Rulings of the Tax Commissioner

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


Dear**************

This will reply to your letter of September 25, 1992 in which you, on behalf of your client,***********(the Taxpayer), take exception to the findings of a recent sales and use tax audit for the period of January, 1988 through August, 1991.

The Taxpayer is in the business of building and repairing ships. Based on the findings of a recent audit, the Taxpayer is taking exception to all, or a portion of, the items listed below.

1) Fuel Oil Purchases

The Taxpayer purchases fuel oil which is used to run their system of boilers to provide energy for three functions; to heat the administrative building, to run machinery used directly in the repair of ships, and to maintain the ship while in dock for the comfort and convenience of the personnel remaining on board during the repair process. The auditor held the fuel oil to be 30 percent exempt as it was used directly in the repair of the ships. The Taxpayer takes exception to this figure and contends that 75-80 percent of the fuel is used directly in ship repair.

2) Rental Boilers and Boiler Parts/Water/Chemical

The Taxpayer utilizes boilers in order to produce steam to be used in the various functions mentioned above. In order for the boilers to function properly, distilled water and chemicals must be used. The Taxpayer takes the position that since a portion of the steam
produced by the boiler is used in an exempt manner, the boilers, boiler parts, water and chemicals also enjoy the exemption.

3) Tags and ID Tags

In order to conduct certain repair processes, numerous pieces of equipment must be removed from the ship to access the repair area. Due to the large number of items removed, each piece must be tagged to ensure that it is properly replaced. Absent the identifying tags, it would be a near impossible task to properly refit and replace all removed parts. The Taxpayer takes the position that the identifying tags are a necessary and integral part of the ship repair process and are therefore exempt.

4) Flashlight and Batteries

Flashlights and batteries are used in certain areas of the ship as temporary lighting where the use of electrical light bulbs would create a fire hazard. They are also used in small areas of the ship where repair work is being conducted and general lighting is totally unavailable and impractical. It is the Taxpayer's position that the flashlights and batteries are a necessary item in the repair process and therefore exempt from the tax.

5) Rented Storage Containers

The Taxpayer rents storage containers to store parts and equipment removed from the ship while repair work is being conducted. The storage containers are only used to store parts and equipment which obstruct the area to be repaired and may or may not store equipment in the process of repair. The Taxpayer feels the storage of equipment removed from the ship is imperative to the repair process and therefore exempt from the tax.

6) Crude Oil Barge Rental

Much of the Taxpayer's repair operations involve the repair of oil tanks on ships. In order to safely and properly repair an oil tank on a ship, the oil contained in the tank must be drained and stored elsewhere. The Taxpayer rents crude oil barges which they moor alongside the ships being repaired and store the oil while repairs are in process. The Taxpayer feels that the barges are a necessary and integral part of the repair process and are therefore exempt from the tax.

7) Coverings

The Taxpayer purchases tarps/coverings to be placed over equipment under repair and equipment not under repair to protect such equipment from dust settling into the equipment and causing damage. Taxpayer feels such coverings should be exempt from the tax.

8) Manuals and Photographs

In order to track the physical process of a ship's repair, and for record keeping and other documentation purposes, the Taxpayer takes photographs and videos of the work in process. These photographs and videos are necessary as a part of the repair process in order to ensure proper replacement of all parts and equipment. Seventy percent of these photographs are used internally by the Taxpayer. The remaining thirty percent of the photographs are charged to a particular repair contract and are submitted to the Port Engineer for the ship's records. The Taxpayer feels that these photographs are directly used in the repair process and should be exempt from the tax.

9) Audit Penalty

During the audit period in question, the Taxpayer underwent extensive changes in their accounting department. These changes included turnover in key personnel handling accounting functions and other financial operations of the company. The Taxpayer also underwent an extensive accounting software conversion process which led to the miscalculation of sales and use tax liability. The Taxpayer advises that all accounting problems have been corrected, and requests that the audit penalty be waived.

Va. Code §58.1-608(A)(3)(d) provides that the Virginia retail sales and use tax does not apply to "ships and vessels used or to be used exclusively or principally in interstate or foreign commerce, or repairs and alteration thereof... or tangible personal property used directly in the building, conversion or repair of the ships or vessels covered by this subdivision." (Emphasis added).

The term "used directly" when used in relation to manufacturing, processing, refining, or conversion is defined under Va. Code §58.1-602 and includes "those activities which are an integral part of the production of a product,... but not including ancillary activities such as general maintenance or administration." While the department is aware that many of the activities carried out by the Taxpayer are necessary to the repair process, the department strictly interprets the phrase "used directly." Keeping this in mind, I will address each area of contention in the same order as presented in the "FACTS" section above.

1) Fuel Oil Purchases

As agreed to in the meeting with members of my staff, 10 percent of the fuel oil in question was used to heat administrative buildings, which is a taxable use. The Taxpayer and the auditor were also in agreement that 30 percent of the fuel oil purchases were used directly in repair machinery, which constitutes an exempt use. The question arises as to the taxable/exempt use of the remaining 60 percent of the fuel oil purchases. As provided by the Taxpayer and also agreed in the recent meeting, the remaining 60 percent of the oil is used to provide steam which is pumped to the repair vessel's boiler to provide energy for cooking, heat and hot water. While it is necessary to maintain acceptable living and working conditions in order to accommodate crew members and workers during the repair process, the fuel oil consumed in providing such conditions in no way directly affects the repair process. For this reason, the 30 percent exempt use as agreed to during the audit is correct.

2) Rental Boilers and Boiler Parts/Water/Chemical

Based on the analysis set forth in section 1 above, the boilers, boiler parts, water, and chemicals will enjoy the same ratio of taxable/exempt use as the fuel oil, i.e. 70 percent taxable/30 percent exempt.

3) Tags and ID Tags

While it may be necessary to remove and identify items taken off a ship or vessel in order to access the area in need of repair, the identifying tags are used in an ancillary activity which in no way enhances, nor hinders, the actual repair work being done. For this reason, I must deem these tags subject to the tax.

4) Flashlight and Batteries

As provided, flashlights and batteries are not only used for illumination purposes, but also to provide a safe working environment in areas where light bulbs may cause a spontaneous fire. Generally, illumination does not constitute a direct use in manufacturing, processing or repair. However, due to the fact that flashlights and batteries are provided to workers as a safety measure to avoid fires, I feel a portion of the flashlights and batteries should be exempt. Provided the Taxpayer can furnish a reasonable taxable versus exempt use, the flashlights and batteries held taxable in the audit will be adjusted accordingly.

5) Rented Storage Containers

To the extent the storage containers are used to store machinery and equipment which is actually undergoing repair, such containers would enjoy the exemption. Therefore, if the Taxpayer can provide a reasonable breakdown as to the percentage of containers storing work in progress, as opposed to those storing nonrepair equipment and machinery, the audit will be adjusted accordingly.

6) Crude Oil Barge Rentals

While these barges are used to store oil removed from a ship or vessel under repair, neither the barge, nor the oil contained in the barge, is used directly in the repair process, thus rendering the rental of the barge a taxable transaction.

7) Coverings

As stated above, "used directly" includes those activities which are an integral part of the repair process, but does not include ancillary activities such as general maintenance. The coverings held taxable in this audit are solely used in a preventive maintenance function and are therefore subject to the tax.

8) Manual and Photographs

Based on the information provided, 70 percent of the photographs and videos taken are for use by the Taxpayer for record keeping and other administrative functions. However, based on the fact that 30 percent of such photos are required under the terms of the repair contracts and do remain with the vessels as a record of work done, I will allow an exemption for the 30 percent of the photographs which remain with the vessel.

9) Audit Penalty

Based on the information provided in your letter, I do find basis to waive the penalty associated with this audit.

A representative from our ********* District Office will be in contact with the Taxpayer in order to make the audit adjustments set forth in this letter.

Sincerely,



W. H. Forst
Tax Commissioner

OTP/6353K

Rulings of the Tax Commissioner