Tax Type
Retail Sales and Use Tax
Description
Tax assessed on pallets used in distribution activities: Exemptions
Topic
Appropriateness of Audit Methodology
Manufacturing Exemption
Records/Returns/Payments
Date Issued
04-23-2012
April 23, 2012
Re: § 58.1-1821 Application: Retail Sales and Use Tax
Dear *****:
This is in response to your letter in which you seek correction of the retail sales and use tax assessment issued to ***** (the "Taxpayer"), for the period November 2006 through October 2009. I apologize for the delay in responding to your appeal.
FACTS
The Taxpayer manufactures, markets, and distributes printed accent rugs, printed floor mats, and other similar items. In addition, the Taxpayer prints designs on semi-finished rugs prior to sale. The Taxpayer also imports finished rugs that may require a hanger or label prior to sale.
As a result of the Department's audit, the Taxpayer was assessed the tax on asset and expense purchases. At issue is the tax assessed on pallets used in distribution activities. The auditor denied the exemption for pallets used in distributing imported finished rugs in which the Taxpayer may apply a hanger or label prior to shipping. The Taxpayer maintains that it is an industrial manufacturer and all pallets are exempt under the manufacturing and processing exemption under Va. Code § 58.1-609.3. In addition, the Taxpayer argues that the application of labels and hangers on imported finished and semi-finished products is the last step of production where the product is finished or completed for sale and conveyed to be palletized and shipped to the Taxpayer's wholesale customers. As such, the Taxpayer maintains that pallets used in packaging imported finished products qualify for exemption from the tax.
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 Va. Code § 58.1-609.3 2 iii 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 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].
This section further provides that "integrated manufacturing includes the production line of a plant . . . 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 . . . and conveyed to a warehouse at the plant site . . . ."
Packaging Materials
The application of the tax to packaging materials is set out in Title 23 VAC 10210-400. This regulation distinguishes exempt packaging materials (such as sacks, cans, and boxes) from taxable transportation devices (such as pallets, strapping, and similar materials). The regulation defines "transportation devices" to mean "items which are used to transport and protect products for sale and to restrain product movement in a single plane or direction." The regulation further provides that transportation devices may not be purchased tax exempt unless purchased for resale.
An exception to this general rule is provided in Title 23 VAC 10-210-920. This regulation notes that the tax does not apply to "materials, containers, labels, sacks, cans, boxes, drums or bags for future use for packaging tangible personal property for shipment or sale (whether returnable or nonreturnable)," when used or consumed by an industrial manufacturer or processor of products for sale or resale.
Distribution
Distribution activities conducted by manufacturers are considered taxable in accordance with Title 23 VAC 10-210-920 C 3. "Distribution" is the transport or conveyance of products after the completion of production and is not part of manufacturing or processing. Distribution includes the storage of a product subsequent to its production (other than storage at the plant site) and the actual transport of the product for sale.
Based on a review of the audit report and information provided with the Taxpayer's appeal, no additional manufacturing or processing takes place on the finished rugs imported for sale to customers. The application of a label or hanger does not result in the creation of a new product, as does raw materials that go through a process where a product is finished or completed for sale. Rather, the Taxpayer is merely applying a hanger or label to a finished product prior to shipment. Such activity conducted at the Taxpayer's facility falls within the definition of distribution under Title 23 VAC 10-210-920 C 3. Accordingly, the contested pallets used in packaging finished products imported by the Taxpayer for distribution to wholesale customers are subject to the tax pursuant to Title 23 VAC 10-210-920 C 3.
The auditor provided the Taxpayer a copy of Public Document (P.D.) 90-110 (7/23/90). In that ruling, the application of the tax to pallets used in both taxable and exempt activities was based on the preponderance of use. However, the preponderance of use rule set forth in Title 23 VAC 10-210-920 D is only applicable when a single piece of equipment is used in both a taxable and exempt manner. Fungible items or supplies that are used either in a taxable manner or an exempt manner must be prorated depending on their use. The ruling in P.D. 90-110 is not consistent with subsequent rulings issued by the Tax Commissioner, and the ruling issued today supersedes the policy set out in P.D. 90-110. Thus, the Taxpayer is required to prorate the use tax on pallets based on their taxable use in distribution activities. See P.D.s 92-189 (9/29/92) and 01-129 (9/14/01).
Penalty
Title 23 VAC 10-210-2032 B 8 provides, in pertinent part, that "[p]enalty generally will not be applied to audit deficiencies occurring in new areas not covered by prior audit(s), provided the application of the tax is not clearly established under existing law, regulations or other published documents of which the taxpayer reasonably should have had knowledge . . . ."
In this instance, it appears that pallets used in a distribution activity were not covered in the prior audit of the Taxpayer. Accordingly, I will agree to waive the penalty assessed on the pallets included in the audit.
In addition, audit deficiencies in new areas are not included in compliance ratio computations. As the pallets constitute a new issue, the use tax compliance ratio will be recomputed without the pallets. If the recomputed compliance ratio meets or exceeds the minimum level of acceptable compliance, the penalty on the use tax will be abated in full.
CONCLUSION
The contested assessment will be revised in accordance with this determination. Because the Taxpayer has paid the assessment in full, a refund will be issued based on the revisions. The refund will include interest owed on the refunded amount in accordance with Va. Code § 58.1-1833.
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 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/1-4748124697.T
Rulings of the Tax Commissioner