In the world of your state’s sales tax, there is often the debate as to whether a process employed by a company is “manufacturing.” If manufacturing occurs, the machines used in the process are often exempt or taxed at a reduced rate. Conversely, without manufacturing, expensive machine purchases can be subject to the full rate of your state’s sales tax.
In Tri-State Scrap Metal, Inc., a recent North Carolina case, the Court was called on to determine whether the process of converting scrap metal qualified as “manufacturing.” The taxpayers involved were secondary metal recyclers. They purchased and used equipment, machines, accessories, and various other items in their recycling activities. The scrap material purchased was processed and converted into useful products that customers for purchase. As manufacturers, the taxpayers availed themselves to the provisions of N.C.G.S. § 105-187.51 (Repealed) and claimed their purchases were ‘milling machinery, parts or accessories’ and paid a reduced rate of 1% sales tax.
On audit, the North Carolina Department of Revenue took the position that the taxpayers did not “manufacture” products. As the audit unfolded, the agency changed its position on one activity (Granular shredding) and accepted it was “manufacturing.” Ultimately Notices of Final Determination were issued and the taxpayers were forced to pay the excess tax or appeal.
In North Carolina, the next appeal is to the Office of Administrative Hearings (“OAH”). After consolidating the multi-taxpayer cases, the OAH issued a Final Decision in favor of the taxpayers. The OAH concluded that the taxpayers proved by a preponderance of the evidence that their operations were in fact manufacturing activities and were entitled to apply the reduced sales tax rate. The Department of Revenue appealed to the judicial court as it is entitled to do.
The Appellate Court noted that the parties had stipulated no dispute of material fact and identified two issues of law to be resolved:
- Whether the taxpayers’ activities were manufacturing; and
- Whether the OAH erred in failing to engage in a purchase by purchase analysis when determining that the taxpayers’ purchases were mill machinery, parts or accessories within the meaning of N.C.G.S. 105-187.51 (Repealed).
On the first issue, as is the case in most states, the taxpayer had the burden to show it was entitled to the reduced sales tax rate. (See Piedmont Canteen Serv., Inc. v. Johnson, 256 N.C. 155, 163, 123 S.E.2d 582, 587 (1962)). The Court observed that the taxpayers purchased useless ferrous and non-ferrous scrap metal and electronic scrap from various sources. At their facilities, the taxpayers used their equipment, machinery, and accessories to put the scrap through one or more processes. What emerged from the activities of the taxpayers were useful and distinct products in a form that customers were willing to purchase. The processes used by the Respondents included:
Stripping – specialized machinery strips coating and insulation from copper wire;
Baling – scrap is crushed and compacted into condensed bales of various sizes;
Torching – metallic materials cut into various sizes with acetylene or oxygen torches; and
Shearing – various machines and equipment used to cut and separate raw materials.
Without a statutory definition, the Court had to look to other case law for guidance. In Duke Power Co. v. Clayton, Comr. of Revenue, 274 N.C. 505, the NC Supreme Court defined manufacturing “as the producing of a new article or use or ornament by application of skill and labor to raw materials” and that “the labor must result in a new and different article with a distinctive name, character or use”. The Supreme Court further noted that the word ‘manufacture’ was not one to which an accurate definition could be ascribed. The definition had to be considered in the context it was being used taking into consideration the specific circumstances and industry.
In the current case, the Court noted that the taxpayers took what was essentially useless material of no value and no consequence and transformed it into something of value which customers ascribed value and were willing to pay for. The Court concluded, “there was no question that [taxpayers] created ‘a new and different article’”. It was further noted that even though the intrinsic nature of the scrap metal remained unchanged it had no bearing on whether “a new and different product with a distinctive use had been created” (Brandenburg Indus. Serv. Co. v. Ind. Dep’t of State Revenue, 60 N.E.3d 300, 307 (Ind. Tax. Ct. 2016)). The Court concluded that the taxpayers were engaged in manufacturing.
After explaining that the taxpayers had prevailed on the second issue, the Court affirmed the OAH’s summary judgment and reversed of the North Carolina Department of Revenue’s Notices of Final Determination to the extent that the OAH determined the Respondents to be manufacturers. However, the Court reversed the OAH’s ruling that all items purchased were subject to the lower tax rate and remanded the case to the OAH for a purchase-by-purchase examination of the items used in the production phase of manufacturing.
This matter is notable in that it reaffirms that, while the Court continues to have a narrow definition of who is a ‘manufacturer’, they also adopt a practical approach to the question. It is an approach that relies on a material change in the nature of the input materials and the resulting output. While it may be difficult, manufacturing exemptions are excellent opportunities to get creative in the sales tax world.
- N.C.G.S. § 105-187.51 (Repealed)
- Piedmont Canteen Serv., Inc. v. Johnson, 256 N.C. 155, 163, 123 S.E.2d 582, 587 (1962)
- Duke Power Co. v. Clayton, Comr. of Revenue, 274 N.C. 505
- Brandenburg Indus. Serv. Co. v. Ind. Dep’t of State Revenue, 60 N.E.3d 300, 307 (Ind. Tax. Ct. 2016)
- 17 N.C. Admin. Code 07D.0102(a)(1)