United States: Morton Buildings Does it Again - The Indiana Tax Court Recognizes Advantage of the Manufacturing/Fabricating use tax "Loophole"

The Indiana Tax Court (the "Court") recently held that the Indiana use tax is inapplicable to raw materials acquired outside of Indiana and subsequently brought into the state after such materials had been substantially transformed into building components. These building components, fabricated with such raw materials, also are excluded from the Indiana use tax because they are not acquired in a "retail transaction" as required by the Indiana statute. Morton Buildings, Inc. v. Ind. Dept. of State Rev., 2004 Ind. Tax LEXIS 117, No. 49T10-9812-TA-187 (Ind. Tax Ct. 2004).

Morton Buildings, Inc. ("Morton") prefabricates agricultural and industrial warehouses and buildings. Morton fabricates building components, including trusses, lower columns, upper columns, purlins, metal panels and overhang rafters, from raw materials acquired in bulk from vendors outside of Indiana. The building components generally are uniform, subject to limited modifications that may be requested by customers. Fabrication of the building components takes place outside of Indiana, and all inventories of raw materials are held outside of the State.

Once fabricated, the building components are shipped to customers located in Indiana. Morton employees then erect the building on-site for the customer. The contract between the customer and Morton is a lump-sum contract that includes the cost of the raw materials, fabrication of the building components, and delivery and erection of the completed building.

Morton paid use tax on the raw materials used in the fabrication of building components delivered to Indiana customers to the Indiana Department of State Revenue (the "Department") from January 1, 1993 through September 30, 1998. Morton then filed refund claims for these amounts paid with the Department in both 1995 and 1998. The Department did not act on these claims for refund which, under Indiana law, acts as a denial of the claim. On December 10, 1998, Morton filed an appeal with the Indiana Tax Court contesting the Department’s failure to refund the use tax paid.

Indiana imposes a use tax complementary to its sales tax. The Indiana use tax statute provides that the tax is imposed on the storage, use, or consumption of tangible personal property in Indiana if the property was acquired in a retail transaction, regardless of the location of that transaction or of the retail merchant making that transaction. The Court construed this statute as requiring two elements: (1) that tangible personal property must be stored, used, or consumed in Indiana and (2) that tangible personal property must be acquired in a retail transaction.

The Court noted that Morton was not claiming an exemption from use tax statute, but rather that the use tax statute was inapplicable to its activities. The relevant question as framed by the Court was one of statutory construction, requiring that the statute be strictly construed against the taxing authority with any ambiguity resolved against the state and in favor of the taxpayer.

Morton contended that the raw materials were used entirely in factories outside of Indiana by virtue of their fabrication into building components. After their fabrication into the building components, the raw materials lost their identity as such and were separate and district items. Because the building components were not acquired in a retail transaction as required by the Indiana statute, the components were likewise exempt from the Indiana use tax.

The Department asserted that the Court should not distinguish between the raw materials and the building components because the raw materials maintained their identity following fabrication into the building components. As a result, the raw materials were subject to the Indiana use tax because both elements of the test were satisfied: the raw materials were acquired in a retail transaction and were used in Indiana.

The Court narrowed its focus to the key issue of whether the raw materials lost their identity as such and became a new item of tangible personal property, the building components. If the raw materials lost their identity as raw materials, the Court reasoned that the raw materials could no longer be "used" following fabrication. For guidance on this issue, the Court looked to the manufacturing exemption applicable in Indiana. The exemption generally provides that manufacturing equipment is exempt from tax if it is essential to the process of transforming property into something different from that in which it was acquired and that the change in form must be a substantial change. Further, the change must result in a transformation of property into a different product having a distinct name, character, and use.

Applying this standard, the Court held that the raw materials substantially changed appearance, character and utility through Morton’s extensive production process sufficient to render the building components different from the raw materials used to fabricate them. The Court further held that the building components themselves are excluded from the Indiana use tax because they are not acquired in a retail transaction. Consequently, neither the raw materials nor the building components fabricated from the raw materials were subject to the Indiana use tax.

Interestingly, the Court acknowledged that Morton had exposed and taken advantage of a loophole in the use tax imposition statute but concluded that it was the Indiana Legislature’s responsibility to correct that loophole. Legislatures in other jurisdictions faced with a similar dilemma have amended their use tax statutes to specifically subject taxpayers conducting operations similar to Morton to the use tax. These states include Connecticut, Massachusetts, Minnesota, New York, Texas and Wisconsin. For example, the Texas Legislature amended its use tax statute to specifically provide that "‘use" means the right of power over tangible personal property, that has been processed, fabricated, or manufactured into other property or attached to or incorporated into other property transported into Texas.

Morton has chosen to litigate this issue in several states prior to its challenge to the Indiana use tax. In addition to the states enumerated above, Morton has achieved victory on this issue in Colorado and Missouri. Given the various state legislatures’ general reaction of amending its statutes to subject such materials to the use tax, taxpayers similarly situated to Morton should carefully review those states’ laws into which they import prefabricated items. The time for filing protective refund claims may be rapidly drawing to a close given the states’ propensity for quickly amending its statutes to address this situation.

We have been informed that the Indiana Department of Revenue will file an appeal to the Indiana Supreme Court but that it is a discretionary appeal.

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