United States: The Long And Narrow Road To A Sales Tax Exemption Supplies And Industrial Tools

Sales and use taxes are significant sources of revenue for the Commonwealth, generating over three billion dollars each fiscal year. However, recognizing the importance of manufacturing to the state, the General Assembly enacted several exemptions from the taxes to encourage manufacturers to locate and remain in Kentucky.

When considering the sales and use tax liability of manufacturing companies, two important exemptions should be kept in mind: the exemption for materials, supplies, and industrial tools and the exemption for machinery for new and expanded industry.  Because there seems to be little dispute about what constitutes raw materials, this article focuses upon the exemption for supplies and industrial tools; in a future article we will address the exemption for machinery for new and expanded industry.

The Exemption for Supplies and Industrial Tools in KRS § 139.470(10)

The exemption for supplies and industrial tools is based on the theory that sales tax should only be collected once – when the final product is sold to its end user. Therefore, supplies and industrial tools "used up" during the manufacturing process should not be taxed. While this is a great "theory," manufacturers know the Kentucky Department of Revenue (KDOR or Department) is really stingy when it comes to allowing exempt purchases of supplies and industrial tools. Instead, the KDOR treats most of these purchases as taxable repair or replacement parts. A recent case (described below) illustrates problems that may be encountered when claiming an exemption from tax for the purchase of industrial tools.

Before turning to the case, some definitions and background are necessary.

To qualify for the exemption, the supplies and industrial tools must be "directly used in manufacturing or industrial processing" and must have a useful life of less than one year.  According to the statute, "supplies" include lubricating and compounding oils, grease, machine waste, abrasives, chemicals, solvents, fluxes, anodes, filtering materials, fire brick, catalysts, dyes, refrigerants, explosives, etc."

"Industrial tools" include "hand tools such as jigs, dies, drills, cutters, rolls, reamers, chucks, saws, spray guns, etc., and . . . tools attached to a machine such as molds, grinding balls, grinding wheels, dies, bits, cutting blades, etc."  Unlike supplies, industrial tools normally must come into direct contact with the product being manufactured to qualify for the exemption.

KDOR's Narrow Interpretation of the Exemption

Although it has the potential to result in significant cost savings for manufacturers, as the title of this article suggests, the KDOR has taken an increasingly narrow interpretation of the exemption for supplies and industrial tools. With respect to industrial tools, for example, the Department has strictly interpreted the requirement that such tools come into "direct contact" with the product being manufactured. The Department has construed this requirement to mean the industrial tools must act upon the product to change its size, shape or character.

As previously stated, the Department finds a vast majority of purchases to be taxable because they are deemed to be purchases of "repair, replacement or spare parts" which are not exempt from tax. The statute states that "[r]epair, replacement or spare parts shall not be considered to be materials, supplies or industrial tools directly used in manufacturing or industrial processing."  "Repair, replacement, or spare parts" are defined as "any tangible personal property used to maintain, restore, mend or repair machinery or equipment" and do not include "machine oils, grease or industrial tools."

For instance, the Department has taken the position that chemicals used to maintain machinery and equipment do not qualify for the exemption because they are by definition repair and replacement parts. The tension between the requirement that industrial tools have a useful life of less than one year and the exclusion of repair, replacement and spare parts from the exemption is illustrated in the recent case of Progress Metal Reclamation Company v. Department of Revenue[1], currently pending before the Kentucky Supreme Court.

Progress Metal Reclamation Company v. Department of Revenue

The taxpayer, Progress Metal Reclamation Company, operates a metal processing business in Ashland, Kentucky. Part of its business involves cutting metal so it can be placed in a furnace and melted. This process employs torches that use a mixture of acetylene and liquid oxygen to create temperatures hot enough to cut the metal, and hammers that break large pieces of metal into smaller pieces. Pins hold the hammers in place; hammer pins have a useful life of two weeks to one month.

During a sales tax audit, the KDOR treated both liquid oxygen and hammer pins as taxable. Progress Metal protested the audit assessment. The company argued the hammer pins are exempt as industrial tools because they function as "chucks" or "tool holders," which are expressly listed in the statute as exempt, and the hammer pins have a useful life of less than one year. The Department argued the hammer pins are not industrial tools, but are repair or replacement parts.

Progress Metal also maintained liquid oxygen is exempt as an industrial supply, noting that the Department previously had exempted liquid oxygen between tax 1965 and 2004.  Progress Metal argued the Department's change of position violated a legal doctrine known as "contemporaneous construction," which provides that an agency may not unilaterally revoke its own longstanding interpretation of a statute. In revoking the exemption, the Department asserted the liquid oxygen was an energy producing fuel and not an industrial supply.

On March 13, 2015, the Court of Appeals issued an opinion affirming the decisions of the lower court and Kentucky Board of Tax Appeals. The court addressed the Department's treatment of liquid oxygen and found the doctrine of contemporaneous construction prohibited the Department from abandoning its "four-decade long pattern" of exempting liquid oxygen from tax as an industrial supply. Regarding Progress Metal's use of hammer pins, the court held the hammer pins are not "industrial tools" but instead are "replacement parts" not exempt from taxation. The court noted that, at best, the hammer pins only have incidental contact with the metal the mechanical hammer destroys, and the hammer pins simply "wore out" and are not intended to be "used up" in the manufacturing process.

Progress Metal has asked the Kentucky Supreme Court to review the case.

The holding of the Court of Appeals results in a very narrow interpretation of the exemption that thwarts the legislature's goal of encouraging manufacturing in the Commonwealth. Hopefully, the Kentucky Supreme Court will weigh in on this issue and hold that the industrial tools exemption must be construed more broadly, in accordance with the General Assembly's intent. In any event, Progress Metal is a case that could have major implications for the manufacturing industry for years to come.

[1] Case Nos. 2013-CA-1765 and 2013-CA-1776 (Ky. App. Mar. 13, 2015), motion for discretionary review filed, Kentucky Supreme Court, No. 2015-SC-175-D (Apr. 9, 2015).

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