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May 29, 2012

Does your company qualify as a manufacturer? States can't seem to agree. Of the 45 states that impose sales and use tax on sales of tangible personal property, most provide an exemption or reduced rate for companies that operate as manufacturers. Nearly every state provides a unique definition of manufacturing. State interpretations also differ greatly about where the manufacturing process begins and ends as well as those industries to which it applies. Reviewing the differences in each state's definition and understanding how the exemption can be applied to your company could result in opportunities to reduce the sales and use taxes paid.

In 1956, the United States Supreme Court held that manufacturing requires something more than the mere change of raw materials into finished products . To qualify as manufacturing, a new and different article should be produced having a distinctive name, character and use. Several states have adopted a similar theory, and several have incorporated other similar activities into their definition, such as "processing, fabricating and assembling." The addition of these "other activities" has allowed taxpayers to expand the scope of the definition and take more aggressive positions in applying the manufacturing exemption to their company.

This article focuses primarily on case law and current litigation where taxpayers have applied the manufacturing exemption to unconventional industries such as telecommunications, restaurants and exploration of natural resources. These industries are just a few examples of where the definition of manufacturing has been challenged over the years.

Other types of activities not included here could also be considered. For example, what if your company recycles a by-product, is merely packaging a product or is assembling certain items for sale? Moreover, what if your company is a contract manufacturer that does not sell a product but provides a service? To the extent you are in an industry not typically classified as manufacturing, your company should consider the positions and arguments presented in these cases and evaluate whether they can be applied to your company's operations to potentially minimize future taxes paid or recover refunds. 

Industry Trends in the Application of the Manufacturing Exemption

Certain trends exist on a state-by-state basis related to certain types of activities that qualify as manufacturing. For example, although most states agree restaurants process food for sale for immediate consumption, which is typically subject to tax, most states do not extend the manufacturing exemption to restaurants. Only a few states, such as Texas and Indiana, include within their definition of manufacturing a sales tax exemption for certain items purchased for use by restaurants. For example, Indiana provides a manufacturing exemption for "machinery, tools, and equipment that are directly used in the production process if they have an immediate effect on the article being produced. A fryer or broiler used to prepare food is exempt from sales tax. However, a refrigerator is taxable because it serves merely as an agent in the preservation of food and does not act directly on the food during preparation."

While most states regard telecommunications providers as service providers, some taxpayers have challenged the definition of manufacturing in states where specific telecommunication equipment exemptions do not exist. Southwestern Bell Telephone challenged the state of Missouri on this exact issue. The Missouri Supreme Court reversed the decision by the Administrative Hearing Commission and held that telephone services constitute the manufacturing of products for purposes of the use tax exemption. The human voice is "manufactured" into electronic impulses that can be transmitted and reproduced into an understandable replica. Thus, the purchases of machinery and equipment used to produce basic and vertical telephone services are eligible for the manufacturing exemption from Missouri use tax.

Unlike Southwestern Bell Telephone in Missouri, GTE Southwest was not successful in claiming the manufacturing exemption in Texas for purchases of telecommunications equipment. The exemption for tangible personal property used in manufacturing, processing or fabrication of tangible personal property for ultimate sale does not apply to equipment used by a local exchange carrier in providing a telecommunications product to customers that is taxed as a service. The term "tangible personal property for ultimate sale" in Texas Tax Code Ann. Section 151.318(a)(2) limits the manufacturing exemption to the manufacturing, processing or fabrication of products whose ultimate sale is taxed as tangible personal property, and excludes products taxed as services. 

In addition to statutory challenges from the restaurant industry and telecommunications providers, those engaged in exploration and production of oil and gas have recently pushed the limits of the manufacturing exemptions. Most recently, Southwest Royalties tried to challenge the State of Texas's long-standing policy regarding the application of the manufacturing exemption. Southwest Royalties has taken the position that its production activities meet the State's definition of "processing"; therefore, the purchases of equipment and consumables used in the extraction of oil and gas should qualify for exemption. Southwest Royalties requested a refund for taxes paid on both "above ground equipment" and "below ground equipment" used to extract the oil and gas from the wellbore.

The State of Texas defended its long-standing policy that the production of oil and gas does not meet the definition of processing and disputed the position that the well equipment causes a "direct" chemical or physical change to the product. Travis County District Judge John Dietz initially ruled from the bench in favor of Southwest Royalties; however, the initial ruling received substantial publicity surrounding the fiscal consequences of the decision. After a rehearing, the final judgment was filed in Travis County District Court. Judge Dietz ruled against Southwest Royalties and in favor of the State, denying all requested sales and use tax refunds. The Court held that the plaintiff did not meet the burden of proof with regard to the claim that machinery and equipment used to extract oil and gas qualifies for the "manufacturing" exemption. Although Texas's long-standing policy currently remains intact, relevant parties should continue to monitor the issue, as another case, Apache Corporation v. Comptroller, et al., is scheduled to be heard September 7.

While Texas is debating whether or not the extraction of natural resources from the earth meets the definition of manufacturing, other states have more clearly defined exemptions specific to extraction of these resources. For example, Pennsylvania has a fairly broad mining exemption and includes "extracting" within the definition of "manufacture." Extracting includes "refining, blasting, exploring, mining, and quarrying for, or otherwise extracting from the earth or from waste or stock piles or from pits or banks any natural resources, minerals and mineral aggregates, including blast furnace slag." As a result of Pennsylvania's broad mining exemption, oil and gas producers are currently able to take advantage of exemptions for items used directly in the mining (extracting) process.

Alvarez & Marsal Taxand Says:

As demonstrated above, atypical industries have been successful in applying the manufacturing exemptions to their companies' operations. We encourage you to familiarize yourself with these exemptions and evaluate whether or not they may apply to your operations. As with all exemptions, there are economic impacts, and consideration should be given to both the potential benefits and any adverse publicity that could result from an aggressive application of these exemptions. It would be beneficial to involve other departments such as community relations and legal prior to committing to litigation.


East Texas Motor Freight Lines, Inc. v. Frozen Foods Express 351 U.S. 49 (1956)

Per 45 IAC 2.2-5-8(c). A machine, tool or equipment has an immediate effect on the product being produced if it is an essential and integral part of an integrated process that produces the product. Indiana Information Bulletin No. ST11, 11/01/2011

Southwestern Bell Telephone Co. v. Director of Revenue, Missouri Supreme Court, Dkt. No. SC83859, 6/11/2002

GTE Southwest Inc. v. Combs, Tex. Ct. App., 3rd Dist., Dkt. No. 03-08-00561-CV, 06/03/2010


Carolyn Campbell Shantz
Managing Director, Houston
+1 713 221 3919

James Bartek, Managing Director, Lisa Barnick, Senior Director, and Gina Pizzo, Senior Director, contributed to this article.

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