Kentucky: Supplies, Including Refractory Materials, Held Exempt from Sales Tax
A Kentucky circuit court recently overturned a ruling of the Kentucky Board of Tax Appeals (“Board”) (now the Kentucky Claims Commission), holding that supplies, including refractory materials, that are completely consumed in the manufacturing process are exempt from sales tax. Novelis Corp. v. Department of Revenue, No. 16-CI-000189 (Madison Cir. Ct. Jul. 2, 2019). Kentucky’s supplies exemption statute lists by name certain manufacturing supplies, like fire brick. Below, the taxpayer, which processes aluminum cans, had argued that the refractory materials it used in its manufacturing process were similar to fire brick. The Board disagreed, and said the materials were not fire brick and thus were not exempt.
Reviewing the case de novo, Madison Circuit Court held that the Board’s decision was not supported by substantial evidence, given testimony that “refractory” meant the same thing as “fire brick.” The Court also held that the statute was not meant to be an exhaustive list of supplies which might be exempt, but rather was meant to provide examples. The Court also disagreed with the Kentucky Department of Revenue (“Department”), which argued that tangible personal property is a taxable repair or replacement part if it is used to repair or replace another piece of tangible personal property used in the manufacturing process. The Court reasoned that if the Department’s interpretation of the statutes were correct, it would essentially eliminate the availability of the exemption all together.
The Court also relied on another recent case which arrived at a similar result in favor of a manufacturing taxpayer. In Century Aluminum of Kentucky, GP v. Commonwealth of Kentucky Finance & Admin. Cabinet, Dep’t of Revenue, No. 17-R-39, Order No. K-25903 (KCC Mar. 27, 2019), the Kentucky Claims Commission (“Commission”) held that the Department incorrectly interpreted KRS 139.470 and its relation to KRS 139.010(35) in denying refund claims to Century Aluminum of Kentucky, GP (“Century”) for sales and use tax paid on certain parts, including anode inductotherm lining; thermocouples and tube assemblies; welding wire and industrial gases; refractory material used to seal pots and keep gases from escaping; refractory paper used in the inductotherm furnace; and refractory material used to fill holes between firebricks in the carbon bake furnace (“parts at issue”). Century argued that these were exempt supplies under KRS 139.470(9)(a)(2)(b). The Department argued they were a taxable repair, replacement or spare parts under KRS 139.470(9)(d).
In finding for Century, the Commission focused on the relationship between KRS 139.470(10)(a)(2)(b) (the supplies exemption) and KRS 139.010(35) (the repair, replacement and spare parts clause). The Department argued that if any part can be construed as affecting any piece of machinery or equipment, then it is a taxable repair, replacement or spare part. But, this interpretation of the test would render the supplies exemption virtually meaningless, as practically all exempt supplies can fit this definition of repair, replacement or spare parts. The Commission noted the absurdity of this analysis in the case of firebrick, which, unlike other parts, is specifically mentioned in the supplies exemption statute.
The Commission stated that the test to determine whether a part is an exempt supply or a taxable supply is whether it is intended to be used up or if it simply wears out. The Commission defined the test as follows:
- Determine the useful life of the tangible personal property at issue if the machine or equipment that the tangible personal property allegedly maintains, restores, mends, or repairs is operating without the introduction of the product being manufactured.
- Determine the useful life of the tangible personal property at issue if the machine or equipment that the tangible personal property allegedly maintains, restores, mends, or repairs is operating with the introduction of the product being manufactured.
- If there is a difference in the useful lives of the tangible personal property between a. and b. above then the tangible personal property is being consumed in the manufacturing process and is exempt from tax.
- If there is no difference in the useful life of the tangible personal property between a. and b. above then the tangible personal property is a taxable repair, replacement or spare part.
Applying this test, the Commission found that each of the items at issue was designed to be used up during the manufacturing process and was exempt under KRS 139.470(10).
The intricacies of Kentucky’s supplies exemption can be difficult to successfully navigate and argue, even when the items are explicitly identified as exempt in the statute, which incorporates examples of manufacturing methods prevalent in the 1960’s. Translating these to the 21st Century can be a challenge, but one that is eminently valuable.
We’ll be keeping our eyes on the Novelis and Century Aluminum cases; the Department has appealed to Franklin Circuit Court in Century Aluminum.