Document Number
10-244
Tax Type
Retail Sales and Use Tax
Description
Tax on purchases of purging compounds used to clean production machinery.
Topic
Amnesty
Assessment
Penalties
Date Issued
10-21-2010


October 21, 2010




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 your client, ***** (the "Taxpayer"), for the period August 2002 through July 2005. I apologize for the delay in responding to your letter.

FACTS


The Taxpayer manufactures products made of plastic resins. The Taxpayer was audited by the Department and contests the assessment of use tax on purchases of purging compounds used to clean production machinery. The Taxpayer also seeks the waiver of compliance and amnesty penalties assessed in the audit.

DETERMINATION


Purging Compounds

The Taxpayer utilizes molds and injection molding machinery in its production process. The injection molding machines are used to manufacture products of different colors and resin formulas. Each machine can produce different products and colors but only one product color or resin formula can be manufactured during a particular production run. Prior to a color or resin formula change for the next production run, the Taxpayer uses purging compounds to purge or remove from the machines' injection lines the resin used in the previous production run.

In the audit, the Department treated the Taxpayer's use of the purging compounds as a taxable general maintenance activity. The Taxpayer contends that the purging compounds are used directly, in production line quality control activities and qualify for the manufacturing exemption. The Taxpayer further suggests the purging compounds are used in a specialized cleaning activity, and the Department has previously agreed that specialized cleaning activities that occur prior to production and ensure product integrity during production qualify for the manufacturing exemption.

Virginia Code § 58.1-609.3 2 (iii) provides an exemption for "[m]achinery or tools or repair parts therefor or replacements thereof, fuel, power, energy, or supplies, used directly in processing, 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 or mining process, but not including ancillary activities such as general maintenance or administration."

While it may be true that the purging compounds are used in a specialized cleaning process that ensures the integrity of the products being manufactured, I do not agree that the purging compounds qualify for the manufacturing exemption. The cleaning of the injection lines occurs between production runs so production must be stopped before the cleaning takes place. Thus, the cleaning process cannot be an integral part of the Taxpayer's production process because production or manufacturing is not occurring when the cleaning is performed. According to the Taxpayer, cleaning takes place every one to four days. This time interval between each cleaning of the injection lines supports the conclusion that the cleaning is not an integral part of production. Title 23 of the Virginia Administrative Code (VAC) 10-210-920 B 2 interprets how the term "used directly" applies to manufacturing activities and states that:
    • 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, and also includes production line testing and quality control.

This part of the regulation indicates that for an item to be used directly in manufacturing, it must be used in an activity that occurs during the actual production process. Production line testing and quality, control activities must occur during production. The regulation elaborates further on this issue and states that items that are used directly must be indispensable to the actual production of products for sale and must be an immediate part of the production process. The use of the purging compounds is not an immediate part of the Taxpayer's production process. Rather, the compounds are used before and after the Taxpayer's production process.

In P.D. 96-337 (11/19/96), the Department addressed a similar issue regarding chemicals used to clean Teflon roll covers used in the manufacture of industrial felts. The roll covers were cleaned after each batch run of a different type of felt. The roll covers were sometimes cleaned daily, but typically they were cleaned after several days of production. The Department ruled that the cleaning chemicals were not actively and continuously consumed in the production process because the cleaning was not performed on a regular and frequent basis. The cleaning chemicals were deemed to be consumed in a general maintenance function and were held taxable. The decision in P.D. 96-337 relies on P.D. 92-139 (8/10/92), which states that cleaning that is performed every two to three days does not constitute active and continuous use for purposes of applying the manufacturing exemption to the maintenance of production equipment.

The Taxpayer cites several public documents, such as P.D. 92-65 (5/11/92) and P.D. 02-62 (4/22/02), to support its position. In both of these cases, manufacturers performed cleaning activities on production equipment at least daily. Based on the specialized nature of the cleaning and the regular frequency with which it occurred, the cleaning activities were deemed to qualify for the manufacturing exemption. However, the Taxpayer's cleaning activities more closely resemble those discussed in P.D. 96­-337 and P.D. 92-139. Consistent with these prior determinations, I find that the purging compounds were properly held taxable in the audit.

Compliance Penalty

The Taxpayer requests waiver of the use tax compliance penalty assessed in the audit. This was the Taxpayer's eighth audit. Virginia Code § 58.1-635 mandates the application of penalty to tax deficiencies. Title 23 of the Virginia Administrative Code (VAC) 10-210-2032 A states, "The application of penalty to audit deficiencies is mandatory and its application is generally based on the percentage of compliance determined by computing the dealer's compliance ratio." With regard to third and subsequent generation audits, the regulation states that penalty will generally be applied unless the taxpayer's use tax compliance ratio meets or exceeds 85%. For this audit, the Taxpayer's use tax compliance ratio is 0%. Because the Taxpayer failed to meet the required 85% use tax compliance ratio for third and subsequent generation audits, the penalty was properly applied.

Amnesty Penalty

The Taxpayer contends the amnesty penalty was erroneously assessed in the audit. The Taxpayer maintains there was no statutory basis to assess the amnesty penalty because it was not eligible to participate in the amnesty program based on Va. Code § 58.1-1840.1 D 2 b, which states:
    • No person, individual, corporation, estate, trust or partnership shall be eligible to participate in the program with respect to any assessment outstanding for which the date of assessment is less than 90 days prior to the first day of the program or with respect to any liability arising from the failure to file a return for which the due date of the return is less than 90 days prior to the first day of the program.

Virginia Code § 58.1-1840.1 F 1 provides:
    • If any taxpayer eligible for amnesty under this section and under the rules and guidelines established by the Tax Commissioner retains any outstanding balance after the close of the Virginia Tax Amnesty Program because of the nonpayment, underpayment, nonreporting or underreporting of any tax liability eligible for relief under the Virginia Tax Amnesty Program, then such balance shall be subject to a 20 percent penalty on the unpaid tax. This penalty is in addition to all other penalties that may apply to the taxpayer.

The Taxpayer asserts that it fails the statutory tests for amnesty participation because the audit assessment was issued close to four years after the June 3, 2003 cutoff date and because the audit liability did not arise from the failure to file returns. Virginia Code § 58.1-1840.1 F 1 clearly states that the amnesty penalty applies to taxpayers that underpaid or underreported their liabilities. This language relates to the filing of returns and would not have been included in the statute if amnesty eligibility was based solely on the failure to file returns. Virginia Code § 58.1-1840.1 D 2 b merely establishes eligibility cutoff dates for assessments and return liabilities. It does not establish criteria for the general eligibility of taxpayers to participate in the amnesty program.

Further, the statute specifically authorizes the Tax Commissioner to establish tax amnesty guidelines and states that these guidelines, in addition to the statutes, are to be used to administer the program. According to the guidelines, a taxpayer registered for retail sales and use tax would be eligible to participate in the Virginia Tax Amnesty Program for the periods of April 2003 and prior. The Taxpayer's audit covered amnesty eligible periods in which the Taxpayer underreported and underpaid its liabilities.

The Department has previously addressed the timing of audit assessments and the application of the amnesty penalty in P.D. 08-29 (4/2/08). This document states that the timing of an audit assessment has no bearing on the validity of an amnesty penalty assessed on a tax liability for amnesty eligible periods. The Virginia Tax Amnesty Guidelines state under Section (C)(4)(j) that the 20% Amnesty penalty would not be applied to:
    • Any assessment generated from a field audit of a business for an Amnesty eligible period in cases where the audit is a second or subsequent audit of the taxpayer, provided that the Compliance Ratio is greater than 85 percent for sales tax and greater than 60 percent for use tax, no penalty has been applied to the tax deficiency, any uncontested liability is paid within 30 days from the date of assessment, and payment for any contested liability remaining upon resolution of an appeal under Va. Code § 58.1-1821 is paid within 30 days from the date of the Tax Commissioner's final determination.

In this instance, the audit was the Taxpayer's eighth audit, the Taxpayer's compliance ratio for use tax was 0% and the audit covered amnesty eligible periods. Therefore, the Taxpayer's argument that it was not eligible to participate in the Virginia Tax Amnesty Program because the audit assessments were issued in April 2007 is not valid. Accordingly, the amnesty penalty was properly applied in the audit.

CONCLUSION


Based on this determination, the purging compounds were properly held taxable in the audit and both compliance and amnesty penalties were properly assessed in the audit. The Department's records indicate that the Taxpayer has paid the audit assessment in full.

The Code of Virginia sections, regulation 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,


                • Craig M. Burns
                  Acting Tax Commissioner



AR/1-1608726841.S


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46