10-105 | Virginia Tax

Tax Type

Retail Sales and Use Tax

Description

The Taxpayer is a manufacturer of certain parts for military programs

Topic

Manufacturing Exemption

Date Issued

06-18-2010

June 18, 2010

Re: Request for Ruling: Retail Sales and Use Tax

Dear *****:

This is in response to your letter to ***** requesting a ruling on the application of the industrial manufacturing exemption to certain building enhancements made by ***** (the Taxpayer). I apologize for the delay in responding to your letter.

FACTS

The Taxpayer is a manufacturer of certain parts for military programs. The Taxpayer requests a ruling that the industrial manufacturing exemption set out in Va. Code § 58.1609.3 2 applies to costs to reinforce floors, HVAC costs, electrical infrastructure used for powering production machinery, lighting in the manufacturing spaces, hydraulic and pneumatic support infrastructure, gas infrastructure, and specific building enhancements associated with air quality (down draft venting, clean room insulation, and paint booths).

The Taxpayer is leasing a warehouse and is in the process of converting a portion of it into a manufacturing facility. Under the terms of the lease agreement for the building, the Taxpayer must generally restore the facility back to a warehouse configuration at the expiration of the lease. Such restoration includes the removal of trade fixtures and equipment, except for insulation, roof mounted heat and cooling units, upgrades to the electrical system, and a ramp for the dock doors. Members of the Department's audit and appeals staff toured the Taxpayer's facility while under construction.

RULING

Virginia Code § 58.1-609.3 2 provides an exemption from the sales and use tax for machinery, tools, fuel, power, energy or supplies used directly and preponderantly in manufacturing products for sale or resale. The term "used directly" is defined in Va. Code§ 58.1 -602 as "those activities which are an integral part of the production of a product, including all steps of an integrated manufacturing . . . process, but not including ancillary activities such as general maintenance or administration."

Subsection B 2 of Title 23 of the Virginia Administrative Code (VAC) 10-210-920 provides that the exemption applies to "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." (Emphasis added). Items which are essential to the operation of a business but not an immediate part of actual production are not used directly in manufacturing. For example, incidental activities such as general maintenance, management, and administration are not an integral part of the production of the product.

In regard to the preponderance of use rule, subsection D of Title 23 VAC 10-210-920 provides the following:

- 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 preponderance of the item's use (fifty percent or more) is in non-exempt activities. Likewise, the item will be totally exempt from tax if the preponderance of its use is in exempt production activities.

Subsection C 2 of Title 23 VAC 10-210-920 provides that equipment used for production line testing and quality control is exempt from taxation. The Department has interpreted this regulation to include that equipment which is used directly in the quality control function on the production line of the plant site during the manufacturing process. See Public Document (P.D.) 98-81 (4/29/98).

As set out in P.D. 98-10 (1/20/98), the fact that an item is essential to production is not sufficient grounds 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." Citing Commonwealth v. Community Motor Bus, 214 Va. 155, 158, 198 S.E.2d 619, 621 (1973) in Webster Brick Company. Inc. v. Department of Taxation, 219 Va. 81, 87, 245 S.E.2d 252 (1978). Also, when there is any doubt as to whether an exemption applies, the Department must adhere to the rule of strict construction of the statutory exemptions as established by the Virginia courts and deny the exemption.

With these authorities in mind, I will now address the issues raised by the Taxpayer.
Special Floors

The warehouse floor is a concrete slab. Because of the weight of the Taxpayer's equipment and the necessity to eliminate equipment vibrations from interfering with production in other areas of the plant, certain concrete flooring in the Taxpayer's facility was removed and replaced by a reinforced floor. I understand that the replacement flooring is built to a much greater depth than the original flooring and uses heavy duty rebar that also ties into the existing floor space. I also understand that a rubber material was inserted between the existing floor and the new floor to reduce or eliminate vibrations from the milling machinery.

Subsection B of Title 23 VAC 10-210-920 provides that "[c]onvenient or facilitative items, such as . . . special flooring . . . 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." Subsection C 2 of Title 23 VAC 10-210-920 also provides that "concrete floors or foundations on which such supports rest or to which machinery is bolted . . . are subject to tax."

In Webster Brick Company, Inc. v. Department of Taxation, 219 Va. 81 (1978), the Supreme Court of Virginia ruled that reinforced concrete flooring was not used directly in manufacturing and thus was not entitled to the industrial manufacturing exemption. Although the reinforced and extra thick concrete is essential to bear the weight of the machinery, it is not used as an immediate part of the production process and is taxable.

I understand that a protective sealant will be applied to the floor of the clean rooms. In P.D. 86-124 (7/11/86), the Tax Commissioner determined that special chemical floor coatings used to protect a concrete waffle floor from chemical and other spills was used indirectly in production and was thus taxable. Accordingly, the sealant is taxable.

HVAC System

The HVAC system consists of several roof mounted units, the related ductwork to deliver, return and expel air, and humidifiers. It is needed to maintain the temperature and humidity within the manufacturing facility at specified constant levels to protect the integrity of the industrial materials throughout each stage of the production process regardless of whether the production occurs in clean rooms or other areas of the facility. It is also needed to expel toxic and flammable fumes from some work areas of the facility. For the clean rooms, the air must also be kept dust free by use of HEPA air filters. The HVAC system is also used to heat and cool office spaces, bathrooms and other administrative areas. None of the roof mounted HVAC units are dedicated to the office spaces.

Pursuant to subsection C 2 of Title 23 VAC 10-210-920, tangible personal property used for general plant lighting, heating, air conditioning, ventilation, etc., is taxable unless such property is specifically designed to protect the integrity of products.

HVAC systems are exempt from the tax to the extent that conditioned air must be set at a certain temperature and humidity level to protect the integrity of the products being produced. However, when conditioned air is used for administrative offices, the HVAC system is subject to the tax. When a HVAC system is used to provide conditioned air for both taxable and exempt purposes, the preponderance of use test set forth in subsection D of Title 23 VAC 10-210-920 will apply.

Based on the facts provided, more than 50% of the conditioned air from each roof mounted unit is supplied for production purposes. If this is correct, then the roof mounted units are not subject to the tax when purchased by the Taxpayer or a HVAC contractor. See P.D. 92-189 (9/29/92).

Because ductwork is considered a supply pursuant to P.D. 92-189, the preponderance of use test set out in subsection D of Title 23 VAC 10-210-920 is not applicable. Instead, because the ductwork is used to supply conditioned air to both exempt (production) and taxable (office) work areas, the tax on the ductwork must be prorated based on the cost of the ductwork used to supply air to taxable areas to the total cost of ductwork used for the entire facility. The prorated tax application also applies to the high capacity natural gas line that supports HVAC requirements.

Based on the plant tour, humidifiers were observed only in the production areas. If not used in non-production areas, the humidifiers may be purchased exempt of the tax.

Lighting

The lighting used in the manufacturing spaces is required to comply with quality and inspection standards of the federal government and other customers. In this regard, the Taxpayer must follow a quality standard that specifies lighting levels required to provide shadow and glare free illumination for product inspections. The Taxpayer contends that this plant lighting protects the integrity of the products being manufactured.

Subsection C 2 of Title 23 VAC 10-210-920 taxes general plant lighting unless it is specially designed to protect the integrity of products. The fact that very bright lighting is mandated by the customer to meet a certain federal or customer inspection standard is not, by itself, dispositive of direct usage in manufacturing. Although the very bright lighting used in the production areas of the Taxpayer's plant is essential for inspectors to inspect products for defects, it does not play an immediate role in protecting the integrity of the product. Accordingly, such lighting is taxable.

Electrical Infrastructure

The electrical infrastructure includes step down transformers, switchgear, electrical buses or bus bars, and controls to provide for the flow of electricity into all areas of the leased facility. Electricity is delivered directly to a bank of step down transformers. The stepped down voltage is routed through various buses to power production machinery and plant lighting and provide electricity for administrative and restroom areas. It is not known what percentage of the electricity is used for production machinery, plant lighting, administrative areas and areas for employee comfort.

Subsection B 2 of Title 23 VAC 10-210-920 extends the manufacturing exemption to machinery, tools and supplies used directly to manufacture or process power or energy used to run exempt production machinery. In essence, the exemption is available for subprocessing activities that produce tangible personal property used directly in the main manufacturing activity.

In P.D. 92-189, the Tax Commissioner determined that the preponderance of use rule is applicable to transformers and switch gears but is not applicable to supplies (such as ductwork, piping, wiring and cable) used in a dual capacity. Instead, the tax on supplies must be prorated depending upon their use.

Provided the preponderance of use of the electricity is for running production machinery, the step down transformers, switch gear and controls used to process electricity to production machinery would be entirely exempt from the tax. However, such transformers, switch gear, and controls are taxable if the preponderance of electrical use is in plant lighting, administrative areas, and employee comfort.

Electrical wiring and conduit¹ used to route electricity from the step down transformers to production machinery are exempt supplies. However, electrical wiring and associated parts used to route electricity for powering plant lights, administrative areas, and restrooms are used indirectly in production and thus are taxable. When dedicated wiring is used to run production machinery, it may be purchased exempt from the tax. Likewise, wiring dedicated to power administrative areas, plant lighting and other nonoperational or nonproduction areas is taxable in full. On the other hand, the tax must be prorated when wiring and conduit are used for both taxable and exempt purposes. For example, if dual purpose wiring is used 10% of the time in administrative and employee comfort areas, 50% of the time for plant lighting, and 40% of the time to run production machinery, the tax will apply to 60% of the total cost of wiring and its associated parts.

Hydraulic Support Infrastructure

The Taxpayer will be using several large molding presses to make its products. Such presses will utilize an external hydraulic system that provides the energy or force required to mold the products. External hydraulic feed lines will connect these presses to a cooling radiator unit used to cool hot hydraulic fluid resulting from operating the presses. To guarantee the integrity of the products during the molding process, the proper pressure and temperature profile must be maintained for items under production.

The external hydraulic system for the large molding presses is indispensable to and an immediate part of such presses. Accordingly, the entire external hydraulic system for such presses is used directly in manufacturing and is thus exempt from the tax.

Chilled Water System

A water chiller will be used to cool down the molds in the presses. Although the chiller and related presses were not installed in the Taxpayer's facility at the time of the plant tour, it would appear based on the facts presented that the water chiller will be an integral part of the presses, provided the presses are designed to be used in tandem with a water chiller system. If this is the case, the manufacturing exemption would apply to the water chiller system.

Pneumatic Support Infrastructure

Two pneumatic lines are installed along the walls in certain milling rooms. One line provides the suction needed to remove highly abrasive debris from materials under production. Such debris could damage the product if it came into contact with the product. The other line delivers filtered high pressure air that is used to clean the molds. The purpose of such cleaning is to prevent the destruction of the structural integrity and surface finish of the part being pressed. This air is also used to blow off debris from parts in the finishing process². In addition to these primary uses, these lines are used to power production tools (e.g., paint spray gun) and to clean tools used in the production process.

Without such cleaning after each pressing, the debris would degrade or contaminate the integrity of the product and render the product useless and unmarketable. The Taxpayer maintains that the air delivery and suction lines protect the integrity of the product and are thus used in an exempt production line quality control function.

In P.D. 06-34 (3/23/06), cleaning wafers used regularly and frequently to remove trace particles, chemicals and any contaminants from tools were deemed used directly in production because they ensured the quality of subsequent production batch runs. In that instance, the production equipment had to be operated free of contaminants. The presence of unacceptable levels of contaminants in the tools during production would result in a manufactured product that failed to meet the quality specification required for a usable final product.

The pneumatic lines at issue are used on the production line primarily to prevent the contamination of the final product by their active and continuous use in cleaning production parts and equipment during production runs. Such activity constitutes an integral part of the production line quality control process. For these reasons and the fact that these lines are also used to power production tools, I find that these lines are used directly and solely in production and thus qualify for the manufacturing exemption.

Down Draft Rooms

These rooms are highly ventilated areas used for grinding operations and bonding composite products. The downdraft airflow is required for employee safety and to ensure that no contaminants from the grinding process get back to the components under manufacture. As discussed above, contaminated products are unmarketable.

The purpose of the down draft ventilation system installed in the milling room is to remove air borne contaminants from the grinding process. Because such system creates a specially controlled environment that is an integral part of the production line quality control process, I find that it is used directly in production. A HVAC system that is dedicated only to the down draft ventilation system of the milling room may be purchased entirely exempt from the tax.

The purpose of the down draft ventilation system installed in the bonding room appears to be mainly for employee safety. While such system is essential to allow production employees to perform their work safely, it does not directly touch upon the production of the product. As such, it is not used directly in production. A HVAC system that is dedicated only to the down draft ventilation system of the bonding room is taxable.

If the HVAC systems are not dedicated to either an exempt or taxable use but are instead used for dual taxable and exempt purposes, the same tax rules explained in the HVAC System section of this response apply here.

Natural Gas for Production

It is my understanding that the Taxpayer will be using natural gas as the fuel to heat ovens used in the production process. Such gas will be delivered to the ovens via pipelines attached to the building's structure.

The industrial manufacturing exemption includes 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. Raw materials are industrial materials that become a component part of the finished product. The natural gas used in the Taxpayer's production process does not become incorporated into the finished product and thus does not constitute a raw material. Rather, it is an exempt supply. While natural gas is an exempt supply, the pipelines, tanks (if any) and other tangible personal property used to store, handle or deliver it to the ovens are taxable. This is consistent with the established policy set out in P.D. 99-115 (5/18/99) and subsection C 2 of Title 23 VAC 10-210-920 that applies the tax to tanks and containers used to store exempt supplies.

Paint Booth

The Taxpayer plans to purchase a paint booth to bake the painted products. It is my understanding that the paint booth will not become a structural part of the building.

As set out in P.D. 04-2 (1/13/04), it has been the Department's established policy that a paint booth does not create a special environment that is essential to the production process. Even if it were shown that a controlled environment is created in the paint booth that is essential to production, the walls, floor and ceiling of the paint booth do not play an immediate role in the production or quality control process. In such an event, only the exhaust system used to remove the overspray would enjoy the manufacturing exemption.

Notwithstanding, the entire paint booth may possibly qualify for the exemption set out in Va. Code § 58.1-609.3 9 (i) if certain conditions are met. Such statute exempts:

- Certified pollution control equipment and facilities as defined in § 58.1-3660, except for any equipment that has not been certified to the Department of Taxation by a state certifying authority pursuant to such section. [Emphasis added.]

Virginia Code § 58.1-3660 defines "certified pollution control equipment and facilities" to mean "any property, including real or personal property, equipment, facilities, or devices, used primarily for the purpose of abating or preventing pollution of the atmosphere . . . of the Commonwealth and which the state certifying authority having jurisdiction with respect to such property has certified to the Department of Taxation as having been constructed, reconstructed, erected, or acquired in conformity with the state program or requirements for abatement or control of . . . atmospheric pollution or contamination." The state certifying authority for air pollution control is the State Air Pollution Control Board of the Department of Environmental Quality. For more information, see Title 23 VAC 10-210-2090.

If the conditions set out in Va. Code § 58.1-609.3 9 (i) are met, a paint booth may be purchased exempt of the tax. Without the proper certification from the state certifying authority, however, the paint booth is taxable in its entirety, except for its exhaust system.

Freezer Room

The Taxpayer is temporarily using a freestanding leased freezer to store raw materials used in production until a permanent freezer room is constructed within the plant. Once constructed, the freezer room will be used only for storage of raw materials used in production. At the expiration of the building's lease, the Taxpayer is required to remove all such improvements.

In P.D. 95-140 (5/31/95), silos used to store raw materials at a plant site were deemed an integral part of production regardless of whether affixed to realty. Because the leased freezer and freezer room will be used to store raw materials at the plant site and the storage of raw materials at the plant site is an integral part of the manufacturing process, I find basis for concluding that such freezers are used directly in production. As such, the charges for the leased freezer and the freezer construction materials used to construct the walls, ceiling and doors, including the temperature monitoring and control device, insulation, metal studs, and ductwork and HVAC equipment dedicated to such freezers, are exempt from the tax. I would note, however, the manufacturing exemption will not apply to the fire suppression systems used in the freezer room or elsewhere because they are not used directly in production.

Granite Tables

Granite tables are used to facilitate the inspection of products made for sale. They provide a thermally stable, isolated and level surface to conduct inspections requiring the use of precise measuring instruments to inspect products for quality control purposes. While such tables are necessary for quality control purposes, they do not play an active and immediate role in the actual production line quality control process. Accordingly, the granite tables are taxable.

CONCLUSION

This response is based on the facts provided as summarized above but without the benefit of observing the Taxpayer's operations in a completed facility. Any change in facts or the introduction of new facts may lead to a different result.

The Code of Virginia sections, regulations and public documents 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 ruling, you may contact ***** in the Department's Office of Tax Policy, Appeals and Rulings, at *****.

- - - - Sincerely,

- - - - Linda Foster
        Deputy Tax Commissioner

AR/1-4107221900.R

1. Pipe hangers, cable trays and other forms of support are deemed used indirectly in production and are thus taxable. See P.D. 86-98 (5/22/86 and 02-152 (12/11/02).
2. The finishing process consists of sanding, drilling, bonding of components together, and cosmetic repairs to remove or fill in small pin hole surface imperfections.

Rulings of the Tax Commissioner