Is contract manufacturing (making goods from a customer's own raw materials) a non-taxable service, and does doing some of it cost a manufacturer the machinery exemption under § 39-26-709?
Plain-English summary
A company uses its machinery and machine tools to make tangible personal property. Sometimes it makes goods from its own raw materials and resells them; other times the customer supplies the raw materials (and keeps title to them), and the company just makes the product and hands it back — classic contract manufacturing. The company predominantly uses its own materials. It asked two things: (1) Is contract manufacturing a service? (2) If so, does doing some of it jeopardize the manufacturing machinery exemption under § 39-26-709?
Is contract manufacturing a service? Yes. Colorado generally doesn't tax services. When a retail manufacturer makes and sells a product, it can't carve out the "service" of manufacturing to shrink the taxable price — § 39-26-102(12) folds the labor and service into the full purchase price. But when the customer supplies all the raw materials, the manufacturer transfers no tangible personal property back to the customer, so there's no taxable sale between them. The deal is purely a service, and sales/use tax doesn't apply to that service transaction. (The Department cited its earlier GIL-12-005 for the same point.)
Does that cost you the machinery exemption? No — and the Department didn't even need to decide the hard version of the question. Machinery and machine tools used in manufacturing are exempt from state sales and use tax under § 39-26-709, provided (among other requirements) they are used directly and predominantly to manufacture tangible personal property for sale or profit. The interesting question — whether the exemption survives when a manufacturer only performs the service of contract manufacturing and never sells the finished good — the Department found unnecessary to reach, because this company predominantly uses its own materials to make goods it then sells. The exemption doesn't require exclusive exempt use, only predominant exempt use, so the company's machinery appears exempt.
The Department flagged, but didn't resolve, a deeper theory: the parallel ingredients-and-components exemption exists to avoid pyramiding of tax through the manufacturing chain and so applies only when the finished good is sold at retail — pyramiding "arguably does not occur" in pure contract manufacturing. But the machinery exemption, it noted, may simply exist to reduce the tax burden on manufacturing and be allowed even without pyramiding. (This same contract-manufacturing-and-machinery theme recurs in [[gil-17-016-manufacturing-machinery]].)
What this means for you
Manufacturers who make goods from customers' materials
If your customer supplies all the raw materials and keeps title, your charge is for a service and isn't subject to Colorado sales or use tax — there's nothing being sold. But be careful: if you supply any of the materials that end up in the customer's product, you're transferring property and the analysis shifts toward a taxable sale, and you can't relabel the making of it as a tax-free "service."
Manufacturers worried about the machinery exemption
Doing some contract-manufacturing work doesn't automatically blow your § 39-26-709 machinery exemption. The test is predominant exempt use, not exclusive use — so as long as your equipment is used mostly to make goods you sell for sale or profit, it can still qualify. Track the mix of how your machinery is actually used.
Accountants and tax professionals
The service-vs-sale line turns on whether any property is transferred to the customer (§ 39-26-102(12) pulls manufacturing labor into the price when there is a sale). The machinery exemption (§ 39-26-709) hinges on "directly and predominantly … for sale or profit," and the Department expressly left open whether pure contract manufacturing (no retail sale of the output) qualifies — a fact pattern worth a binding PLR if it's yours. Note the equipment qualifications in the footnotes (Colorado use; former federal investment-tax-credit "section 38 property" character; >$500 invoice; capitalized; used-equipment cap of $150,000/yr).
Common questions
Q: Is contract manufacturing taxable in Colorado?
A: When the customer supplies all the raw materials and you only perform the work, no property is transferred to the customer, so it's a non-taxable service rather than a sale.
Q: Can a manufacturer separately state "manufacturing labor" to reduce sales tax on a product it sells?
A: No. When you make and sell a product, § 39-26-102(12) includes the materials, labor, and service in the full taxable purchase price. You can't carve out the manufacturing as a tax-free service.
Q: Does doing contract manufacturing cost me the machinery exemption?
A: Not if your machinery is still used directly and predominantly to make goods for sale or profit. The exemption requires predominant — not exclusive — qualifying use.
Q: What if I ONLY do contract manufacturing and never sell the finished goods?
A: The Department didn't decide that here, because this company predominantly used its own materials and sold the output. Whether the machinery exemption reaches a pure contract manufacturer who never sells the product is an open question — a good candidate for a binding private letter ruling.
Q: Can I rely on this letter?
A: No. A General Information Letter is general guidance and is not binding on the Department; it makes no determination on any specific facts. It also doesn't cover self-collected home-rule city taxes.
Citations and references
Statutes and rules:
- § 39-26-709, C.R.S. (manufacturing machinery and machine-tools exemption; "directly and predominantly … for sale or profit")
- § 39-26-102(12), C.R.S. (purchase price includes materials, labor, and service in manufacturing)
- Department Rule 24-35-103.5 (GIL / PLR procedure)
Department guidance:
- GIL-12-005 (04/04/2012) (customer-supplied materials = non-taxable service)
Related rulings in this library:
- [[gil-17-016-manufacturing-machinery]] (machinery exemption reaches contract manufacturing even when finished goods aren't sold)
Source
- Landing page: Colorado Sales & Use Tax Letter Rulings
- Original PDF: GIL-15-004.pdf
Original ruling text
Office of Tax Policy, P.O. Box 17087, Denver, CO 80217-0087 ([email protected])
GIL-15-004 — January 30, 2015
Re: Contract Manufacturing
You submitted on behalf of your client (the "Company") a request for guidance to determine whether equipment used in manufacturing and contract manufacturing is eligible for the manufacturing machinery exemption pursuant to § 39-26-709, C.R.S. […] The Department initially treats your request as one of a general information letter.
Issue
- Is contract manufacturing a service?
- If it is a service, how does it affect the manufacturing machinery exemption set forth in § 39-26-709, C.R.S.?
Background
Company uses its machinery and machine tools to manufacture tangible personal property from raw materials that are either purchased by the Company or supplied by customers. When the customer supplies the raw materials, the customer will receive the product manufactured from their raw materials. Customer will own and retain title to, and security interest in, all raw materials necessary to manufacture its products. Company predominantly uses its machinery and machine tools to manufacture goods from its own raw materials and that it subsequently resells.
Discussion
1.) Contract manufacturing. In general, Colorado does not levy sales or use tax on services. However, sales tax on manufactured goods includes any charge by a manufacturer for the labor used to produce a product. [§ 39-26-102(12), C.R.S.] For example, a retail manufacturer of tangible personal property cannot separately state a charge for the "service" of manufacturing its product and, thereby, exclude that cost from the sales tax calculation. However, when a customer supplies all the raw materials used by the manufacturer to manufacture the product, then there is no transfer of tangible personal property from the manufacturer to the customer and therefore no taxable sale between the manufacturer and customer. In such cases, the transaction is solely one for services and sales and use tax does not apply to that service transaction. [See also GIL-12-005, 04/04/2012.]
2.) Manufacturing machinery exemption. Purchases of machinery or machine tools and parts thereof are exempt from state sales and use tax when the machinery is used in manufacturing. [§ 39-26-709, C.R.S.] In addition to other qualifications, the machinery or machine tools must be used directly and predominantly to manufacture tangible personal property for sale or profit. The question posed in this general information letter is whether the manufacturing machinery exemption applies if the manufacturer does not sell the manufactured product but, rather, performs the service of manufacturing for a customer who owns all the materials used to manufacture the product and the customer either uses or sells the manufactured product. We think it is unnecessary to reach this question because Company predominantly uses its own raw ingredients to manufacture products that it subsequently sells. The manufacturing machinery exemption does not require the machinery or machine tools to be used exclusively in an exempt manner — the exemption applies when the machine and machine tools are predominantly used in an exempt manner. Therefore, Company's purchase of manufacturing machinery appears to be exempt from sales or use tax.
[Footnote on qualifications: To qualify, the machinery must (1) be used in Colorado; (2) be used directly and predominantly to manufacture tangible personal property for sale or profit; (3) be of a nature that would have qualified for the federal investment tax credit under "section 38 property" of the Internal Revenue Code of 1954, as amended (tangible personal property with a useful life of one year or more; used-equipment purchases limited to $150,000 annually); (4) be included on a purchase order or invoice totaling more than $500; and (5) be capitalized. (For machinery used solely and exclusively in an enterprise zone, see § 39-30-106, C.R.S.)]
[Footnote on pyramiding: The language in the manufacturing machinery exemption is notably similar to the exemption for ingredients and components used to manufacture products. The latter exemption applies to avoid pyramiding of sales tax in the manufacturing process and therefore applies only if the manufactured good is subject to a retail sale. That pyramiding arguably does not occur for contract manufacturing because the manufacturer does not sell the manufactured good. However, the manufacturing machinery exemption may simply be an exemption to reduce the tax burden on manufacturing and allowed even in the absence of pyramiding taxes.]
Miscellaneous
This letter represents the good faith opinion of Department personnel who are knowledgeable on state taxes issues. However, the Department does not make a specific determination here on any of the issues raised and the Department is not bound by this general information letter. The Department administers state and state-administered local sales and use taxes; this letter does not address sales and use taxes administered by home-rule cities and home-rule counties.
(Condensed from the official PDF; see the linked source for the complete text and footnotes.)