Tax Type
Retail Sales and Use Tax
Description
Direct use in-production criteria of the industrial manufacturing exemption not satisfied.
Topic
Appropriateness of Audit Methodology
Manufacturing Exemption
Property Subject to Tax
Date Issued
07-23-2012
July 23, 2012
Re: § 58.1-1821 Application: Retail Sales and Use Tax
Dear *****:
This will reply to your letter in which you seek correction of an assessment issued To ***** (the "Taxpayer"), for the period July 2009 through May 2011. I apologize for the delay in responding to your letter.
FACTS
The Taxpayer manufacturers paper towels and paper tissue products. 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 Taxpayer contests the tax assessed on (i) Manufacturing Execution System Software, (MES), (ii) a wireless gun system, and (iii) a WMS maintenance contract. The Taxpayer believes that the contested items are used directly in the production process and qualify for the manufacturing exemption. The Taxpayer has paid the assessment and requests a refund for the tax assessed on the contested items.
DETERMINATION
Manufacturing Exemption
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:
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- 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 riot 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].
Accordingly, the fact that an item is essential to production is not sufficient for exemption based on the Virginia Supreme Court's holding that "essential items which are not an immediate part of actual production are not exempt." See Webster Brick Company, Inc. v. Department of Taxation, 219 Va. 81, 245 S.E.2d 252 (1978).
Further, in the case of 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 the statute is intended to narrow the scope of the exemption. An exemption, therefore, applies only when an item is indispensable to actual production and is primarily used or consumed immediately in the actual production of products.
Administrative Activities
Title 23 VAC 10-210-920 C 1 provides that the managerial, sales, and nonoperational aspects of manufacturing and processing, which includes selling, marketing and record keeping, are indirect to the actual production of a product and are therefore taxable. Such property includes:
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- Office furniture, supplies and equipment, textbooks and other educational materials, books, and records, and all other items used in record keeping and other administrative or managerial activities, whether on or off the assembly line. Also included are computer hardware and canned software, calculators, and other such items used to record the quality and quantity of work in production or goods in storage, the flow of work, and the results of inspections . . . . [Emphasis added].
Keeping these statutory and regulatory provisions in mind, I will address the contested issues raised in the Taxpayer's appeal.
MES
Based on product information, MES primarily manages and monitors work-inprogress on the factory floor. Machine monitoring sensors and shop floor data collection terminals transmit production data from the factory, floor to the MES to allow a real-time view of the plant-floor production, providing key information to support supply chain management and sales activities. MES is designed to improve asset productivity, reduce order-to-ship times, and eliminate costly rework. The scope of MES can vary from scheduling a small set of critical machines to managing an entire fabricating operation for a manufacturer. Some MES products can be used to schedule tasks by facility, work center, machine, and/or employee skill set. Products that include capacity planning features allow schedulers to load jobs against an organization's total production capacity.
The Taxpayer claims that the MES software is an integral part of the production process and is exempt under Va. Code § 58.1-609.3.2. Further, because the primary intent and use of the MES software system is for production activities, including production line control and quality control operation, the Taxpayer claims that the preponderance of use test as explained in Title 23 VAC 10-210-920 is also met.
According to the audit comments, the Taxpayer explained that the MES was used for inventory control purposes during the audit period. The Taxpayer further explained that the MES did not currently control or operate any production equipment. However, it could perform this function with the purchase of additional components.
Based on the information presented, the MES software serves an administrative function collecting and processing production data for inventory control purposes. Based on the established policies set out above, and the strict construction of exemption statutes required by the courts, the contested MES does not satisfy the direct use in-production criteria of the industrial manufacturing exemption. Rather, the MES is used for administrative purposes and, therefore is subject to the tax.
With regard to the quality control issue, Title 23 VAC 10-210-920 C 2 addresses taxable and exempt manufacturing activities and provides, in part, that "equipment used for production line testing or quality control is classified as exempt production equipment. Testing for the purpose of approving administrative efficiency or any other testing not relating to quality control is taxable." This section goes on to give examples of exempt items, including:
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- Computer hardware and software used to direct or control production line and/or quality control operations (as contrasted to computer hardware and software used merely to monitor production operations, e.g., computers used to produce production reports, make production information available to plant personnel, monitor the efficiency of production machinery, etc., which are deemed to be taxable administrative items).
Like the manufacturing process itself, equipment used in the quality control function must be used directly to influence or control the quality of the product being produced. In this instance, the MES does not ensure the integrity of the product being produced.
The Department's policy on this issue is well established. See Public Documents 88-50 (4/4/88), 07-173 (11/14/07), and 86-46 (3/14/86).
Based on the above facts and authorities, the MES is not directly used in the production process or in production line quality control. Therefore, the MES does not qualify for the exemption in Va. Code § 58.1-609.3 2. Accordingly, the assessment with respect to the MES is correct.
Wireless Gun System
The Taxpayer claims that the wireless gun system is used 75% for the handling of raw materials from the time the raw, materials arrive at the plant until the saleable pallet is placed into the distribution area. The Taxpayer maintains that the wireless gun system is considered an integral part of the production process and exempt from the tax.
The Taxpayer has presented no evidence to support its contention that the wireless gun system is indispensable to the actual production of products for sale and is used as an immediate part of such production process. Rather, based on the information furnished by the auditor, the wireless gun system held taxable in the audit was solely for use in internal tracking and inventory control. Based on this information, the wireless gun system is not an immediate part of the Taxpayer's production process but used in a taxable administrative activity. Accordingly, the wireless gun system does not qualify for the manufacturing exemption. Therefore, the assessment of use tax on the Taxpayer's wireless gun system is proper.
WMS Maintenance Contract
The contested maintenance contract is for the wireless gun system. Because the wireless gun system is an integral part of the production process, the Taxpayer claims that the maintenance contract should also be considered exempt.
Virginia Code § 58.1-609.5 9 provides that "maintenance contracts, the terms of which provide for both repair or replacement parts and repair labor, shall be subject to tax upon one-half of the total charge for such contracts only . . . ."
Title 23 VAC 10-210-910 B 3 provides, in pertinent part:
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- Maintenance contracts that provide for the furnishing of both repair or replacement parts and repair labor are a combination of taxable sales and nontaxable services. As it is impossible to determine in advance the percentages of labor and parts that will be provided under the contract, the contract will be deemed to be a contract for one-half labor and one-half parts, regardless of the percentages of labor and parts actually provided under the contract. Thus, one-half of the total charge for such contract is subject to the tax.
Generally, the application of the tax to maintenance contracts will follow the same application of the tax to the equipment for which such contracts are intended. In this instance, the maintenance contract is for the wireless gun system discussed above that does not qualify for the manufacturing exemption. Because the maintenance contract provides parts and labor, and because the wireless gun system is deemed to be taxable, the maintenance contract is also taxable. Accordingly, the assessment of the tax on one-half of the charge for the maintenance contract is correct.
CONCLUSION
Based on the above, the assessment is correct. Accordingly, there is no basis to refund any portion of the tax previously paid.
The Code of Virginia sections, regulations, public documents, and court cases cited 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 about this determination, you may contact ***** in the Department's Office of Tax Policy, Appeals and Rulings, at *****.
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- Sincerely,
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Craig M. Burns
Tax Commissioner
AR/1-4941432797.T
Rulings of the Tax Commissioner