United States: Taxation Of Clean Rooms

Originally published in 5/10/2001

The Arizona Legislature has provided substantial tax benefits for clean rooms and their equipment. For property tax purposes, clean rooms will be treated as personal property and thus will be eligible for accelerated depreciation, and will not be taxed while under construction.

On the sales and use tax side, there is an exemption for the sale of clean room machinery and equipment. Additionally, the installation, assembly, maintenance and repair of clean rooms will not be subject to tax under the prime contracting classification.

II. VALUATION OF CLEAN ROOMS AS PERSONAL PROPERTY.

As background, although the Department of Revenue in its Personal Property Manual, characterized clean rooms as personal property (see Chapter 2, Table 2.2, p. 2.15), the Maricopa County Assessor had taken the position that clean rooms should be considered a part of the building and valued as real property. As personal property, the clean rooms would be entitled to accelerated depreciation and would not be taxed during construction. On the other hand, if they were treated as a part of the structure and valued as real property, their useful life would be much longer and they would not be eligible for accelerated depreciation or not being taxed while under construction.

In response to Maricopa County’s position, Laws 1997, ch. 61 (S.B. 1050) clarifies the historical administrative practice of valuing and assessing clean rooms as personal property and to state the intent of the legislature that this historical practice should be continued. This legislation establishes a new A.R.S. § 42-235.04 (now § 42- 15066) which provides as follows:

A. Clean rooms that are used for manufacturing, processing, fabrication or research and development of semi-conductor products shall be valued and assessed as tangible personal property.

B. "Clean room" means all property that comprises or creates an environment where humidity, temperature, particulate matter and contamination are precisely controlled within specified parameters, without regard to whether the property is actually contained within that environment or whether any of the property is affixed to or incorporated into real property. Clean room:

1. Includes the integrated systems, fixtures, piping, moveable partitions, lighting and all property that is necessary or adapted to reduce contamination or to control air flow, temperature, humidity, chemical purity or other environmental conditions or manufacturing tolerances, as well as the production machinery and equipment operating in conjunction with the clean room environment.

2. Does not include the building or a permanent, non-removable component of the building that houses the clean room environment.

III. PROPERTY TAX BENEFITS OF TREATMENT AS PERSONAL PROPERTY.

Following is an overview of the two major tax benefits available to clean rooms as personal property.

Both secured and unsecured personal property construction work in progress is exempt from taxation until the construction work has progressed to a significant degree for the personal property to be used. Once the property is placed in service and is being used, it will generate income, at which time it will be subject to tax. Prior to the time that it generates income, there will be no tax. See A.R.S. § 42-5066. "Personal property construction work in progress" means the amount spent and entered on the taxpayer’s accounting records as of December 31 of the preceding calendar year as construction work in progress.

An accelerated depreciation schedule is available for class three (commercial or industrial) (now class 1.12) and class four (agricultural) (now class 2) personal property. To encourage capital investment in Arizona, the legislature has adopted a four-year accelerated depreciation schedule for class three and class four personal property. The 1998 legislature increased those accelerated depreciation factors, beginning in the 1999 tax (calendar) year. The accelerated depreciation factors are as follows:

These accelerated depreciation factors do not apply to centrally valued property (property valued by the Department).

See A.R.S. § 42-13054.

The minimum value prescribed for Class 3 (now Class 1) personal property is reduced by 2-1/2 percentage points per year for tax years 1996 through 1999, from 20% to a 10% floor (which is the residual value at which the personal property, after all depreciation, will be valued at). Beginning in 2000, the minimum value is reduced again by 2.5% per year for 3 years to a new floor of 2.5% in 2002. See A.R.S. § 42- 13055.

Although clean rooms rarely cost less than $50,000, the first $50,000 of value of personal property is exempt from tax. As background, in the November 1996 general election, the voters approved an amendment to the Arizona Constitution which exempts the first $50,000 by value of personal property from taxation. This exemption is applicable beginning from and after December 31, 1996 (in other words, it applies to the 1997 calendar year). The exemption applies only to personal property in Class 3, (now Class 1.12) commercial and industrial, and Class 4 (now Class 2), agricultural. It does not apply to personal property in other classifications, such as mining properties (Class 1.1) or utilities properties (Class 1.3).

The Department of Revenue must increase the maximum amount of the exemption on an annual basis to take into account inflation. Specifically, on or before December 31 of each year, the Department is to increase the maximum amount of the exemption for the following tax year based on the average annual percentage increase, if any, in the GDP price deflator in the two most recent complete state fiscal years. "GDP price deflator" means the average of the four implicit price deflators for the gross domestic product reported by the United States Department of Commerce or its successor for the four quarters of the state fiscal year. See A.R.S. § 42-280 (now § 42- 11127).

Senate Bill 1007, Chapter 3, Laws 1998, further elaborated on the $50,000 personal property exemption. It expands the exemption to include each location, rather than restricting the exemption to each taxpayer. Thus, a taxpayer with multiple locations, except leasing companies and local telecommunications property, will be entitled to the $50,000 exemption at each location where its personal property is located. This legislation is effective from and after December 31, 1998, so the multiple location exemption will apply beginning in the 1999 property tax year. See A.R.S. § 42-11127. This provision is currently being challenged by Maricopa County in a case pending in the Arizona Tax Court.

Both the sale of clean room equipment is exempt from the sales tax under the retail classification (as well as the use tax) and its installation and assembly is exempt from the sales tax under the prime contracting classification.

Clean rooms that are used for manufacturing, processing, fabrication or research and development of semiconductor products are exempt from the sales tax under the retail classification. See A.R.S. § 42-5061.B.17 (clean rooms are also exempt from the use tax. See A.R.S. § 42-5159.B.17).

Clean rooms are defined to mean all property that comprises or creates an environment where humidity, temperature, particulate matter and contamination are precisely controlled within specified parameters, without regard to whether the property is actually contained within that environment or whether any of the property is affixed to or incorporated into real property. The statutory exemption goes on to clarify that a clean room:

(a) includes the integrated systems, fixtures, piping, moveable partitions, lighting and all property that is necessary or adapted to reduce contamination or to control air flow, temperature, humidity, chemical purity or other environmental conditions or manufacturing tolerances, as well as the production machinery and equipment operating in conjunction with the clean room environment.

(b) does not include the building or permanent, nonremovable component of the building that houses the clean room environment.

In short, the clean room exemption applies to all of the necessary machinery and equipment used in a clean room environment except for the building that houses the clean room environment.

Not only is clean room machinery and equipment exempt from the sales and use tax, but its installation, assembly or repair is exempt from the sales tax under the prime contracting classification. Specifically, the gross receipts of a contractor from the installation, assembly, repair or maintenance of clean rooms is deductible from the prime contracting classification, where the clean rooms in question qualify for the sales tax exemption under A.R.S. § 42-5061.B.17 (see above). Thus, if the clean room equipment qualifies for exemption from the sales tax under the retail classification (or the use tax), then its "installation, assembly, repair or maintenance" will not be taxable under the prime contracting classification. See A.R.S. § 42- 5075.B.12.

Retroactive Effective Date. This deduction for the installation of clean room equipment is retroactive to December 31, 1989.

Additionally, a contractor that contracts with a manufacturer for the furnishing and installation of clean room equipment does not need to enter into a purchase agency agreement with the owner to act as the owner’s agent in purchasing the exempt clean room equipment in order to deduct the cost of the clean room equipment from its contracting gross receipts. The elimination of the purchase agency requirement is effective January 1, 1999. Previously, for a contractor to be able to deduct the cost of otherwise exempt machinery and equipment that it was furnishing and installing from the prime contracting tax base, that contractor had to enter into a purchase agency agreement with the owner to act as the owner’s agent in purchasing the exempt machinery and equipment. The reason being that the machinery and equipment was under the retail classification of the sales tax statutes and not under the prime contracting classification. This legislation eliminates the need for contractors to enter into a purchase agency agreement with the property owner when selling and installing otherwise exempt machinery and equipment. Additionally, prime contractors are no longer required to enter into a purchase agency agreement for the building materials when performing work for qualifying hospitals and health care centers. The legislation eliminates the purchase agency requirement by listing the machinery and equipment deductions under the prime contracting classification in addition to the retail classification. See A.R.S. § 42-5075.B.9. (Laws 1998, ch. 90 S.B. 1323).

Note: This legislation eliminates the need for a purchase agency agreement at the state level and not at the city level. The Model City Tax Code was also recently amended to eliminate the need for a purchase agency agreement effective retroactively to January 1, 1999.

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