove some of the items originally contested by the Taxpayer. This response addresses the issues that remain after revision of the audit.

DETERMINATION

Virginia Code § 58.1-609.3 2 iii provides an exemption from the retail sales and use tax for "machinery or tools or repair parts therefor or replacements thereof, fuel power, energy, or supplies, used directly in processing, manufacturing, refining, mining or converting products for sale or resale ...." [Emphasis added.] Virginia Code § 58.1-602 defines the term "used directly" to mean "those activities which are an integral part of the production of a product, including all steps of an integrated manufacturing or mining process, but not including ancillary activities such as general maintenance and administration." Title 23 of the Virginia Administrative Code (VAC) 10-210-920 B 2 interprets the above statutes and states the following:

- Items of tangible personal property which are used directly in manufacturing and processing are machinery, tools and repair parts therefor, fuel, power, energy, or supplies which are indispensable to the actual production of products for sale and which are used as an immediate part of such production process. Convenient or facilitative items, such as fuel storage tanks, platforms, structural steel, grating, equipment supports, special flooring, etc., or items which are essential to the operation of a business but not an immediate part of actual production, are not used directly in manufacturing or processing even though such items may be directly attached to exempt production machinery. [Emphasis added].

Keeping these statutory and regulatory provisions in mind, I will address the contested issues raised in the Taxpayer's appeal.

Forklifts

The Taxpayer contests the inclusion of lease payments for two forklifts in the audit. The Taxpayer contends the forklifts qualify for the manufacturing exemption. In situations where an industrial manufacturer uses a single piece of equipment in both a taxable and an exempt manner, Va. Code § 58.1-609 3 2 provides that a preponderance of use rule determines the tax application. This rule is explained in Title 23 VAC 10-210-920 D, which states that:

- When a single item of tangible personal property is put to use in two different activities, one of which is an immediate part of the industrial production process (exempt) and the other of which is not (taxable), the sales and use tax shall apply in full when the preponderance of the item's use (fifty percent or more) is in non-exempt activities. Likewise, the item will be totally exempt from the tax if the preponderance of its use is in exempt production activities.

The auditor observed the forklifts in question being used to perform construction renovations at a new facility owned by the Taxpayer. The Taxpayer plans to use this new facility for manufacturing and production activities; however, at the time of the audit, the facility was not being used as a manufacturing site. The Taxpayer notes that the intended use of the forklifts will eventually be in manufacturing activities.

Public Document ("P.D.") 08-39 (4/15/08) discusses a lumber manufacturer that used forklifts in various activities that occurred at its manufacturing site. This determination explains that the forklifts qualify for the manufacturing exemption only if the preponderance of use of the forklifts is in exempt manufacturing activities. The Taxpayer's use of the forklifts to move building materials and construction debris at the building renovation site is a taxable use because the forklifts are not used in industrial manufacturing activities. The Taxpayer has presented no evidence that the forklifts in question were directly used in its manufacturing and production activities.

P.D. 98-125 (8/5/98) discusses a case in which a manufacturer purchased a piece of equipment with the intent to use it in an exempt manufacturing process. The business was unable to produce a saleable product with the equipment so the equipment was used to pelletize scrap materials for landfill, which was a taxable use of the equipment. The Tax Commissioner ruled that, regardless of the manufacturer's intent to use the equipment in an exempt manufacturing activity, the equipment was first used in a taxable activity and was properly treated as taxable in the audit. While the Taxpayer may intend to use the forklifts in its manufacturing process in the future, the forklifts were first used for building renovations, which is a taxable use.

Based on the information available and applying the preponderance of use test, the forklifts were used in a taxable manner by the Taxpayer. Further, the forklifts were first used by the Taxpayer in taxable activities at a site that was riot a manufacturing facility at the time of the audit. The lease payments for the forklifts were properly held taxable in the audit.

Floor Scrubbers

The Taxpayer purchased two floor scrubbers that were held taxable in the audit. The scrubbers are used to vacuum and clean the floors in the production and warehouse areas of the Taxpayer's manufacturing facility. The auditor indicates that one of the floor scrubbers was used at the site of a future manufacturing facility, which was being renovated at the time of the audit. The Taxpayer states that the plant and warehouse floors must be kept clean to prevent insect infestation, which protects the integrity of the products it manufactures. The Taxpayer also notes that state and federal laws require that adequate sanitation levels must be maintained in its manufacturing facilities.

Based on the statutes and regulations cited previously, the floor scrubbers are not used directly in manufacturing. While the scrubbers may be essential to the Taxpayer's manufacturing operation, the scrubbers are not an integral or immediate part of the production process. The floor scrubbers are a step removed from the actual production of the Taxpayer's products. In addition, Title 23 VAC 10-210-920 B 2 states that the required use of a particular item by a manufacturer due to federal, state or local law does not, by itself, constitute direct usage of that item in the manufacturing process. The floor scrubbers were properly held taxable in the audit.

Storage Racks

During the audit period, the Taxpayer purchased storage racks that were installed in the building being renovated for future use as a manufacturing facility. The auditor observed that some storage racks in the Taxpayer's existing manufacturing facility were used to store finished manufactured goods. Since the storage of finished goods is a taxable activity, the auditor determined the percentage that the racks in the existing manufacturing facility were used for storage of finished goods. This percentage was then applied to the cost of the storage racks installed in the new facility to determine the taxable amount for the racks listed in the audit.

Virginia Code § 58.1-602 defines "manufacturing" to include "the production line of the plant starting with the handling and storage of raw materials at the plant site and continuing through the last step of production where the product is finished or completed for sale and conveyed to a warehouse at the production site . . . ." Title 23 VAC 10-210-920 B 2 also state;, in part:

- The integrated manufacturing process . . . includes the production line of a plant, factory, mill, etc., starting with the handling and storage of raw materials at the plant site and continuing through the last step of production where products are finished or completed for sale and conveyed to a warehouse at the same plant site . . . .

Both the statute and the regulation are clear that the manufacturing process ends when production of the product has been completed and the product has been conveyed to storage. For purposes of the manufacturing exemption, the storage of finished products is a taxable activity because the actual manufacturing process has ended. Any property used by a manufacturer in activities that occur after the end of production is a taxable use of the property, absent another exemption. Storage racks used to store finished goods is such an example of property used in a taxable manner. Public Document 98-22 (2/11/98) discusses a case in which racks were used by a manufacturer to store finished carpet products. This letter explains that, once production was completed, the storage of the carpet products on the racks was a taxable activity that was one step removed from the actual production process.

Based on a review of this issue, the Taxpayer has not provided information that demonstrates the racks in the new facility are used solely for exempt purposes. The auditor's methodology in calculating the taxable amount of the storage racks is reasonable.

Desk and Table

The Taxpayer contracted with a cabinet maker to fabricate and install cabinets in one of its buildings. The cabinet maker also fabricated and sold the Taxpayer a desk and table. The Taxpayer's purchases of the cabinets, desk and table were held taxable in the audit. The cabinets were later removed from the audit after it was determined that the cabinets became real property upon installation. The cabinet maker was deemed to be a using and consuming real property contractor and liable for payment of the tax on the cabinets. The desk and table were not removed from the audit because these items remained tangible personal property after purchase and should have been treated as a retail sale with sales tax charged by the cabinet maker. The Taxpayer contends that the cabinet maker acted as a using and consuming contractor and paid the applicable sales and use tax on the materials used to fabricate the desk and table.

Title 23 VAC 10-210-410 B discusses contractors that operate in a dual role of real property contractor and retailer. In cases where a contractor sells tangible personal property that is not part of a real property construction contract, the contractor is treated as a retailer with respect to those sales. The contractor must collect the Virginia retail sales tax from the customer on such sales. In P.D. 97-289 (6/26/97), a business manufactured and sold cabinets, doors, windows, built-in shelves and similar items that became real property upon installation. This business also sold movable desks, credenzas and conference tables. The business was deemed a retailer with respect to sales of these items and instructed to collect and remit Virginia sales tax on the sales.

The desk and table at issue did not become part of real property but remained tangible personal property when purchased by the Taxpayer. The cabinet business made a retail sale of the desk arid table and was responsible for collecting retail sales tax on the sale of these items. In accordance with Title 23 VAC 10-210-6030, when a retailer fails to charge a customer retail sales tax, the customer is responsible for remitting use tax to the Department on the cost of the property. Because the Taxpayer failed to remit the use tax due on the desk and table, there is no basis to remove these items from the audit.

Repair and Maintenance Items

There were various purchases held taxable in the audit such as tools, cleaners, lubricants, floor brushes, light bulbs, maintenance supplies and construction materials. The Taxpayer claims that some of these items qualify for the! manufacturing exemption because they protect the integrity of the products it manufactures. The Taxpayer maintains that other items are used in exempt subprocessing activities at the production plant.

In Commonwealth of Virginia v. Community Motor Bus Co., 214 Va. 155, 198, S.E.2d 619 (1973), the Virginia Supreme Court held that the use of the word "directly" in a statute was intended to narrow the scope of the exemption. In Webster Brick Company, Inc. v. Department of Taxation, 219 Va. 81, 245 S.E.2d 252 (1978), the Virginia Supreme Court stated that "essential items which are not an immediate part of actual production are not exempt." Thus, the manufacturing exemption applies only when an item is indispensable to actual production and is primarily used or consumed immediately in the actual production of products.

A review of the contested items and the manner in which the items were used by the Taxpayer indicates that some items were used to perform repairs and maintenance to production equipment, which is a taxable general maintenance activity. Title 23 VAC 10-210-920 C 2 states that the manufacturing exemption does not apply to tangible personal property used in the repair, servicing, or maintenance of production machinery. Generally, hand tools, such as those discussed in P.D. 01-129 (9/14/01), are taxable regardless that they may be used to work on exempt production equipment. Likewise, machinery and equipment used to repair and maintain production equipment are taxable in accordance with the statutes and regulations previously cited. The actual replacement parts for exempt production machinery and equipment qualify for exemption. Cleaning products, general lubricants, chemicals to control insects and vegetation, replacement light bulbs and many of the contested purchases in the audit are subject to the tax as these items are not used directly in production.

The manufacturing exemption for subprocessing activities is discussed in Title 23 VAC 10-210-920 B 2, which states that "an exemption is available for subprocessing activities which produce tangible personal property used directly in the main manufacturing or processing activity." P.D. 96-140 (6/19/96) discusses a manufacturer that self-manufactured machinery and replacement parts for use in its own manufacturing process. The Tax Commissioner agreed this was an exempt subprocessing activity. The Taxpayer has not indicated what types of subprocessing activities are used to manufacture or fabricate property used in its main manufacturing process and how that property is used in the manufacturing process. It is clear that exempt subprocessing activities do not include the repair and maintenance of production equipment and machinery. Thus, I am unable to conclude that any of the contested items qualify for exemption on the basis they are used in subprocessing activities.

Audit Sample

The audit sample was revised by the Department's auditor to remove certain purchases that the Taxpayer maintained were not representative of its normal business activity. Because it is not clear if the Taxpayer continues to contest the Department's purchases sample since the revision of the audit, I will briefly address this issue.

Sampling is an audit technique of significant value that is widely used in both the public and private sectors. The Department uses sampling in sales and use tax audits where a detailed audit would not prove beneficial to either the auditor or the taxpayer. When sampling techniques are properly applied, the final results should be within a narrow percentage range of the actual amounts that would be determined by a detailed audit. Virginia Code § 58.1-205 1 states that a tax assessment issued by the Department is prima facie correct. Based on this statute, the courts have held that the burden is upon the Taxpayer to prove that an assessment is incorrect. Thus, the burden is on the Taxpayer to provide evidence that shows the audit sample is invalid and has resulted in an assessment that exceeds the amount that would have been determined by a detail audit.

A review of the sample methodology for this audit reveals that the auditor reviewed purchases from selected expense accounts in the Taxpayer's accounting system. An error factor was computed based on the untaxed purchases found in a one year sample of the selected accounts. The error factor was then applied to the balances from the same expense accounts over the entire audit period. This sample methodology is commonly used by the Department. I find no reason to conclude that the sample is invalid based on a review of the expense accounts sampled, the sample period used or the calculation of the taxable purchase measure and tax liability.

CONCLUSION

The revised assessment is upheld. An updated bill with accrued interest will be issued to the Taxpayer. The bill should be paid within 30 days to avoid the accrual of additional interest.

The Code of Virginia sections, regulations and public documents cited, along with other reference documents, are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions concerning this determination, please contact ***** in the Department's Office of Tax Policy, Appeals and Rulings, at *****.

- - - - Sincerely,

- - - - Linda D. Foster
        Deputy Tax Commissioner

AR/1-3145335248.S

Rulings of the Tax Commissioner