Can an asphalt-making paving contractor qualify for the manufacturing machinery exemption by splitting its paving jobs into separate contracts for the asphalt and the installation?

Plain-English summary

A company makes hot-mix asphalt (bituminous concrete) and works as a paving contractor. On 80% or more of its jobs it applies the asphalt to the customer's surface itself (paving services); on 20% or less it just sells asphalt to buyers who have their own paving equipment. It wanted to qualify for the manufacturing machinery exemption (Conn. Gen. Stat. § 12-412(34)) — which requires an establishment whose predominant (more than 50%) purpose is manufacturing a product to be sold — by re-papering its paving jobs as two separate contracts: one for the sale of asphalt, one for installation.

DRS said no: splitting the contracts doesn't work, and the company does not qualify for the exemption when its paving-service receipts exceed 50% of total sales.

The core rule is that in Connecticut a contractor consumes the materials it incorporates into real property rather than selling them. Road and paving contractors are contractors (Conn. Agencies Regs. § 12-426-18), materials become part of the real property when installed (§ 12-407(2)(i)(I)-1), and Connecticut courts have long held that a contractor uses/consumes its materials rather than reselling them (Fusco-Amatruda Co. v. Tax Commissioner, 168 Conn. 597 (1975); White Oak Corp. v. DRS, 198 Conn. 413 (1986)). A regulation even says that producing an item and installing it into the customer's real property makes you a contractor, not a retailer (§ 12-426-18(d)).

DRS then applied the true object test (used to decide whether a transaction is a sale of services or of tangible personal property — Sanitary Services Corp. v. Meehan; American Totalisator Co. v. Dubno; Andersen Consulting v. Gavin), noting that exemptions are strictly construed against the taxpayer (United Illuminating Co. v. Groppo). Where the company paves a customer's surface with its own asphalt, the customer's true object is a paved surface, not the separate purchase of asphalt — "regardless of the number of contracts used." So on those jobs the asphalt is consumed in performing the paving service, not sold.

The consequence for the exemption: only asphalt sold as a product (with no paving services) can count toward the "more than 50%" manufacturing-plant threshold. Asphalt the company consumes in its own paving can't. Since paving-service jobs are the large majority, the establishment's predominant purpose is not manufacturing a product to be sold, so the § 12-412(34) exemption doesn't apply. (DRS also noted that Massachusetts and Tennessee decisions favoring taxpayers rest on different statutes lacking Connecticut's contractor-consumption rule, while a majority of states agree with Connecticut.)

What this means for you

Paving contractors and asphalt producers

If you install your own asphalt (or concrete) into a customer's real property, Connecticut treats you as consuming that material as a contractor — not selling it — and you cannot re-characterize the job with separate "materials" and "installation" contracts to reach the manufacturing machinery exemption's more-than-50% threshold. Only material you sell without installation counts as a "product to be sold."

Construction contractors generally

The contractor-consumption rule is durable: materials you incorporate into real property are consumed by you, so you generally owe tax on your purchases of them (absent a specific exemption), and paperwork splitting the job doesn't change the true object analysis.

Manufacturers evaluating the § 12-412(34) exemption

To be a "manufacturing plant," an establishment's predominant purpose (>50%) must be manufacturing a product to be sold. Output your business consumes (e.g., in providing a service or a construction result) doesn't count toward that threshold. Exemptions are strictly construed against you, so document genuine product sales.

Common questions

Q: Can I split a paving job into a "materials" contract and an "installation" contract to look like a manufacturer?
A: No. The true object test looks past the contracts — the customer wants a paved surface, so you consume the asphalt as a contractor regardless of how many contracts you write.

Q: Why doesn't the asphalt I make count as a "product to be sold"?
A: Because when you install it yourself, Connecticut treats you as consuming it in performing paving services, not selling it. Only asphalt sold without paving services counts toward the manufacturing threshold.

Q: So when could a paving/asphalt company get the manufacturing machinery exemption?
A: If more than 50% of its sales were of asphalt as a product (sold without installation), the establishment could meet the "manufacturing plant" predominant-purpose test. Here, paving-service jobs were the large majority, so it didn't.

Q: Other states let asphalt pavers claim the exemption — why not Connecticut?
A: DRS explained that the Massachusetts and Tennessee decisions rest on statutes that lack Connecticut's contractor-consumption rule; a majority of states agree with Connecticut's approach.

Citations and references

Statutes:

• Conn. Gen. Stat. § 12-412(34) (exemption for machinery used directly in a manufacturing production process)

Regulations:

• Conn. Agencies Regs. § 12-412(34)-1(a), (c), (d), (e) (defining "manufacturing," "manufacturing production process," "manufacturing plant," and "predominant" (more than 50%))
• Conn. Agencies Regs. § 12-426-18 (construction contracts; road/cement contractors are contractors) and § 12-426-18(d) (producer that installs its product into real property is a contractor, not a retailer)
• Conn. Agencies Regs. § 12-407(2)(i)(I)-1 (materials incorporated into and becoming a permanent part of real property)

Cases:

• Fusco-Amatruda Co. v. Tax Commissioner, 168 Conn. 597, 362 A.2d 847 (1975)
• White Oak Corp. v. Department of Revenue Services, 198 Conn. 413, 503 A.2d 582 (1986)
• United Illuminating Co. v. Groppo, 220 Conn. 749, 601 A.2d 1005 (1992) (exemptions strictly construed against the taxpayer)
• Sanitary Services Corp. v. Meehan, 235 Conn. 393, 665 A.2d 895 (1995); American Totalisator Co. v. Dubno, 210 Conn. 401, 555 A.2d 414 (1989); Dine Out Tonight Club v. DRS, 210 Conn. 567, 556 A.2d 580 (1989); Andersen Consulting, LLP v. Gavin, 255 Conn. 498, 767 A.2d 692 (2001) (true object test)

Source

• Landing page: Connecticut DRS Rulings
• Ruling: Ruling 2005-1

Original ruling text

Ruling 2005-1, Sales and Use Taxes/Contractors/Machinery (Manufacturing)

FACTS:

The Company makes bituminous concrete, otherwise known as hot asphalt, and provides services as a paving contractor. When the Company provides paving services, it uses the hot asphalt it makes, which is a mixture of aggregates (rocks and sand) and asphalt cement, which must be kept hot enough to remain a semi-solid from the time it leaves the Company’s facility until the Company spreads and compacts the hot asphalt on a surface.

In all cases, the asphalt that the Company produces is intended to be installed within a short time, and cannot be stored.  Twenty percent or less of the Company’s sales are made to purchasers that have the equipment necessary to maintain the hot asphalt in a semi-solid state and to spread and compact the hot asphalt on a surface.  Eighty percent or more of the Company’s sales are paving services where the Company applies the asphalt to the customer’s surface.

The Company proposes to treat the paving services as two separate contracts, one for the asphalt and one for installation. The Company states that the prices for the materials and for the labor will be set at arm’s-length and be competitive with businesses that sell only asphalt or installation, and will be separately invoiced.

ISSUE:

Whether the Company can qualify for the manufacturing machinery exemption of Conn. Gen. Stat. § 12-412(34) by satisfying the requirement in Conn. Agencies Regs. § 12-412(34)-1 that it is predominantly (more than 50%) engaged in selling products it manufactures by entering into separate contracts for the sale and installation of asphalt, despite the fact that no more than 20% of its total sales are of asphalt alone, with the balance of the asphalt being consumed by the Company in providing paving services.

RULING:

The Company will not qualify as a “manufacturing plant” for purposes of the manufacturing machinery exemption of Conn. Gen. Stat. § 12-412(34) when the Company’s gross receipts from transactions where the Company performs paving services using its asphalt exceed 50% of its total sales.

DISCUSSION:

Conn. Gen. Stat. § 12-412(34) exempts from sales tax “sales of and the storage, use or other consumption of machinery used directly in a manufacturing production process.”

Conn. Agencies Regs. § 12-412(34)-1 contains two broad requirements that a taxpayer must meet to be entitled to the exemption. First, the taxpayer must show that it is engaged in a manufacturing production process that creates a product to be sold (“the term ‘manufacturing’ means an operation . . . that substantially transform [sic], by physical, chemical or other means, the form, composition or character of raw or finished materials into a product possessing a new name, nature and use which is intended for sale ,” Conn. Agencies Regs. § 12-412(34)-1(c) (emphasis added), and “the term ‘manufacturing production process’ means the activities . . . of which manufacturing consists, beginning with the movement of materials . . . and ending with the packaging of the manufactured product for its sale to the ultimate consumer ,” Conn. Agencies Regs. § 12-412(34)-1(d) (emphasis added).)  Second, the manufacturing production process must occur at “an establishment that has manufacturing as its predominant purpose and that is generally recognized as such.” Conn. Agencies Regs. § 12-412(34)-1(e). For purposes of the exemption, “predominant” “means more than fifty percent.” Conn. Agencies Regs. § 12-412(34)-1(a).

The issue is whether the Company can satisfy the requirement that its establishment be a “manufacturing plant” as defined in Conn. Agencies Regs. § 12-412(34)-1(e).  A “manufacturing plant” is defined in pertinent part as an establishment that has manufacturing as its predominant (more than 50%) purpose, and as discussed above, “manufacturing” requires that the product be intended to be sold.

The rule in Connecticut is that a contractor consumes the tangible personal property it incorporates into real property rather than selling it as tangible personal property.  A construction contract is a contract for the repair, alteration, improvement, remodeling or construction of real property. Conn. Agencies Regs. § 12-426-18(a). “Contractors” “include . . . among others . . . cement [and] road contractors . . . .” Id.  Conn. Agencies Regs. § 12-407(2)(i)(I)-1 provides that materials are used in fulfilling a construction contract when they are physically incorporated in and become a permanent part of real property, and Connecticut courts have consistently held that a contractor that purchases materials for construction is in the business of using or consuming them in the construction, and not the business of reselling the materials; see, e.g., Fusco-Amatruda Company et al. v. Tax Commissioner , 168 Conn. 597, 362 A.2d 847 (1975) (materials purchased by a contractor and used in constructing housing for exempt entity were “consumed” by contractor and were taxable unless exemption certificate was furnished by exempt entity) , and White Oak Corporation v. Department of Revenue Services , 198 Conn. 413, 422, 503 A.2d 582 (1986) (services and tangible personal property rentals to ensure highway safety during construction were held not to be resold to the State but were “consumed” by the contractor). Furthermore, Conn. Agencies Regs. § 12-426-18(d) treats a taxpayer that produces an item of tangible personal property and installs its product into the customer’s real property as a contractor engaged in improving real property, not as a retailer of tangible personal property. In light of this rule, and based on the facts provided, the Company is a contractor providing services to real property.

Two other states, Massachusetts and Tennessee, have court decisions that support the taxpayer’s position, holding that asphalt or concrete is “sold” immediately before the paving company that made the materials applied them to the road surface.  Lawrence-Lynch Corp. v. Commissioner of Revenue , Mass. Appellate Tax Board No. 195193 (Sept. 30, 1997), and Rogers Group, Inc. v. Huddleston , 900 S.W.2d 34 (Tenn. Ct. App. 1/6/95), app. den’d (May 30, 1995). However, the Department finds that fundamental differences between the governing statutes and regulations in those states and the controlling law in Connecticut render those decisions inapplicable to the issue addressed here.

For one thing, neither Massachusetts nor Tennessee has a statutory or regulatory rule that contractors “consume” the materials they use.  Additionally, the Tennessee decision was in part based on a decision by the Tennessee Supreme Court in an early sales and use tax case that a contractor using goods to satisfy its contracts was a “seller to itself,” Townsend Electric Co. v. Evans , 193 Tenn. 536, 246 S.W.2d 967 (1952); furthermore, Tennessee law looks to “consumption” of the manufactured product off the premises of the manufacturer, not its “sale.” The Massachusetts decision followed San-Vel Concrete Corp. v. Commissioner of Revenue , 16 Mass. App. Tax Bd. Rep. 41 (1993), aff’d 38 Mass. App. Ct. 1114 (1995), which held that a contractor installing its precast concrete products was selling them to customers, not consuming them as a contractor.  In addition, Massachusetts case law does not require narrow construction of manufacturing exemptions, and so in Lawrence-Lynch Corp. , supra, the Tax Board deliberately decided not to follow the Massachusetts Department of Revenue’s rules governing contractors, in favor of focusing solely on the legislative intent behind the manufacturing exemptions.

A majority of other states have case law or have taken administrative positions that support the Department’s conclusion that the Company consumes the asphalt it uses to perform its paving services.  See, e.g., In the Matter of Midland Asphalt Corp., v. Chu et al ., 136 AD2d 851, 523 NYS2d 697, (1988) (machinery purchases were not exempt because taxpayer was primarily engaged in manufacturing asphalt for its contracting business); Illinois General Info. Letter No. ST 02-0154-GIL, 7/15/02 (highway contractor converting asphalt into road surface is “legally using” the asphalt and not selling it and could not buy machinery exempt as manufacturer); The Cleveland Trinidad Paving Co. v. Limbach , Ohio Board of Tax Appeals, Docket No. 89-X-877 (10/9/92) (manufacturing exemption did not apply because paving contractor consumed its asphalt product in paving roads); and Blevins Asphalt Construction Co. v. Director of Revenue , 938 SW2d 899 (Mo. Sup. Ct., 1997) (paving materials and machinery were not exempt because title passes after asphalt is installed). While none of the cases or matters cited above involved separate contracts, there is no reason to believe any of these states would reach a different conclusion after applying the “true object test.” See discussion, infra.   In addition, Alabama by regulation acknowledges that separate contracts do not change the result that a contractor consumes the materials it uses; see Ala. Admin. Code 810-6-3-.69.02(3)(a) (fact that the materials are sold and installed under separate contracts does not qualify the contractor's purchase of the materials for the exemptions for sales to governmental entities).

The Company attempts to meet the regulatory definition of a “manufacturing plant” by replacing its current practice of using a single contract for transactions where it provides paving services with two separate contracts, one for the sale of asphalt, and one for the sale of services. It is well established that statutes that grant exemptions from sales and use taxes must be strictly construed against the taxpayer, and any ambiguities in such statutes must be resolved in favor of the Department. See, e.g., United Illuminating Co. v. Groppo , 220 Conn. 749, 752-3, 601 A.2d 1005 (1992). The Department has long used a "true object" test to assist it in determining the proper application of sales and use taxes to a particular transaction. Sanitary Services Corp. v. Meehan , 235 Conn. 393, 395, 665 A.2d 895 (1995); Dine Out Tonight Club v. Dept. of Revenue Services , 210 Conn. 567, 571-2, 556 A.2d 580 (1989); see also Ruling Nos. 92-13 and 94-2. Connecticut courts will apply the true object test “where the applicability of the sales tax depends on the purpose of the sale, which is necessarily a question of intent.” Andersen Consulting, LLP v. Gavin , 255 Conn. 498, 526-27, 767 A.2d 692 (2001) (citations omitted).  Here, in order to determine whether the Company’s facility meets the definition of a “manufacturing plant” we must apply the true object test to establish whether the true object of the purported transaction is a sale of services or a sale of tangible personal property.

“The determinant is to be found in the intention of the parties to those contracts.” United Aircraft Corp. v. O'Connor , 141 Conn. 530, 537-38, 107 A.2d 398 (1954) (citations omitted). “That determination depends, in turn, upon whether the taxpayer provided the property to its customers as an independent part of their contractual relationship or whether the property was in itself incidental to the primary purposes of the contracts.” Sanitary Services Corp.. v. Meehan , 235 Conn. 393, 395, 665 A.2d 895 (1995) (citations omitted). See also, American Totalisator Co . v. Dubno , 210 Conn. 401, 409-10, 555 A.2d 414 (1989) (citations omitted).  Where the Company provides paving services for a single customer, whether stated by one contract or by several, the true object of the transaction is to obtain a paved surface, and not to sell asphalt separately from paving services. Therefore, in these transactions, the Company does not sell its asphalt as tangible personal property but consumes it in rendering its paving services.

On the facts provided, the Company may treat only those sales of a “manufactured” product to be sold, or only those sales of asphalt where the Company provides no services, as contributing to the “more than 50%” requirement for establishing a “manufacturing plant” for purposes of the manufacturing exemption. Sales where the Company renders paving services to a customer using its own asphalt may not be included in the calculation of the percentage of sales of a “manufactured” product to be sold. Rather, in those transactions where the Company provides paving services, the Company is deemed to consume the asphalt in its performance of the service contract, whether that transaction is memorialized by one contract or several. Asphalt that is consumed by the Company may not be counted as a manufactured product to be sold and therefore may not be included in determining the “predominant purpose” of the “establishment.”

The true object test leads to the inescapable conclusion that regardless of the number of contracts used, where the Company provides paving services to a customer using its own asphalt, the customer intends to receive a paved surface and the Company consumes the asphalt in rendering its paving services. Therefore, the predominant (more than 50%) purpose of the establishment creating the asphalt is not to create a product to be sold, but rather to create tangible personal property that will be consumed by the Company rendering paving services. Because the Company cannot meet the regulatory requirement of Conn. Agencies Regs. § 12-412(34)-1(c)(1) that the creation of the asphalt occur at a “manufacturing plant,” where the “predominant purpose” is manufacturing a product to be sold, the Company is not entitled to the sales tax exemption for manufacturers provided in Conn. Gen. Stat. § 12-412(34).

LEGAL DIVISION

January 13, 2005