Tax Type
Retail Sales and Use Tax
Description
Cooling towers, Maintenance of production machinery; Samples withdrawn from inventory; Calculation of use tax compliance ratio
Topic
Exemptions
Penalties and Interest
Property Subject to Tax
Date Issued
04-03-1996
April 3, 1996
Re: § 58.1-1821 Application: Retail Sales and Use Tax
Dear****************
This will reply to your letter of November 27, 1995, in which you seek correction of the recent sales and use tax audit of**** (the "Taxpayer") for the period of April 1992 through August 1995.
FACTS
The Taxpayer is in the business of manufacturing polyester yarn which is used as a raw material in the manufacture of tires. The Taxpayer was audited and assessed tax, penalty, and interest on a number of items that the Taxpayer believes fall within the integrated manufacturing process exemption provided in Code of Virginia § 58.1-609.3(2), (copy enclosed). I will address each item separately below.
DETERMINATION
Code of Virginia § 58.1-609.3(2) provides an exemption from the sales and use tax for "machinery or tools or repair parts therefor or replacements thereof, fuel, power, energy, or supplies, used directly in... manufacturing... products for sale or resale." The term "used directly" is defined in Code of Virginia § 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." (Emphasis added).
Interpreting the above statutes, § B(2) of Virginia Regulation (VR) 630-10-63 provides:
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- Items of tangible personal property which are used directly in manufacturing...are machinery, tools and repair parts therefor, fuel, 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... or items that are essential to the operation of a business but not an immediate part of actual production, are not used directly in manufacturing... (Emphasis added).
Ultrasonic Cleaner
During the manufacture of polyester yarn, molten polymer is extruded through spinnerette dies. After time, these spinnerettes become coated and clogged with hardened polymer. Clogged spinnerettes are removed and put through a cleaning process and then reused. The cleaning process consists of placing the spinnerettes in an ultrasonic cleaner that uses superheated hot water and ultrasonic waves to remove the majority of the hardened polymer. After this process the spinnerettes are placed in a bake oven to remove the remaining residue and then placed back into production equipment. The Taxpayer contends the ultrasonic cleaner is part of the integrated manufacturing process and should enjoy the exemption.
The Taxpayer's contentions are based on P.D. 94-28 (3/2/94) and P.D. 92-65 (5/11/92). In P.D. 94-28, the department extended the integrated manufacturing exemption because the process involved not only the sandblasting and baking of extrusion tubes, but also the process of recoating the extrusion tubes with a teflon coating. It is the department's position that the recoating of the tubes goes beyond the general maintenance of tubes and qualifies it as a subprocessing activity. In P.D. 92--65, the department granted the exemption to sanitizing chemicals as being an indispensable part of the quality control function of the process. VR 630-10-63.B(2) provides that the integrated manufacturing exemption extends to production line testing and quality control. In this case the entire production process was shut down in order to sanitize it.
VR 630-10-63.C.2 provides that tangible personal property used in maintenance of production machinery is taxable. Based on the fact that the ultrasonic cleaner is not in active and continuous use on the production line, and is clearly used in the maintenance of production line parts, I find no basis for removing this item from the audit findings. It is the department's position that the maintenance in the present case differs from those set forth in the aforementioned public documents. In addition, l have enclosed P.D. 92-139 which upholds this position and is directly on-point with the issues contained herein.
Gear Box Oil Cooler
In order to keep the lubricating oil for a piece of manufacturing equipment cool, the Taxpayer added a gear box oil cooler to the equipment. Cooling the oil will keep the oil from breaking down and will extend the useful life of the oil. The Taxpayer is of the opinion that since the gear box oil cooler is directly attached to production machinery and continuously cools machinery oil, it is part of the integrated manufacturing process and therefore exempt from the tax.
While the department agrees that the oil used to run exempt production equipment is exempt from the tax, any ancillary activities used to treat the oil would be taxable. The gear box oil cooler is used indirectly in the manufacturing process, as it merely keeps the oil from overheating which, in turn, prevents the oil from breaking down, and prolongs the useful life of the oil. In actuality, the production machinery ran for a number of years without cooling the oil. This further substantiates the department's position that the oil cooler equipment is indirectly used in the manufacturing process.
Cooling Tower Additions
The Taxpayer has a water cooling system which receives heated water from the production equipment and returns it at a lower temperature to keep the production equipment from overheating. The water cooling system consists of a cooling tower that stores the water. The Taxpayer added additional equipment to the water tower which automatically adds chemicals to the water and monitors the chemical levels. The Taxpayer takes the position that the additions to the cooling tower are a part of the integrated manufacturing process and is therefore exempt.
The purpose of the equipment is to automatically add chemicals to the water and to monitor the chemical levels of the water. Like the oil in the situation above, the water used to cool production equipment is exempt from the tax; however, the chemicals used to treat the water are considered to be used indirectly and subject to the tax.
Fixed Asset v. General Expense Purchases
The Taxpayer purchased a scrubber which it readily admits to being a taxable item. However, the Taxpayer listed this item as an expense purchase and the scrubber was included in the audit sample and extrapolated over the entire audit period. The Taxpayer contends that the scrubber should have been capitalized and should be included on the itemized list under fixed assets. The Taxpayer is requesting that this item be removed from the purchases sample and included in fixed assets.
Provided the Taxpayer capitalizes the scrubber, the department will remove the scrubber from the expense purchases sample and separately itemize it on the fixed assets exceptions list.
Samples Withdrawn from Inventory
The Taxpayer withdraws polymer yarn from its finished goods inventory and gives the yarn to customers and potential customers to entice more sales. The Taxpayer was assessed the tax on the sample based on the fabricated cost price. The Taxpayer believes the tax should be assessed on the cost price of the raw materials, minus labor and overhead.
Code of Virginia § 58.1 -623.C provides that:
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- If a taxpayer... makes any use of [resale] property other than an exempt use or retention, demonstration, or display while holding property for resale..., such use shall be deemed a taxable sale by the taxpayer as of the time the property... is first used by him, and the cost of the property to him shall be deemed the sales price of such retail sale. (Emphasis added).
"Cost price" is defined in Code of Virginia § 58.1-602 to mean "the actual cost of an item... of tangible personal property computed in the same manner as the sales price as defined in this section without any deductions therefrom on account of the cost of materials used, labor, or service costs, transportation charges, or any expenses whatsoever." (Emphasis added).
Based on the above, the sample withdrawn from the Taxpayer's resale inventory was properly held taxable in the audit. In addition, the tax was assessed on the cost price of the finished product.
Audit Penalty
The Taxpayer was assessed audit penalty on the purchases portion of the audit. This penalty was assessed as a result of a use tax compliance ratio of 45%. Based on an assumed removal of the above listed items, voluntary use tax paid to the Commonwealth, and sales taxes paid directly to vendors, the Taxpayer feels their use tax compliance falls well within the accepted level of compliance to merit waiver of audit penalty.
The Taxpayer takes exception to the department's method of computing the use tax compliance ratio for purposes of assessing audit penalty. Specifically, the Taxpayer feels that in computing the use tax compliance ratio, the department should include the sales tax paid to vendors in the "Use Measure Reported" figure used in the numerator and the denominator. VR 630-10-109 addresses use tax and states, in part, the following:
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- The use tax applies to the use, consumption or storage of tangible personal property in Virginia when the Virginia sales or use tax is not paid at the time the property is purchased. The rate of the state and local use tax are the same as the rates of the state and local sales tax. There is no duplication of the tax. (Emphasis added).
Therefore, the tax paid to vendors at the time of purchase is "sales" tax, not "use" tax. The purpose of the "use" tax compliance ratio is to determine how well the taxpayer has complied with Virginia tax laws in accruing and remitting use tax on untaxed purchases. To include sales tax paid to vendors in computing the use tax compliance ratio would inaccurately portray the taxpayer's compliance with the Virginia use tax laws.
Based on the above, provided the Taxpayer moves the scrubber from general expense purchases to fixed assets, the audit will be adjusted accordingly. If you should have any further questions, please contact***** , Office of Tax Policy, at**************
Sincerely,
Danny M. Payne
Tax Commissioner
OTP/10695K
Rulings of the Tax Commissioner