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Tax Exemptions for Manufacturers

Manufacturing is a very important segment of Kentucky’s economy and has been for many years.  Its importance to Kentucky is particularly evident in the sales tax arena.  Ever since Kentucky enacted its sales tax in 1960, there have been exemptions provided specifically for manufacturers.  While these sales tax exemptions certainly encourage businesses to locate their manufacturing facilities in Kentucky, they also perform another important function – avoiding tax pyramiding, a form of multiple taxation.  

In the context of a sales tax, tax pyramiding occurs when a particular good is taxed multiple times in the course of its manufacture, distribution and sale to the end user.  The Commonwealth of Kentucky has long recognized the evils of tax pyramiding.  In one of Kentucky’s very first sales tax cases, George v. Scent, 346 S.W.2d 784 (Ky. 1961), the Commonwealth’s then Highest Court recognized that the “pyramiding of taxes” would “visit an oppression” on taxpayers and refused to interpret Kentucky’s newly enacted sales tax to do so.  

To prevent pyramiding of the sales tax on multiple sales of the same finished good in a chain of distribution – a sale by a manufacturer to a distributor, then a sale to a retailer, and a sale  to a consumer – the sales tax excludes a sale for resale from the definition of a taxable retail sale.  See KRS 139.010(18).  Without the resale provision, a finished good could be subject to tax up to three times (or perhaps more), but with it, a finished good should be (in theory) subject to sales tax only once 

In the context of manufacturing, exemptions are also essential to prevent pyramiding of sales tax on the various inputs that go into and the processes involved in the manufacture of a finished good.  Among others, three important manufacturing exemptions are those for: [i] manufacturing materials, supplies and industrial tools; [ii] energy used in manufacturing; and, [iii] manufacturing machinery.  Each plays an important part in preventing (or at least, the lessening of) the pyramiding of Kentucky’s sales tax.  

Manufacturing Materials, Supplies and Industrial Tools

Items purchased to be used in manufacturing or industrial processing at a plant of a good for sale, i.e., manufacturing materials, are regarded as having been purchased for resale, and are thus, exempt from sales tax pursuant to KRS 139.470(11).  This is fundamental.  

The manufacture of a good, however, entails more than simply putting items together.  Other items are consumed in manufacturing a good such as industrial supplies, industrial tools and materials that become an ingredient or component part thereof, and KRS 139.470(11)(a)2 provides an exemption for these categories of tangible personal property that are “directly used in manufacturing or industrial processing, if the property has a useful life of less than one (1) year.”   

Interestingly, this exemption began as an administrative regulation and was later codified by the General Assembly in the early 1990’s.  Perhaps it is this heritage that explains the examples of industrial supplies set forth in the exemption statute itself.  By statute, examples of exempt industrial supplies include, “lubricating and compounding oils, grease, machine waste, abrasives, chemicals, solvents, fluxes, anodes, filtering materials, fire brick, catalysts, dyes, refrigerants, explosives, etc.”  KRS 139.470(11)(a)2.b.  Examples of industrial tools include, “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.”  KRS 139.470(11)(a)2.c.  

As is apparent from the examples themselves, many industrial supplies and tools are used in the operation of manufacturing machinery.  For example, a manufacturer will often use a boiler to produce steam for use in its manufacturing processes.  Chemicals can be essential to the operation of such a boiler, and thus, chemicals so used have been held to be exempt from sales tax.  See e.g., Schenley Distillers, Inc. v. Commonwealth, 467 S.W.2d 598 (Ky. 1971).  

Even with this exemption, a good’s cost of manufacture may include some amount of sales tax.  For example, it is important to note that the exemption provided for by KRS 139.470(11) does not include repair, replacement or spare parts.  KRS 139.470(11)(b).  As a bit of historical context, the 1994 General Assembly enacted this quite specific carve-out less than two years after the Kentucky Court of Appeal’s decision in Revenue Cabinet v. Armco, Inc., 838 S.W.2d 396 (Ky. App. 1992), which held that the KRS 139.470(11) exemption extended to certain parts.  Not surprisingly, whether an item is an exempt industrial supply versus a non-exempt repair part can be a significant issue.  See e.g., Revenue Cabinet v. Lexington Herald-Leader Co., No. 1998-CA-001481-MR (Ky. App. 2001).  And, manufacturers continue to wrestle with it.

Energy Used in Manufacturing

Manufacturing finished goods necessarily entails the use of energy in some form or fashion.  In apparent recognition of this, the General Assembly has provided KRS 139.480(3) which exempts from sales tax all energy or energy producing fuels (and related distribution, transmission, and transportation services) used in the course of manufacturing or processing to the extent that the costs of the energy or fuel exceeds 3% of the manufacturer’s cost of production.  When you do the math, the 3% threshold can appear to be a high hurdle – depending on the ratio of energy costs to other costs of production.  As such, a question often arises as to which manufacturing operations and what costs a business must include in computing the three percent threshold.  

The seminal case on this issue is Revenue Cabinet v. James B. Beam Distilling Co., 798 S.W.2d 134 (Ky. 1990).  In that case, the Kentucky Supreme Court held that, “It seems only logical that a taxpayer which can demonstrate that the operation for which the exemption is claimed is a truly separate and complete operation, not dependent on the other operations at that site for production of a completed product or process, need not include the costs of the other unrelated operations in its costs of production for that one operation.”  

Quite recently, in Department of Revenue v. Rohm and Haas Co., No. 2008-CA-000022 (Ky. App. Feb. 6, 2009), the Court of Appeals considered the application of the energy exemption to Rohm and Haas’ operations, which consisted of three operations:  distilling, plexi-glass and emulsions.  The distilling operation produced a product that was both used in the downstream processes (plexi-glass and emulsions) and sold to third parties.  The Court relied on Jim Beam in holding that Rohm and Haas’ distilling operation was separate from its other operations for purposes of computing the cost of production component of the energy exemption to which it was entitled.  

Manufacturing Machinery

Although not all manufacturing machinery is exempt from sales tax, machinery for new and expanded industry is exempt.  See KRS 139.480(10).  Machinery qualifies for this exemption when it: [i] is used directly in manufacturing; [ii] is incorporated for the first time in a Kentucky plant facility; [iii] does not replace existing machinery, unless it increases consumption of recycled materials by not less than 10%, performs different functions, manufactures a different product, or has a greater productive capacity (measured in units of production) than the machinery replaced.  See KRS 139.010(13). See also 103 KAR 30:120.  

A quick read of this exemption raises multiple issues.  A fundamental issue is where does a manufacturer’s manufacturing process begin and end?  Another is what processes are included in the manufacturing process?  The first time incorporation in Kentucky requirement raises other issues.  Moreover, as a piece of machinery that merely replaces another, it is critical to determine if new machinery does something other than merely replace another piece of machinery.  Administrative Regulation 103 KAR 30:120 provides some insight as to the Department of Revenue’s administrative position as to these issues.  

Future Legislation?

There have been reports that there may be a Special Session of the General Assembly called in the late spring or early summer.  The restructuring of some of Kentucky’s tax systems – including sales tax – could be considered.  

Although the form of restructuring, if any, is unknown, H.B. 51, a Bill proposed in the 2009 General Assembly, may provide one possible view of the future.  H.B. 51, if enacted, would have eliminated the personal and corporate income tax as well as the limited liability entity tax.  And, it would have dropped the sales tax rate from 6% to 5%.  To replace the revenue loss from making these changes and perhaps to raise additional revenue, H.B. 51 would have expanded the sales tax to many services (e.g., real estate services, repair and maintenance services, drycleaning and laundry services, etc.) and eliminated many sales tax exemptions including those for energy used in manufacturing and machinery for new and expanded industry. 

It would seem that these three manufacturing exemptions, which form part of the bedrock of Kentucky’s sale tax structure, could be expected to endure, but manufacturers cannot take them for granted.  Ironically, the removal of one or more of these three exemptions would result in at least some amount of pyramiding of Kentucky’s sales tax.  Be vigilant.



About the author: Mark A Loyd, Esq., CPA, is a member of Greenebaum Doll & McDonald in Louisville and chairs its State and Local Tax Team. He is a member of the KyCPA board of directors; chair of the editorial board; member of the industry task force; and former chair of the taxation committee. He can be reached at mal@gdm.com; 502.587.3552.

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