We see signs everywhere that states are becoming more aggressive with both their strict interpretations of long-standing exemptions and audits of businesses subject to their sales tax compliance laws. In our recent experiences assisting clients with sales tax matters, we have encountered these aggressive taxing policies toward businesses for both purchases as well as sales to customers. Some of the most time-honored exemptions have become the target of these policies.
The manufacturing exemption appears to be most susceptible. Most states do not have a statute or regulation that specifically defines what constitutes manufacturing. Some have issued extensive bulletins to determine what activity qualifies as manufacturing, which can include activities such as processing, fabrication, and research and development.
The manufacturing exemption requires careful examination to determine when the manufacturing activity begins and ends – more commonly referred to as pre and post manufacturing – and whether the activity qualifies as manufacturing. Adding slightly more complexity are mixed use assets – those items that are used in both manufacturing and non-manufacturing activities.
The manufacturing exemption can be a complicated exemption to manage. Mismanagement of the exemption could result in a use tax assessment in the event of an audit. It requires businesses to be diligent and scrutinize their activities and vendor purchases on a regular basis. For example, businesses should assess where equipment is being used and whether it is being used in an activity that is exclusively manufacturing, non-manufacturing, or mixed use.
A common piece of equipment typically used in a mixed use activity is a forklift. A forklift can be used to bring raw materials to and from the point where manufacturing begins, as well as to take manufactured product to be stored in a warehouse. These activities are not considered to be manufacturing and could be subject to sales tax upon purchase. Forklifts can also be used to take partially manufactured goods to another area where the goods are finished. This activity would be integrated with the manufacturing process and would be eligible for the exemption. Mixed use assets must be predominantly used in an exempt activity, like manufacturing, to qualify for the exemption from sales tax. If the predominant use is not manufacturing related, the asset is subject to sales tax at the time of purchase.
Another area where we often encounter the manufacturing exemption is in connection with construction contracts. In this scenario, it becomes critical to determine if the contract is a real property contract or the sale of tangible personal property. Some states will allow the contractor to identify certain purchases as retaining their identity as tangible property, even when affixed to real estate, and treat those purchases as exempt manufacturing equipment.
The determination of what is real property and what remains tangible personal property continues to be an area of contention during state audits. In a recent audit, a manufacturer of equipment that was specifically identified as tangible personal property in guidance issued by the state was ultimately determined to be real property by the auditor and his supervisor. This determination was based on the equipment being bolted to the ground and connected to the facility’s utilities.
Businesses need to be aware of their current internal policies related to vendor purchases to determine that their activities and those purchases associated with the activity continue to qualify for the manufacturing exemption from sales tax. They also need to make sure that the exemption is not being used too broadly. Vendors have likely expanded their product sales and could include the sale of items used both in manufacturing and non-manufacturing. Having an exemption certificate on file could result in certain taxable items being treated as exempt.
Another common issue we see is when individuals in the accounts payable process determine that everything the business purchases should be exempt because they are a manufacturer and deduct the sales tax from the invoices when remitting payment. Sometimes vendors catch it on the back end, sometimes they don’t.
Some due diligence on the front end could avoid a big headache on the back end. The key takeaway is that the status quo no longer goes unquestioned. Once a manufacturer, always a manufacturer is no longer hallowed ground. Businesses should implement a routine and regular review process to ensure that they are still eligible for the exemption and that it is being applied properly.
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