Our December Edition of the Libertas Review includes an article by a Guest Contributor, Jonathan Liss, MST. Jonathan is senior revenue policy analyst for the Philadelphia Department of Revenue. He is also an adjunct professor at Drexel University and Villanova University School of Law.
In many states, businesses are able to obtain sales tax exemptions that allow otherwise taxable items to be purchased without paying sales tax. This article provides a brief overview of the sales tax manufacturing exemption and how it applies to businesses. Although many states provide statutory exemptions for items used in the manufacturing process, these vary from state to state.
“As an eligible manufacturer, make sure your company is getting the most from applicable exemptions. ”
MANUFACTURING DEFINED
You first need to determine how the state defines manufacturing by examining the relevant state laws and regulations.
For example, Pennsylvania Code 32.1 defines manufacturing as “an integrated series of operations which places personal property in a form, composition or character different from that in which it was acquired.” In Pennsylvania, activities that qualify as manufacturing include compounding, fabricating, and processing. Research and quality control activities are also considered part of a company’s manufacturing operation.
THE PROCESS
What is manufacturing? In Commonwealth v. Air Products and Chemicals, Inc.[1], the Pennsylvania Supreme Court ruled that conversion of a liquid to a gas was a sufficient change in “form, composition or character.” Conversely, the PA Commonwealth Court held that assembling pre-cooked frozen ingredients into frozen sandwiches and other entrees to be sold at wholesale was not manufacturing.[2] The court held that merely assembling pre-cooked frozen food ingredients in a package does not qualify as manufacturing. For a taxpayer to qualify under the manufacturing exemption in Pennsylvania, there must be a physical change in form to the product.
THE INCLUSION
What is the scope of the manufacturing exemption? The exemption generally includes machinery and equipment and consumable supplies used in the manufacturing process. Most states require exempt property to be “used directly” in production (i.e., the direct use standard). State statutory definitions stress that the property is essential to the production process and actually touches the in-process product. According to the Pennsylvania Department of Revenue’s guidance, manufacturers are exempt on purchases of property that will be incorporated into the product and materials and supplies “predominantly and directly used” to produce the product. The property must be used more than 50% of the time in manufacturing operations to be considered a predominant use.[3]
Pre-production, post-production, and administrative items are not exempt from sales tax under the Pennsylvania manufacturing exemption. Pennsylvania Code 32.1 further defines the manufacturing operation as “the series of production activities, beginning with the first production operation ending with the packaging of the final product for the ultimate consumer.” Activities such as collecting, weighing, or storing raw materials and loading or delivery of packaged goods to the consumer will not qualify for the sales tax manufacturing exemption.
THE EXPANSION
Other states take a much broader view of what items qualify under the sales tax manufacturing exemption, applying the “integrated plant theory” to define the parameters of the exemption. Under the integrated plant theory, machinery and equipment that is necessary and essential to the manufacturing process can be exempt from tax. Integrated exemptions frequently cover all production-related activities on the plant site, starting with the handling and storage of raw materials and ending with the conveyance of finished products to initial storage at the plant site, including product packaging. Integrated exemptions may also include “one-step removed” activities, such as quality control, fabrication of equipment or tools, and specialized maintenance activities.
THE MISSED OPPORTUNITY
Some businesses may not be taking full advantage of the tax savings available to them under the sales tax manufacturing exemption. For example, almost 30 states exempt utilities like water, gas, and electricity used in the manufacturing process. In order to qualify for a utility sales tax exemption, a business is typically required to perform an on-site “utility study.” A utility study analyzes the use of utilities for each piece of equipment (both production and non-production) serviced by the utility meters at a company’s facility. If a utility meter is used predominantly for production, some states allow the sales tax exemption for all of the energy consumed through that meter. Most states require utility studies to be certified by a licensed engineer.
THE EXEMPTION
As you can see, manufacturing businesses may significantly reduce their sales tax liabilities by carefully analyzing allowable sales tax exemptions in states where they have production and research facilities.
[1] 475 Pa. 318, 380 A.2d 741 (1977),
[2] Quality Driven Copack, Inc. v. Commonwealth of Pennsylvania, No. 879 F.R. 2013 (2021)
[3] PA Code 32.32(a)(2)